The need for prudent and well-sequenced liberalization
by Chakravarthi Raghavan
GENEVA: Developing countries embarking on a process of financial liberalization may prefer to adopt a "prudent and well-sequenced" process of internal and external liberalization, and analyzing the effects at each phase before proceeding further.
This was one of the agreed conclusions of a three-day UNCTAD intergovernmental experts' meeting on the growth of domestic capital markets, particularly in developing countries, and its relationship with foreign portfolio investment.
The experts also agreed that a pre-requisite for preventing a financial crisis is the existence of a healthy financial system, with a good regulatory framework and strong supervision of the operations of the banking, securities and insurance sectors, and commended in this connection, the Basle Committee Core Principles (for international banking supervision).
The meeting, from 27-29 May, heard some experts' views on the various aspects of the financial sector and markets, including the pros and cons of liberalization, capital mobility and policies to attract foreign capital. Among those who presented these expert views were Prof. Gerald Helleiner of the Toronto University and Research Coordinator of the G-24 Technical Support Project, Mr. Charles Freeland of the Basle Committee on Banking Supervision, Mr. Perfecto Yasay Jr, Chairman of the Philippine Securities and Exchange Commission and Prof. Hans Gensberg of the Geneva Graduate Institute of International Studies.
In opening the meeting, UNCTAD Secretary-General Rubens Ricupero noted that in the wake of the Asian crisis, whose end cannot be predicted yet, and a reassessment of the attractiveness of emerging markets for portfolio flows, there was now a new perception that the earlier perceptions about the attractiveness of returns in emerging markets, compared to the traditional industrial markets, are somewhat exaggerated.
There was the perception that the attractiveness of emerging markets had been sold to the public, and that the negative impact of the turmoil in East Asia had been felt not only in Asian markets, but also as a result of contagion effects of volatility in some other markets - for example, in Russia and in Brazil and some other areas. At the same time, there has been an extraordinary recovery of markets in Europe, apart from the case of the United States, with its own uniqueness.
The trends in portfolio flows and investments, Ricupero said, had to be viewed against the background of the Asian crisis. While an increasing number of developing countries and transition economies, by their policies of openness to trade and capital accounts have been gaining access to foreign private capital in recent years, "the vast majority of developing countries have experienced very limited foreign interest."
Highly mobile capital flows
But the very elements that have facilitated the inflow of foreign capital into developing countries have also meant that foreign capital can now be withdrawn from these countries far more quickly than had been possible during the 1980s. "And in those developing countries that have hosted large amounts of foreign private capital, volume of inflows has complicated macro-economic management and in several notable cases has contributed to significant overheating, particularly in countries with an open capital account."
The recent experiences with highly mobile capital flows, Ricupero said, have highlighted the need to promote sound capital market development, in order to draw maximum benefits from these flows.
In most developing countries, the financial sector is dominated by the banking sector, which represents the major provider of credit. And in the absence of a well-developed capital market, there are often few alternatives to bank credit, other than utilization of entrepreneurs' own funds. "A well-regulated and supervized banking sector, run by practitioners competent in credit analysis and risk management is absolutely critical in order to ensure an efficient allocation of resources into productive use," the UNCTAD head said.
The existence of these elements in the banking sector, Ricupero continued, represented an important pre-requisite to financial liberalization. A sound banking system was of the utmost importance in preventing the transmission of a crisis from the currency markets into the real economy. But this was not enough. It was also necessary to develop a wider capital market, including stock and bond markets, so as to allow a more efficient balance between equity and debt financing of domestic companies and to provide wider alternatives as a source of financing available to them.
Large degree of contagion
"But the events in East Asia," Ricupero underlined, "have exposed a number of flaws in international arrangements for economic crisis management. These have resulted in widespread discussion in the international community, including calls from varied quarters for a new architecture for dealing with international finance."
"In the light of the surprising degree of contagion arising from the East Asian crisis, this debate has assumed greater urgency and importance."
Beyond the issues of crisis management, several long- standing issues need to be addressed:
How can countries so far largely neglected by foreign investors gain access to such private external finance? How can the few who experience large inflows of foreign capital can avoid the problems associated with the East Asia crisis? And how can countries, to benefit from foreign capital inflows guard against potentially negative impacts, including the generation of credit booms and possible reversal of capital flows?
The real challenges, Ricupero said, were: determining the amount of external capital that domestic economies can absorb; putting in place an appropriate policy framework, both at national and international levels; and establishing continuous and genuine dialogue between recipient countries and foreign investors so as to improve the flow of information on both sides, and avoiding panic and herd-like behaviour as much as possible.
The existence of a healthy financial system, governed by a good regulatory framework and strong supervision to oversee the operation of the banking, securities and insurance sector, is an important pre-requisite in preventing financial crises, the expert group said in its agreed conclusions and recognized in this regard the potential benefits of internationally agreed principles, such as that of the Basle Committee Core Principles.
But there is "no quick fix" for putting into place prudential regulations and a supervisory system for its implementation, Charles Freeland from the Basle Committee on International Banking Supervision told the meeting, in explaining the Core principles.
The Basle Committee and its supervision, he wryly joked, had been called as attempting to close the stable after the horse was stolen, but it was very difficult to do so before. "The situation is such that the industry and markets are constantly evolving new instruments, and all that we can say is that it is a long programme to improve banking supervision, not a quick fix at all."
Implementation, Freeland said, needs a legal culture, and a credit culture. In many developing countries, banks are used as an agent of development and not too many questions are asked how the money is used. "It is a reasonably satisfactory approach for faster growth, more so in an economy which is managing to move from a rural to cosmopolitan role. But if you want to play in the global financial markets, then you have to do something different."
But nothing dramatic can be expected by adopting these principles, and very much depended on the implementation which itself is a long process of inculcating the "cultures" for it - a "credit" culture among private operations, a "legal" culture in relation to bankruptcy laws and their administration and a prudential regulatory "culture" among supervisors and regulators of banks, security and insurance firms.
Putting in place prudential regulations and implementing it, and the technical expertise and knowledge needed for it, could not be achieved through a 15-day seminar at Basle, Freeland wryly commented, in a reference to those pushing for fast liberalization of financial markets by developing countries and suggesting that they could quickly put in place prudential regulations and administration to avoid risks.
The Basle Core principles, he underlined, had been evolved before the Asian crisis, but the Committee had seen no reason for revising them in the light of the crisis. The Committee did not agree with the IMF view that the principles need to be modified for emerging markets and transition economies. Rather, there is a case for standards to be tightened in emerging markets, and banks everywhere should be made to follow the same principles.
Freeland also did not hue the ideological line (of the IMF/World Bank/WTO) about privatization and said in respect of the banking sector that some of the developing countries had government-owned banks. "But we could not recommend that all of them should be privatized; privatization may be appropriate but one cannot make a blanket recommendation that all government banks should be privatized."
In his paper, Prof. Gensberg spoke from the neo-liberal theoretical premise that free capital flows and international trading in assets benefit home and host countries and that financial intermediation enables mobilization of savings and their efficient use globally, for developing countries to benefit. He thus argued in favour of capital account liberalization and free capital flows, but conceded the need for some measures in developing countries to deal with financial crises and risks. It was structural weaknesses in financial institutions and markets that made an economy particularly susceptible to a financial crisis and hence, solutions lay in solving such weaknesses, rather than putting restrictions on capital (inflows and outflows). But in the process of financial liberalization, reasonable macroeconomic stability should be restored before carrying out domestic financial reforms, he added.
"It is a waste of time trying to argue in 'yes' or 'no' terms about capital account liberalization, and the issue is how to regulate the international financial markets and the risks they carry in a practical fashion," Prof. Gerald Helleiner said in his subsequent intervention.
Helleiner drew attention to the G-24 technical papers (published in the UNCTAD series on "International Monetary and Financial Issues for the 1990s"). These included papers on the problems of effective banking supervision even in developing countries which have had stringent supervision - like Chile; that the implementation of the WTO agreement on financial services, particularly its "national treatment" provision for financial institutions may pose problems to finance ministers and bank supervisors in developing countries; that in the draft MAI (Multilateral Agreement on Investment), the definition of investments includes portfolio capital and therefore, will pose problems; and the G-24 papers on capital account liberalization in developing countries.
Commending the approach of the BIS and the Basle Committee on Banking Supervision to some of these questions, Helleiner said these were "non-dogmatic, and carefully balanced and sensible", and provide more "frankness and caution" in their advice than one gets from the international financial institutions.
Underscoring the inter-connection between international portfolio flows and development of domestic capital markets, he referred to the comment of the World Bank chief economist, Joseph Stiglitz that the financial sector is "an earthquake prone-zone", and even countries at the early stage of development need to build an effective financing system.
Development of financial markets
Development of financial markets in developing countries sought to achieve effective mobilization and use of savings, both at global and national levels. "It does not necessarily imply liberalization and what most developing countries need is not liberalization but restructuring of their entire financial systems," Helleiner said. If there was liberalization, without restructuring, "it will pile disaster upon disaster," he warned.
There was a need to provide insurance and protection against risks of shocks, both positive and negative, and at reasonable cost. This needed more prudential supervision, deposit insurance and so on. And in the event of a crisis one needs credit lines, and of course the IMF.
"But new guidelines are needed on 'adequate foreign exchange reserves' since the old ones based on reserves for imports were obsolete in a world of mobile capital," Helleiner pointed out.
In terms of institutions and reforms, "what we need to look for are incremental changes and processes that will produce incremental improvements, rather than debating the 'Yes' and 'Nos' of ideal policies."
Virtually everyone agreed that existing arrangements for the effective mobilization and use of savings and providing insurance against crisis need to be addressed globally and will continue to be for the foreseeable future. While they were working towards it, "the process will be slow."
The second objective of smooth and steady expansion of private capital flows was one which involved continuing controversy. However, liberalization of capital accounts should be the last in the sequence of reforms. In normal circumstances, capital account liberalization should come last.
Helleiner said that in respect of short-term flows and volatility, most judgements over the last 7-8 months, even within the IMF, had shifted from a discussion of whether volatility of short-term capital flows is a problem to be addressed, to a discussion of how the problem of volatility of short-term capital flows is to be addressed.
In much of the discussions of the G-10 countries, there has been little account taken of the considerable experience not only in Chile and Colombia but even in South-East Asia, of many of the measures taken which are market-friendly. Indonesia, Korea, Malaysia and Thailand all had a variety of tools to deal with inflows and outflows before the crisis.
Chile and Colombia had used reserve requirements and all manner of restrictions on external and inward flows.
"It is a waste of time trying to argue in 'yes' or 'no' terms about capital account liberalization. The issue is how to regulate the international financial markets and the risks they carry in a practical fashion."
Basle Committee guidelines
Helleiner said that Basle Committee guidelines (Core Principles) did not address the behaviour of non-banks or funds, hedge funds, pension funds, insurance companies and non-financial companies including transnational corporations. The question arose as to whether these attempts to monitor and regulate the international financial sector should be undertaken in some coherent, systematic and integrated fashion?
Henry Kaufman had recently raised the question of whether assessment of risks on behalf of private investors is not a public good and whether it should not be addressed as such. The IMF had been suggesting some solutions about transparency. But this was an issue about how to supply the information, who is to provide it, and how this could be integrated into an overall approach of prudential supervision of the international financial system.
Helleiner also raised the question on whether the capital adequacy ratios suggested by the Basle Committee would need to be revised in relation to the new concerns over short-term capital flows and their volatility.
Another issue, in terms of bank credits, was the need to protect trade credits to countries through some kind of export credit insurance.
While the Basle Core Principles are useful, countries need some guidance on what a country should do when it is short of resources and staff to administer regulations.
In Helleiner's view it was a more important priority for countries to devote human resources to prudential banking supervision and regulating bank structures rather than deploying them to administer the World Trade Organization's Intellectual Property rules and regime.
Referring to short-term capital flows and volatility, Helleiner wondered why the G-10 countries could not use the same methods to collect information on these, as they did now, to deal with drug laundering. Developing countries and their central banks had been extremely cooperative in providing such information, he noted.
"Why cannot the same kind of activities be undertaken in respect of short-term capital flows and movements," Helleiner asked and suggested that the difficulties posed and objections raised were due to the lobbies involved in short-term capital flows.
There were now some on-going turf battles on these issues involving the IMF, BIS and the WTO and it would be more useful to have systematic and transparent discussions in a coherent fashion, Helleiner added.
Perfecto Yasay Jr of the Philippines Securities and Exchange Commission in his presentation said that the easy in- out access of foreign portfolio investments had its downside, "the volatility of the capital market."
The experience of the Philippines showed that there was a flipside to the advantage of quick entry big sums of foreign- owned capital through portfolio funding: fund managers could also quickly sell the securities and run back home and this usually happened in instances of market convulsion or political instability.
The recent experience of the South-East Asian "tiger" economies showed that following years of tremendous growth rates, speculators soon spotted economic weaknesses. Slowly but steadily, fund managers adopted quick entry and exit strategies, "and one-by-one in the fashion of a domino effect, Asian currencies tumbled."
At the same time, the smart fund managers cashed in on their windfall profits. But when it was no longer profitable to keep them in the region, "foreign funds stampeded to the exit doors, leaving in their trail, Asian economies in disarray with their currencies falling to all-time lows vis-a- vis the US dollar and other major currencies along with stock market indices."
It was clear that emerging economies must adopt to these realities if they intend to keep on competing for and attracting foreign capital, Yasay added.
"Emerging markets," he said "must face the realities of the changing structure of foreign capital markets, notably the portfolio investments phenomenon. It must do so, with a better understanding of the pros and cons of the widespread liberalization and globalization of financial markets, including the integration of emerging economies into the global financial system."
Referring to the experience of the Philippines, Yasay said that while its banking sector had remained strong under the crisis, resilient economic fundamentals did not ensure stability of capital flows for the Philippines. What the Asian crises revealed were "the abnormalities created in the capital markets by globalization and unfettered liberalization of financial markets, especially in developing economies."
New measures, he suggested, should be instituted individually by nations and regionally among them to ensure that the Asian contagion did not happen again.
Emerging economies need to adopt certain structures and mechanisms conforming to the needs of the times. These could be adopted by corporate borrowers alone. Government and the private sector must join hands in forging and adopting these rules.
Through legislation, governments must exert utmost effort to set new rules to conform to emerging global standards. While the capital markets abound with portfolio investors interested in short-term investments with large profit-taking potential, there were also portfolio investors willing to park their funds in shares for longer periods of time. "To minimize the speculative attacks on our currencies, we should establish and implement more stringent rules and regulations covering foreign investments by portfolio investors," the Filipino Security and Exchanges Commission official said.
The portfolio investors had managed to profit significantly from currency devaluations by employing sudden withdrawal of funds when the value of the dollar was increasing. And once they start withdrawing, the demand for dollars continue to escalate, pushing the exchange rates to an all time high. This vicious circle repeated itself as foreign investors are given a freehand in investing and pulling out their investments from the country at a time most profitable to them. As investors maximize on arbitrage, Asian currencies will continue to be subject to speculative attacks.
Hence measures to curb speculative attacks should be put in place including requiring foreign portfolio investments to have a minimum holding period before withdrawals, thus ensuring that "hot" money would stay long enough in a market to get "cold" in the host country.
But such a policy should be instituted across neighbouring countries or regional emerging markets.
In parallel, there should be an unbending policy to strive for development of a stock market where stock price fluctuations are based substantially on fundamentals and not on market rumours.
Side by side, there should be new legal enforcement rules on company disclosures, improvement in corporate governance, and a higher discipline on corporate reporting and transparency to proper government authorities and the general investing public. Also, domestic savings should be mobilized through appropriate legislation and incentives so as to minimize dependency on foreign capital. (Third World Economics No. 187/188, 16 June-15 July 1998)
Chakravarthi Raghavan is the Chief Editor of the South-North Development Monitor (SUNS)from which the above article first appeared.