Global financial reforms and developing countries

Global financial reform means different things to different groups of countries. Kavaljit Singh provides the perspective of developing countries in this critical question.

PRESENTLY much of the current debate on global financial reforms is centred on financial systems of the developed economies - the epicentre of the global financial crisis. Even though the financial systems of poor and developing countries are considered to be undeveloped and unsophisticated, these countries can bring new perspectives into the ongoing debates. It is likely that the perspectives of developing countries would be markedly different from the developed-country one given the diverse roles and objectives of the financial system in their economies.

For developing countries, systemic risk issues are of greater importance because, more often than not, the main sources of systemic risk lie outside their jurisdictions. Take the case of capital flows. For decades, developing countries have been finding it difficult to cope with volatile capital flows. A boom-bust pattern of capital flows engenders both macroeconomic and financial instability. The management of volatile capital flows becomes more difficult for those developing countries which follow a highly open economy.

Since the 1980s and 90s, several developing economies have experienced sudden reversals in capital flows due to changes in the monetary policies of developed economies. The domestic authorities in the developing countries have no control over such developments. Periods of large capital inflows have been followed by a sudden outflow of capital. A surge in capital inflows can contribute to higher inflation and asset price bubbles. The sudden withdrawal of capital can seriously affect the exchange and interest rates, and thereby threaten macroeconomic management and economic stability not only in one country but several others, depending on the degree of economic integration.

The crisis has proved that increased financial integration and presence of large financial conglomerates can transmit financial shocks across countries. Financial innovation in certain products and markets can also augment financial shocks. The presence of large financial conglomerates in the domestic financial system requires close monitoring by supervisory authorities in developing countries.

The risks of open capital accounts

The role of financial liberalisation in triggering financial crises and in misallocation of capital is well documented. The 1997 Southeast Asian crisis emphatically demonstrated to the world that capital account liberalisation is a vexatious issue with numerous reverberating effects. An open capital account should be perceived as a source of risk rather than benefit. Therefore, it is imperative for developing countries to manage their capital account. Thanks to capital controls, India was not badly engulfed by the Southeast Asian crisis. If India had adopted capital account liberalisation, it would have been difficult to protect its economy from getting severely affected by the Asian turmoil.

For developing countries, the costs of an open capital account are enormous because volatile capital flows can cause sharp swings in real exchange rates and financial markets, thereby engendering instability in the financial system and the real economy. The costs of financial instability and crisis are more pronounced in the poor and developing world because of weak regulatory and supervisory institutions. The social costs of financial crises are also much higher in the poor and developing countries since they lack social security nets and fiscal space for counter-cyclical policy measures is rather limited. Therefore, it is very important for these countries to maintain financial stability.

Contrary to popular perception, capital account liberalisation does not lead to higher economic growth. China and India are prime examples of achieving higher economic growth without liberalising the capital account. The potential costs of free capital movement are much higher in comparison with the much-touted benefits.

For developing countries, the problems associated with capital flows are essentially two-fold: First, capital flows don't enter a country at the right time. But they can leave a country quickly at a time when they are badly needed.

Second, the quality of capital flows poses new risks and policy dilemmas. The developing countries have witnessed a sharp rise in 'hot money' and portfolio investments in recent years. Since the bulk of portfolio investments are short-term and speculative in nature, their contribution to economic growth in host countries is minimal. Besides, a great deal of portfolio investments are prone to reversals. Sudden withdrawal of capital can negatively impact on the exchange and interest rates. Several episodes of financial crisis in Mexico, Southeast Asia and Turkey in the 1990s point to the preeminent role of unregulated short-term portfolio flows in precipitating a financial crisis.

Rethinking FDI

Even foreign direct investment (FDI) is not a panacea for economic growth and development. There is hardly any reliable cross-country empirical evidence to support the claim that FDI per se accelerates economic growth. In the present circumstances, it is quite difficult to establish direct linkages between FDI and economic growth if other factors such as competition policy, labour skills, policy interventions and a comprehensive regulatory framework are not taken into account. Further, in the absence of  performance requirements and other regulations, many of the stated benefits of FDI would not materialise.

In the last two decades, the attributes of FDI flows, known for their stability and spillover benefits, have also changed profoundly. FDI is no longer as stable as it used to be. The stability of FDI has been questioned in the light of evidence which suggests that as a financial crisis becomes imminent, transnational corporations (TNCs) indulge in hedging activities to cover their exchange rate risk, which, in turn, generates additional pressure on the currencies.

Since the bulk of FDI flows are associated with cross-border mergers and acquisitions, their positive impact on the domestic economy through technological transfers and other spillover effects has also been significantly diluted.

In most developing countries such as India, China and Malaysia, FDI is often encouraged because it is non-debt-creating capital. It is true that FDI does not involve the direct repayment of debt and interest, but at the same time, it does involve substantial foreign exchange costs. Capital can move out of a country through remittance of profits, dividends, royalty payments, and technical fees. In the case of Brazil, foreign exchange outflows in the form of profits, royalty payments, and technical fees rose steeply from $37 million in 1993 to $7 billion in 1998.

Due to rapid financial liberalisation, the trend of significant foreign exchange outflows with a resulting negative impact on a country's balance of payments has gained additional momentum. This trend is most evident in several African economies such as Botswana, the Democratic Republic of Congo, Gabon, Mali, and Nigeria where profit remittances alone were higher than FDI inflows during 1995-2003.

If FDI is not related to exports, it can have serious implications for developing countries which are usually short of foreign exchange reserves. In India, a recent study by the central bank, the Reserve Bank of India (RBI), found that over 300 TNCs were net negative foreign exchange earners. Most services are usually not tradable, meaning that they need to be produced and consumed domestically. Given that the share of services in total FDI inflows has increased in recent years, foreign investments in the telecom, energy, construction, retail and other non-tradable sectors would involve substantial foreign exchange outflows over time in the form of imports of inputs, technology, royalty payments, and repatriation of profits. Thus, any cost-benefit analysis of foreign investment in the service sector should include such capital outflows based on an initial investment.

In addition, capital can also move out of the country via illegal means such as abusive transfer pricing and creative accounting practices. It is an established fact that transnational corporations indulge in manipulative transfer pricing to avoid tax liabilities.

Only recently, tax authorities, particularly in the developing world, have taken cognizance of widespread abuse of transfer pricing methods by TNCs. Several African leaders have used Western banks and tax havens to move millions of dollars in illicit money out of their countries. A recent study by Global Financial Integrity (Dev Kar and Devon Cartwright Smith, Illicit Financial Flows from Developing Countries 2002-2006, Global Financial Integrity, Washington DC, December 2008) estimated that 'illicit financial flows out of developing countries are some $850 billion to $1 trillion a year'.

Policy challenges

For developing countries, it becomes very difficult to maximise the benefits and minimise the costs of capital flows. How can they manage the impossible trinity - free capital movement, a fixed exchange rate and an independent monetary policy? As pointed out by D Subbarao, Governor of the RBI, 'If central banks do not intervene in the foreign exchange market, they incur the cost of currency appreciation unrelated to fundamentals. If they intervene in the forex market to prevent appreciation, they will have additional systemic liquidity and potential inflationary pressures to contend with. If they sterilise the resultant liquidity, they will run the risk of pushing up interest rates which will hurt the growth prospects.' (D Subbarao, 'India and the Global Financial Crisis: Transcending from Recovery to Growth', Comments at the Peterson Institute for International Economics, Washington DC, 26 April  2010)

If the developing countries hold large foreign exchange reserves as a buffer against sudden capital outflows, it poses new challenges and risks. Large forex reserves put pressure on a country's exchange rate so that the currency appreciates, negatively affecting the competitiveness of exports. Excessive reserves could induce asset price bubbles and higher inflation by way of an excessive money supply. There are fiscal costs as well, as the authorities may lose control of monetary policy.

Therefore, current approaches advocating liberalisation of the capital account in the developing countries should be revisited. In particular, attempts to liberalise the investment regime of the developing countries through bilateral investment and trade agreements should be reconsidered. The existing frameworks of investment treaties are highly biased in favour of protecting foreign investors' rights while constricting the policy space of countries to intervene in the public interest. Take the case of the North American Free Trade Agreement (NAFTA). Private corporations from NAFTA member countries have exploited the provisions of the agreement to challenge those regulatory measures that infringe on their investment rights. The growing conflicts between private corporations and regulators are the outcome of the investment provisions under Chapter 11 of NAFTA which entails non-discriminatory treatment to foreign investors. It is in the interest of developing countries to make sure that investment treaties do not constrict the policy space to manoeuvre investment policies in accordance with their developmental priorities.

In the wake of the financial crisis, certain bilateral agreements (such as US-Chile and US-Singapore) which curb the use of capital controls need to be revised. The US and other developed countries' insistence on curbing capital controls is baffling particularly when there has been a rethink on capital account liberalisation due to recent financial crises.

Promoting financial inclusion

For a large number of developing economies, financial inclusion remains a key policy objective. There are vast sections of the population which lack access to banking and other financial services. These countries are seeking financial innovation to deliver financial services to remote and poor areas. Therefore, financial innovation should be driven by the objectives of social and developmental banking.

The recent experiences in many developing countries including India and China clearly show that unlike state-owned banks, both foreign and private banks are reluctant to provide affordable banking services (such as bank accounts, credit, remittance and payment services) to disadvantaged and poor people who are financially excluded. The urban-centric foreign banks in India largely serve the niche market segments consisting of high-net-worth individuals and large corporations. In India, the role of foreign banks in social and development banking is negligible. The inclusive banking is carried out by state-owned and local cooperative banks.

Since financial inclusion helps people to come out of poverty, any new financial architecture should emphasise financial inclusion. A stable financial system should contribute to economic growth and sustainable development. The linkages between finance and development need to be strengthened. Rather than resembling a casino in which assets are traded primarily for speculative profits, the financial system should serve the real economy and sections of society who are financially excluded.

For developing countries, a selective de-linking from fly-by-night financiers and 'hot money' flows is not only desirable but also feasible. Countries should strongly resist the temptation to set up offshore financial centres within their jurisdictions. In addition, countries will have to take precautionary measures to strengthen their domestic financial system and closely supervise their external debt position, especially short-term debt.

This could be followed up with a fundamental reorientation of the domestic financial system and the real economy with selective linkages with the globalisation processes. The financial system should be modified to serve the needs of the real economy and particularly those sections of society who have been marginalised by market forces. Though the role of foreign investment cannot be negated, growth must emanate primarily from domestic savings and investment. Rather than a focus on export-led growth, domestic markets should act as the prime engines of growth. Besides, the principle of equity must be at the top of the agenda of governments.

Domestic resource mobilisation is essential for building sustainable development. A progressive broad-based direct taxation system has the ability to enhance domestic financial resources. This will help poor and developing countries to finance an increasing share of their development needs from domestic sources. The developing countries should also rethink the costs and benefits of bilateral tax treaties in the form of double taxation avoidance agreements. At present, there are more than 3,000 tax treaties in force throughout the world. India alone has entered into over 75 bilateral tax treaties. The tax authorities should undertake provisions to prevent the frequent abuse of tax treaties through treaty shopping and round-tripping.

The poor and developing countries should effectively use credit controls to encourage disbursement of credit to agriculture, small businesses and weaker sections of society.

Banking services liberalisation

In the wake of the global financial crisis, there should be serious rethinking on banking sector liberalisation and deregulation at the international level. The proponents of banking services liberalisation tend to overlook the potential costs associated with the entry of foreign banks in host countries. If the entry of foreign banks is allowed through acquisition of domestic banks, it may lead to concentration of banking markets and loss of competition. In many Latin American countries such as Brazil and Chile, there was a considerable decline in competition in the aftermath of liberal entry of foreign banks.

The foreign banks can be a source of cross-border contagion from adverse shocks originating elsewhere. As illustrated by the global financial crisis, a large presence of foreign banks from crisis-ridden countries could lead to rapid transmission of financial shocks in the host countries. The parent bank may also reduce exposure in a host country or move out completely due to losses suffered in home or other countries. A number of European banks have exited from Asian countries as the crisis forced them to focus on their home markets. The Royal Bank of Scotland is seeking to exit from or shrink its operations in 36 countries (including India and China) due to problems at its parent bank.

In the light of recent experience, it is highly debatable whether the presence of foreign banks has a stabilising role in the case of a systemic crisis. In Argentina, for instance, several foreign banks chose to leave the country when a financial crisis erupted in 2001.

In addition, the entry of foreign banks poses new challenges to regulation and supervision. The regulatory and supervisory authorities are restricted to their national borders while foreign banks can easily cross national borders and operate internationally. The overall responsibility for the parent bank remains with the regulatory authorities in the home country. But there is little coordination and sharing of information among the regulatory authorities of home and host countries.

Keeping these important developments in view, policy makers in developing countries should rethink the benefits of opening up banking and financial services under bilateral trade agreements with developed countries.

Trade finance is another area where the impact of the global crisis was disproportionately felt by small-  and medium-sized enterprises (SMEs) in the poor and developing world. Evidence suggests that SMEs in the Philippines, India and Mexico were crowded out by large firms trying to access trade finance. The deterioration in trade finance markets led to a sharp rise in spreads on credit and insurance costs, which in turn made trade finance transactions highly expensive. In the earlier episodes of financial crisis in emerging markets such as the Southeast Asian crisis in 1997 and the Argentine crisis in 2001, trade finance (particularly the short-term segment) dried up.

One of the main causes behind the current contraction in trade finance is the pro-cyclical effect of Basel II rules devised by the Basel Committee on Banking Supervision of the Bank for International Settlements. Basel II rules impose a significant increase in the risk weight for trade finance in comparison with Basel I rules. Certain provisions need to be amended to make sure that trade financing is not constrained by capital adequacy rules outlined under Basel II.

Even though securitisation and derivatives markets are in the nascent stage in most developing countries, the national regulatory authorities should strengthen the regulatory and supervisory frameworks before such financial products are allowed.

Giving developing countries a say

The poor and developing countries are not adequately represented in international financial policy forums and institutions (other than the United Nations). This is best reflected in the Group of 20 (G20), which is considered to be a major international institutional innovation of recent times. At the G20, only a handful of big developing economies are part of discussions on global monetary and financial issues. South Africa is the only African country, representing over one billion people at the G20. Critics have pointed out that the agenda-setting of the G20 is predominantly done by the developed countries.

The Bank for International Settlements (BIS) is an international financial institution where 13 of its 19 board members represent Europe.

Unlike developed countries, there is hardly any meaningful coordination among the developing countries on global financial and monetary issues. The existing forums consisting of developing countries lack multilateral credibility because of poor representation of smaller and weaker developing economies.

The G24 (Intergovernmental Group of Twenty-Four on International Monetary Affairs and Development) is an old forum which represents the position of developing countries on monetary and development finance issues. But the G24 lacks strong political backing by some of its large member countries such as India and Brazil, which diminishes its potential role in reforming the international financial system.

The new forums among developing countries such as IBSA (a trilateral developmental initiative between India, Brazil and South Africa to promote South-South cooperation) and the BRIC (Brazil, Russia, India and China) Summit have pushed the agenda of reforming the international financial system but are very limited in their memberships.

What is missing is the voice and representation of non-BRIC developing countries in the ongoing debates at various international forums.     

Kavaljit Singh is associated with Madhyam, a non-profit research organisation based in New Delhi (www.madhyam.org.in). This article is based on a forthcoming research study to be published by Madhyam and SOMO (Netherlands).

*Third World Resurgence No. 238/239, June-July 2010, pp 34-37