South countries need capital controls
A recent volume of research papers of the Group of 24 published by UNCTAD, concludes that capital account controls have played an important positive role in the macroeconomic management of many successful industrialising developing countries, and recommends against full liberalization of financial services by developing countries. Two papers in the volume argue that new "conditionalities" relating to governance and environment imposed by the international financial institution have increased the political and transaction costs of borrowing from multilateral banks. This has created tension within borrowing countries as well as between borrowing countries and the MDBs. Chakravarthi Raghavan reports on the views set out in the Group of 24 research papers.
by Chakravarthi Raghavan
GENEVA: Capital account controls have played an important positive role in the macro-economic management of a great many developing countries, and the successful industrializers among them, and it would be premature, and inappropriate for a long time, to require them to achieve an open capital account.
This is one of the important policy conclusions and recommendations in the research papers of the Group of 24 (developing country group at the IMF/World Bank, established in 1971) published by the UN Conference on Trade and Development in the eighth volume in the series "International Monetary and Financial Issues for the 1990s" (UN Sales No E.97.II.D.5).
An overview paper in the volume by Gerald Helleiner, Professor of Economics at the University of Toronto (Canada), and papers by some others, question the drive in the WTO for full liberalization of financial services by developing countries, as also the basis on which presently the current account and balance of payments of developing countries are assessed by the IMF.
Traditional measures obsolete
The IMF views become the basis for pressures at the WTO on developing countries for liberalizing their trade.
Helleiner says: "What is clear is in the new world of volatile private capital flows, traditional measures of the adequacy of international liquidity, based primarily upon the relationship between owned foreign exchange reserves and imports of goods and services, are obsolete. Appropriate guidelines for reserve management in a world of large and volatile capital flows are unfortunately still nowhere to be found.
"Presumably new guidelines would have to take account of stocks (of external debt, domestic money supply etc) as well as flows.
"The capacity of the IMF, with current resources, to address the likely liquidity requirements of emerging markets in coming years remains very much in doubt. IMF quota increases and further SDR issues are minimum necessary steps in the rebuilding of a credible multilateral liquidity system."
Article VI of the IMF now precludes members from using IMF general resources to meet large or sustained outflows of capital, and (in such conditions) the IMF is required to advice the country to institute controls on capital account.
But the IMF Managing Director, in a series of speeches in 1994 and 1995, advocated amendment of these provisions and for changes to require countries to commit themselves to convertibility on capital account.
IMF discourages tightening of controls
Helleiner notes that in Article IV consultations with developing countries, the IMF has approached issue of capital account controls on a case-by-case basis, but generally discouraging tightening of controls over capital movements. And in its technical assistance to developing countries, the IMF has been more forceful in advocating full capital convertibility.
However, in 1995 and 1996 (in the aftermath of the Mexican peso crisis), the IMF staff papers has been taking a more nuanced position to the effect that controls may serve some useful purpose.
But says Helleiner, from the experience of a number of developing countries studied in the G-24 project, that "it would certainly seem premature at this time, and, quite possibly, inappropriate for a much longer time, to consider an amendment to the IMF Articles of Agreement that required all members to commit themselves to the achievement of an open capital account."
The UNCTAD G-24 project, to provide technical support and analysis of issues, for the G-24 deputies at the IMF and World Bank institutions, was set up in 1975, and funded by the UN and UNDP, till 1990 by the late Sydney Dell. Since 1990, the project work has been resumed under the direction of Prof. Helleiner - with funding by the G-24 countries themselves, the International Development Research Centre of Canada, and the Governments of Denmark, Netherlands and Sweden; UNCTAD provides secretariat backstopping.
Caution against conditionalities
Besides the Helleiner overview, the papers in the volume include one by Prof. Rudi Dornbusch advocating a cross-border payments tax (covering all transactions) that any developing country could put in place on its own to moderate and manage the pace of cross-border flows and discouraging short-term transactions, and a paper by Davesh Kapur of the Brookings Institution cautioning the Bretton Woods Institutions on the many "governance conditionalities" they are instituting (in response to Northern NGO demands), and the backlash it is producing.
Increase in capital flows
The Helleiner paper notes that private capital flows to developing countries, after slumping in the 1980s has increased dramatically in the first half of the 1990s, stabilizing (according to the World Bank) at about $160-170 billion in 1994-1995 as the US interest rates rose and the Mexican crisis hit. But these remain highly concentrated - with only 20 countries being considered credit worthy by capital markets and banks. Foreign Direct Investment too is equally concentrated.
In the 1990s, there has been also a sharp increase in international portfolio investments, both in debt instruments and equity.
While shocks in external terms of trade have long been recognized as a particular problem for developing countries, changes in global interest rates and their effect on private international capital flows, are now revealed as a "further major source of exogenous shocks".
While capital flows internationally, with or without government controls over the capital account, an increasing numbers of developing countries have opted for full capital- account convertibility and integration with global capital markets and the principal gains flowing from these - those derived from increased efficiency of both national and global capital markets.
"But none of these potential gains are assured, and capital account liberalization also involves risks and potential costs," Helleiner warns, outlining several of the problems, including severe macroeconomic management problems and even financial crisis that can arise as a result of surges of private capital flows.
This is why monetary authorities of many developing countries have sought to deploy direct and indirect controls over private international capital flows as additional macro- economic policy instruments - seeking typically to reduce the level, slow the pace or alter the composition of these flows.
Governments also resort to measures to restrain expansion of consumer expenditure which might otherwise be associated with capital inflows (and in many cases with import liberalization) may also be considered appropriate - measures such as limits on domestic consumer and mortgage credit, or compulsory private savings programmes, etc which can reduce the prospect of credit-driven booms in private consumption of the recent Mexican type.
[At the WTO in March, the EC and the US, who pursue neo- mercantalist policies, found fault with Korea for its public campaigns for 'frugality' and discouraging luxury consumption, fuelled by easier consumer credit]
Capital account liberalization and increased openness in the capital market, Helleiner says, may involve domestic banks and other financial institutions in increased risks - both of increased deposit volatility and increased foreign exchange risk. Capital account liberalization thus is likely to require strengthened prudential supervisory and information disclosures.
Direct regulation of international capital flows, both inward and outward, has been common in developing countries. Of 155 developing countries surveyed (on the basis of IMF data), 119 employ some form or other of control over international capital flows, although 75 have accepted Art. VIII (convertibility) obligations on the current account. The forms of the controls have been numerous, and regulation of outward flows more frequent than of inward flows.
Of inward flows, FDI is more frequently regulated than purely financial flows, but there is also increasing interest in and resort to controls over the latter. Positive lists, in which only listed transactions are 'free' are more restrictive than negative lists in which only listed transactions are restricted or prohibited.
FDI is often distinguished from portfolio flows, and generally believed to be motivated differently, as far as stability and macroeconomic consequences are concerned, and often inward FDI is treated more liberally than foreign portfolio capital flows.
"But these presumed differences can be overdone (and) FDI flows can also be volatile," Helleiner says.
Capital outflows more difficult to control
"TNCs manage liquid funds as well as flows of real goods and services, and they usually do so very effectively. (A) Foreign director investor can also, when appropriate, borrow from foreign or domestic financial institutions in pursuit of their international financial flow objectives. FDI can therefore be associated with higher, rather than lower, variability in capital flow, reflecting TNCs' capacity for managing international intra-firm financial transactions to respond quickly to changing national circumstances."
Controls over capital outflows are difficult to enforce, and capital flight could occur even in the tightest control regimes - via misinvoicing of trade transactions, leads and lags in external payments, alterations in terms of trade credit, changes in overseas workers remittances etc.
But it would be a "considerable logical leap" from this to reach the conclusion that "controls are always totally ineffective," Helleiner says. "Particularly, in the large scale formal financial sector, they are likely to have some effect. The issue is rather whether actual social benefits of such controls warrant their administrative and other costs."
It would be easier to make controls work if monetary authorities at both ends of the flows cooperate - but they rarely do at present except with reference to the 'laundering' of illegal funds.
Use of market-friendly policy instruments
G-24 studies of experiences of countries in dealing with large inflows of capital surges, suggest that vigorous use of market-friendly policy instruments has helped many developing countries in their pursuit of macroeconomic policy objectives and stability. These instruments include flexible central bank intervention in foreign exchange markets, with varying limits and bands; flexible intervention by monetary authorities in domestic financial markets; maintenance of fiscal discipline; and use of reserve requirements.
The East Asian and Latin American countries studied have been remarkably successful in responding to surges of private capital inflows. The purpose of controls in the more "successful" ones has not been to maintain a fundamentally unsustainable exchange rate, but to assist in real exchange rate stabilization.
And, as Prof. Dornbusch notes, in advocating a small tax by individual countries on all cross-border transactions so as to discourage short-term capital flows and lengthening investor horizons, "while a near-perfect system of managing capital flows would be desirable, something that falls far short may still do the job much better than doing nothing."
Positive role in macroeconomic management
Referring to various IMF policy pronouncements on capital controls, Helleiner says: "On the basis of experience to date... one must conclude that capital controls, both indirect and direct, have played an important positive role in macro- economic management of a great many developing countries ... It would certainly seem premature at this time, and, quite possibly, inappropriate for a much longer time, to consider an amendment to the IMF Articles of Agreement that required all members to commit themselves to the achievement of an open capital account." Referring to the various international regimes - the IMF rules relating only to controls and regulations on international capital flows, the WTO attempts to develop a regime for foreign financial services, the regimes of the BIS, OECD, the EU, Nafta etc, the Helleiner paper questions the wisdom of pressuring developing countries to liberalize their financial services.
More detailed analysis needed
Helleiner says: "There is considerable clutter, confusion and overlapping jurisdictions in the international regimes for capital flows and financial transactions. Are these various regimes mutually consistent? Are the needs of developing countries different and are they taken into account? "Is the march towards liberalization of financial services in developing countries any more defensible than the arguments for the total liberalization of their external capital accounts?"
Citing the assessment of Prof. Dornbusch about the financial services trade issue, Helleiner adds: "These issues urgently require more detailed and comparative analysis."
The sudden hiking of interest rates in 1979 by the US Federal Reserve, known as the "Volcker shock", at least in hind sight is seen as a major contributor to the international debt crisis of the 1980s. But the links now between interest rates in the US (and to a lesser extent those in Germany, Japan and other industrial countries) and macroeconomic developments in developing countries are much tighter, Helleiner notes.
Those modelling the functioning of today's global economy must take account of these linkages through capital account and "the increasingly important feedback effects" from the economic performance of developing countries to that of high-income countries. Macroeconomic policy makers of major industrial countries, and those who assess or advise them, including the IMF, must recognize the potential economic consequences of their policy choices, he warns.
Helleiner also draws attention to the liberalization of financial systems in many developing countries to the extent of allowing domestic residents to hold foreign currency deposits, and says these have profound implications for macro- economic management.
Since private international capital flows have become a much more important and potentially volatile element in many developing country economies, their policy makers need accurate and timely information of the size and composition of such flows. The IMF should do all in its power to assist member countries to improve their data on such flows.
Helleiner underlines the need for greater consideration of the fairly immediate consequences of private international capital flows to the macroeconomic policies of major industrialized countries, given the much tighter links between the developing and developed countries as a result of greater integration of financial markets.
Monetary authorities in developed countries should actively assist and cooperate with those in developing countries in the collection of data, monitoring of developments and, in some cases, implementation of controls on international private capital flows, Helleiner says.
The IMF should be encouraged to recognize capital account controls, direct and indirect, as important policy instruments in most developing countries for the foreseeable future.
The IMF should be encouraged to expand its role, in conjunction with other relevant bodies, in surveillance of international capital markets - a role that would be facilitated by an amendment of the Articles of Agreement.
Early efforts should also be made to clarify the rules and jurisdictions relating to international capital account transactions and international financial institutions in the many areas of potential overlap - those of the IMF, WTO and other international and regional institutions and agreements.
And the IMF, Helleiner recommends, should be formally mandated (and this too may require amendments to its Articles) to lend into financial crises in developing countries, both to provide emergency liquidity and, in conjunction with the World Bank and others, to support sovereign debt problems.
"Decisions as to the appropriate procedures for such lending and decisions actually to lend should be taken via the fully multilateral decision-making mechanisms of the IMF. To permit it to perform its role, the IMF will have to be provided with significantly expanded resources, particularly through quota increases and SDR issues." (TWE No. 159/160, 16 April-15 May 1997)
The above article was originally published in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.