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Sunday, January 21, 2007

Does Financial Liberalization Help Developing Countries?

This commentary by Gerard Baker makes the claim that developing countries that allowed the most financial liberalization have seen the best economic performance in terms of moderation in the variability of inflation and output:

It is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle. These changes gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods. ... The economies that took the most aggressive measures to free their markets reaped the biggest rewards.

I noted that the evidence for this claim that financial liberalization stabilized developing economics is scant (e.g. below it states "Nor, on balance, has liberalization of capital flows stabilized consumption") and there remains quite a bit of uncertainty and ongoing research on the source of the Great Moderation.

This Project Syndicate piece by Dani Rodrik of Harvard continues the discussion on whether financial liberalization is a key factor in generating higher growth and stability for developing countries. He argues that there is little evidence that financial liberalization is beneficial:

The False Promise of Financial Liberalization, by Dani Rodrik, Project Syndicate: Something is amiss in the world of finance. The problem is not another financial meltdown in an emerging market, with the predictable contagion that engulfs neighboring countries. Even the most exposed countries handled the last round of financial shocks, in May and June 2006, relatively comfortably. Instead, the problem ... is ... that relatively calm times have helped reveal: the predicted benefits of financial globalization are nowhere to be seen.

Financial globalization is a recent phenomenon. One could trace its beginnings to the 1970’s, when recycled petrodollars fueled large capital inflows to developing nations. But it was only around 1990 that most emerging markets threw caution to the wind and removed controls on private portfolio and bank flows. Private capital flows have exploded since, dwarfing trade in goods and services. So the world has experienced true financial globalization only for 15 years or so.

Freeing up capital flows had an inexorable logic – or so it seemed. Developing nations, the argument went, have plenty of investment opportunities, but are short of savings. Foreign capital inflows would allow them to draw on the savings of rich countries, increase their investment rates, and stimulate growth. In addition, financial globalization would allow poor nations to smooth out the boom-and-bust cycles associated with temporary terms-of-trade shocks and other bouts of bad luck. Finally, exposure to the discipline of financial markets would make it harder for profligate governments to misbehave.

But things have not worked out according to plan. Research at the IMF, of all places, as well as by independent scholars documents a number of puzzles and paradoxes. For example, it is difficult to find evidence that countries that freed up capital flows have experienced sustained economic growth as a result. In fact, many emerging markets experienced declines in investment rates. Nor, on balance, has liberalization of capital flows stabilized consumption.

Most intriguingly, the countries that have done the best in recent years are those that relied the least on foreign financing. China ... has a huge current-account surplus, which means that it is a net lender.... Among other high-growth countries, Vietnam’s current account is essentially balanced, and India has only a small deficit. Latin America, Argentina and Brazil have been running comfortable external surpluses recently. In fact, their new-found resilience to capital-market shocks is due in no small part to their becoming net lenders to the rest of the world, after years as net borrowers.

To understand what is going on, we need a different explanation of what keeps investment and growth low in most poor nations. Whereas the standard story – the one that motivated the drive to liberalize capital flows – is that developing countries are saving-constrained, the fact that capital is moving outward rather than inward in the most successful developing countries suggests that the constraint lies elsewhere. Most likely, the real constraint lies on the investment side.

The main problem seems to be the paucity of entrepreneurship and low propensity to invest in plant and equipment ..., especially to raise output of products that can be traded on world markets...

When countries suffer from low investment demand, freeing up capital inflows does not do much good. What businesses in these countries need is not necessarily more finance, but the expectation of larger profits for their owners. In fact, capital inflows can make things worse, because they tend to appreciate the domestic currency and make production in export activities less profitable...

Thus, the pattern in emerging market economies that liberalized capital inflows has been lower investment in the modern sectors of the economy, and eventually slower economic growth (once the consumption boom associated with the capital inflows plays out). By contrast, countries like China and India, which avoided a surge of capital inflows, managed to maintain highly competitive domestic currencies, and thereby kept profitability and investment high.

The lesson for countries that have not yet made the leap to financial globalization is clear: beware. Nothing can kill growth more effectively than an uncompetitive currency, and there is no faster route to currency appreciation than a surge in capital inflows.

For those countries that have already made the leap, the choices are more difficult. Managing the exchange rate becomes much more difficult when capital is free to come and go as it pleases. But it is not impossible...

Given all the effort that the world’s “emerging markets” have devoted to shielding themselves from financial volatility, they have reason to ask: where in the world is the upside of financial liberalization? That is a question all of us should consider.

I believe in markets and their ability to coordinate economic activity. But we have to pay attention to the evidence. If the evidence just isn't there that opening markets aids economic growth and stability, then promoting open markets for developing countries based upon the belief that markets are always and everywhere the best solution to problems of economic development and coordination is counterproductive. Such advocacy threatens, when success does not follow more open markets, to undermine support for the free-market institutions the advocates of open markets are generally promoting. A better approach would be to drop the ideological promotion of free markets, accept that markets can fail, and figure out what market failure is leading to the sub-par performance of these policies.

    Posted by on Sunday, January 21, 2007 at 11:27 AM in Economics, International Finance, International Trade | Permalink  TrackBack (0)  Comments (5)

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