"Emerging Market Economies and Financial Globalization" offers a comparative analysis of the capital account liberalization process and the variety of policy responses generated among a reduced group of Latin American and Asian countries. In particular, the book critically examines these varied responses from a three-fold perspective: macro, micro-financial and institutional. From a macro perspective, the book compares exchange rate regimes, monetary policies and capital account liberalization paths adopted at each of the selected countries. In other words, the book analyzes how emerging economies confronted the challenge imposed by the monetary trilemma posed by Mundell. The book analyzes different corner solutions (for example, exchange rate pegging) and whether there is life inside the triangle. The Asian financial crises have certainly induced a debate on the benefits of foreign exchange reserve accumulation and the increasing policy space generated since then. But emerging countries policy-makers realized the perils of sailing in uncharted waters and, consequently, began to introduce a series of instruments to prevent sudden reversals in capital flows.
The micro-financial perspective, in turn, directs our attention to the financial sector structure, how the process of financial deepening transformed it in recent years and how local authorities responded to the increasing pressures generated by an increasingly globally connected banking sector. But cross-funding, local regulation and financial stability are certainly difficult to match, even at developed countries as the European crisis demonstrates. This triplet conforms the so-called financial trilemma introduced by Schoenmaker, and analyzed in the book--particularly observing how selected countries performed it.
Finally, the institutional perspective center on the legal treatment granted to the capital account openness process--both at the multilateral and bilateral levels. From a policy perspective the interrelationship between open macro, international financial markets and institutions has been often neglected but hardly significant with sovereigns founding periodically challenged by legal constraints. The founding fathers of Bretton Woods institutions shared a common vision: avoid large imbalances created by international capital flows. Coincidences, however, vanished after the collapse of the Bretton Woods system. Thereafter leading countries' claims for the opening of the capital accounts and financial liberalization became common parlance. Institutionally, these pressures were present at both multilateral and bilateral fore.
About the Author
Leonardo E. Stanley reports as an associated researcher at the Center for the Study of State and Society (CEDES), Argentina. He is a graduate in economics from the School of Economics, University of Mar del Plata, Argentina; MSc in Economics from Queen Mary University, London and a MsPhil/DEA from Université d’Evry Vald’Essone, France.
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In the past, foreign shocks to emerging economies (EMEs) spread out mainly through the trade channel, and transmissions to local economies took time to come into effect. This could certainly be considered a by-product of the international financial setting designed at the Bretton Woods Conference, where capital flows remained mostly local. As sovereign states benefited from more policy room, they were less constrained when fixing monetary and fiscal policies. The availability of policy options did not shield them, however, from macroeconomic instability and recurrent gaps on both the external and the fiscal front, and particularly affecting (by the time categorized as) developing Latin American and Asian economies. Yet this relatively harmonious world was predestined to alter, as cross-border flows began to erupt in the late 1960s, pushing local financial markets towards unchartered waters. Thus, we can trace the origins of the 2008 global turmoil to the collapse of the Bretton Woods system in the early 1970s, when leading developed nations agreed to a progressive dismantling of the former controls on capital flows and when the banks' transnationalization journey began. Overflowing with liquidity, thanks to large, readily available deposits (Eurodollars) and strongly rising petroleum prices (petrodollars), US (basically) transnational banks set out to find new clients everywhere – including those living in distant and less developed countries. A new era for global banks began. Small (and now open) economies were suddenly at the mercy of the constraints imposed by the so-called monetary trilemma.
The shift towards free markets was accelerated after Margaret Thatcher in the United Kingdom and Ronald Reagan in the United States came to power in 1979 and 1980 respectively. The dominant (neo-liberal) view perceived increased financial activity as beneficial for development, and Keynesian–Myskian caveats were suddenly set aside by policymakers and disregarded by mainstream economists around the world. By the same token, the efficient market hypothesis gained space and substituted Keynes's beauty contest parabola in trying to explain how financial markets actually behave. That was the central message that emanated from international financial institutions (IFIs) through the instructions and the recommendations laid out by the Washington Consensus. From then on, developing countries were urged to liberalize their capital account and deregulate their financial sector.
Capital returned to the developing world in the early 1990s, but now under a new format: bonds were replacing (syndicated) bank loans, a popular financial scheme during the 1970s. Capital inflows were not free of cyclical downturns and sudden stops, however, the consequences of which were observed elsewhere. In some cases, the crisis responded to internal factors as macroeconomic imbalances originated at public or private dislocations that made unsustainable the peg being adopted. In most cases, however, the crisis followed external factors.
Irrespective of the country fundamentals, officials at the International Monetary Fund (IMF) replicated the same (orthodox) recommendation: sustain the macroeconomic adjustment and announce important structural changes. Among the changes requested by IMF staff, maintaining the capital account liberalization process remained key for those expecting its financial help – although the Fund was now willing to debate whether sequencing should overtake shock therapy. Furthermore, and even after the collapse in Asia, the leading nations of the IMF, headed by the United States, attempted to amend the Articles of Agreement to extend the Fund's jurisdiction to capital movements, associating them to members' current obligations under the current account chapter.
Thereafter, the crisis would affect the Fund as few emerging market economies (EMEs) remained interested in being part of its loan programmes – 'Not Even a Cat to Rescue' ran a headline in The Economist} In any case, conscious of the constraints that were imposed in the past and their failures, EMEs' leaders began to abandon the neo-liberal template offered by Washington, DC. Governments in emerging markets and developing countries decided to better accumulate foreign reserves in an attempt 'to immunize themselves' against a hypothetical sudden stop. Other countries went even further and reintroduced capital controls. In one way or another, all of them were clearly trying to enhance their financial resilience and to expand their policy space. All these changes were signalling the beginning of a new era, although few were aware of it.
In the North, few were ready to acknowledge either the procyclicality of the financial system or the destructive power of financial innovations (sometime later described as 'weapons of mass destruction' by Warren ('Buffett Warns on Investment "Time Bomb" ', BBC News, 4 March 2003)). They were just enjoying life under the 'great moderation' years (Ben Bernanke, 'The Great Moderation', 20 February 2004, federalreserve.gov). Monetary policy was primarily centred on price stability, and it disregarded the mounting credit balloon and asset price booms being generated by market liquidity. Mainstream economists, in contrast, were hardly attracted to the idea of integrating financial factors into their models.
Despite this business as usual picture on mainstream minds, a new financial boom mounted, which was now associated with the arrival of new funding sources (non-core financing), including derivatives and other non-lraditional products. Independently of the original sources, global liquidity would be transmitted to EMEs through transnational banks. The arrival of this non-core banking funding (foreign creditors) permitted local banks to support the entry of new borrowers at home – formerly exclusively backed by domestic savers. But a financial system based on cross-border banking tends to raise risks at home as external liabilities (wholesale funding) prove more volatile than normal retail funding (domestic depositors). Additionally, in most cases financial flows remained weakly regulated as monetary authorities pursued banks' self-regulation and financial micro-prudential measures.
External pressures were not eliminated after the 2008 global financial crisis, however. Initially economic authorities accurately responded to the challenge, but unconventional monetary policies in the United States and other developed countries rapidly created important spillovers in EMEs. The prospects of an increasing path for US interest rates generated a reversal of expectations and a sudden flight to quality, implying increasing foreign exchange (FX) volatility among EMEs. This new scenario would call for additional coordination at the multilateral level, alongside the activation of non-traditional weapons by policymakers in the developed world and also among EMEs. Unfortunately, this has not happened, as Raghuram Rajan, the former governor of India's central bank, recently affirmed: 'International monetary cooperation has broken down.'
The first section of the book introduces the theoretical scheme, which lays the foundation for the comparative analysis to be entered in the second part. Explicitly, it proposes three sets of constraints (macro, micro and institutional) as to evaluate the policy space left to policymakers. When considering each of them, the book offers a particular theoretical framework highlighting the specific collection of constraint sovereign states face after deciding to open its capital account and become global. Surprisingly, all the topics under consideration are subject to a particular trilemma: a trilateral space, whose resolution calls for a dual policy configuration. All of these concepts would be observed by EMEs in their globalization journey, a context (apparently) limiting sovereign states' choices.
International Capital Flows and Macroeconomic Dilemmas
Chapter 2 briefly introduces the constraints on a sovereign state's policy space which are imposed by capital flow mobility to traditional monetary and exchange rate policies. In such a context, the national government can either fix the exchange rate (at the cost of sacrifice their monetary policy autonomy) or maintain a flexible a flexible exchange rate (to preserve the central bank's policy space). This is the basic trade-off originally described by Robert Mundell in the early sixties, the famous monetary trilemma: international transmission of monetary (and fiscal) policy depends on the exchange rate regime. In particular, when capitals are free to move, policymakers can either opt for fixing the exchange rate or delineating the monetary policy, but not both. In the early nineties, all bets were on fixing, for example but the Mexican crisis led to dismissing this option to lose weight and a new consensus was arrived at. Now flexible exchange rates were favoured. From a monetary perspective, the model was centred on the presence of two concepts: central bank independence (CBI) and inflation targeting (IT). Sooner rather than later, however, the scheme proved not to be a solution for EMEs. After the Asian financial crisis, EME policymakers began to move away from corner solutions, applying mixed strategies instead. Fearful of keeping an artificial exchange rate and the presence of a highly volatile nominal exchange rate, officials were ready to intervene in FOREX markets. Simultaneously, aware of the timid financial cooperation coming from advanced nations and the considerable restrictions imposed by IFIs in the aftermath of the crisis, they initiated a massive build-up of international reserves. Another group of countries avoided the constraints by regulating capital flows. Ironically, after 50 years of financial deregulation, more and more professionals were considering this latest alternative as a unique solution to tame unfettered capital and to avoid extreme financial volatility.
Financial Deepening and the New Microeconomic Dilemmas
Chapter 3 traces an evolutionary view of all financial issues and political restrictions imposed following the deregulation of financial markets. The provision of financial services in EMEs has undergone a transformative expansion in recent decades, moving from a largely domestic market to an increasingly internationalized space. This process has so often involved the passing from a state-directed to a market-driven system, by means of a privatization process, that, in most cases, it has ended with the denationalization of the banking industry.
One of the latest explanations for the financial crisis is the presence of a financial trilemma, as recently introduced by Dirk Schoenmaker, as national regulators could not manage to attain financial stability when the local economy was being opened to international capital markets. In order to solve the problem, policymakers should either deregulate the market (the status quo scenario), propose a multilateral agreement (to solve the coordination problem) or ring-fence global banks' activities within national borders (to avoid costly bankruptcies). The first and third alternatives do not technically solve the trilemma but involve either accepting financial instability or maintaining financial autarky. Regulatory coordination is neither easy nor impossible. Starting in the early seventies, developed countries' central banking authorities and finance ministers began to gather at the Basel Committee on Banking and Supervision (BCBS) forum. As time passed and new crises erupted, new tasks were undertaken. The latest global financial crisis (GFC) gave a new impetus to this forum, expanding their membership in order to include a group of EMEs. In any event, international cooperation remains a difficult game, as leading nations are not interested in restricting foreign operations of their local banks, although they have firmly decided to regulate foreigners at home. So, in order to delineate a new regulatory scheme at the global level, some developed nations are pushing for financial defragmentation.
Financial Globalization and Capital Account Management: An Institutional View
Chapter 4 introduces the interrelationship between international financial markets and institutions. The Bretton Woods Conference basically centred on macro-imbalances, monetary issues and how to coordinate them. Financial issues, in contrast, were left behind as financial markets (and banks, in particular) were national 'at both life and death' (Bank of England Governor Mervyn King and economist Charles Goodhart), and financial services were regulated by sovereign states. The collapse of the post-Second World War consensus implied the advance of a new financial pattern in which institutional deregulation became a central chapter.
Market deregulation has easily mutated into banking underregulation, particularly benefiting global banks – a dangerous trend which influences both multilateral and bilateral schemes. Unfortunately, this unregulated vision has impinged on financial regulators, while they have remained silent on the problems posed by cross-border funding and related systemic risks. The GFC would come to challenge this vision, with both global leaders and IFIs now advocating for re-regulating them locally A similar deregulation trend was followed in the derivative market, a tendency that remained practically untouched after the GFC. Prudential regulation, however, might still be challenged by a series of legal commitments being settled at the multilateral (General Agreement on Trade and Services; GATS) or the bilateral (free trade agreement (FTA)-bilateral investment treaty (BIT)) level. This push will be analysed in detail, particularly as it has gone further and has particularly affected those without negotiating power. Similarly, some AEs are now pushing, both multilaterally and bilaterally, to condemn exchange rate undervaluation practices.
A Comparative Analysis
The second part of the book introduces the preceding debate from a comparative perspective, in particular by observing the recent experience of a group of emerging countries from Latin America (Argentina and Brazil) and Asia (China, South Korea and India).
Following the financial crisis of the 1930s and the depression that followed, Latin American countries began to introduce a battery of policies in order to industrialize their societies, which was a policy response to massive unemployment, and was also directed at curbing technological progress and avoiding a recurring balance-of-payments crisis. From the start, a heterodox exchange rate and monetary policies accompanied industrialism in order to bring the necessary funds to articulate structural change. To favour local production, governments in the region promoted dual exchange-rate regimes. Meanwhile financial repression became a widely used tool for redirecting savings from consumers and primary sectors to nascent industry. All this happened in a context in which there was little cross-border movement of capital, with Argentina and Brazil among the earliest adopters of this repressive approach. The import substitution industrialization (ISI) process initiated a process of economic progress and sustained growth but also induced increasing tensions as many governments made use (and abuse) of inflationary financing tools. All of these measures pushed Latin American countries to recurrently confront a balance-of-payments crisis, whose complexity mounted in scale as local savings were exhausted. This, in turn, prevented them from maintaining a stable and competitive real exchange rate (SCRER) necessary to bolster industrialization and sustainable growth.
Asia, meanwhile, remained a lagged agrarian society trying to escape from extreme poverty and colonial rule – mostly Japanese, though British in the case of India. Paradoxically, the pro-development path adopted by Japan in the aftermath of the Second World War came to be followed by those neighbouring sovereign states dreaming of industrialization and economic progress. In order to advance with industrialization, authorities subscribed to heterodox macroeconomic policies meanwhile the presence of important trade barriers permitted them to isolate their markets from external competition. In contrast to the Latin American experience, Asian policymakers adverted to the relevance of improving industrial competitiveness in order to compete globally. Inheriting a highly backward economy, South Korean authorities decided to set up a large industrialization process. As previously observed in Japan and later in China, South Korean global insertion responded to a gradualist approach. Forty years later, South Korea would become a leading post-industrial society. Under China's Mao Zedong, industrialization was pursued under a highly centralized regime to be modified after his death. Whereas
Chinese elites adopted an export-led growth model, it came with variations as the government enthusiastically open their doors to foreign capitals – although they prevented them from entering the financial sector. At South Asia, India remained an exception to the export-led growth pattern, showing a more inward-oriented economy during the post-war period.(Continues…)
Excerpted from "Emerging Market Economies and Financial Globalization"
Copyright © 2018 Leonardo E. Stanley.
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Table of Contents
Chapter 1: Introduction;
Chapter 2: International capital flows and macroeconomic dilemmas;
Chapter 3: Unfettered finance and the persistence of instability;
Chapter 4: Financial Globalization, Institutions and Growth;
Chapter 5: Argentina;
Chapter 6: Brazil;
Chapter 7: China;
Chapter 8: India;
Chapter 9: Korea;
Chapter 10: Final Remarks on Financial Globalization and Local Insertion; References; Index.
What People are Saying About This
‘The book is original as it encompasses theoretical chapters, using an international political economy framework as well as case studies of emerging economies in the financial globalization setting.’
Daniela Magalhães Prates, Associate Professor of Economics, University of Campinas, Brazil
‘This […] work insightfully analyses the political economic problems entailed by international capital flow and financial globalization, which bring new serious challenges at macro and micro levels to such emerging markets as those in Latin America and Asia.’
Won-Ho Kim, Dean and Professor, Graduate School of International and Area Studies, Hankuk University of Foreign Studies, South Korea