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No urgency for financial liberalization, says study

by Chakravarthi Raghavan

Geneva, 7 Nov 2000 - Liberalization of financial markets may be desirable in the long term, but it is risky in the short to medium term, and developing countries should approach this as a delicate step calling for cautious policy reactions, according to a research study for the Group of 24 on International Monetary Affairs, the developing country grouping at the IMF and the World Bank.

The study, “How Risky is Financial Liberalization in the Developing Countries” is by Mr. Charles Wyplosz of the Graduate Institute of International Studies in Geneva, under the UNCTAD project on technical support to the Group of 24 coordinated by Harvard economist Dani Rodrik and to be published jointly by UNCTAD and Harvard University in the series “G-24 Papers on International Monetary and Financial Issues.

The 1990s, says the study, have been years of activism. The developed countries and most international financial organizations have been urging the developing countries to undertake rapid and comprehensive domestic and external financial liberalization. The crises that followed have now installed some prudence. It is being increasingly recognized that financial markets suffer from occasional failures. Promoting proper governance, economic and political, makes good sense in theory; but in practice it amounts to ignoring how difficult it is to challenge entrenched interests and to reshape the political status quo. A silver lining of the recent crises is that liberalization activism of the 1990s is now passe.

“Liberalization,” says the Wyplosz study, “may be desirable, if only because it increases competition and reduces monopoly powers, not just in financial markets. But liberalization is a risky step, one on which our knowledge remains rudimentary. This concerns the exchange markets but also many other aspects, including welfare and growth performance. Many countries, in Europe but also in Asia, have considerably grown in a context of heavy-handed financial restraints.

“There is no urgency to undertake liberalization, even though that step should be clearly planned for somewhere down the road. And when it is being undertaken, it should be approached as a delicate step calling for cautious policy reactions.”

While the study addresses the question of liberalization of financial sectors pushed by the International Monetary Fund, the study and its conclusions have also implications for the drive at the World Trade Organization through the new round of negotiations on liberalization of trade in services to the attempts of the US and other demandeurs from the industrial world to push developing countries to undertake more on liberalising their trade in financial services or in asking these countries to ‘schedule’ in the WTO/GATS their autonomous liberalizations undertaken as a result of the IMF/World Bank programs.

In theory the liberalization of capital accounts and financial markets, promoted and pushed by the International Monetary Fund and the international financial institutions (IFIs) is different from the push at the World Trade Organization for liberalization of trade in financial services.

However, according to many trade and financial experts, the dividing line is rather thin, because of the links between current accounts, balance-of-payments (structural and cyclical), operations of external market players (granted access through commercial presence under the WTO financial services agreement) on the stock and exchange markets. And whether it be through capital account liberalization or via the liberalization of trade in financial services, the effect on developing countries could be the same, particularly in the absence of major reforms to the international monetary and financial systems and the virtual abandonment of major reforms through the new international financial architecture.

At a seminar organized by UNCTAD and chaired by Secretary-General Rubens Ricupero in May 1998, Canadian academic Gerry Helleiner had pointed out that whether it be through a Multilateral Agreement on Investment (MAI) at the OECD, or investment talks at the World Trade Organization (WTO), or the WTO’s agreement on financial services or the capital account convertibility proposals at the International Monetary Fund, the objective sought to be achieved was the same.

Helleiner quoted the OECD’s Development Assistance Committee (DAC) annual report of 1997 to bring out that the OECD-DAC had clearly identified three major international initiatives (meeting the OECD’s objectives of consolidating and extending the liberalization process to all countries): the IMF process for liberalisation of international capital movements, the WTO/GATS financial services talks for liberalising access for financial services (banking and insurance) and the OECD MAI that is to be opened to non-members too.

The OECD-DAC report said that the Hong Kong Interim Committee Statement (Sep 1997) on Liberalisation of Capital Movements under an amendment of the IMF articles, was of ‘historic significance’ in that ‘it represents the final formal break with the original Bretton Woods concept of an international monetary order based on current account equilibrium and official financing both of adjustment (by the IMF) and development (by the World Bank). The new IMF mission, DAC said, was to promote multilateral non-discriminatory liberalisation of capital movements to enable international financial markets to contribute safely and securely to world prosperity in an age of globalization.

The WTO’s financial services negotiations (which subsequent to the DAC report concluded with an agreement in Dec 1997) were “highly complementary to the IMF agreement,” the DAC report had said.

Posing the question whether the path to free markets is inherently dangerous, the Wyplosz research paper says that the evidence based on studies of the experience with liberalization in a sample of 27 developing and developed economies seems to be converging to the view that liberalization contributes to both banking and currency crisis.

Based on surveys by Michael Dooley (1996), published in the IMF staff papers No 43, and by Barry Eichengreen et al (1998) in IMF Occasional Papers No 172, Wyplosz says that some reasonably robust conclusions could be drawn:

·        Financial restrictions allow authorities to insulate domestic interest rates.

And when there are off-shore markets, the effect is well documented by the emergence of an interest differential between the free off-shore and controlled on-shore rates, as also in the unusually large domestic bid-ask spreads.

·        While they generally fail to affect the volume of capital flows and their elasticity to interest rate movements, controls change the composition of flows, reducing the proportion of short-term capital.

·        External controls are unable to thwart an attack on a pegged currency when the underlying policies are unsustainable. Yet,when crisis gathers steam, external controls may provide the authorities with some breathing room to either organize a defense or realign their exchange rates.

·        And not all currency crises are due to bad fundamentals - i.e. macroeconomic policies inconsistent with an exchange rate target. A rising body of evidence suggests that crises can be self-fulfilling. Measures that slow down market reactions may make all the difference between a temporary turmoil and a currency meltdown.

When there is liberalization of existing financial restrictions, Wyplosz study says, evidence seems to be converging to the view that liberalization contributes to both banking and currency crises.

A study by Eichengreen, Andrew Rose and Wyplosz (1995) found that the presence of capital controls reduces the possibility of a currency crisis. This result has been confirmed in a 1999 study by Marco Rossi (IMF working paper WP/99/66) for a sample that includes developing countries. And working with a sample of 53 developed and developing countries, Asli Demigure-Kunt and Enrica Detragiache (IMF working paper) find a strong effect on bank crises, even if the visible impact is delayed several years (a lag of 3-5 years according to a study by Gil Mehrez and Daniel Kaufmann). A study by Graciela Kaminsky and Carmen Reinhart (1999) concluded that currency and banking crises are “closely linked in the aftermath of financial liberalization.”

The Wyplosz study explains that domestic financial liberalization opens up new possibilities for the banking and financial sectors, resulting in more risk-taking. In the absence of adequate supervision and regulation, risk-taking may easily become excessive. When the external restrictions are lifted, open external positions often emerge and become very large as capital flows in, creating a situation of high vulnerability. The related literature on capital inflows show that large inflows tend to be followed by sudden outflows with drastic impact on exchange rates.

Studies exploring the link between liberalization and policy, show that there is little doubt that macro-economic policies which are inconsistent with an exchange rate target eventually result in currency crises. But it could well be that financial repression encourages policy misbehaviour. As confirmed by several recent studies, high inflation and credit growth are among the most reliable predictors of currency and banking crises.

In and by itself, the study finds that liberalization does not pose a lethal threat to the balance-of-payments and may carry significant long-term gains. But this is not the only criteria to consider. The welfare case for liberalization is still to be established. Does liberalization speed up growth by increasing investment? Does it allow consumers to borrow and save as needed to smooth out spending?

While simple first principles deliver an unambiguous positive answer, the result is based on too many assumptions that violate the evidence—for e.g. they assume away financial market failures—to be taken at face value without reservation.

Does financial liberalization spur faster growth? While some early results suggest that fast growth and financial development go hand in hand, the positive influence of liberalization is not easily confirmed and most recent studies find little or no effect, says the Wyplosz study. As brought out in a 1998 study by Dani Rodrik, do countries become rich thanks to liberalization or do rich countries liberalise their financial markets.

“At this stage of knowledge,” Wyplosz says, “the growth-enhancing case for liberalization is simply not made. If it is present, it is too tenuous to be easily detected; at best therefore, it is a second-order effect.”

If liberalization is not doing much good, it is found to do no harm either, in the long run. But the relevant question is whether the road to free markets is bumpy enough to deter the trip? Given that liberalization is often followed by a crisis, and that crises typically lead to sharp recessions, is it worth it? Are there short-run output costs of liberalization and if so how deep are they.

A simulation analysis, Wyplosz says leads to several conclusions:

Liberalization is a source of macro-economic instability, much as it increases exchange rate pressure volatility. A boom-bust cycle is detected for developing countries.

In the case of capital account liberalization, the peak to trough decline in the output gap exceeds 20 percent. No other shock ever seems responsible for such a massive contraction.

The boom exceeds the bust in magnitude, but not in length. Thus liberalization brings about an overall gain in terms of output and, if one ignores the instability, there is no income case against liberalization.

However, the bust can be of considerably amplitude and therefore can be a serious setback—economically, socially and politically. “Once the bust is taken into account, there is an income case against liberalization.”

The contrast between the effects in developing and developed countries is sharp.  Further investigation is needed to pinpoint which specific factors account for the difference.

“At this stage of knowledge, a reasonable view might be that liberalization brings about desirable, albeit second order of magnitude long-run effects but that it is dangerous in the medium-run.”

How is one to reap benefits without incurring the costs, or with minimal costs?

The ubiquitous contrast between the effects of liberalization in the developing and developed countries suggests that if one wants to avoid, atleast limit boom-and-bust cycles and high exchange pressure volatility, “it may be useful to wait until a proper economic, and possibly political infrastructure has been built,” says Wyplosz.

“This may take years, if not decades,” he adds looking at the experience of European financial liberalization.

“The implicit strategy advocated in the early 1990s, that economic liberalization will force economic and political progress is dangerous: its success remains to be demonstrated and it is a tad too machiavellian to be comfortable with.”

The experience from both developing and developed countries suggests that liberalization is a source of widespread instability, leading to some conclusions:

It is important to set up adequate welfare systems before liberalising. Free markets may raise efficiency, but they are known to raise inequality, atleast initially. Boom and bust cycles affect more seriously the poorer, less educated segments of the population. In addition boom years must be used to prepare for the bust years.

Fiscal policy in particular ought to be used to build up public savings which will be available to combat financial meltdowns and protect those most hurt by the bust. While currency crises cannot formally occur when the exchange rate is freely floating, pressure can take the form of excessive exchange rate fluctuations which may have severe effects, in terms of both competitiveness and currency exposure by various economic agents. The view that floating is an option for each and every country fails to recognize the benefits from exchange rate stability, especially in countries which are open and have limited financial market services.

Hard pegs, on the other hand, are in vogue, but their costs, e.g. in Argentina, and the difficulty of designing a credible exit strategies, are being increasingly recognized.

It seems fair to predict that the debate will end up in a draw, much as happened to the older debate about fixed vs flexible rates. Since exchange rates carry enormously widespread implications, a few simple criteria are unlikely ever to settle the debate.

On the other hand, it is crucial to recognize ex ante that liberalization rocks the exchange market. Building some form of exchange rate flexibility - either by floating or by being ready to realign pegs - into the liberalization program is essential.

The seminar sequencing strategy, advocated by Ronald McKinnon (1991) is to start with domestic goods market liberalization, then to open up to trade, and then to proceed to domestic financial liberalization before opening up the capital account, possibly leaving the short-term for the last step, has so far not been proved wrong. The most delicate steps are those involving domestic financial and capital account liberalization. Since they tend to work in the same direction at the same horizon, spreading these measures several years apart seems reasonable.

Several studies, including the latest by the US Meltzer Commission, have blamed the actions by IFIs, chiefly the IMF, and its early policy recommendations, for worsening the crisis. The IMF has been applying a methodology developed in the 1950s when most capital accounts were severely controlled and with developed countries in mind. The result that developing countries react differently to financial liberalization provides some support to the critique.

There is the distinct possibility that future BOP crises will be circumscribed by developing countries. If that were the case, the IMF would become an institution run by developed countries - which hold an overwhelming majority of the votes - but at the service of the developing countries. This was not the intention of the founding fathers, and raises complex economic and political issues that have surfaced around the crises in Mexico, Asia, Russia and Brazil.

The IMF has now tempered its early enthusiasm towards rapid liberalization but it has failed to recognize early enough the associated dangers. It has been seen as protecting the lenders, financial institutions from developed countries. It has sought to impose intrusive structural reforms that developed countries have been long to apply to themselves.

“The debate on the ‘New Architecture of the International Monetary System’ is concerned with the need for change. The outcome will affect the process of liberalization and the way the IMF deals with countries at times of crisis. The developing world has a huge stake in this debate, and yet its voice is rarely heard. Eventually, developing countries should be more in charge of their Fund.”

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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