Name:	Elaine Baker
Student number:	115927
Course:	MSc Political Economy of Development
Module:	International Economics II
Assignment: 	Discuss i) the forces driving the cycles in foreign lending to the developing countries; and ii) policy options to counter the resulting vulnerability of these economies
Due date:	27th April 2001
Word count:	6324

Introduction

This paper first reviews developments in international capital markets and the way inflows and outflows are experienced regionally rather than sectorally or individually by investment project.  It then discusses theories about the causes of international capital flow volatility by qualifying arguments based on policy inconsistency and investment fundamentals, and presenting arguments based on investor expectations, herd behaviour and self-fulfilling crises.

Domestic policy measures are then discussed such as those relating to domestic financial market, exchange rate policy, capital flow regulation and monetary policy.

The relationships between the feasibility of some of these domestic policies and global pressures towards capital movement liberalisation, information disclosure, deflationary monetary policy and financial deregulation are then presented.

Improved global policies such as financial regulation standards, reforms of the international currency lender of last resort, an international bankruptcy court and the Tobin Tax are discussed.  Suggestions are made regarding the institutional framework needed to make these global policies incentive compatible for a global financial international institution.

Developments in international capital markets

Recent years have seen increasing integration of capital markets, and growing participation by developing countries in these markets.  For example, between 1985 and 1990, there were $133bn in inflows to Asia and Latin America, while this multiplied to $670bn between 1990 and 1994 (Calvo et al, 1996).

International capital market integration means that private, financial and public institutions in one country finance investment or consumption by borrowing from foreign financial institutions or governments, issuing securities (IOUs) to foreign institutions or non-residents, selling equity (shares or ownership rights) to foreign institutions or non-residents, or accessing parent company finance through foreign direct investment.  The promise to repay, issue dividends or pay interest can be denominated using the currency of the borrower or the lender.  Since the 1970s, bank loans, equity investment and foreign direct investment have become increasingly important relative to government loans and aid, especially in Latin America and Asia (Akyuz and Cornford, 1999, part II).

Recent years have been marked by extreme volatility in capital flows, where countries experience large-scale inward investment followed by crises involving large capital outflows.  While developed countries have experienced currency problems (Europe in 1992/93) and banking problems (Scandinavia in 1992), developing countries are increasingly experiencing large-scale crises encompassing capital markets, currency value, asset markets and the banking sector (Akyuz and Cornford, 1999, p.15).  

Capital inflows and outflows

Rodrik and Velasco (1999) define a financial crisis as a large reversal in capital flows, i.e., when a country previously experiencing inward investment then experiences a dramatic capital outflow.  In five countries of East Asia, private capital inflows amounted to $93bn in 1996, and this was reversed to an outflow of $12bn in 1997 (Griffith-Jones and Kimmis, 1999, p.69).  In the last 15 years, 67 capital outflow crises in 52 developing countries have exhausted most bank capital in the country (Goldstein, 1997, Ch.2).  The most severe crises include Latin America’s public sector debt crisis in the 1980s and another in 1994, East Asia’s private sector debt crisis in 1997/1998, especially in Indonesia, Thailand, South Korea and Malaysia, and recent crises include Russia in 1998, Brazil in early 1999 and Turkey in early 2001  (Akyuz and Cornford, 1999, p.17; Michalos 1997).  

Real effects of capital outflows

Capital outflows involve sales of equity and securities thereby pushing down their price, and demands for immediate repayments of loans.  When the price of equity falls, the market value of a business may fall below the value of its assets and so shareholders may force it to go into liquidation.  When loan repayments are demanded businesses may be forced to sell assets or give up collateral.  Businesses may be forced to cut wages, to scale down, or may not have access to capital for growth.  When the price of government securities fall or government loans are called in, the government cannot raise enough to finance previous levels of public services unless it raises taxes.  Therefore crises have severe negative effects on employment, wages and growth (Michalos, 1997).  

National and regional nature of capital flows

Large capital outflows often occur nationally or regionally rather than in isolated businesses or sectors (Palley, 1999).  The same factors often affect lending to different borrowers in the same country or region.  Therefore a capital outflow from one part of a country’s economy cannot be offset by growth in other sectors.  This is the case for the following reasons:
•	Currency  
o	The effects of the currency market on financial claims (loans, equity or securities) denominated in the domestic currency. Currency depreciation means that claims lose value to international investors and so lead them to demand liquidation or repayment or to sell their claims.
o	The effects of the currency market on financial claims denominated in the foreign currency.  Currency depreciation means that the cost of repaying or paying interest or dividends rises for borrowers, and they may be unable to do so, forcing them into liquidation. 
§	Information - borrowers from the same country are perceived by lenders as having similar characteristics and being subject to similar forces.  Therefore perception of the risk of different borrowers in a country are linked. (Rodrick and Velasco, 1999)
§	Domestic linkages - the success or viability of different domestic borrowers can be linked through being each other’s suppliers and using each other’s services.  The domestic financial services sector and the domestic business sector are often highly interdependent, as are the public and private sectors.  Financial interdependencies mean that different sectors demand liquidation of their claims on other sectors, and trade interdependencies means that demand in the economy as a whole decreases.

Links between capital, currency and asset markets

As outlined above, falls in currency value can trigger corporate bankruptcies and capital outflows (Palley, 1999).  Capital outflows in turn decrease the demand for domestic currency and cause its value to decrease, unless it is adequately defended using central bank foreign reserves.  Capital outflows mean that banks which are committed to long-term investments using shorter-term international loans are not able to pay their international creditors, causing the prospect of bank illiquidity and bank runs.  Bank closures mean the payments system and liquidity of an economy is compromised, reducing economic activity (Goldstein, 1997, Ch.2).  Capital outflows  cause falls in asset prices due to lack of investment.  When assets of domestic companies lose value due to capital outflows and depreciation (Rogroff, 1999), they are made less attractive investments, and when collateral assets lose value, liquidising them is not sufficient to service debt.  Therefore falls in asset values also trigger capital outflows.
 
Capital inflows

Capital inflows stimulate growth and finance investment (Calvo et al, 1996; Obstfeld, 1998, p.10), enabling imports of important inputs and capital goods.  However unsustainable capital inflows can also cause problems (Nissanke, 1993).  Capital inflows can drive the value of the domestic currency up, making exports less competitive and causing inflation (Calvo et al, 1996).  They can also drive up the prices of assets such as land and buildings, making them less accessible to domestic residents (Griffith-Jones and Kimmis, 1999, p.71).  If capital flows stimulate consumption rather than investment (as in Latin America), or are invested unproductively, they can become unsustainable (Calvo et al, 1996) and can bring on a large capital outflow.

Underlying causes of capital market volatility

There is much debate in recent literature as to whether the causes of outflows are due to “bad” policy in the domestic public and financial sectors, or to the nature of international capital markets.

Inconsistent policies

First generation models propose that an outflow crisis is caused by inconsistency which is uncovered.  For example, a government may want to lower interest rates and increase money supply in order to create demand and improve the domestic business environment.  It may also want to maintain a fixed exchange rate in order to create a stable climate for international trade and investment.  However, if there are no currency exchange controls or international capital controls, these policies may be inconsistent.  The former policy will cause investors to withdraw money and reinvest where there are higher interest rates and lower inflation.  This withdrawal will cause demand for the domestic currency to fall.  Governments may try to maintain the currency value by using its international reserves to buy domestic currency, and therefore the expansionary policy and the fixed exchange rate can co-exist for a time.  However when reserves run low, the currency collapses, creating further incentives for investors to withdraw and a crisis ensues.  

In first generation models, a crisis is caused by inconsistent fundamentals, i.e., interest rates, exchange rates and monetary expansion (Obstfeld, 1996).  The “impossible trinity” (of which only two of three are achievable) of fixed or pegged exchange rates, capital liberalisation and monetary autonomy is solved by sacrificing monetary autonomy and making domestic monetary policy consistent with the fixed exchange rate.  However, as outlined in a later section, other ways of resolving the impossible trinity are more effective in stemming capital flow volatility.

Investment fundamentals
Another “fundamentals” understanding of capital outflows attributes the causes of crises to bad lending decisions in the domestic financial sector.  For example, foreign lenders may invest in domestic banks, and the banks may lend the money domestically on the basis of political ties or other factors rather than on the basis of the productivity of businesses.  This may be unknown to the international investors for a time, but when it becomes known through new information they collectively withdraw their capital.

Goldstein (1997, preface) considers too much government involvement and connected lending as causes of bad lending decisions in the financial sector, and therefore crises.  If domestic banks base decisions about lending and concessional interest rates on government directives or political connections, they will not direct lending towards the most productive businesses.  A country experiences capital inflows while they conceal the unproductivity of their investments from their own international investors.  When it is realised in international markets that investments are unproductive, international investors withdraw en masse.  Financial liberalisation is seen as a mechanism for increasing competition among financial institutions, therefore reducing political lending (Palley, 1999).
 
However, this neglects the important role governments often play in industrial development through directing lending towards businesses which may be unviable individually, but viable collectively through mutual dependency and supply linkages.  Connected lending played a very important role in Newly Industrialised Countries such as South Korea (Wade, 1990).  Strategic interaction with the world economy rather than liberalisation, and strategic use of competition policy and long-term bank-company relationships, had important positive effects (Singh, 1999, part III).  This model of development has provided rapid growth, poverty reduction, lifetime employment and a relatively high degree of equity (Singh, 1999, part I).  Eichengreen (1999) bases his analysis on the assumptions that government involvement in "picking winners" is no longer possible and that liberalisation is inevitable, without elaborating on the reasons for this assertion.

Investor expectations and herd behaviour

Second generation models, in contrast, examine the expectations of investors about interest rates, inflation, currency value and the viability of businesses, rather than the actual interest rate, inflation rate, currency value and business solvency, as the important force driving capital flows.  If investors expect the value of the currency to fall or businesses to become insolvent, they withdraw their capital.  This in turn causes the currency to depreciate and businesses to be forced to liquidate.  Expectations of investors become self-fulfilling  (Griffith-Jones and Kimmis, 1999, part II; Obstfeld, 1996). Stiglitz (in Griffith-Jones and Kimmis, 1999, part II) sees the cause of the East Asian crisis as being confidence rather than fundamentals.  While the 1994 Mexican crisis was preceded by low domestic interest rates and an overvalued exchange rate (Boughton, 2000, p.274) government deficits were falling.  Before the Asian crisis exchange rates were not overvalued and countries were experiencing high growth, single figure inflation and high savings, with public current accounts in small deficit or surplus (Singh, 1999, part V).

Securities and equity markets can exhibit herd behaviour.  This may mean that the actual productivity of an investment has little bearing on whether investors will invest.  If one investor thinks that other investors will buy, s/he will buy, as the price of the security or equity is expected to rise.  The investor will hold on to the security as long as s/he thinks other investors will continue holding on to it, even if s/he knows it will not be productive.  Short-term investment relies on capital gains rather than interest or dividends for its yields.  Therefore it is not so much knowledge that an investment is unproductive as awareness that it is common knowledge that it is so, and commonly intended to act on it, that is important.  Prices in currency exchange markets and financial markets adjust much more quickly than prices for goods and services.  This means that the gains of buying and selling, as opposed to holding, debt assets, are large.  This gives rise to overshooting in currency and financial markets and bubbles i.e. herd behaviour in inflows followed by herd behaviour in withdrawals (Dornbusch, 1999) (Griffith-Jones and Kimmis, 1999, part II).

The expectations of investors are likely to be largely influenced by news, by announcements by influential institutions such as governments, central banks and the International Monetary Fund (IMF).  Information can play an important role in both creating and eroding confidence (Singh, 1999, part IV).

Domestic Policies

There are large gains to taking part in international capital markets, including greater capital inflows which allow more investment and imported inputs without the need for reductions in consumption, the ability to diversify risk through holding assets abroad which can be drawn on for domestic needs, and the technology transfer and market access that comes with foreign direct investment (Rogroff, 1999; Griffith-Jones and Kimmis, 1999, p.70).  However, engaging with international capital markets can mean high volatility of capital flows.  Domestic policies which maximise the benefits of taking part in international capital markets while minimising the volatility costs are important.

“Investment Fundamentals” policies and bank regulation

Policies which make investment productive are necessary (but not sufficient, due to second generation factors) to decrease the likelihood of outflows due to lack of international investor confidence.

Increased regulation and supervision of banks at the domestic level is important to ensure inflows are invested productively.  However, this may imply more involvement of the government in regulation and direction of lending towards productive uses, rather domestic financial liberalisation.  As stated above, the prospects for one business in one sector may depend on many economy-wide linkages and on strategic government intervention as well as its internal characteristics such as payment status, borrower record, capacity to repay and collateral.  In order to decrease government failure in investment direction, government policy should be based on well-defined arguments and criteria and the qualitative and quantitative performance of investments must be evaluated on these grounds.  The productivity and risk of different investments are not straightforward to account for, and practises for supervision of banks take time to develop.  

Liquidity standards for domestic banks are important for averting domestic-level bank runs.  Capital adequacy standards are be important in creating incentives for domestic bank shareholders to effectively monitor lending practises.  These require banks to have a certain degree of their own capital (i.e. their own shareholders) which will be used before resorting to the central bank lender of last resort.  Shareholders do not wish this capital to be eroded and so have an incentive to ensure the bank lends productively and retains adequate liquidity (Goldstein, 1997, Ch.3).  While these measures are important for preventing domestic level maturity-mismatch/liquidity banking problems, they are unlikely to be sufficient to prevent or deal with large-scale countrywide capital outflows which involve currency as well as maturity mismatch.  This is discussed further in the global policies section.

Legal measures – domestic bankruptcy legislation, defining borrower and creditor rights

Lack of co-ordination of creditors can mean that illiquidity can turn into insolvency (Radelet and Sachs, 1998).  This happens if an investment has a number of creditors who are un-coordinated.  The investment is solvent, i.e., it is productive, but only if all the creditors do not demand premature payment or liquidation, and provide rollover finance if necessary.  However, if one creditor withdraws, the investment is no longer productive.  If the project experiences liquidity problems, creditors rush to “grab their assets”, fearing that if other creditors grab first, they will not be repaid.  The fact that creditors are grabbing their assets makes the investment insolvent.  Domestic bankruptcy legislation which clearly defines borrower rights, and which specifies the order in which creditors are to be paid, is important to protect borrowers from illiquidity turning into insolvency.  In addition, other legislation establishing rights of creditors to change managers of companies they invest in can lessen the tendency for them to demand liquidation (Eichengreen, 1999, Ch.2).

Choosing two of the trinity

The nature of the exchange rate regime affects the volatility, nature and scale of capital flows, and the feasibility of appropriate monetary policy.

Fixed exchange rates create a more stable environment for foreign trade and investment.  In order to attain fixed exchange rates, countries must either have capital controls or must gear their monetary policy toward exchange rate, rather than domestic monetary, goals.  

Irrevocably fixed exchange rates may be appropriate for smaller economies where trade with and investment from the currency partner(s) are very important.  This arrangement could involve 100% of the benefits of fixed change rates and, say, 90% of the benefits of capital market freedom and 10% of the benefits of some leeway in interest rate policy.

However, for large or more autonomous economies, irrevocably fixed exchange rates mean money supply is wholly determined by the needs of the currency partner and not by domestic needs, and interest rate policy is also largely pre-determined.  Fixed exchange rates mean that all the prices in the domestic economy need to adjust according to partner country prices, rather than simply adjusting an exchange rate.

If exchange rates are pegged rather than irrevocably fixed in order to allow for exchange rate adjustment (i.e. devaluation), they may be attacked due to foreign investors wishing to sell investments before a prospective devaluation, in turn making devaluation necessary (McKinnon, 2000).  It is necessary for the central bank to retain large amounts of foreign reserves during times of capital inflow, to give it a greater capacity to defend the currency peg during times of capital outflow.  These reserves have high opportunity costs as they could otherwise be used to finance investment, important imported inputs or incentive goods (Akyuz and Cornford, 1999, p.20).  The reserves are still finite, so pegged exchange rates tend to mean periodic devaluations and capital outflow crises.

Pure floating exchange rates, in contrast, allow complete monetary autonomy together with free access to international capital markets.   However, they can be subject to bubbles and high volatility, which is a disincentive to trade and to foreign investment.  Low interest rates can cause capital outflow-currency depreciation spirals and lead to imported inflation.  A depreciating currency may not be limited by rendering exports more competitive if Marshall-Lerner conditions are not present.  Long-term investors are interested in the long run prospects for the exchange rate, and so may be somewhat less penalised by floating exchange rates than short-term investors for whom liquidity is a high priority.  Floating exchange rates mean that international volatility is addressed through adjustment of the exchange rate, rather than adjustment of all the prices in the domestic economy.  

The penalties to international traders and borrowers of floating exchange rates can be tempered with adequate hedging mechanisms.  The negative aspects of floating exchange rates may also be tempered with a combination of some exchange rate management (giving up a little monetary autonomy) and some capital controls.  This would involve having, say, 90% of the benefits of free capital movements, 95% of the benefits of monetary autonomy and 15% of the benefits of more stable exchange rates (adding up to 2 of the impossible trinity). 

Management of floating exchange rates would involve some limited intervention to slow down rates of increase and decrease of exchange rates (i.e., a crawling band).  However, even the monetary intervention needed to attain this can be either costly or not effective in the absence of capital controls.

Regulating the nature of capital inflows

Liberalisation of the financial sector involves removing controls on currency transactions (buying and selling the domestic currency) and capital movements (borrowing or lending abroad).  Major crises have been preceded by financial liberalisation (Akyuz and Cornford, 1999, p.16).  For example, under Kaminsy and Reinhart’s classification (in Michalos, 1997), 18 out of 26 banking crises followed recent capital liberalisation.  India, which was not severely affected by the Asian crisis, does not allow foreign borrowing by corporations, and didn’t liberalise to the same degree as East Asian countries (Singh, 1999, part V).

Rodrick and Velasco (1999) argue that short term capital inflows may have some benefits, as they force the borrower to continually seek approval (roll-over) from creditors, thereby increasing the control creditors have over borrowers and preventing borrowers from using the finance unproductively.  However, collective action problems among creditors, together with lack of creditor monitoring, render this argument difficult to support.  Short-term lending to developing countries means that lenders benefit from their higher returns without giving up any liquidity.  The relationship between the short-term foreign debt to international reserves ratio and the occurrence of a crisis is very noteworthy (Rodrik and Velasco, 1999).  

One method of concentrating capital controls on short-term capital flows is putting in place deposit requirements.  These involve a requirement that foreign lenders must place a non-interest bearing deposit of around 10% of the value of the loan for one year in the central bank.  This decreases the liquidity of the lender, which a long-term investor would be doing in any case, but which is a disincentive to short-term lenders. These have been very effective in reducing the ratio of short-term to long-term debt in Chile (Rodrick and Velasco, 1999, p.24) and are now being tried in Malaysia (Rogroff, 1999).  Chile reduced short-term inflows, has been better able to operate counter-cyclical interest rate policies, and was less affected by the 94/95 Mexico crisis (Griffith-Jones and Kimmis, 1999, p.80).

Another policy would be to impose a small tax (less than 1%) on transactions between the domestic currency and foreign currencies, along Tobin Tax lines.  It would penalise short-term capital flows simply by being a tax on transactions, rather than needing to distinguish a priori whether an investment is intended to be long term or short term.  It would reduce the level of short-term currency transactions, and therefore exchange rate volatility.  This would be very useful only in stabilising normal exchange volatility, rather than in averting periodic large-scale crises, as the taxation margin would be insignificant in relation to prospective loss in value of investment by staying in the domestic economy.  However, as discussed below, this tax may be costly or unfeasible for developing countries to impose unless a similar tax was imposed in other countries.

Capital controls can also be concentrated on loans rather than equity (Rogroff, 1999; Obstfeld, 1998, p.26).  Equity means that lenders rather than borrowers bear more of the risk, in return for exercising more control (shareholders right to vote for a change of management).   Foreign direct investment involves lenders giving up still more liquidity, in return for still more control, so it is less volatile.  Some forms can also facilitate technology transfer.  However, aiming to attract foreign direct investment should be based clearly on the benefits of particular types of investment, and conditional on key quality and quantity of employment and skills transfer criteria, rather than taking part in a “race to the bottom” in terms of labour and environmental standards and corporate taxation (Obstfeld, 1998, p.19), in order to attract multinational companies.
 
Regulation must keep up with financial innovation.  For example, if one type of financial transaction or instrument is regulated, financial institutions may create new types of transactions of instruments which are very similar in effect but different in legal form, in order to avoid regulation (Akyuz and Cornford, 1999, p.30).

Dealing with crises

During times of capital outflow, most countries have pursued deflationary policies under international pressure, despite the fact that this is pro-cyclical (Griffith-Jones and Kimmis, 1999, part IV). IMF structural adjustment programmes are based on theories such as the Polak model and the monetary approach which explicitly assume there is no capital market (Tarp, 1993, Ch.3).  The IMF have traditionally focussed on monetary and fiscal policy as causes of crises, and therefore remedies.  However, monetary and fiscal policies were not the cause of the Asian crisis, and currency problems have increasingly been caused by capital outflows rather than current account deficits (Eichengreen, 1999, Ch.3).  

The IMF advocate cuts in money supply, increases in interest rates, fiscal austerity and increased financial liberalisation (Singh, 1999, part VI).  This means prioritising full capital market freedom and aiming at exchange rate stability (often at a new devalued rate) rather than exercising counter-cyclical monetary policy.  However, increasing interest rates increases the risk of defaults, so worsening the panic (Akyuz and Cornford, 1999, p.19; Singh, 1999, part VI), while devaluation of pegs involves the problems discussed above, both worsening the self-fulfilling aspects of crises.  In contrast, counter-cyclical policies would involve reducing the inflationary effects during times of capital inflows through some capital control and monetary intervention rather than focusing on deflation in times of capital outflows.

In times of outflows, putting in place a freeze on capital outflows may force international creditors into negotiations in order to resolve their collective action problems, and prevent.  However, again as discussed below, retaining the right to do this unilaterally may mean international investors are unwilling to invest in the country.

Global policies

Present global financial policy
The degree to which individual countries are free to exercise some of the domestic policy options outlined above is limited.  In recent years, domestic regulations about capital inflows and outflows and currency exchange controls have been steadily dismantled under the influence of conditionality of aid, debt relief and help during crises by international institutions.  This is despite the fact that when the IMF was originally set up in Bretton Woods, it was to advocate capital controls as a way of preventing balance of payments crises (Felix, 1998 in Michalos, 1997).  Under the auspices of the World Trade Organisation, a General Agreement on Trade in Services is presently being negotiated, which includes negotiation on the liberalisation of financial services (Cornford and Brandon, 1999, p.2).   If principles of non-discrimination between foreign and domestic financial institutions are included in this agreement, this could mean that capital controls, regulation and creditor priorities in insolvency could be legally challenged if they affect domestic banks and foreign banks differently  (Cornford and Brandon, 1999, parts V and VI).  The development of OECD countries took place under regimes of high capital controls, and financial liberalisation has been advanced at a slow pace in OECD countries until recently (Cornford and Brandon, 1999, part VII).  

International institutions also advocate increased information as a remedy for international capital market volatility.  The information argument proposes that a crisis is caused by large-scale inflows under the illusion that investments are profitable, followed by large-scale outflows when it is realised they are not.  On this understanding, the IMF has recently focused on increasing the transparency and information on the health of companies and the risk portfolios of banks in developing countries, so that inflows and outflows will be gradual according to changes in conditions.  It is argued that information dissemination should be coordinated by an international institution such as the IMF, as individual countries would be less likely to issue “bad” news unless required to do so under international standards.  The IMF has introduced a special data dissemination standard for this purpose (Eichengreen, 1999, Ch.3).  

However, a lack of information is not an important cause of capital flow volatility, as it does not prevent the herd behaviour phenomenon outlined above, where investors may not necessarily act on their information unless they think others will act on it also (Griffith-Jones and Kimmis, 1999, part III). For example in East Asia, information on balance of payments, short-term and long-term private and public external debt, the scale of capital inflows and the exposure of banks were available before the crises, but were not acted on gradually  (Akyuz and Cornford, 1999, p.21).  Publicly issuing “bad news” may trigger larger scale outflows than is warranted by the content of the news due to herd behaviour (Akyuz and Cornford, 1999, p.22)  (Griffith-Jones and Kimmis, 1999, part III). 

International policy also concentrates on advocating and focusing conditionality on the reduction of government intervention in the domestic financial sector, and on dealing with crises in a deflationary way. The arguments against these policies have been presented above.

Proposed changes to global policies

The shortcomings of the present global financial institutions do not mean that global institutions to deal with financial issues are not needed.  Many domestic policies have implications according to the presence of similar policies in other countries, so global institutions are needed to deal with international policy externalities.

Governments experience pressure to lower banking standards and requirements in order to make domestic banks competitive.  This is especially the case if domestic banks must compete with international financial institutions in a liberalised environment.  There may be pressure not to create disincentives to invest in one country relative to another.  Imposing deposit requirements, putting Tobin-style currency transaction taxes in place unilaterally or retaining rights to order temporary stays on capital flows may mean that a country loses out on international investment relative to other countries.  Regulations which cover financial institutions operating in the domestic economy may mean that a country fails to become a financial centre (Patterson and Galliano, 1999; Tobin and Wyploz 1995 in Michalos, 1997), or that speculation against the domestic currency and domestic financial instruments simply takes place in other locations.

For these reasons, agreement on international standards and policies is important.  This creates the problem of ensuring such standards cater to the needs of developing countries and not solely to developed countries with their greater bargaining power based on trade, military and negotiating capacity characteristics.  Akyuz and Cornford (1999, p.32) point out that IMF policy surveillance is applied only to developing countries without regard for developed country policies which may contribute to crises.

International bankruptcy court

An international bankruptcy court, for countries in general and governments rather than businesses, could function as a mechanism by which countries experiencing large capital outflows could halt the outflows, without the prospect of countries doing this in an arbitrary way which would be a disincentive to international investment.  This would be an international institution to which countries experiencing large outflows could apply for a stay on payments (Miller and Zhang, 2000).  The court could judge whether this was warranted based on the magnitude of the outflows and whether most debts in the country were illiquid or insolvent.  If illiquidity was the primary cause, a stay on payments (through a temporary halt of capital outflows) could be granted, forcing creditors into negotiations.  During this time, trade credit capital could be declared senior in order to prevent the collapse of exports and further loss in currency value through that mechanism.  If there was widespread insolvency, or sovereign debt could not be paid without causing severe hardship, the court could define senior categories of creditors and non-senior creditors would not be paid (Rogroff, 1999).  This would increase the incentives for lenders to monitor their investments, and invest productively (Miller and Zhang, 2000).

A bankruptcy court can protect creditors from each other, as prior knowledge of creditor seniority would mean that each creditor knows that rushing to pull out or sell before other creditors will be fruitless.  It puts it in creditors interest not to grab their assets if investments are solvent (Miller and Zhang, 2000).

A bankruptcy court can be argued to cause moral hazard for borrowers, due to their being able to file for bankruptcy without any sanctions, in terms of their assets being seized (Miller and Zhang, 2000).  However, if a certain level of capital outflow is needed before bankruptcy can be filed for, it is unlikely that borrowing countries would endure the high costs involved in this unnecessarily (Strass-Kahn in Griffith-Jones and Kimmis, 1999, part IV).

Lender of last resort

Maturity mismatch in a domestic setting occurs when domestic banks borrow short term and lend long term.  Without maturity mismatches, the resources available for investment would be much less.  Transforming short-term finance into long-term finance is one of the functions of the financial system (Rodrick and Velasco, 1999, p.20); for example, banks take short-term deposits from customers and use them to make long-term loans.  Maturity mismatches, however, create the possibility of bank runs.  This can be dealt with domestically through a combination of a domestic lender of last resort or central bank to create depositor confidence, and bank regulations regarding liquidity and capital adequacy to prevent moral hazard on the part of banks.

The same is true for currency mismatches, which involve domestic banks borrowing internationally and lending domestically.  Without them the finance available for investment in developing countries would be greatly lessened, but they create the possibility of currency runs, i.e., capital outflows and currency depreciation/devaluation due to changes in investor expectations.

An international currency lender of last resort guarantees to lend in times of currency runs in order to support the currency.  The presence of a lender of last resort gives international lenders confidence that runs involving currency will not wipe out the value of their assets.  In the international context, the G7, and the IMF in which they are the major shareholders, act as the de-facto lender of last resort in this way (Rogroff, 1999).  

However, the costs of bailouts are increasing dramatically, as they are not complemented by bankruptcy procedures.  In addition, the moral hazard problem that a lender of last resort creates (Rogroff, 1999) are not sufficiently dealt with internationally, as banks know they can lend internationally in irresponsible ways or not retain enough liquidity or adequately hedge and rely on the lender of last resort if needed.  

Bank regulation

The creditor moral hazard problem can be circumvented by bankruptcy procedures as above, and by regulations of investment risk, liquidity reserves and capital adequacy requirements.  

Regulation of global capital markets is far less stringent and detailed than regulations within domestic markets.  International lenders are not required to retain adequate finance for currency hedging.  Capital adequacy standards are also inadequate, for example, the Basle standards on capital adequacy requirements for banks lending internationally do not discriminate between the risk of investment in different companies or sectors in developing (non-OECD) countries.  In addition, except for some 1999 revisions, the standards weigh short term debt as less risky than long term debt, creating incentives for international banks to lend short term, while this is being re-lent by domestic banks in developing countries for long-term investments (Rodrick and Velasco, 1999, p.22) (Akyuz and Cornford, 1999, p.26).   Goldstein (1997) outlines deficiencies of present global bank regulation, and proposals for an international banking standard.

Tobin Tax

Currency transactions are necessary for international trade, long-term productive investment, and also for insurance, hedging and arbitrage (Patterson and Galliano, 1999).  However, of $1 to $1.5 trillion’s worth of transactions every day, only 5% are directly related to trade.  80% of transactions buying one currency and selling another are reversed in seven days or less (Raffer, 1998, p.529).

As discussed above, a Tobin tax would reduce the level of short-term currency transactions, and therefore exchange rate volatility, and would primarily be useful in stabilising normal exchange volatility, rather than in averting periodic large scale crises (Patterson and Galliano,1999).  It reduces the amount of monetary intervention necessary to maintain some stability in floating exchange rates, thus creating monetary autonomy for domestic governments.  It would also have extremely beneficial side effect of raising a large amount of revenue which could be put to purposes such as financing international institutions such as the United Nations, decreasing its dependence on developed country funds which are sometimes (such as in the case of the USA) offered only conditionally on UN policy catering to their needs.

Global financial institutions

Due to the fact that present global institutions (such as the IMF and G7 as lenders of last resort and the Bank for International Settlements as financial regulator) are accountable to developed countries as their shareholders, their willingness to bail-out creditors depends on the importance of the creditors in developed countries, and the connections between the debtor country’s economy and the G7 economies through trade, rather than criteria based on the health of developing country financial systems.  The IMF in its present form is also not a neutral arbitrator for a potential bankruptcy court, being a creditor itself (Akyuz and Cornford, 1999, p.38).  

This could be resolved by global financial institution funded independently (perhaps by the UN using a small portion of Tobin Tax proceeds) and mostly independent but accountable in terms of its overall aims to the UN (as domestic central banks and courts are accountable to governments).  It could act as lender of last resort, monitor international banking standards, monitor implementation of an internationally applied Tobin tax and act as a bankruptcy court.  Its costs as lender of last resort would be very much less than those of the G7 and IMF at present, as its power to grant stays on capital outflows would reduce the frequency and impact of capital flow crises (Miller and Zhang, 2000).  

Conclusion

Domestic policies improving the productivity of investment are necessary, but not sufficient, to prevent large capital outflows, as capital market volatility is primarily due to the nature of international capital markets rather than to investment fundamentals.  Important domestic policies required include an exchange rate which is either irrevocably fixed or a lightly managed float such as a crawling band, and some degree of capital controls, especially those focused on reducing short-term capital inflows.

However global policies are necessary which both facilitate appropriate domestic measures such as those outlined above, and include measures which are only feasible multilaterally such as an international bankruptcy court, a Tobin tax, and global banking regulation standards.

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