Capital Without Borders: Challenges to Development available in Hardcover
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About the Author
Ashwini Deshpande is a professor in the Department of Economics at the Delhi School of Economics. She holds a PhD and an MA in Economics, and was awarded the Exim bank award for an outstanding dissertation in 1995. She is also the 2007 recipient of the VKRV Rao Prize in Economics, awarded to economists below the age of 45 for their outstanding contribution to the field.
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Capital Without Borders
Challenges to Development
By Ashwini Deshpande
Wimbledon Publishing CompanyCopyright © 2011 Ashwini Deshpande
All rights reserved.
Department of Economics, Delhi School of Economics
The introduction to this volume was first written in August 2008 with this opening paragraph: 'The global economy is reeling under one of the severest crises since the Great Depression of the 1930s, with record high oil prices, the global food crisis and a financial crisis, reverberating across the globe. As the US economy slides deeper towards a full-fledged recession, precipitated by the sub-prime mortgage crisis, the ability of financial markets to play havoc with the "real" economy could not have been more apparent. While some commentators, especially those associated with the mainstream media, are still debating the extent of the downturn in the US economy and defending the innovative aspects of financial markets, inside the US, the grim reality seems to have hit home. The implications of the collapse of the housing boom, the associated collapse of major banks with high exposure in the housing markets, coupled with the financial burden of the Iraq war has meant rising unemployment, cut back in consumer spending and overall economic downturn, with no signs of reversal in sight. These events bring to the fore the myriad connections between the "real" and the "financial" – and point to the urgency of understanding these connections, especially in the present era of globalization and financial deregulation.'
Exactly a year later, with a series of bank collapses, as the developed economies grapple with stimulus/rescue packages and bail-out measures to counter the cascading impact of lay-offs and closures, the debate is not whether this is a recession but on how bad it will get before it starts to get better. The terms of the discussion have shifted decisively: kudos to financial innovation have given way to demands for prudential regulation that ensure safety of investors' savings; an active role of the government in the economy is no longer seen as anathema as creation of new jobs to counter the increasing unemployment takes utmost priority; indeed, a wider role of the state in ensuring a welfare safety net is seen as inescapable. This enormous shift in the terms of the debate, several aspects of which validate the concerns of the ACDC, would not have been possible without this deep crisis.
While the spread and depth of the current events was not foreseen at the conference, all the participants, as is evident in the selection of studies that follow, were concerned about the implications of under-regulated financial flows and were very aware of the possible adverse consequences of a financial crisis on the real economy. At the time, some of these commentaries could have been dismissed as the usual anti — globalization rhetoric. However, given the turn of events in the real economy, when several of the pro-globalizers too are now raising questions about the implications of unbridled globalization and deregulation and are especially concerned about governance issues, the concerns raised by the collection in this volume not only stands up to scrutiny, but in fact, highly relevant.
The title of Gabriel Palma's chapter sums up the central concern of the volume: How Financial Liberalization Led in the 1990s to Three Different Cycles of 'Manias, Panic and Crashes' in Middle Income Countries. He focuses on four major financial crises that hit middle income countries since the 1982 debt crisis: Mexico 1994, East and South East Asia 1997, Brazil 1999 and Argentina 2001. The common characteristic of these crises was that all these countries had recently opened up their capital accounts at a time when international liquidity was high and the investment options in the OECD countries were limited. Palma identifies three different routes that these countries followed to absorb the sudden and large increase in inflows and shows that each of these routes ended up in a financial crisis in the recipient country. We can call this the crisis of absorption. He contrasts these crises with the better experience of India, China and Taiwan: countries that avoided financial crises due to their cautious and selective approach to opening up their capital accounts and integration with international financial markets.
Under Route 1, characterized by Mexico (1988–1994), the surge in inflows led to a pro-cyclical revaluation of the real exchange rate, explosion of credit to the private sector, consumption boom, asset bubbles and a massive deterioration in the current account. Route 2, characterized by Brazil (1994–1999), resulted in high interest rates and an aggressive sterilization of inflows led to fragilities in the banking system and public sector finance. Route 3, seen in Korea (1988–1997), led to very high corporate debt-equity ratios and made the balance sheets of banks vulnerable to currency depreciation. As was the case during the 1970s surge of international lending, Palma discusses how these high volumes of inflows (in Brazil, for example, as high as 129 percent of its exports in 1998) were a result of a combination of push and pull factors.
What needs to be noted and understood, especially in retrospect, is that during the time that a surge in lending/capital inflows is taking place, mainstream contemporary commentaries see it as yet another indicator of global integration, of soundness of markets and of 'good fundamentals' in the recipient countries. In this phase of mania, those who advocate a more cautious and/or a regulatory approach to financial inflows are branded as doomsayers and Cassandras. The other point worth noting is that despite the different end uses to which the inflows are directed, any 'excessive' volume of inflows is bound to create absorption problems and therefore is bound to be unsustainable. For example, under Palma's Route 1, the inflows were largely directed towards consumption whereas under Route 3, they were used to increase corporate investments.
How does one determine whether financial inflows are 'excessive' or not? Again, one of the big lessons from the 1970s debt explosion and the subsequent crisis is that international financial and regulatory bodies have a big role to play in determining warning signals and critical threshold levels and ranges of sustainability so that both national governments as well as private agents have benchmark values of key indicators that serve as warning signals indicating how vulnerable, if at all, they are to a financial crisis. Indeed, the work of many scholars, such as Ilene Grabel, has shown that such warning systems can easily be put in place, provided the international investor community is willing to be supervised.
Palma's point is that given the sheer volume of inflows that the four countries in his study experienced, a crisis is inevitable. However, when a financial crisis erupts, many other explanations are offered. One of the most common and popular explanations offered is that investors start withdrawing their capital out of the recipient country as soon as they feel that the economic fundamentals are diverging from conditions that are considered 'sound' and of course, especially in emerging economies, the impact of ebbing investor confidence can be devastating.
Edmund Amman and Moritz Cruz's chapter Timing the Mexican 1994–5 Crisis Using the Markov Switching Approach attempts to examine the validity of this very common explanation. They find that there is superficial support to this explanation but raise the important point about the need to make a distinction between an objective phenomenon (change in fundamentals) and the subjective perception of agents. They argue that a change in the subjective perception is not always backed by changes in the objective fundamentals. Their basic point reinforces Palma's analysis: that the Mexican crisis was not accompanied by a deterioration of external or internal balance (the two key fundamentals), but rather, was the result of the growing exposure of private agents to risk because of their high accumulated debt levels.
They propose an alternative approach, strongly influenced by Minsky to quantify changes in investor confidence by looking at the broad-money-to-international – reserves ratio as the key variable. The larger this ratio, the lower is the ability of the country to weather a speculative currency attack. In the case of the Mexican crisis, they identify which events contributed to the start and end of a financial crisis.
The events that eventually ended the financial crisis in Mexico merit special mention. The first one was an announcement by the government to further reinforce the liberalization agenda, especially the plan for trade and financial deregulation. Second, the government decided to honor the outstanding debts. Thus, in order to regain investor confidence, it had to reinforce the precise measures that had led to the crisis in the first place! This highlights very accurately how, for developing countries, the path of non-selective and unregulated opening up of the capital account constrains policy options both ex-ante and ex-post. The only way to regain investor confidence following a financial crisis (that follows opening up) is to open up even more.
Does all this suggest that developing countries have very few, if any at all, policy options left? Undoubtedly, policy autonomy is constrained in a globalized world. However, the purpose of this volume, in addition to highlighting the constraints, is also to suggest policy options. The beauty of the next chapter is that it manages to do both tasks elegantly. Since developing countries cannot issue international currency, they typically have to adjust their current account to the availability of foreign finance. Thus, their GDP targets, as well as their ability to intervene in the determination of the exchange rate, is thus constrained by the availability of external finance. Nelson Barbosa-Filho's contribution examines this very crucial constraint rigorously. The chapter argues that rather than being an inevitable constraint, the BOP determinants of economic growth can be shaped by economic policy and thus can become endogenous in the long run, as the examples of China and some of the East Asian economies demonstrate.
Barbosa-Filho extends Thirlwall's model of BOP constraint (in the long run, an open economy must have balanced growth of imports and exports) to include debt and financial variables, thus making a direct link with financial fragility, i.e. the idea that changes in international financial conditions can lead to currency crises and thus have an impact on growth, independently of trade movements. The implication of this adjustment, in the short run with constant trade elasticities, is that the trade surplus of the home country has to adjust to maintain liquidity ratios that would put it beyond the risk of currency crises. However, in the long run, there is no reason to assume that trade elasticities will be constant, and thus, the very elements that constitute the BOP constraint are likely to change. Thus, the chapter shows, in line with other heterodox research, that macroeconomic policy can influence growth in the long run.
The chapter then discusses how the level of the real exchange rate, (as opposed to its rate of change), via its effect on the prices of tradables versus non-tradables sector, can influence both the BOP constraint as well as growth. Thus the real exchange rate, in this scenario, is potentially a key policy variable. Mainstream economists are skeptical about the use of the real exchange rate, as it is supposed to be stationary in the long run. However, Barbosa-Filho argues that in the short run, effective management of the exchange rate can produce structural changes (e.g. growth of the tradable sector) to affect the BOP constraint in the desired direction. Additionally, especially for Latin American economies, the issue of inflation targeting is as crucial as that of growth, but the author cautions against a policy of inflation reduction that produces an appreciation of the currency, as it could be detrimental to growth.
Ozden Birkan's contribution on currency and asset substitution in Turkey discusses the complications introduced by the existence of multiple currencies in Turkey since 1989 when all controls on international capital movements were lifted. This policy brought in its wake huge challenges to government in its attempt to control its balance sheet, made more complicated by international events like the First Gulf War but mainly because of the unsustainable nature of government finance. This created a fragile financial environment and eventually led to a crisis in 1994, with a heavily depreciated Turkish Lira, loss of reserves by the Central Bank, soaring interest rates, bankruptcies in the banking sector and reduced growth. This was followed by another crisis in 1998 when external financial flows slowed down due to the East Asian and Russian crises.
Her econometric investigation points towards substantial irreversibility in currency substitution (use of multiple currencies as media of exchange), which does not mean that most transactions are carried out in foreign currencies, but that the liquidity of Turkish Lira denominated assets has been declining and those of foreign exchange denominated assets has been rising.
Confirming the conclusions of Barobsa-Filho, Birkan discusses how the policy of inflation targeting has involved a real appreciation of the exchange rate, which has successfully lowered inflation, but at the cost of increasing the vulnerability of the economy to foreign shocks, and additionally causing problems such as persistent current account deficits, fragile banking structures and no reduction in unemployment.
Several of the developing countries are abundant in natural resources and potentially their comparative advantage in this sector should enable them to take advantage of gains from trade and thus enable a diversification of their economic structures. Leandro Serino's contribution highlights the structural limitations to diversification in resource abundant countries like Argentina. Serino's model shows how the presence of a high productivity natural resource sector (like the agricultural sector in Argentina) constrains the development of other tradables sector and thus prevents competitive diversification.
The main results of his chapter show the following: an increase in productivity in the natural resource sector will lead to an increase in nominal and real wages: an increase that is positively associated with the size of the natural resource sector, but with ambiguous effects on employment. There is a size effect: if the natural resource sector is as large as it is in oil exporting countries, then a positive shock can lead to an increase in employment.
Other than this, the other effects that favor an increase in employment are productivity differences between the tradable manufacturing sector and the natural resource sector. Coming to external balance, the model points out conditions under which a positive shock will not lead to an improvement in the trade balance. Thus, resource abundance can hinder competitive diversification through a negative impact on the trade balance. However, the model also highlights why resource abundant countries need to diversify.
What could be the macroeconomic policies that would increase the productivity of the non-resource (manufacturing) sector? Serino discusses nominal devaluation as the main policy that enhances overall competitiveness, increasing employment and increasing the external balance. A traditional result in the literature shows that a devalued exchange rate increases the price of natural resource products, further reducing the real wages. What Serino shows is that since large decreases in real wages do not improve the competitiveness of the manufacturing sector, devaluation is more costly in economies with structural characteristics like Argentina that in economies with different structural characteristics. His analysis has another noteworthy result that is often omitted in other studies: creation of devaluation rents favoring the most productive natural resource sector. On balance, thus, in economies with abundant natural resources, devaluation has some clear benefits (e.g. increase in employment through tradable diversification), but with significant costs (e.g. decrease in real wages and a worsening of income distribution through the creation of devaluation rents. However, an export tax can transfer the rent to the government, which it can use to promote diversification policies, and presumably reverse the worsening of the income distribution.
Excerpted from Capital Without Borders by Ashwini Deshpande. Copyright © 2011 Ashwini Deshpande. Excerpted by permission of Wimbledon Publishing Company.
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Table of Contents
Introduction; How Financial Liberalisation Led in the 1990s to Three Different Cycles of 'Manias, Panic and Crashes' in Middle Income Countries; Timing the Mexican 1994-95 Financial Crisis Using a Markov Switching Approach; Exchange Rate, Inflation and Growth; Alternative Measures of Currency Substitution in Turkey; Competitive Diversification in Resource Abundant Countrie; Foreign Portfolio Investment in India; Transnational Corporations and the Internationalisation of Research and Development Activities in Developing Countries; External Debt Nationalization a Major Tendency on Brazilian External Debt in the Twentieth Century; Prudential Regulations and Safety Nets; Understanding New Threats to Development in Comparative Regional Perspectives