Follies of capital account liberalisation

TThe Bangladesh cabinet has endorsed lifting of an embargo in place since independence, on

investments in foreign countries by local businesses and individuals, under a liberalised

foreign exchange regime. A daily reported that the “preferred sectors in the new investment

criteria includes deposits in banks and investments in stocks, real estate and other industrial

units in foreign countries.”

The report quoted a senior Finance Ministry official as saying that the blanket changes are

needed “to keep pace with changed world economic order and modernise investment outlook

as decades [of] long restrictions on capital account convertibility makes no financial sense

given the country’s current buoyant reserve position.”

Alas, the senior official seems to be unaware of an increasing volume of evidence that capital

account liberalisation lies at the heart of most financial crises. Both frequency and depth of

financial crises increase with the capital account liberalisation. There is now a great deal of

consensus that capital account liberalisation together with rapid financial sector deregulation

played a large role in the Asian financial crisis of 1997-98 that punctured more than three

decades of rapid growth of East Asian economies under a regime characterised by financial

restraint and control. Malaysia could come out of the crisis only after it introduced

restrictions on foreign capital transactions.

Countries, such as China and Viet Nam that remained unaffected by the contagion, had

restrictions on capital account. The same is true of India who could largely insulated itself

from the 2008-9 global financial crisis.

Countries with liberalised capital account also are vulnerable to monetary policy changes in

advanced countries. For example, in recent years, countries that have liberalised their capital

account in the hope of overcoming their structural balance of payments deficit or savings-

investment gap through short-term capital flows, experienced sharp fluctuations in financial

markets, including sudden depreciation of their currencies when the market anticipated a shift

in the US Federal Reserve’s monetary policy.

This means the Bangladesh Bank has to have strong macro-prudential regulation to protect

our financial sector from external shocks. It must also have “very large” foreign exchange

reserves to withstand storms hitting our shores arising from changes in macroeconomic

policies abroad. But keeping large foreign exchange reserves has an opportunity cost as this

could have been invested in socially desirable sectors. Moreover, as some countries in the

region with large accumulated foreign reserves (e.g. South Korea) have found out in the wake

of the 2008-9 crisis and during the volatility caused by changes in the US monetary policy,

that their “large reserves” may also quickly disappear.

Furthermore, if the Bangladesh Bank is not extra-vigilant, the blanket deregulation of the

foreign exchange regulations act is likely to open the door for large-scale capital flight

through “legalised” channels. One just hopes that the Bangladesh Bank has the capacity to

bear this huge prudential regulatory and policy-making- as well as vigilance- burden.

It is understood that “a group of influential businessmen had long been pressing the

government to lift the ban on current capital account convertibility so that they could invest

outside the country.” However, apparently the decision was “largely dictated by the

International Monetary Fund” (IMF), a source at the Bangladesh Bank told the daily.

This, in fact, is contrary to IMF’s Article of Agreement VI (Section 3) which explicitly states,

“Members may exercise such controls as are necessary to regulate international capital

movements …”

Under the leadership of IMF Managing Director, Jacques de Larosiere, the Fund stayed away

from financial globalisation or internationalisation until 1987. Jacques de Larosiere has

famously said, “We had our catechism: Thou must give freedom to current payments, but

thou must not necessarily give freedom to capital.” He further noted, “I was comfortable with

the idea that the Fund would not move toward compulsory freedom of capital. By the time I

left the Fund in 1987, I was not aware of any discussions of changing the Articles to bring the

capital account within our jurisdiction.”

Only during the 1990s, the IMF became an enthusiastic advocate of capital account

liberalisation, and its Executive Board, led by Managing Director, Michel Camdessus, sought

to amend its Articles as the status quo was portrayed and increasingly seen as anachronistic

and naïve. Thus, the IMF under his leadership began to encourage the staff to give greater

emphasis to capital account issues in Article IV consultations and technical assistance and to

promote capital account liberalisation more actively.

However, the Asian financial crisis from mid-1997 forced the Interim Committee at the

Annual Meeting in September 1997 in Hong Kong to ask for caution in the implementation

of capital account liberalisation. Although the Asian financial crisis dealt a blow to the

supporters of capital account liberalisation, it did not diminish their enthusiasm. Despite the

deepening of the Asian financial crisis and the financial crises in Russia and Brazil in 1998,

the Interim Committee renewed its call for capital account liberalisation at the 1998 Spring

Meeting of the Board.

It is argued that capital account liberalisation would see capital outflows from capital

abundant developed countries to capital-scarce developing countries. This sounds very

logical, as water flowing downstream. This is also consistent with economic theory which

states that marginal returns decline with higher stock of capital. Therefore, as capital

competes or rushes in seeking opportunities for better returns where the stock of capital is

low, the cost of capital should decline.

Paradoxically, developing countries are financing large current account deficit of the richest

country in the world, the US. With some exceptions, opening up the capital account has

facilitated capital flight, rather than inflows, especially of a long-term nature, to develop new

economic capacities. Developing countries continue to provide net financial resources to

developed economies, peaking with an all-time high of $883 billion in 2008. The lost decade

of the 1980s in Latin America, the lost two decades at the end of the 20th century in Africa,

and protracted stagnation in post- ‘shock’ transition economies have accompanied financial

liberalisation. And when capital has flowed to emerging markets, such episodes have often

been temporary and eventually reversed with devastating consequences, as in the 1997-1998

East Asian, 1998 Russian, 2000 Turkish and 2002 Argentine crises.

Not surprisingly, recent IMF research acknowledges that financial liberalisation has not

ensured higher growth. In fact, one of its recent publications attributed the rise in inequality

worldwide to capital account liberalisation (“Who Let the Gini Out?” Finance &

Development, December 2013, Vol. 50, No. 4).

Capital account liberalisation has also not ensured significantly cheaper finance. Instead, the

cost of finance rises sharply during economic downturns (forcing real interest rates to rise)

and falls during booms (involving low real interest rates). More rents have accrued to finance

in the OECD economies in recent decades. Meanwhile, financial liberalisation has led to

financial deepening which has increased the levels of intermediation and corresponding

claims to financial rents.

One can explain politicians’ enthusiasm towards the idea of local investors investing

overseas. This may be seen as a sign of maturity or progress towards becoming a developed

or capital exporting country! They can presumably take the credit for this progress. But

juxtapose this with our begging for foreign aid and loan. If we do have surplus capital that

needs invested overseas, then why not encourage our local investors to invest here to

overcome our huge deficits in infrastructure, energy and other essential services instead of

looking for foreign investors?

Why are our investors not attracted to domestic opportunities and instead pressing for

deregulating our capital account? Is that not one sure way of saying that “we do not have

confidence or stake in this country. So, we need ‘legalised’ channels to take our assets and

money to a safe-haven.”