Economic benefits and costs of free movement of capital part 1
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What can economic theory tell us about the economic benefits and costs of the free international movement of capital? By reference to one of more recent financial crises, assess whether there is a significant case for the adoption of restrictions on such movements.
Widely thought of as an important aid to development, the record of capital market liberalisation for developing countries has been mixed. What follows is a discussion of the benefits and costs of liberalisation which leads to an argument for capital restrictions given the recent events of the Asian crisis.
The most cited benefit of capital flows is the international de-linking of savings and investment which allows for a more efficient global allocation of capital. This idea is coupled with the neo-classical production function, in particular Solow’s Growth model, which exhibits diminishing returns to capital, demonstrates that greater returns to capital can in theory be achieved by transfer to developing countries. This transfer of capital will enhance growth and living standards in the developing country if utilised in sound investment for the future. Second, financial benefits which include portfolio diversification, risk sharing and intertemporal trade (Eichengreen, et al. 1999) raise welfare for both developed and developing countries by improving allocative efficiency of investment; maximising investment options as a result of different age structures, saving rates, opportunities for investment and risk profiles between countries. The greater urgency and opportunities for a developing country to invest today allows them to borrow in advance to invest, and indeed there should be an even greater potential to do this in the future with the ageing population of developed countries becoming a larger source of savings. Third, the ability of a country to borrow should allow it to act counter-cyclically to falls in national consumption and thus smooth major fluctuations, although as explained later this is not always possible. Fourth, there are gains of specialisation and competition to be made. Firstly a small developing country will be able to import financial services, freeing resources enabling it specialise elsewhere. Alternatively it is argued that the presence of foreign financial services will promote efficiency in the domestic sector, raising productivity.
Another commonly cited benefit is that capital flows put governments under a “Golden Straitjacket” (Friedman, T. 2002), a recent example being the experience of Lula’s government in Brazil. Capital mobility is believed to promote good policies as the government’s decision are keenly watched by the market, and thus unsound macroeconomic policies will be severely punished; in effect “your economy grows and your politics shrinks” as capital flows fix in political support for reforms. However, this relationship may prove capricious as capital inflows switch from flood to drought, in addition to the perverse short term anti-growth policies that the straitjacket may enforce.
Special mention should be made of the benefits of Foreign Direct Investment (FDI). FDI’s have proved stable during times of crisis and present a developing country will additional spillover benefits. The relocation of manufacturing plants and customer services have not only improved human capital and managerial know-how but also bring rapid technological transfer and facilitate access to the international markets by establishing a competitive export capacity. Recently however the stability of FDI has been called into question as multinational companies have increasingly hedged their short term foreign exchange risks, and increased financial engineering and re-labelling have blurred the relative volatilities of flows.
The costs of capital market liberalisation are more numerous and shall be covered expediently. The most common argument is the presence of asymmetric information, resulting in three market failures: adverse selection, moral hazard and herding. These asymmetries prevent the efficient allocation of resources, and are amplified by international transactions typically associated with low quality information. Adverse selection will deter desirable transactions, because perverse incentives ensure that lower quality firms crowd out high quality firms. Moral hazard identifies the propensity for borrowers to increase the risk of their project once they have carried out the transaction. Two prime examples are when the government guarantees various firms without necessary supervision to prevent excessive risk taking, and when the government guarantees against domestic bank failures which encourages excessive inflows. Herding behaviour carries the burden of systematic risk, since the presence of information cascades give rise to rational volatility. This has been emphasised by the increasing use of market sensitive risk management techniques (Persuad, 2000) and increasing salience of short term profits for investment managers. Furthermore, correlations between industry segments and emerging markets give rise to inter-industry and international contagion, deepening the consequences of volatility. Second, the effect of domestic trade distortions reduces allocative efficiency, as demonstrated by Brecher and Diaz-Alejandro (1977). They show that protection of capital intensive industries attracts capital to lower-value uses which reduces world welfare.
Third, the economic theory of the “incompatible trinity” (Obstfeld and Taylor, 1998) – specifically the inability to maintain a fixed exchange rate, free capital mobility and an independent monetary policy at the same time – leaves a country with a fixed exchange rate unable to lean against the wind. Reducing capital flows enables a country to “square the triangle” (Williamson et al., 2003), and act counter cyclically to its employment, inflation and the balance of payments variations. This is in contrast to perfect mobility which generates strong biases toward pro-cyclical macroeconomic policies (Kaminsky et al, 2004).
Fourth, Ocampo and Martin (2003) discuss the three asymmetries that exist between developed and developing countries. Firstly the “Original sin” (Eichengreen, Hausman and Panizaa, 2003) of developing countries’ inability to issue liabilities in their own currencies leading to currency mismatches. Secondly the undersupply of long term financial instruments causing maturity pressures. Thirdly the small size of the domestic financial market against the speculative pressure they face (Mead and Schwenninger, 2000). Whilst these are strictly not problems with capital market liberalisation, they demonstrate the vulnerabilities the emerging market face if they liberalise too fast.
Fifth, IMF statistics show the rapid tripling of net flows to $150 billion from 1987-1997 lead to a real appreciation of the exchange rates of emerging markets. This occurs either via the nominal exchange rate under a flexible regime or an increase in prices under a fixed exchange rate. Bhagwati (2004) suggests that these excessive capital
