Covering Globalization: A Handbook for Reporters

FROM THE 1940s to the late 1980s, capital controls, or restrictions on the flow of money across borders, were the norm around the world. In Europe, anyone who needed a foreign exchange to trade with another country (so-called current account transactions) to buy goods or services could get it. But it was not so easy to get money that could be used for financial transactions such as currency speculation or buying and selling stocks in another country’s equity markets. Often there was a special, less-favorable exchange rate for such transactions. Ordinary individuals confronted these capital controls when they wanted to take a trip abroad: typically, they were allowed only a limited amount of foreign exchange.

It hadn’t always been this way. In the nineteenth century there were no man-made restrictions on the flow of capital. But, at least partly because of the lack of technology, capital moved far more slowly than it does today. Until the 1930s, the world was on the gold standard—a system by which all domestic money had to be backed, in full, by the government’s gold reserves. This meant that for every dollar in circulation, you had to have one dollar’s worth of gold sitting in the central bank’s vault. In essence, the government promised to convert any or all of the country’s local currency for gold at a constant rate of exchange. The idea behind the system was easy: if a country ran a balance-of-payments deficit, which meant it needed to borrow to pay for imports, gold would leave the country as payments for imports went out faster than payments for exports came in. To maintain full backing, the government would have had to respond by taking money out of circulation, which would, in turn, cause the money supply to fall. A shrinking money supply, theory suggests, contributes to a decline in the prices of goods and services. This would make local goods more attractive and imported goods less so. Exports would climb and imports would fall and the balance-of-payment deficit would, in theory, turn into a surplus. The process reverses as gold returns and equilibrium is restored. Thus, for the gold standard to work, the capital account had to be liberal. Otherwise, gold could not be shipped from one country to another.

The gold standard broke down and was abandoned by the United States during the Great Depression: maintaining the system required a process of declining prices (i.e., deflation) that was simply too painful to sustain, especially during a period of deep economic contraction. Other countries, such as Great Britain, France, Ireland, Scandinavia, Iraq, Portugal, Thailand, Japan, and a number of countries in Latin America, abandoned the system in droves, each hoping that freeing the exchange rate from the gold standard’s “straitjacket” would increase exports. But, of course, when all countries tried to do this simultaneously, nobody’s exports rose; imbalances remained and currencies weakened. Capital controls had to be imposed.

As World War II came to an end and the advanced industrialized countries tried to reestablish the global economic order, a system of fixed exchange rates was again set up, and the International Monetary Fund was created to help make it work. The idea was to set up a system that would make it easy to finance trade in goods and services rather than in mere financial transactions. The system, in other words, centered on reducing the foreign-exchange restrictions associated with trade, a process known as current-account liberalization. It was designed to maintain stability in exchange rates and a ready availability of foreign exchange, both of which were required to facilitate trade. Today, almost all countries have fully liberalized their current account. While current-account liberalization was being aggressively pushed, however, the system was much more cautious about pushing for the liberalization of capital account. (Current-account liberalization refers only to loosening restrictions on money used to pay for imports and exports; capital-account liberalization means allowing the free flow of money that can be used for things like buying stocks, speculation on the foreign exchange markets, and purchasing assets. Typically there is more worry about the effects of taking capital out of the country than allowing it in.) The United States was an exception to this globally cautious attitude toward capital-account liberalization. Indeed, the United States had open capital markets throughout most of the twentieth century, except for two brief periods: the Great Depression of the 1930s and in the 1970s.

It was only in the 1960s that some European countries began to gradually ease restrictions. Since then, the trend spread gradually until, by the 1990s, most developed countries in the world had full capital-account liberalization. In countries that liberalized global financial transactions, anyone could buy and sell any other currency that was fully liberalized, for whatever purpose. Supposedly, the only reporting requirements were those designed to ensure compliance with tax laws. Money could travel to buy stocks in other countries, to invest in other countries, or to buy other currencies. Soon, enormous markets in foreign exchange developed with New York, London, Frankfurt, and Tokyo becoming the major money-market centers and with active trade also in Hong Kong and Singapore. The UK lifted controls in 1979 and then Germany in 1984. Spain lifted theirs in 1992 and Greece in 1994. At first, a number of European countries pegged their currencies to one another and traded in a band known as the European Exchange Rate Mechanism. Later many countries abolished their currencies in favor of the euro.

Some developing countries, such as China, India, and Sri Lanka, largely kept their controls, but others, especially in Latin America and East Asia, began to liberalize. In the developing countries, the process started with Chile in the early 1970s and soon spread to almost all Latin countries. Asia was a latecomer to the game of liberalizing capital accounts a decade or so later, mostly in the 1980s, although China retained its controls. Malaysia reimposed capital controls after the 1997 Asian economic crisis, and, in the last couple of years, capital controls have come back in some parts of Latin America such as Chile, Argentina, and Venezuela.

The trend toward full capital account liberalization was part of a larger push for economic liberalization that began in the United States with the election of President Ronald Reagan and in the UK with the election of Prime Minister Margaret Thatcher—both of whom were great believers in free markets. Economists did not do much research, either theoretical or empirical, as to whether liberalization was a good idea. Nonetheless, many believed that the free flow of capital would enrich countries all over the world. After all, trade and investment had helped wealthy countries develop in the nineteenth century.

SIDEBAR

THE IMF AND CAPITAL-ACCOUNT LIBERALIZATION

NICHOLAS ROSEN

The issue of financial market liberalization has been a difficult and controversial one for the International Monetary Fund. Throughout much of the 1990s, the IMF aggressively pushed nations to open their countries to the flow of international financial capital. But they have since reversed their position—at least in theory.

The IMF originally argued that by removing barriers to foreign inflows, perennially capital-short developing countries could harness a powerful engine for growth, diversify risk, and increase welfare while creating new investment opportunities for international investors. These convictions were so strong that in 1997 the fund’s executive board launched a campaign to have the IMF charter amended to include the promotion of capital market liberalization as part of the fund’s mandate.

In the meantime, numerous countries, including Russia and the Asian “new industrializers,” followed the IMF’s prescription for capital-markets reform. Some of those countries were, with hindsight, simply not ready for open capital accounts. They relied heavily on short term borrowing to finance inefficient and uneconomical investments. In July 1997, the “chickens came home to roost.” Thailand, for instance, which was running huge current-account deficits that were financed with extremely short-term external borrowing had to abandon its fixed exchange rate regime. The baht—the Thai currency—collapsed, and financial contagion spread from Thailand to South Korea, Indonesia, and eventually Russia and Brazil. The bonanza of capital inflows these countries had enjoyed was quickly reversed as a stampede of panicked investors fled the region. A decade of solid growth and rising incomes screeched to an abrupt halt as bank failures, unemployment and poverty gripped the region.

In the wake of the crisis, many observers blamed the capital-account policies championed by the IMF and the U.S. Treasury for opening financial markets too fast and rendering them vulnerable to unpredictable shifts in short-term capital flows. The IMF itself adopted a more cautious tone after the crisis and now stresses the need for extensive preparation before starting the liberalization process—though it’s certainly not advocating capital-market controls as a long-term solution.

A March 2003 paper authored by then IMF chief economist Kenneth Rogoff concluded that liberalization should be “approached cautiously, with good institutions and macroeconomic framework” as important prerequisites. He has said that developing countries should not rush to liberalize their capital markets, and, in many cases, the IMF has actually conceded that controls on capital mobility—particularly those that curb inward flows, like the ones used by Chile—may be advisable. Meanwhile, plans to add capital-account reform to the IMF’s charter mandate appear dead.

But the downside of the process proved to be painful. True, the heavy inflow of capital into developing countries that liberalized their capital accounts initially triggered a period of rapid economic growth. It is also true that the inflows pushed the value of those countries’ currencies upward against the U.S. dollar. But when foreign investors lost confidence in the economies of these countries, they began to pull their money out. The value of the currencies then fell sharply against the U.S. dollar, making it ever more difficult for the developing countries to pay back their debts and causing foreign investors to lose even more confidence. The years after capital-market liberalization spread were punctuated by a series of financial crises, including the Asian crisis in 1997, the Russian crisis in 1998, the Brazilian crisis in 1999, and the crises in Turkey and Argentina in 2001. Over a hundred countries have faced crises in the past thirty years.

In 1997, the Asian crisis began when foreign-exchange speculators began selling off Asian currencies. The countries were stuck in a tight place. The way to stop money going out of a country is to raise interest rates, but raising interest rates rapidly is terrible for the banking sector of any country and poses especially difficult problems for banks in developing countries. For one thing, banks face maturity mismatches between the deposits they attract and the loans they have made—a mismatch that is at the core of banking but whose balance sheet impact can be fatal when interest rates rise. Banks borrow short term (that is, their depositors can withdraw their money at any time) but lend long term (for mortgages, for example). This means that when interest rates rise suddenly, what banks pay to depositors may rise suddenly, though what they receive adjusts very slowly. This can be seen another way. The market value of a long term loan (such as the mortgage) that has a fixed interest rate falls dramatically as market interest rates rise. If market interest rates are 10 percent, a mortgage paying only 5 percent interest will sell at a deep discount. But meanwhile, the bank’s commitment to its depositors remains unchanged. In short, the value of its assets plummets, while the value of its liabilities remains relatively unchanged. A bank with a positive net worth can suddenly become a bank with a negative net worth. The sudden rise in interest rates by the Federal Reserve Board in the early 1980s brought on the failure of the savings and loan associations. But the problem is particularly severe in developing countries, where banks are more likely to be undercapitalized and where markets are thin, so that banks will find it more difficult to raise additional capital At the same time, higher interest rates mean that people and companies who have borrowed money find it harder to pay back. When they stop repaying, banks go out of business and stop lending. Less-developed countries do not have strong stock markets and so rely far more on bank finance to grow the economy and create jobs. Bank closures can mean that the economy stops growing. After currencies collapsed in Thailand, South Korea, and Indonesia, so did their banking systems. As things got worse, commercial banks with long-term relations with many of the affected countries also reduced their credit lines. The end result was massive bankruptcies and an increase in unemployment. Ultimately, flows equivalent to some 12–15 percent of gross domestic product left these countries.

Of course, Thailand, South Korea, and Indonesia did not have perfect economies, and there were problems with some of their companies and banks, including shaky lending practices; over-investment in bubble assets, such as real estate; and lack of regulation and oversight, all of which contributed to the weakness in the region’s banks. But despite these serious flaws, the crisis itself was triggered by the massive outflows of capital. Many people began to question whether rapid capital-market liberalization was really a good idea—what was the point of bringing in millions of dollars of foreign capital, driving up the value of your own currency, and then seeing it leave again? They noted that countries such as China, India, and Vietnam that have capital controls were relatively unaffected by the crisis. In 1998, Malaysia imposed controls on hot money and, to some extent, was vindicated when it turned out that these worked far better than people had predicted before they were imposed.

There is a difference between foreign direct investment (that is, foreign investment in factories, businesses, and things that produce goods and services) and portfolio investment in stocks and bonds, which tends to be more speculative. FDI money is sunk into ownership of companies and property and so can not be pulled out of a country overnight. Early supporters of capital-account liberalization did not really think about the differences between these two kinds of capital flows, but, now while most people agree that FDI is important, they worry about unregulated portfolio investment and the effect it has on developing countries.

Free capital mobility makes macroeconomic management difficult not only in bad times but also in good ones. In prosperous times, the rush of money into a country can lead to an overvalued exchange rate, which has a negative impact on exports. Flows also swell the country’s liquidity, which, in turn, fuels inflation. To avoid inflation, countries often raise interest rates, but this simply makes matters worse, as more capital is attracted into the country. Finally, surges in inflows can overtax the ability of banks to mediate the capital prudently, often contributing to bad investment decisions and to speculative and sometimes even corrupt transactions.

While many countries have had problems implementing capital controls, some have done so with remarkable success, such as Chile and Malaysia. Even if controls are imperfect and partially evaded, they still may help stabilize the economy (as Paul Volcker, former chairman of the U.S. Federal Reserve, put it, a leaky umbrella still may provide some protection on a rainy day). But it’s important to distinguish between controls that stop capital from coming in, as in Chile, and those that stop capital from flowing out, as in Malaysia. The two types of controls have very different implications.

Bank (prudential) regulations. Bank regulations can make sure that banks limit foreign borrowing as a ratio of their foreign-denominated assets. It is this so-called currency mismatch that often gives rise to problems. Restrictions can also be placed on the extent to which banks concentrate their lending to particular firms and/or sectors. Liquidity regulations that restrict the ratio of short-term liabilities to banks’ assets have also become fairly common. Such regulations are today typically considered part of prudential bank regulations and thus are not as subject to as much criticism.

There are examples of success and failure. Critics of capital controls point to the failures, suggest that controls can be and often are easily circumvented, and note that success requires a high level of sophistication. Advocates argue that we now know much more about how to make controls work. Bank regulations in Malaysia succeeded in limiting the foreign-exchange exposure of domestic companies and banks, resulting in Malaysia’s having a shallower downturn than neighboring countries while being left with less debt. But critics say that Malaysian capital controls were imposed “after the horse left the barn.” In other words, by the time the controls were imposed, capital had already flowed out and the controls were superfluous. For example, South Korea and Malaysia ended with a similar postcrisis outcome, even though the former did not impose controls and the latter did. Chilean controls succeeded in reducing inflows of short-term capital, with little adverse effect on long-term flows. But Chile later abandoned the system, at a time when its problem was a shortage of flows rather than an excess. Ultimately, while the capital controls did not isolate the country from the vagaries of the international market place, it did reduce the impact.

Economists now generally agree that rapid liberalization of capital markets can be dangerous for developing countries unless they have a stable macroeconomy, strong banking sectors, and developed ways of overseeing the financial sector. The idea of controls on short-term borrowing has also become increasingly accepted, even if the idea of imposing controls during a crisis is still controversial. However, it is unlikely that the trend of liberalization will be reversed. Countries that have liberalized will find it difficult to go back to the old system, but it seems likely that countries that have not fully liberalized (China, Vietnam, Laos, Malaysia) will not rush to do so.