Liberalization, Financial Instability and Economic Development

Front matter

Anthem Frontiers of Global Political Economy

The Anthem Frontiers of Global Political Economy scries secks to trigger and attract new thinking in global political economy, with particular reference to the prospects of emerging markets and developing countries. Written by renowned scholars from different parts of the world, books in this series provide historical, analytical and empirical perspectives on national economic strategies and processes, the implications of global and regional economic integration, the changing nature of the development project, and the diverse global-to-local forces that drive change. Academics featured in the series extend earlier economic insights to provide fresh interpretations that allow new understandings of contemporary economic processes.

Series Editors

PART ONE LIBERALIZATION, STABILITY AND GROWTH Chapter I

B. Interest Rates and Savings

C. Financial Liberalization and Deepening

D. Allocative Efficiency

E. Productive Efficiency and Cost of Finance

E Regulation of Finance and Financial Stability G. Options in Financial Organizations

H. External Liberalization and Financial Openness I. Conclusions

Chapter II

Managing Financial Instability in Emerging Markets: A Keynesian Perspective

B. The Keynesian Instability Hypothesis and Financial Cycles

C. Investment and Jobs over the Financial Cycle

D. The Policy Problem

E. Capital Flows and Countercyclical Monetary Policy

E Reserve Accumulation as Self-Insurance

G. Financial Regulations, Capital Controls and Risk Management H. — Conclusions

Chapter III From Liberalization to Investment and Jobs: Lost in Translation

A. — Global Economic Integration and the Labor Market B. Capital Formation, Growth and Employment

C. Managing Profits and Accumulation

D Macroeconomic Policy: What Policy?

19 19 22 24 27 29 32 37 45

73 76 88 92 vill LIBERALIZATION, FINANCIAL INSTABILITY AND ECONOMIC DEVELOPMENT

E. Financial Instability, Investment and Employment 97 E Policy Priorities 104 Chapter IV

Exchange Rate Management, Growth and Stability: National and Regional Policy Options in Asia

A. Introduction 117 B. Exchange Rate, Trade and Growth 119 C. Capital Flows, Exchange Rates and the Real Economy 131 D. Managing Capital Flows and Exchange Rates 135 E. Recent Experience in Asia 145 E Regional Monetary Cooperation for Stability 152 G. — Conclusions 165 Chapter V

Reforming the IMF: Back to the Drawing Board

A. Introduction 183 B. The Original Rationale and the Postwar Evolution of the IMF 184 C. Mission Creep into Development Finance and Policy 189 D. _ Trespassing in Trade Policy 191 E. Crisis Management and Resolution: Bailouts or Workouts? 194 E Restructuring IMF Lending and Supplementing Resources 198 G. — Ineffectiveness and Asymmetry of Fund Surveillance 202 H. Governance: Making the Fund a Genuinely Multilateral Institution 207 I. Summary and Conclusions 210 PART TWO

THE GLOBAL ECONOMIC CRISIS AND DEVELOPING COUNTRIES Chapter VI

The Current Global Financial Turmoil and Asian Developing Countries

A. Introduction 223 B. The Role of Finance in the Recent Global Expansion 224 C. Expansion and Crisis in the United States 225 D. Capital Flows and Vulnerability in Asia 231 E. External Shocks and Policy Options in Asia 241 F Conclusions 249

CONTENTS

Chapter VII The Global Economic Crisis and Asian Developing Countries: Impact, Policy Response and Medium-Term Prospects

Introduction

The Great Financial Bubble, Global Expansion and Imbalances Asian Vulnerabilities and Spillovers from the Crisis

Policy Response and Recovery

Medium-Term Prospects and Policy Challenges a Oy eS

Conclusions: Policy Issues and Lessons

Chapter VIII The Staggering Rise of the South?

Introduction and Summary

The Growth Record

Global Economic Conditions

Impact on Macroeconomic Balances in DEEs Impact on Growth in DEEs

The Role of South-South Trade and China

Crisis and Recovery

Sustainability and Vulnerabilities

Conclusions: Reconsidering Policies and Strategies

Mon Oh oO & >

259 260 264 274 278 285

INTRODUCTION!

Globalization is understood and promoted as absolute freedom for all forms of capital, above all financial capital, while restrictions continue to shape the markets for goods, labor and technology. This has reduced the power of nations to regulate and control their own economic space, shifted the playing field against labor and industry, and led to growing financialization of the world economy. Two important consequences are increased instability and inequality. Moreover, for developing countries (DCs) the benefits of unleashed finance have proved to be highly elusive. It has not only meant loss of crucial policy tools for industrialization and development, but has also exposed them to severe global financial cycles, as seen once again during the recent turmoil originating in the US and Europe. Thus, the belief that DCs have decoupled from the North and become new engines of global growth has turned out to be a myth.

This book urges DCs to be as selective about globalization as advanced economies (AEs), better manage their integration into an inherently unstable international financial system, rebalance domestic and external sources of growth, and manage market forces by strengthening public control. It brings together several papers written since the mid-2000s, except the first one which goes back two decades. It is organized in two parts. Part One examines the impact of financial liberalization on stability and growth in DCs and national, regional and global policy options in reducing instability. Part Two focuses on the current financial crisis in AEs, its spillovers to DCs and consequences for their medium-term prospects.

Chapter I, on the pitfalls of financial liberalization, was written in the heydays of globalization and the Washington Consensus and addresses the kind of issues that have become hotly debated since the onset of the financial crisis in AEs. It examines potential risks associated with domestic financial deregulation and capital account liberalization that were widely pursued by DCs at the time. Its main message is that the focus of financial policies in DCs should be stability, industrialization, growth and development, noting that in all modern examples of industrialization, finance was made to serve industry and trade not the other way round. This necessitates a considerable degree of public intervention and control over financial institutions and markets. While in some cases interventions may have been misguided in the past, the waste and inefficiencies they generated cannot be compared with enormous damages and misery resulting from the operation of unfettered financial markets, as seen time and again during recurrent crises in emerging and mature economies since the great waves of liberalization in the 1980s and 1990s. Ironically and for the same reason, liberalization has not diminished but significantly increased public intervention in finance, though in different forms — to clean the mess and repair the damages that financial crises create, including bailouts and nationalization of insolvent financial institutions.

The chapter starts with a critical examination of orthodox propositions on the benefits of financial liberalization, notably removal of control over interest rates and credit allocation, recommended as a remedy to many ills of DCs including poor savings, investment and productivity. It is argued that there are no compelling theoretical reasons for a shift to a regime of higher real interest rates to raise aggregate savings and investment. On the other hand, while liberalization often leads to financial deepening, this does not always result from higher savings or a shift from unproductive assets to productive investment. A shift into financial assets does not necessarily improve efficiency because financial markets and institutions often fail to direct resources to their socially more productive uses. Market signals governing resource allocation do not always reflect fundamentals. This is a main reason why DCs need government intervention in the form of directed and preferential credits to support socially productive investment and accelerate industrialization, as successfully practised in late industrializers such as Japan and Korea. Nor are financial institutions always productively efficient. Liberalization may reduce intermediation costs by creating competition, but can also raise the risk premium and hence the cost of finance by leading to greater instability and uncertainty.

Stability is an essential attribute of an efficient financial system and this is what governments strive to achieve through prudential regulations. However, the record in this respect is quite dismal. ‘There has been a constant battle between regulators and the market, with the latter successfully innovating and introducing new practices to escape restrictions or moving business to unregulated segments of the system. Regulations are often designed to fight the last crisis not the next one, thereby falling behind market practices. The international community has now landed on “macroprudential policy” — not an altogether reliable or well-developed tool to curb excessive risk taking (Elliott et al. 2013).

The efficiency and stability of the financial system also depend on how it is organized. Traditionally a distinction is made between two systems. In the Anglo-American market-based system of finance, banks focus on short-term lending and hence need only adequate reserves and access to lender-of-last-resort financing to avert liquidity crises, while corporate investment depends mainly on share and bond issues in the capital market. By contrast, the German- Japanese bank-based system involves long-term lending by banks and hence necessitates substantial own capital to safeguard solvency. Historically the latter is found to be more stable. It reconciles the Keynesian dilemma of the need of the society for productive investment with the desire of individuals to remain liquid without leading to short-termism and instability.

However, there are a number of prerequisites for an efficient and stable bank-based system and these are not always fulfilled in practice. Thus, important instances of severe banking instability and crises are found not only in DCs but also in AEs. Moreover, not only are there variations within the bank-based and market-based systems, but also the distinction between the two has become hazy over time. For instance with the repeal of the Glass-Steagall Act in 1999, the US moved toward a system of market-based banking with a significantly increased role for banks (Hardie and Howarth 2013). Overall, the benefits claimed for market-based systems are unsubstantiated and DCs are well advised to strengthen their banking system to suit their needs rather than emulate the market-based model. However, it should not be forgotten that under a hands-off approach, any system of finance can go awry.

Chapter I finally turns to financial openness. It is argued that the mainstream view, widely held at the time of the writing of the chapter, that capital account liberalization may cause difficulties only if there are imbalances and distortions elsewhere in the economy, has no sound theoretical or empirical basis. This is also true for the benefits claimed for international capital flows in the allocation of global savings. The bulk of gross flows of capital are motivated by prospects of short-term gains rather than real investment opportunities and considerations of long-term risks and return. Rather than securing greater fiscal and balance of payments discipline they tend to support inappropriate policies with potentially very damaging consequences for economic and social welfare.

The chapter goes on to examine the recovery of capital inflows to Latin America in the early 1990s, after a ten-year drought during the preceding debt crisis, and finds parallels with the surge to the Southern Cone in the 1970s, which had culminated in a severe crisis. It thus anticipates a series of subsequent crises in emerging economies (EEs) beginning in Mexico in 1994—95.? While the ideal response to such a surge is to raise investment in traded goods sectors, the conditions attracting foreign money such as high interest rates and currency appreciations do not favor such investment. Nor could this always prevent an eventual crisis because of maturity mismatches due to the financing of long-term investment with short-term and highly fickle foreign money. Thus, there is a need to exercise considerable control over capital inflows.

Chapter II focuses in greater detail on policy options in managing financial instability in EEs, noting that boom—bust cycles in such economies are closely related to global financial cycles and international capital flows. In the past two decades in the developing world currency and balance of payments crises have occurred under varying conditions with respect to current account and budget balances, inflation, currency appreciations, public or private indebtedness, consumption or investment booms, and regulatory oversight of financial institutions. This experience casts serious doubts on the orthodox thinking that such crises arise mainly from domestic policy shortcomings and inconsistencies and exposes the dogma that price stability is necessary and sufficient for macroeconomic and financial stability. The endogenous unstable dynamics analysis developed by post-Keynesians, notably Hyman Minsky, goes a long way in providing a framework for understanding boom—bust cycles driven by international capital flows in EEs.

Keynesians do not have much faith in monetary policy in restraining bubbles or fighting debt deflation and recessions. Bubbles can better be checked by controlling the growth of bank assets through regulatory instruments. During downturns, the “Big Bank,” the lender-of-last-resort, can deal with debt deflation while a “Big Government,” a spender-of-last-resort, can stimulate income and employment. However, as the chapter warns, such interventions could sow the seeds of the next crisis. For instance, the monetary policy response to the bursting of the dot-com bubble in the early 2000s played an important role in the subsequent subprime bubble while the response to the subprime crisis through zero-bound rates and quantitative easing (QE) now risks creating yet another bubble.

In EEs, where boom—bust cycles are closely intertwined with swings in capital flows and external debt is denominated in reserve currencies, stabilization is much more complicated than in the US and other major reserve-currency issuers. In these economies during downturns and capital flight, the “Big Government” cannot borrow abroad in reserve currencies and the “Big Bank” cannot print international liquidity. Even a straightforward liquidity crisis can thus lead to widespread insolvencies among banks and other private debtors, as seen in Asia in the 1990s. For these reasons, it is all the more important to start countercyclical policy in good times and manage surges in inflows and avoid the build-up of fragility.

However, under capital account openness the erosion of monetary policy autonomy goes well beyond what is portrayed in the standard theory of the impossible trinity.’ There are limits to how effectively macroeconomic policy can be used to simultaneously overcome currency and payments imbalances and credit and asset bubbles caused by a surge in capital inflows and without compromising domestic policy objectives. Still, in its latest institutional view on capital controls the Fund insists that in managing capital flows “a key role needs to be played by macroeconomic policies, including monetary, fiscal and exchange rate management” while capital controls should be used in exceptional circumstances, only as a last resort and on a temporary basis.‘ However, there is no practical or theoretical reason for any economy with judiciously designed policies to attain stability and growth, and debt and balance of payments sustainability to alter the mix and stance of its macroeconomic policies when faced with an externally generated unsustainable surge in capital flows. For such an economy, capital controls can be the first best measures to insulate domestic conditions from external financial pressures.

In reality many governments in EEs use interventions in currency markets to deal with surges in capital inflows and accumulate reserves as self-insurance against sudden stops and reversals. Indeed, contrary to expectations that the need for reserves would diminish as DCs gained access to international capital markets, there is a strong correlation between reserve holding and capital inflows. Interventions and reserve accumulation could no doubt prevent appreciations and deterioration of the current account, but they cannot always be fully sterilized. Nor can they prevent currency and maturity mismatches in private balance sheets. They, in effect, provide public insurance against private risks with the full carry costs, estimated to be in the range of $100 billion per annum in 2007, borne by governments. There is little rationale to allow hot money to enter the economy and invest it in low yielding reserve assets as self-insurance against its exit.

The chapter concludes that a central and permanent role should be played by financial regulations and capital controls in managing surges in inflows. Prudential rules appropriately extended to foreign exchange positions and transactions including quantitative limits, special loan loss provisions, and liquidity, reserve and capital requirements can help mitigate maturity and currency mismatches and exchange-related credit risks. But, since a very large proportion of capital inflows are not intermediated by the banking system, there is a need to go beyond such measures and introduce market-based and/or direct controls over portfolio and FDI inflows and foreign borrowing.

Chapter III reviews the record under globalization, as of 2006, on capital formation and job creation, focusing on the role played by liberalization of capital flows as well as macroeconomic policy. Its main message is that increased international capital flows have served to redistribute investment and jobs among countries rather than leading to a generalized acceleration of capital formation and employment generation. Capital has become increasingly footloose in all its forms and this, together with a large global reserve army of labor, has created opportunities for labor arbitrage for transnational corporations. However, this has not produced a significant convergence of wages between DCs and AEs, but swung the playing field in favor of capital, reducing the share of labor income in world output — a trend that has continued unabated since the writing of the chapter (UNCTAD TDR 2013; Stockhammer 2012). Increased concentration of incomes has not resulted in faster accumulation of productive capital. Indeed, a distinct feature of the period since the 1980s is that investment typically generates more profits while profits are invested less and less in productive capital.

In DCs in the past two decades, inward FDI as a percentage of GDP has shot up but the investment ratio has shown no tendency to rise. A large proportion of FDI, as conventionally defined, constitutes financial operations involving transfer of ownership of existing assets rather than expansion of productive capacity. As the chapter shows, the record of DCs that embraced a strategy of reigniting capital accumulation and growth through a combination of rapid external liberalization, increased reliance on foreign capital and reduced public investment is particularly dismal.

Macroeconomic and financial policies have played a major part in the paucity of productive accumulation and jobs. Governments in many AEs have shifted to fiscal orthodoxy and abandoned fiscal policy as a tool of macroeconomic management whereas procyclical policy has been widespread in DCs, except for a brief period after the collapse of Lehman Brothers in 2008. However, despite the growing aversion to Keynesian fiscal management, chronic public deficits emerged and public debt has grown faster than output in most major AEs, in large part due to supply-side tax policies and financial bailout operations. In DCs, although external sovereign debt generally declined, there has been an unprecedented accumulation of domestic liabilities, an increasing proportion of which has been acquired by nonresidents.

Almost all financial bubbles are associated with excessive investment, not only in property but also in industry, which cannot be sustained with the return to normal conditions, leading to prolonged underutilization and even destruction of productive capacity. This is a main reason why investment is the most unstable component of aggregate demand and why its volatility has increased in the recent period of financial liberalization. Typically, it falls a lot faster under financial busts than it rises during booms. This is also true for wages and employment.

Recoveries from recessions brought about by financial crises are weak and protracted because it takes time to repair balance sheets — to remove debt overhang and unwind excessive and unviable investments generated during the bubbles that culminate in such crises. They also tend to be jobless and yield little investment as increases in incomes are used to pay off debt. This was the case in the US during recoveries in the early 1990s and 2000s from recessions brought about by the bursting of credit and asset bubbles. It has been even more so in the current recovery from the subprime recession — the precrisis income had been restored by the second quarter of 2011, but employment was lower by some 6.5 million. In this latter case policy shortcomings regarding debt restructuring and fiscal stimulus have also played a major role in delaying recovery, thereby leading to unnecessary losses of output and employment (Akyüz 2014). A similar pattern of sluggish job and investment growth is also a common feature of recoveries in DCs following financial crises.

Chapter IV turns to exchange rate management, noting that it occupies a central position in the policy debate in DCs for two reasons. First, as a result of the increased emphasis on export-led growth and reduced barriers to trade, the exchange rate has gained added importance. Second, because of growing integration of DCs into international financial markets, exchange rate gyrations have become a major source of macroeconomic and financial instability.

Trade is the main link between the exchange rate and economic growth but this is not always adequately accounted for in the literature. The conventional trade theory emphasizes supply-side linkages between trade and growth while the Keynesian analysis focuses on the demand-side and the balance of payments constraint. However, since growth cannot be sustained without accumulation, any link between trade and growth should encompass investment. Successful examples of late industrializers in East Asia suggest a virtuous link between exports and investment, or a dynamic “export—investment nexus,” incorporating both supply and demand linkages. While there are limits to what the exchange rate can achieve on its own, stable and competitively valued exchange rates are an essential part of industrial development and call for a judicious management of capital flows.

It is the capital account regime not the exchange rate regime that holds the key to success in maintaining stable and appropriately aligned exchange rates. Under a hands-off approach to capital flows, neither fixed nor freely floating rates can work. Stable and competitively valued exchange rates would require occasional adjustments in the nominal value of the currency in order to realign them and avoid gyrations. A viable system thus combines a certain degree of flexibility in the exchange rate regime and a considerable degree of control in the capital account regime.

While most East Asian DCs use considerable discretion in the management of capital flows and exchange rates, there have been large swings in intraregional exchange rates during the boom—bust cycles in capital flows in the new millennium. This instability owes a great deal to inconsistencies in the exchange rate regimes pursued by the countries in the region, spanning the whole spectrum between the two corners of independent floating and the currency board, with the intermediate regimes also showing significant variations with respect to how tightly the pegs are managed. ‘The coexistence of a variety of regimes entails significant intraregional swings at times of large movements of the dollar against other reserve currencies. This is a matter of concern at a time of rapid economic integration of the region and provides a strong rationale for intraregional exchange rate cooperation.

The scope for replicating the European Monetary System (EMS) by pegging bilaterally and floating collectively faces a number of hurdles. Fixing all regional currencies to the dollar (or any other reserve currency) would secure intraregional stability, but this would imply loss of monetary policy autonomy as well as wild fluctuations against third currencies. Such an option might be appropriate for countries looking for a credible external anchor but not for East Asia which has a better record of monetary and fiscal discipline than the US. A viable option could be a crawling peg vis-a-vis a common basket of reserve currencies with agreed central parities and bands. This would have to be supported by regional institutions and mechanisms designed to prevent the emergence of imbalances and crises. A number of lessons can be learned from the EMS, including its shortcomings in areas such as macroeconomic policy coordination, currency adjustment, market regulation and surveillance, the capital account regime and intraregional lending.

Regional arrangements are second best, defensive mechanisms against systemic global financial instability. Addressing the root causes of the problem requires a major overhaul of the international financial architecture to establish its key missing ingredients. These include effective multilateral disciplines over misguided policies in systemically important, reserve-issuing countries whose macroeconomic and exchange rate policies and financial institutions exert a disproportionately large impact on international monetary and financial conditions. Effective rules and regulations needed to bring inherently unstable international financial markets and capital flows under control are also lacking.

As discussed in Chapter V, the IMF holds a central position in this undertaking.” However, it has increasingly moved away from its central task of prevention of imbalances and crises toward crisis lending as well as areas which fall outside its mandate and expertise. The IMF needs to go back to its core objectives and stay out of development finance and policy and poverty alleviation. Its main task is crisis prevention not crisis lending. The more it has failed to prevent instability and crises, the more it has become involved in crisis lending; so much so that it has come to depend on crises to remain relevant. IMF bailouts tend to add to systemic instability by undermining market discipline and creating moral hazards for lenders. They also distort the balance between creditors and debtors. There should be strict limits to IMF crisis lending and ways and means should be found to involve private creditors in crisis resolution through voluntary and involuntary mechanisms and orderly debt workouts. Temporary debt standstills and exchange restrictions should become legitimate ingredients of multilateral financial arrangements.

To bring greater authority and legitimacy to the IMF, any reform should address shortcomings in its governance system. The IMF cannot be an impartial institution if it continues to rely on a handful of its members for funds needed to lend to others in payments difficulties and if its financial operations remain linked to bilateral debtor— creditor relations among its members. Consideration should be given to using special drawing rights to fund the resources needed. This would also help move away from the dollar-centered international reserves system and the problems associated with it (Akyüz 201 2a).

Part Two has three overlapping papers written at different points of time during the crisis in AEs. Chapter VI, written in the early months of 2008 before the collapse of Lehman Brothers, focuses on the causes and depth of the subprime crisis and its potential impact on DCs, notably in Asia. It traces the subprime crisis back to financial deregulation that started in the early 1980s.

The US banks lost their cost advantage as a result of removal of control over deposit rates in the early 1980s, at a time when deposits were losing importance as a source of funds for financial intermediation and growth of markets for commercial papers and increased securitization put a downward pressure on lending rates. They responded by going into riskier areas of lending, including for property and leveraged buyouts, and expanding their fee-based off-balance-sheet activities in the capital market through subsidiaries and affiliates. Simultaneously, securities firms and insurance companies started engaging in traditional banking activities without being subject to conventional prudential oversight.

All these strengthened the link between credit and asset markets, with credit expansions increasingly translated into asset bubbles and the bubbles leading to credit growth thanks to the practice of mark-to-market valuation. Rather than adapting regulatory policies to the new financial environment, the US authorities submitted to pressures for further deregulation, effectively demolishing the firewalls between commercial banking and investment banking in the late 1990s. This, together with sharp cuts in interest rates made in response to the bursting of the dot-com bubble in the early 2000s, allowed rapid expansion of speculative lending and investment which culminated in the subprime crisis.

The chapter maintains that a vigorous monetary policy response to the crisis would be helpful, but would not be able to overcome the difficulties since the crisis was one of solvency rather than liquidity. In the absence of measures directly addressing the debt (mortgage) overhang in the household sector, the recovery would be slow since marketdriven balance sheet restructuring 1s a protracted process.

The vulnerability of DCs to adverse financial spillovers from the crisis varied according to their prevailing macroeconomic and financial conditions which, in turn, depended largely on how the precrisis surge in capital flows was managed. Most Asian countries had been successful in avoiding unsustainable currency appreciations and balance of payments positions and were able to accumulate sufficient reserves through interventions in currency markets to counter any sudden stops and reversals in capital flows. However, they had not been able to prevent the surge of inflows from generating asset, credit and investment bubbles, in large part because of their reluctance in imposing sufficiently tight controls. As a result, they were exposed to certain risks from a reversal of capital flows, but not of the kind that had devastated the region during 1997—98.

The chapter argues that a sudden stop and reversal in capital inflows could happen as a result of a widespread flight toward quality, with investors taking refuge in the safety of government bonds in AEs, and/or of a growing need to liquidate holdings in EEs in order to cover mounting losses and margin calls — something that indeed happened later in the year after the collapse of Lehman Brothers. However, this was not expected to create serious payments difficulties in Asian DCs, but several countries in Central and Eastern Europe with large current account deficits and high levels of external debt. On the other hand, it was also recognized that capital flows to Asian DCs could accelerate if

Europe joined the US in easy monetary policy — as indeed happened after the Lehman collapse.

The prevailing view before the Lehman collapse was that Asian DCs would not be affected very much by the subprime crisis, partly because the severity of the crisis was underestimated and partly because exports to the US were seen to constitute a relatively small percentage of GDP in both China and other Asian DCs. However, the chapter argues, this did not account for the dependence of intraregional trade and domestic manufacturing investment on exports. Furthermore, the impact would deepen significantly with a possible spread of the crisis to Europe. Even then, however, sound macroeconomic conditions in the region would allow a strong countercyclical policy response to counter the contractionary impulses from the crisis. Nevertheless, China needed more than a countercyclical policy response — a durable shift from exports toward domestic consumption — since the crisis was expected to bring a sizeable and possibly durable external adjustment in the US.