The risk of commercial capital flows causing a crisis (or compounding a crisis caused by other factors) greatly reduces the policy options available to governments. As the economy becomes more dependent on inflows of equity investment and FDI, so it becomes more important to keep the capital flowing in; and, as the stock of investment becomes greater, so the potential outflows grow, and it becomes ever more critical to avoid a loss of investor confidence which could precipitate a crisis. This means providing a policy environment that is attractive to foreign investors.
The volatility of commercial capital flows has important implications for economic policies.
“The greatest concern I have about canonizing capital-account convertibility is that it will leave economic policy in the typical “emerging market” hostage to the whims and fancies of two dozen or so thirty-something analysts in London, Frankfurt, and New York. A finance minister whose top priority is to keep foreign investors happy will be one who pays less attention to development goals. We would have to have blind faith in the efficiency and rationality of international capital markets to believe that these two sets of priorities will regularly coincide” (Rodrik, 1998, p11)
At the same time, recipient countries need both to prevent large capital inflows overheating the economy (ie., causing excessive demand growth, which tends to fuel inflation and causes a deterioration of the current account as imports grow faster than exports), and to deal with the economic volatility arising from variations in inflows.
Large and variable capital flows limit the ability of governments to control the money supply and the exchange rate for policy purposes, narrowing the policy options available. The money coming into the economy from export sales and capital inflows has, in effect, to be converted into local currency - that is, the dollars coming in are used to buy local currency. Conversely, local currency has to be used to buy foreign exchange to pay for imports and to finance capital outflows. If more money is coming in than going out, then more local currency is being bought than sold; and this means, either that the price of local currency (that is the exchange rate) rises; or that the Central Bank supplies the extra local currency required by buying the surplus foreign exchange to add to its international reserves, which increases the money supply, and thus inflation.
This creates potential problems. If the exchange rate goes up (appreciates), the production cost of exports increases in foreign exchange terms, so that the country's exports become less competitive in international markets. Similarly, imports become cheaper in local currency terms, and local producers have greater difficulty competing in the home market. If, on the other hand, the money supply is allowed to increase, so as to keep the exchange rate steady, this will fuel inflation, increasing production costs, and again making local producers less competitive. In either case, there is a serious risk that production will be reduced, increasing unemployment.
The government can act to counteract these effects, by "sterilising" the balance of payments surplus. This means that it sells bonds in local currency to the domestic market, so as to take back the money it needs to put into the economy to buy the surplus foreign exchange. However, this too has costs: by issuing bonds (that is, in effect, borrowing money), the Central Bank increases the demand for lending, which increases its price - that is, the interest rate. This deters investment by local producers. Since the rate of return on the reserves will almost certainly be lower than the cost of domestic borrowing, there will be a negative effect on the public finances.
The World Bank's (1997e) preliminary work on the policy issues arising from private sector capital flows has found that the most effective policies are the avoidance of real rises in the exchange rate and the pursuit of tight fiscal policies (ie., maintaining a small budget deficit or a budget surplus). An increase in the exchange rate is generally prevented by sterilisation, as described above. Tighter fiscal policies are intended in part to moderate the growth of demand by keeping government spending in line with tax revenue.
Pursuing tight fiscal policies during periods of large capital inflows also gives governments the option of loosening them (ie., allowing the budget deficit to increase or surplus to fall), to limit the contraction in demand caused by a sudden outflow of capital, without running unsustainably large deficits. Furthermore, it is argued, they allow the government to establish a reputation for sound budgetary policies, which is intended to increase the market's tolerance for less stringent policies when the circumstances require them.
This raises some interesting issues. Firstly, as noted above, the process of sterilisation increases local interest rates and thus discourages locally-owned investment. Therefore there is a trade-off: an increase in investment financed by foreign commercial flows will be at least partly off-set by a reduction in domestically-financed investment. While capital inflows should still increase total investment, the increase is likely to be less than the amount of capital inflows, and the shortfall will depend critically on how much new productive capacity they create17. This also accelerates the shift from local to foreign ownership of productive capacity in the domestic economy.
Secondly, higher interest rates, coupled with a fixed exchange rate, keeps the rate of return available locally above that in the international market. As long as foreign investors expect the fixed exchange rate to be maintained, this will promote still higher capital inflows, requiring still more sterilisation, and pushing interest rates yet higher. Sterilisation may therefore contribute to an ever-accelerating growth of capital inflows, which can be expected to come to an end (rather abruptly) only when the market loses faith in the fixed exchange rate, and anticipates a devaluation (as in East Asia in 1997). This adds still further to the "boom-bust" tendencies of commercial capital flows.
Thirdly, the implication that fiscal policy should be relaxed when financial flows are reversed is in marked contrast with the policy responses to the East Asian crisis imposed by the IMF just months after the World Bank study was issued in April 1997. In general, the fiscal positions of the countries concerned were already strong. Far from making use of the space thus created to adopt more expansionary fiscal policies when the crisis struck, the East Asian countries were pressed to exacerbate the economic decline by making their fiscal policies still more contractionary by increasing their budget surpluses, adding to the financial problems of domestic producers.
In practice, rather than being used an instrument for evening out the economic fluctuations associated with variations in capital flows, the process envisaged seems to be a ratchet effect, whereby fiscal policies are to be tightened in order to attract inflows, tightened further to avoid overheating while capital is flowing into the economy, and then tightened still further when the capital flows back out. It is far from clear that this is sensible or even coherent.
Fourthly, as well as the fiscal and exchange rate policies discussed above, at least seven countries which received large commercial inflows also imposed or reimposed capital controls in the first half of the 1990s. These "were effective in the short run in reducing the overall magnitude of capital inflows as well as influencing their composition" (World Bank, 1997e, p172); and they appear to have been largely effective in limiting the contagion effect of the Mexican crisis (though not in protecting Mexico itself)18. The World Bank is somewhat negative in its conclusions on capital controls:
"The role of restrictions on capital movements...needs to be carefully circumscribed....In the longer term...the desirability of capital controls [is] questionable." (World Bank, 1997e, p217)
However, its grounds for taking this position seem extraordinarily weak, only one argument being presented.
"Regarding desirability, the central problem...is that by restricting the degree of financial integration, controls limit the gains that can be derived from [financial] integration - if for no other reason than they create perceptions of an unfriendly environment." (World Bank, 1997e, p218)
This would seem to cast some doubt on the case for extending the IMF's mandate to promote capital account liberalisation. If the World Bank cannot find any substantive argument against capital account restrictions, is there really a sufficient basis for adopting it as a universal policy prescription for developing countries?
Finally, the Bank sees both sterilisation and capital controls as becoming progressively less effective as financial integration advances, implying that policy options will be narrowed to almost exclusively fiscal instruments. Coupled with the single-mindedness with which fiscal tightening has been pursued at every stage of the process, this seems to reduce the scope for discretion in macroeconomic policy to virtually zero.