Financial Times Wednesday March 25 1998
Joseph E. Stiglitz: Boats, planes and capital flows
As capital shifts rapidly across the globe, emerging markets are left adrift.
The answer is to regulate flows...
Small open economies are like rowing boats on an open sea. One cannot predict when they might capsize; bad steering increases the chances of disaster and a leaky boat makes it inevitable. But their chances of being broadsided by a wave are significant no matter how well they are steered and no matter how seaworthy they are.
The financial movements of the past few years are like the sea. Net long-term private capital flows to developing countries rose sixfold from 1990 to a record $256bn (£153bn) in 1997, according to the Global Development Finance 1998 report by the World Bank released today. These include foreign direct investment, investment in equity and credits of over a year's maturity. The stock of short-term debt by countries in mid-1997 was $360.9bn.
All developing countries are afloat on this sea. Bond issues and loan commitments to east Asia, south Asia and Latin America all fell by more than half in the fourth quarter of 1997. This illustrates that developing countries are more vulnerable to vacillations in international flows than ever before. Without volatile international capital flows, the East Asian crisis of 1997 would probably have been no more memorable than the South Korean crisis of 1980 or the Thai one of 1983.
Everyone recognises that this is not the best of all possible worlds. What can we do about it?
Part of the answer is easy: insist on more information and greater disclosure. Both the Mexican and the east Asian crises were triggered and exacerbated partly when investors found out that reserves were smaller than they had thought and that short-term debt was higher. Perhaps more important than misleading information was the general lack of it: when the problems became apparent, this made it hard for lenders to distinguish bad companies from good, leading them to shy away from all.
The returns to better information are great, but we should not delude ourselves into thinking that this alone can resolve all the problems. Much existing information seems not to be fully incorporated into market assessments, so there is no guarantee that markets will respond perfectly to perfect information. In a world dominated by private-to-private capital flows, it will be very difficult to estimate the external exposure of an entire economy. And with the increased use of derivatives, it will be virtually impossible. Better information is like a better navigation chart: useful, but not everything.
For emerging markets, another part of the answer is also easy: domestic reforms can create more robust financial markets, more transparent systems of corporate governance, and less error-prone macroeconomic policy. But as with better information, so with better policies. It would be foolhardy to base domestic regimes and the international financial architecture on the assumption that these will be perfect. Developing countries have less capacity for financial regulation and greater vulnerability to shocks. Policy regimes need to be resilient against human fallibility. Aircraft are not designed to be flown just by ace pilots.
So we - investors, emerging markets and the international financial community generally - need to consider a third policy response: towards international capital flows. We cannot expect it to eliminate all crises, let alone all economic fluctuations. But along with domestic reforms and greater disclosure, it reduce their frequency and magnitude.
Some people object to this in principle, arguing that governments should not intervene in international capital markets. This objection is not a good way to begin the discussion. The $110bn package for east Asia is clearly a major intervention in the workings of the free market.
Intervention has been justified on the basis of systemic risk, which is the classic case of what economists call an externality. Externalities can occur when the private risk of investing in a country is smaller than the social risk. This discrepancy may be especially large for short-term speculative capital flows. Whenever there are large discrepancies of this kind (and they would exist if investors believed a bailout were likely even if systemic risk did not exist), then some form of intervention would be justified to bring the private risks into line with the social risk. But what kind of intervention?
There is now broad agreement that foreign direct investment is valuable. It brings not just capital but also technology and training. Preliminary evidence from east Asia confirms that foreign direct investment is relatively stable.
Short-term capital does not bring with it ancillary benefits. True, some short-term capital, especially trade credits, is essential. But when the savings rate is already high, and when the marginal investment is being misallocated, additional short-term capital flows just increase the vulnerability of an economy. The net benefits appear even smaller when the reserves set aside to protect against the volatility of short-term capital are taken into account. From the consolidated balance sheet of the borrowing country, it seems as if emerging economies are borrowing from developed countries at higher rates, only to relend a large fraction back in the form of treasury bills and other low-rate-of-return instruments. The economic slowdown resulting from the crisis in east Asia may more than wipe out the gains from the recent capital inflows.
To extend the airplane metaphor that has been used in this discussion, what is at stake is not just a dramatic aircraft crash, an occurrence so rare that almost no one would question the superiority of air travel, especially for long distances, nor the role of government in enhancing safety. But the record of small planes travelling short distances is in greater doubt.
So what would a new regime for short-term capital flows involve? There are many components.
First, we need to eliminate the tax, regulatory and policy distortions that may have stimulated such flows. Examples of distortions are evident in the case of Thailand where the Bangkok International Banking Facilities in effect encouraged short-term external borrowing. Subtle examples exist almost everywhere.
Second, several countries have imposed prudential bank regulations to limit the currency exposure of their institutions. But these measures may not go far enough, because they do not address the issue of corporate exposure. Among the ideas under discussion are inhibitions on capital inflows, especially of the Chilean type. Chile has imposed a reserve requirement on all short-term capital inflows - essentially a tax on short-maturity loans. Even critics of the Chilean system acknowledge that the reserve requirement has significantly lengthened the maturity composition of capital inflows to Chile. This, together with solid fundamentals and a sound financial system, may be the reason that Chile has been relatively unaffected by recent financial crises.
Still other possibilities that may be more feasible for others include the use of tax policy by, for example, limiting the extent of tax deductibility for interest in debt denominated or linked to foreign currencies.
Other issues have to be addressed at the international level. In spite of repeated resolutions that lenders should bear more of the cost of their risky decisions, the moral hazard problem in the 1990s is, if anything, larger, not smaller than it was in the 1980s. At the same time, workers and small businesses in borrowing countries - innocent bystanders who did not engage in risky transactions - continue to bear huge costs. Now is the time, before the next crisis, to devise orderly procedures for work-outs that will provide better incentives and more equitable cost-sharing.
The financial architecture for nation states took centuries to build; today, concepts like national banking are still controversial in parts of the US. Arriving at a consensus about international reforms could be even more difficult. But the intensified international dialogue on these issues, at the very least, is a promising start.
The author is chief economist at the World Bank
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