by Kanes
Capital flows is a broad term which includes quite different kinds of financial transactions: bank lending short and long term; investment in public or private bonds; investment in equities and direct investment in productive capacity. The gains from capital inflows depend on what kind of capital is flowing. Borrowing from banks is risky; the borrower has to service it, even if his income falls; the banks may call in loans or refuse to roll over short-term credits; if loans are taken at floating interest rate or denominated in foreign currency the risks are greater. At the other end, foreign direct investment (FDI) is relatively safe; it shares much of the receiving country’s risk; it is difficult to withdraw when times are hard. It brings in technology, managerial knowledge, overseas marketing contacts and money.

Although it is the safest, FDI maybe expensive in the long-term. In return for shouldering extra risk, investors require a bigger income/profit, which may be higher than the interest payments on a bank loan. In recent years, bank lending has fallen sharply, while portfolio investment (in bonds and shares) and FDI have risen in emerging markets. From 1998, short-term debt turned negative repayments and interest exceeded new loans while FDI rose from $ 5 billion in 1980 to $ 24 billion in 1990 and $160 billion in 2000 and net portfolio investment rose from zero in 1980 to $ 26 billion in 2000.

Developing countries borrow from banks although it is risky mainly because they are unable to get the money they need from FDI or portfolio investments. There are several developing countries who do not receive much FDI for whatever reasons, and they resort to bank borrowings when they are in difficulties, even if they know it to be risky. There are also others who borrow from foreign banks as it is easier and cheaper than their domestic banks. The foreign banks on their part are ready to lend to developing countries partly because they have excess cash and partly because they can earn higher returns from such lending in normal times.

Neo-liberal economists and the IMF advocate removal of all restrictions to ensure free movement of capital in the world, including developing countries. Capital account liberalization is an article of faith for the IMF. In fact, the IMF told South Korea to press on with liberalizing its capital account even as the crisis of 1997-1998 was unfolding. The US too opposes capital accounts restrictions and it wanted at the beginning both Chile and Singapore to liberalize their capital accounts fully before signing the free trade agreements with the two countries. Now Sri Lanka too is considering negotiating a free-trade agreement with the US. It will not be surprising if the US presses for full capital account liberalization as a precondition and it will also be not surprising if those who have already advocated capital account liberalization, pressurize the authorities to agree to it.

Those who advocate capital account liberalization seem to forget the costs incurred in recent financial crises by the developing countries. Financial crises that hit Latin America in the 1980s, Mexico in 1994 and East Asia in 1997-1998 caused recessions equivalent to years of growth forgone. It is estimated that the GDP losses from financial crises in the 1980s was $ 207 billion for Latin America and in the 1990s was $ 260 billion for Asia and $ 123 billion for Latin America. Average annual GDP loss in the 1980s was 2.2 per cent for Latin America and in the 1990s, 1.4 per cent for Asia and 0.7 per cent for Latin America as shown in the table.

The 1980s were aptly called Latin America’s "lost decade" and Argentina and Brazil are even now struggling with severe recession and the threat of a new financial collapse. Financial distress is also a factor in Japan’s never ending economic difficulties and in Europe’s and America’s current slow down. These financial crises in recent years, caused mainly by volatile short-term capital movements, have led many economists and financial analysts to question the theory of free capital movements. They now emphasize that capital movements must be intelligently regulated at home as well as internationally in ways that normal commerce does not require. The risks of international finance need to be frankly acknowledged. That involves weighing the costs and benefits of different kinds of capital mobility and setting policies cautiously and liberalizing within prudent limits. It also means abandoning certain orthodoxies of international economic policy.

The main ground on which the free capital movement advocates argue their case is free-capital movement is a prerequisite to inflows of capital to developing countries. There is no doubt that developing countries need foreign capital but is liberalization of the capital account an essential prerequisite to ensure its inflow? China proves otherwise. The one developing country which is achieving the highest economic growth rate in the world and which is receiving the largest amount of FDI of developing countries is China, but China has not yet liberalized its capital account. Inflows of foreign capital are strictly controlled; it is allowed only in specific sectors or industries and disallowed in others and it is subject to several conditions, but those restrictions have not discouraged FDI. Vietnam too is receiving significant FDI despite its controls over capital movements. In fact, it is those controls over the capital account, which saved those two countries from the contagious effects of the East Asian currency crisis of 1997-1998 and allowed them to grow without interruption.

While there is general agreement that trade improves economic welfare, financial integration has no significant effect. This is according to a new review of the empirical literature by economists at the IMF, traditionally devoted to the cause of open capital markets. This review finds no consensus that financial integration through open capital accounts yields any net benefits in growth at all — although the IMF insists in theory it ought to. Of the 14 papers reviewed, only three find that financial integration has a positive effect: another four find that effects are mixed; and the rest - seven - find no effect one way or the other. The absence of a clear conclusion suggests two possibilities. One is that financial integration has costs as well as benefits, making net benefits hard to spot. Second, unlike free trade, financial integration may be good for economies only if certain conditions are met. If countries meet these requirements they gain; if not, they lose.

This means that we need not come to an all-or-nothing judgment about capital flows, for we can get benefits if we reduce or eliminate the costs of integration by finding a middle-way. This is not easy; we can never eliminate the risk of financial crisis but we can reduce them. Chile has for example, demonstrated how this can be achieved by imposing holding period taxes subjecting imports of capital to a one-year 30 per cent non-interest bearing deposit. This tax succeeded in tilting the balance away from short-term towards longer-term inflows.

The tax is simple and transparent; like tariffs, it still allows access to short-term capital, but at price. Other developing countries too should use this method until their financial systems are ready to participate properly in the global capital market. Malaysia overcame its financial crisis of 1997-1998 by using selective exchange controls to supervise all foreign currency transactions for financial (as opposed to trade) purposes. It was illegal even to take $ 100 abroad. The aim was to allow the authorities to ease fiscal and monetary policy without provoking a capital flight. It was a success. The Economist too supported these controls in the following words:

"This newspaper, too long, maintained that capital controls are always wrong. Yet the evidence reviewed in this survey shows that the global capital market is a turbulent and dangerous place, especially for poorly developed economies that may be ill equipped to navigate it. To be sure capital controls are not the best way to prepare; but for some countries, imposing certain kinds of control on capital will be wiser than making no preparations at all".

A new voice in the campaign against free capital movements is the Economist. The Economist of May 3rd 2003 points out that contrary to orthodox theory and IMF prescriptions, capital controls have a role to play in developing countries. It is a mistake, it argues, to treat trade and capital movements in the same way, while liberal trade can be supported, liberal capital movements cannot be. It argues as follows:

"Why is trade in capital different from trade in goods? For two main reasons. First, international markets in capital are prone to error, whereas international markets in goods are not. Second, the punishment for big financial mistakes can be draconian, and tends to hurt innocent bystanders as much as borrowers and lenders. Recent decades, and the 1990s most of all, drove these points home with terrible clarity.

Great tides of foreign capital surged into East Asia and Latin America, and then abruptly reversed. At a moment’s notice, hitherto successful economies were plunged deep into recession.

These experiences served only to underline the lesson of previous financial debacles. Yet it is a lesson that governments remain decidedly reluctant to learn. Big inflows of foreign capital present developing countries with a nearly irresistible opportunity to accelerate their economic development. Where these flows are of foreign direct investment, they are all to the good. But in other cases, disaster beckons unless a series of demanding preconditions are met first. A flood of capital into an economy with immature and poorly regulated financial institutions can do more harm than good".

"Poor countries need all the foreign direct investment they can get; let inflows of FDI be unconfined. Other long-term inflows also pose little threat to stability. The chief danger lies with heavy inflows of short-term capital, bank lending above all. These can be difficult to stem, but many developing countries would do well to emulate the successful experience of Chile, which has imposed taxes on such inflows, with the rate of tax varying according to the holding period".

"In negotiating new free trade agreements with Chile (and with Singapore) the United States has recently sought assurances of complete capital account liberalization. Bitter experience suggests that such demands are a mistake. It is past time to revise economic orthodoxy on this subject".