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inflows have distorted the benefits of free trade as a result of the loss of competitiveness for the emerging markets. Whilst sterilisation or fiscal contractions can combat the appreciation, they are costly methods and hence politically unpalatable.

Sixth, capital controls can be used in a developing country as a source of revenue for the government when tax collection is difficult, or to allocate credit without risking capital flight (Johnston and Tamirisa, 1998.) Additionally the tax may be welfare improving in accordance of the Theory of the Second Best if they are used to correct an existing distortion, market failure or negative externality. Seventh, liberalising the capital market offers access for domestic investors to risky foreign investments and holdings which when unhedged can cause widespread insolvency in the event of large currency movements.

Eighth and perhaps the most important is that the inherent volatility of capital flows – particularly if not supported by credible regulation and sound macroeconomic policies – can lead to sudden reversals which cause developmentally and financially costly crises. Reinhart et al. (2003) point to the phenomenon of the “sudden stop” (Calvo, 1998) and reversals of capital experienced by developing countries, where they are suddenly unable to borrow and consequently unable to service their debt. Even countries with excellent track records such as Korea and Malaysia were victims of this, thus emerging markets are said to have a low debt tolerance. This experience is contrasted with that of a developed country, whose high debt tolerance enables it to use counter-cyclical policy in response to a negative shock, whilst a developing country has to tighten, intensifying the shock. Finally, the costs of crises are huge; Eichengreen (2004) estimated that crises countries suffered a 25% loss of income over the last twenty five years as a result of the crises, with an average annual cost of all the crises being $100 billion.

In mid summary it is worthy to note that the benefits of liberalisation are too large to ignore; indeed the inevitable momentum of developing countries liberalisation illustrates this. However, the costs being both numerous and potentially devastating are enough to justify public policy efforts, and perhaps multilateral efforts, to encourage more stable flows and discourage highly reversible volatile flows or to slow down the liberalisation process.

Whilst full capital liberalisation is seen as the most efficient outcome for a developed country by a majority of economists, the path for an emerging market is less clear cut. The rapid elimination of all capital controls was treated as an essential element for emerging markets in the 1990’s, prompting discussion in April 1997 to make it a concrete long term policy target in the IMF articles of agreement. The subsequent Asian crisis beginning in mid-1997 was both devastating and prolonged, despite the region’s previous stability, sound macroeconomic fundamentals and unprecedented size of international rescue packages (upward of $100 billion). For this new breed of crises the interplay of fast capital account liberalisation and a vulnerable financial sector were largely to blame. The result was to force a major rethink on capital market liberalisation and has brought support for reducing capital account liberalisation in emerging markets, although so far without international consensus.

Whilst other candidates have been proposed as a causal factor for crises to shift the blame from capital account liberalisation – including the macroeconomic fundamentals, exchange rate regime, degree of prudent supervision, and crony capitalism – capital account liberalisation stands tall as the most common denominator. Williamson et al (2003) utilised a simple correlation between the Asian crisis countries and each explanatory candidate previously mentioned to demonstrate that “…there is an almost-perfect fit, with countries that had liberalised (scored LL or L) being exactly the ones that succumbed to the crises.” There was one exception, Singapore, which was highly liberalised but interestingly had utilised an anti-speculative capital control. The same correlation can be shown for the Latin American countries that suffered speculative attacks in the 1980’s. Even Soros (1999) himself likened the role of increasing capital mobility to a “wrecking ball” in its ability to cause financial crises. It is simplistic and anachronistic to suppose that sound economic fundamentals provide a solid defence against crises. Whilst unsound fundamentals were largely to blame for the older crises in the 1980’s, the new round of crises in the 1990’s, notably the Asian crisis, occurred despite largely sound policies. Indeed it was the sound fundamental policies which enabled these emerging markets to take on so much short term currency mismatching foreign debt.

The most common argument against capital controls remains the benefit for a country to borrow on the international market to achieve higher growth. However, controls (or restricted liberalisation), if well implemented, will not necessarily undermine a country’s ability to borrow. An emerging market country must consider whether there are sufficient additional benefits to perfect capital mobility to a stylised partial liberalisation, given the devastating negative effects of crises. Empirical findings are mixed: Quinn (1997) and Rodrik (1998) disagree on the presence of a relationship between liberalisation and growth; whilst qualitative studies emphasise that the lion’s share of benefits are to be reaped from FDI and long term capital. Consequently the improved stability from imposing controls on volatile short term capital may outweigh the minor benefits. Rogoff (2002) succinctly explains that when restricting capital flows the “real debate is about debt instruments”, highlighting that debt does not possess the risk sharing properties of FDI and equity flows and thus the most vulnerable to major reversals and subsequently crises. Consequently if controls are utilised they need only to be strategic and limited, focusing on changing the structure of debt.

In conclusion, the experience of the Asian Crisis has shown that while sound macroeconomic fundamentals are a pre-condition to avoid the crises of old, they were not sufficient to avoid the new kind. The tendency to blame the weaknesses of the financial sectors is plausible, but ultimately financial systems need time to mature and thus rapid liberalisation was the wrong answer given the circumstances. A brief foray into possible capital restrictions has shown that as a temporary measure restrictions can be put in place that sharply reduce the probability of a crisis at little cost to the benefits of capital flows. However, rather alarmingly, the inertial trend towards liberalisation continues at a rapid pace whilst many of the original vulnerabilities remain. It is unfortunate to postulate that the future promises many more financial crises, both old and new.

References

Bhagwati, Jagdish N. (2004) “In Defense of Globalization”. New York: Oxford University Press, 2004

Brecher, R.A. and Carlos F. Daiz Alejandro., 1977. ‘Tariffs, foreign capital and immiserizing growth’, Journal of International Economics,7(3): 317-322.

Calvo, Guillermo A., 1998, “Capital Flows and Capital Market Crises: The Simple Economics of Sudden Stops,” Journal of Applied Economics, CEMA, Argentina, Vol. 1, No. 1, November 1998, pp. 35-54.

Eichengreen, Barry. (1999) Toward a New International Financial Architecture: A

Practical Post-Asia Agenda, Institute for International Economics, 1999.

________, Michael Mussa, Giovanni Dell’Ariccia, Enrica Detragiache,

Gian Maria Milesi-Ferretti, and Andrew Tweedie. (1999) “Liberalizing Capital

Movements: Some Analytical Issues,” IMF Economic Issue No. 17,

February 1999.

__________, Ricardo Hausman and Ugo Panizza (2003). Currency mismatches, debt

intolerance, and original sin: why they are not the same and why it matters. NBER

Working Paper, No. 10036. Cambridge, Massachusetts: National Bureau of

Economic Research.

Friedman, Thomas L. (2002). “The Lexus and the Olive Tree: Understanding Globalization”, Anchor

Johnston, Barry R., and Natalia T. Tamirisa. “Why Do Countries Use Capital Controls?” IMF Working Paper 98-181, December 1998.

Mead, Russell Walter, and Sherle R. Schwenninger (2000). A financial architecture for middleclass-oriented development: a report of the Project on Development, Trade, and

International Finance. A Council on Foreign Relations Paper. New York: Council

on Foreign Relations.

Obstfeld, Maurice, and Alan M. Taylor, (1998) “The Great Depression as a Watershed:

International Capital Mobility over the Long Run.” In Bordo, Michael D., Claudia D. Goldin, and Eugene N. White, eds., The Defining Moment: The Great Depression and the American Economy in the Twentieth Century. Chicago: University of Chicago Press, 1998, pp. 353-402.

Ocampo, Jose Antonio and Martin, Juan eds. (2003). Globalization and Development: A Latin American and Caribbean Perspective. Palo Alto, California: Stanford University Press and World Bank.

Persaud, Avinash (2000). “Sending the herd off the cliff edge: the disturbing interaction

between herding and market-sensitive risk management practices.” Institute of

International Finance Competition in Honour of Jacques de Larosiere. First Prize

Essay on Global Finance for 2000. Washington. D.C.

Quinn, Dennis (1997), “The Correlates of Change in International Financial

Regulation”, American Political Science Review, 91(3), Sep., 531-51.

Reinhart, Carmen M., Kenneth S. Rogoff, and Miguel A. Savastano (2003), “Debt

Intolerance”, paper presented to the Brookings Panel on Economic Activity, March.

Rodrik, Dani, (1998) \Who Needs Capital-Account Convertibility?” mimeo, Harvard University, February 1998.

Rogoff, Kenneth S. (2002). “Straight Talk — Rethinking capital controls: When should we keep an open mind?” Finance and Development, IMF Publications, December 2002, Volume 39, Number 4

Soros, G. (1999). “To Avert the Next Crisis.” Financial Times

(January 7).

Williamson, J.; Griffith-Jones, S.; and Gottschalk, R. (2003) “Should Capital

Controls Have a Place in the Future International Monetary System?” (2

May). Paper prepared for a meeting of the International Monetary Convention

in Madrid (www.ids.ac.uk/ids/global/pdfs/Madrid3.pdf).

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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