Global credit and financial markets need regulations

by Chakravarthi Raghavan

GENEVA: A UN regional body has called for measures at the global level to moderate the cycles of capital flows to developing countries by strengthened prudential regulations and supervision in the industrialized countries of short-term bank loans and portfolio investments of institutional investors like mutual funds.

Such prudential supervision of global credit and financial markets, the UN Economic Commission for Latin America and the Caribbean (ECLAC) has said, should be supplemented with "a small international tax levied on all international transactions denominated in foreign currencies."

The Tobin tax

Such a tax would act as a disincentive on short-term speculative capital flows, would have negligible effects on long-term flows, and would increase the autonomy of national economic authorities in managing their monetary and foreign exchange policies.

The tax on international transactions, popularly known as the Tobin tax, was suggested in the 1970s by US academic James Tobin to deal with the volatility of capital flows, and calls for it have surfaced from time to time. But the chances of its adoption were politically zero even then, with the major financial centres arguing against it on the ground it would be effective only if all financial centres and offshore operations are part of it - an argument that the advocates of the tax have always seen to be an alibi for inaction.

However, there have always been some doubts as to whether in fact such a tax would curb volatility or discourage speculative short-term flows. Even more questions surround the design of such a tax, given today's reality of banks and funds using complex financial derivatives to keep one step ahead of regulations and taxes.

Only the determined actions of major centres, whose banks are, after all, the main players, whether offshore or onshore, can deal effectively with the problem. And if they do determine to act, the international tax route may not even have to be pursued.

The ECLAC views are contained in a report called, "Impact of the Asian Crisis on Latin America". The report analyzes the effects of the crisis and its transmission channels to the region, and says that the feeling of "moderate satisfaction" in the region over the handling of the crisis by governments and the robustness of the economies needs to be tempered with the costs entailed, which have affected growth prospects.

The region will experience 3% GDP growth in 1998, a decline of two percentage points compared to 1997, of which the effects of the Asian crisis would account for one percentage point of decline, says ECLAC. The value of regional exports would rise by 8% compared to 10% in earlier years, import values will fall by around 10%, and current account deficits would rise from 3.0% to 3.5% of GDP.

However, several processes are under-way with still unknown outcomes, particularly the situation facing Japan and the oil markets, that might alter these projections, ECLAC said.

In looking to the future, ECLAC says it is a "good time to rethink international financial arrangements, but not one to contemplate further liberalization of financial markets or capital account convertibility."

Referring to the current discussions on capital account convertibility in relation to the IMF articles, ECLAC comments that the lessons of the Mexican crisis seem to be overlooked "surprisingly fast, and costly adjustments in the wake of the crashes caused by financial imbalances regarded with far too much complacency".

The regional body also comes down on the rating agencies and the financial traders, respectively through their ratings and expectations published widely in the economic press, that strengthen financial flows to "winner" countries, raising prices of financial and real estate assets and appreciating currencies (regardless of the prudential supervision of the markets), generating 'bubbles' that sooner or later burst when all the signals are reversed, "accentuating the slide and deepening the crisis."

An examination of the origins and magnitude of the Asian crisis and the mechanisms through which its effects are being transmitted to Latin America, reveals the nature and inherent danger of current international movements of capital and the need for strengthening the capacity of countries in the region to respond through interrelated national and international measures.

Policy prescriptions for macroeconomic stability

At the national level, ECLAC recommends macroeconomic and institutional measures to complement one another, and related measures for changing production patterns and competitiveness.

The management of economic policy in expansionary periods in both Asia and Latin America, prior to the crisis, goes a long way towards explaining subsequent difficulties.

In the periods of expansion, external flows were channelled into a rapid expansion of public and private spending, with the encouragement of creditors. The external flows led many agents into overindebtedness, which prompted foreign banks to withdraw their loans abruptly in subsequent periods.

When the flow of external capital was re-established at the beginning of the 1990s, several countries adopted policies to differentiate between different types of capital and to guard against inflows that could lead to situations of overindebtedness during periods of expansion. Still, the crisis that affected Mexico at the end of 1994 showed that not every country implemented policies capable of preventing such situations.

Policies need to be formulated that contribute to macroeconomic stability by cutting back on spending during times of expansion and thereby moderating declines during downturns. And in countries with slow or negligible economic growth and a backlog of social problems, during expansionary periods there should be policies combining macroeconomic- stability aims with prudent use of additional resources to resolve production bottlenecks or finance reforms yielding high economic and social returns.

It would be desirable to adopt fiscal and monetary policies designed to even out spending over time. During periods of expansion, there should be greater selectivity with regard to the kinds and amounts of capital flows and temporary taxes should be levied to discourage private spending. Such measures can act as a brake on the private spending boom in periods when there is a surge in external inflows, and vice versa.

And, instead of setting fiscal goals on the basis of the current deficit, policy makers might use a structural-deficit indicator, as OECD countries do. This approach preferably entails sterilizing the transitory tax revenues characteristic of expansionary periods and setting up stabilization funds to manage the less stable types of fiscal revenues.

Many countries may also find it beneficial to offset short- term trends in private spending (both expansionary and contractionary) in whole or in part through compensatory changes in public expenditure or revenue.

In practice, application of these fiscal policy criteria, in the face of abrupt fluctuations in inflows, calls for different efforts on the part of the countries of the region, depending on their stage of growth and reform. Those countries that have initiated sustainable growth and have made progress with reforms would be able to apply the proposed criteria more easily. Other countries confronted by more serious problems require additional efforts. They will need to increase investment considerably in order to overcome relative stagnation or very slow growth, redress social lags that seriously compromise equality of opportunity and the productive potential of human capital, and finance reforms that can be very costly, such as reform of the banking system, social security and the health and education sectors.

Long-term focus

In this context, advantage can be taken of periods of expansion to carry out spending programmes that can eliminate bottlenecks in the economy, thus overcoming stagnation. This requires, however, that programmes be put in place to ensure the efficient use of increased fiscal revenues and access to external credit and to prevent the effects of greater expenditure on demand from overwhelming the economy's capacity to respond in a non-inflationary way.

In macroeconomic management, short-term approaches must be replaced by a medium-or long-term vision. To assess the dynamic equilibrium of the balance of payments, ECLAC advocates an approach that seems to depart from the IMF assessments of the BOP (projected by the IMF at the WTO). ECLAC suggests examining trends in four areas jointly: exports, imports, foreign capital and reserves.

When changes in the evolution of any of these variables give rise to a significant deficit in the BOP current account, it is vital to be able to assess the sustainability of that deficit.

The situation of imports growing faster than exports but being sustained by the inflow of capital has "proved to be the prelude to crisis in both Latin America and Asia." The internal counterpart of this disequilibrium relates to the evolution of public and private spending and the behaviour of the banking sector.

In this and other cases, vulnerability, and especially the opinion in that regard formed by important external agents, is linked to the level and fluctuation of reserves. In addition, any assessment concerning the entry of capital must take into consideration the purposes for which such capital is intended, and in particular whether it is being invested in export sectors or is strengthening competitiveness in the production of tradable goods.

ECLAC also advocates policy measures for greater autonomy on monetary policy, through mechanisms to discourage excessive inflows of short-term capital, such as the reserve requirements imposed in Colombia and Chile, and variable taxes on financial movements in Brazil. "There is growing consensus that, despite their flaws, such mechanisms play a positive role in discouraging excessive inflows and decreasing the proportion of short-term flows."

The latter action, in particular, makes a country less vulnerable to exchange crises. Discouraging excessive capital inflows, moreover, helps lessen pressure to strengthen the value of the national currency excessively; this in turn helps to maintain export competitiveness and dynamism and to control the size of the BOP current account deficit.

Institutionally, while the regional economies have made progress towards improving extremely weak banking systems (since the crises of the 1980s and 1994-95), much remains to be done.

Among the latter, ECLAC advocates the regional economies instituting a higher capital-to-assets ratio for banks than the ones proposed by the Basle Committee on supervision, since a potential foreign exchange crisis in the region will have a particularly pronounced adverse effect on banks' assets. There is also a need for the regional economies to tighten consolidated prudential supervision of the financial system and to use mechanisms to discourage excessive capital inflows and reduce the proportion of short-term flows.

The Asian crisis also brings to the fore the issue of changing production patterns and competitiveness. The Asian problems are not limited to the financial sector, and an old lesson still relevant for the ECLAC region is the need to continue diversification of output and exports. The rapid changes witnessed in global markets for non-financial goods and services mean that the progress made in some countries on export growth and diversification is not "a self-perpetuating" state of affairs and "competitiveness is something that requires constant attention."

International-level measures

At the international level, while supporting the need for augmenting the resources of the IMF to enable the Fund, with other institutions and governments, to be able to limit the effects of financial and foreign exchange crises in individual countries and prevent the spread of contagion effects, ECLAC says this should be done without increasing 'moral hazard' by encouraging investors and creditors to assume excessive risks knowing they would be rescued in a crisis situation.

"When crises [occur], creditors should contribute to early resolution by rolling over their loans, without increasing interest payments or demanding government guarantees," ECLAC says. That way, the resources of the international financial institutions (IFIs) and governments can be used to finance recovery of ailing economies rather than go towards paying off past debts.

Ideally, says ECLAC, such problems should be prevented from arising in the first place and the best way to do that would be to take steps at the global level, during periods of excessive optimism, to moderate the cycle of capital flows to emerging countries, thus making such flows more sustainable.

Towards this end, ECLAC advocates improving and supplementing international prudential supervision of large volatile flows. This should be done by strengthening existing prudential supervision and regulation of short-term international loans in developed countries. Also required is a measure of prudential regulation of portfolio investments of institutional investors, such as mutual funds. This could be achieved, for example, through variable liquidity requirements linked to a weighted average of country risk for portfolio investments in developing countries.

Such prudential supervision of global credit and capital markets, ECLAC suggests, should be supplemented "with a small international tax levied on all international transactions denominated in foreign currencies."

"Such a tax," ECLAC says, "would serve as a major disincentive to very short-term flows of speculative capital (since they would be taxed frequently), whereas the effects on long-term flows would be negligible. Were such a tax introduced, the effect would be to increase the autonomy of national economic authorities in managing their monetary and foreign exchange policies." (Third World Economics No.186, 1-15 June 1998)

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