9:10 AM Sep 13, 1995


Geneva 13 Sep (Chakravarthi Raghavan) -- Developing countries were cautioned against over-reliance on short-term capital flows and overhasty liberalisation of their financial markets to such flows through portfolio investments, and trading in bonds and securities.

The volatility of such flows, and the speed with which they spread across markets (bond, securities, commodities etc) within a country and across borders, makes the task of macro-economic management more and more difficult for governments of individual countries, destabilize long-term trade and investment decisions, and have a serious deflationary effect on national and world economies.

These were among broad points made by a group of outside experts at an informal exchange on interdependence at UNCTAD' Trade and Development Board session Tuesday.

The experts who participated in the discussions were: Robert N. McCauley of the New York Federal Reserve, now currently a visiting economist at the Bank of International Settlements in Basel, Jose Gabriel Palma of Chile, currently teaching at Cambridge University, Yung Chul Park, Professor of Economics at Korea University and President of the Korea University of Finance and Lord John Eatwell, now teaching at Cambridge and who was advisor to British Labour leader Kinnock.

Park who spoke on financial interdependence between Industrial and Developing countries, said the most important development over the last ten years had been the "economic globalization" -- with most of the Industrial Countries (ICs) and Developing Countries (DCs) liberalising their domestic markets and trade regimes, opening them up to international competition and leading to integration of the world economy and integration of financial markets, globally and regionally.

While most economists view this positively and as leading to better allocation of resources and contributing to higher growth rates in some parts of the world, the result of integration was rather mixed, Park said.

It was not clear, and hard evidence is yet to be assembled, whether allocative efficiency of globalization or integration of financial markets at the regional levels has been as impressive as many economists thought in the past, he added.

The Korean economist, and former advisor to President Doo Hwan Chu, noted that there has been significant flows of capital from North to South in the 1990s. These, he said, were largely due to economic performance and structural reforms in many developing countries, a cyclical downturn and low interest rates in early 1990s, and the ongoing international diversification of rapidly expanding institutional portfolios in industrial countries.

But there were three major problems with these flows, Park said.

Firstly, there was an uneven distribution of such flows. Among the developing countries, economies capable of financing their domestic investment -- such as Chile, Taiwan province of China, and other East Asian countries had received a disproportionately large share, while other developing countries that needed foreign capital, specially long-term capital, to sustain a reasonable rate of growth have had limited access to international markets.

"Such an uneven flow could potentially intensify the North-South problem," he said.

Secondly, the bulk of capital flows to developing countries had been in the form of short-term portfolio investment in tradable bonds and equity shares rather than longer-term FDI.

Short-term flows tended to be speculative and unstable, and neither the inflows, outflows, or the duration of their stay were predictable. As a result they had been the major cause of increase in stock-market volatility which in turn disrupted financial markets, rather than supporting domestic capital formation.

Foreign Direct Investment itself, Park stressed, had been declining rather than increasing.

Finally, Park said, there was also a contagion or spill-over effect. If one country experienced a financial crisis resulting from large capital outflows, neighbouring countries would also experience financial turbulence.

He cited the example of the turbulence in Mexico early in 1995 being transmitted to other emerging markets in Latin America and East Asia as investors re-evaluated the country risk of emerging economies. This led to macro-economic difficulties including a stock-market plunge in these economies.

In Park's view, there were many benefits in stabilizing and reducing share of short-term speculative capital flows. These benefits included increased domestic monetary policy autonomy, a reduced likelihood of speculative attack in foreign exchange markets and shift in emphasis to longer-term investments rather than short-term speculative opportunities.

One way to restrict short-term speculative capital flows could be a Tobin tax on foreign exchange trading or short-term cross-border loans. But to be effective it needed to be adopted worldwide and uniformly. Like attempts to reduce exchange rate volatility "international cooperation starting at regional level is necessary to reduce short-term speculative capital flows", Park said.

In their absence, other useful measures could include setting prudential limits on non-trade related swap activities, offshore borrowing, banks' net open market foreign exchange positions and bank's foreign currency liabilities. For many developing countries, direct controls on such inflows and outflows could be useful. He noted in this regard that many countries in East Asia, with heavy regulatory control over financial markets and institutions, were being criticised and pressured to deregulate and open up their financial services markets -- equities, bond markets, short-term security markets etc.

Under pressure from the US and the EU, countries like Japan and South Korea had liberalized their markets rapidly "but the results have not been as promising as had been expected".

In Korea, the domestic interest rates adjusted for inflation and exchange rates was very high, three times in relative terms to those of Japan, US and EU. Such high rates were not compatible worth the needs of a rapidly growing and industrializing economy, and was making domestic macro-economic management very difficult. If the managers of funds decide to send large sums of money into small economies like that of Korea, these could be managed with available instruments of monetary or fiscal policies.

"The only way to manage is to use direct control measures that are used in the developing countries, but which are heavily criticised by many industrial countries," Park added.

"Opening up of the financial services industry in a country, if carried out at a reasonable speed and consistent with domestic economic management, could be very beneficial to the countries opening up through better allocation of resources and more efficient management.

"But opening up markets for short-term flows and instruments is a totally different story," Park said.

"There are a growing number of countries including industrialized countries like New Zealand and countries in Latin America and East Asia that have experienced many difficulties as a result of such opening up. We cannot ignore the growing accumulation of experience in this and we have to be very careful about the deregulation and opening up of financial markets."

Park was not sure whether existing international institutions could act to rectify this situation or whether new arrangements would be needed.

"But if something is not done, it is going to intensify problems in the North and the South countries," he added.

Robert McCauley said that recent bond market volatility loses some of its mystery when two regularities of such volatility were recalled. Bear markets were often more volatile than bull markets and links across bond-markets often strengthen in volatile periods. Two new developments, he said, had rendered bond market developments more inter-dependent. Portfolio flows across borders were larger and more volatile than any time in living memory. Also, international investors in bonds were prepared to leverage up.

McCauley underlined that the record-high volatility in the US bond market had followed the errors of the late 1970s -- which allowed inflation and inflationary expectations to get as high as they did and made the efforts to put the genii back into the bottle more of a disruptive process -- came well before large international flows, leveraged investment or derivatives.

That said, market participants were there making judgements, often ignoring adverse evidence, and suddenly their optimism gives way to pessimism and they react by turning bearish. But governments would do well not to wait for wake-up calls from the market, but anticipate the market and act.

This conclusion of McCauley though seemed easier said than done. While individual governments could perhaps anticipate the market in looking more closely at data about their own conditions, how could governments collectively or even groups of the majors anticipate the market-mind sets across the socalled 'global markets'.

The expert did not elucidate in his opening remarks, and none of the participants asked him either.

In his assessment of economic reforms in Latin America, Jose Gabriel Palma said that as shown by the current Mexican and Argentine experiences, the results of the process of adjustment and new economic policies in Latin America were quite mixed.

On the positive side, he said, the public sector finances have been balanced; inflation has been brought down to low levels, by Latin American standards; volume of exports, particularly of manufactures, have grown rapidly; the profitability of the private sector has shown a fast increase; and economic growth has resumed, albeit at a moderate rate. At the same time, there had been political stability, a broad consensus on economic policy, and substantial support from the World Bank and the IMF. Access to the US market had also improved.

But there was a negative side. The level of investments, particularly in machinery and equipment, as well as infrastructure, has been low. And so has been the level of national savings. Neither huge interest rates, huge inflows of foreign capital and low fiscal deficits, nor low levels of public investment proved to be a significant incentive to private investments or savings. Foreign savings have been a substitute for, rather than a complement to, national savings.

As compared with East Asia, where the inflow of foreign capital was associated with rising national savings, these financial resources have not been used sufficiently for productive investments in Latin America. In several countries, the resumption of growth was too heavily based on private consumption, rather than on investment and exports. As a result growth was more solidly based and sustainable in some countries than others.

Some countries, such as Argentina, Peru and Mexico, Palma noted, run up large current account deficits, equal to about half of their exports. These countries have been considerably more vulnerable to a sudden halt in capital inflows than others - such as Colombia, Chile, Costa Rica, Uruguay, the Dominican Republic and Ecuador -- where the external deficit was smaller. The use of the nominal exchange rate as a price anchor in some of the Latin American countries, Palma said, has led to a massive over-valuation of some currencies. Financial liberalization has also generated only mixed results. On the negative side, the financial liberalization has had an adverse impact on national savings, exchange rates and scope for domestic macro-economic policies.

The lessons to be drawn from the recent experience in Latin America, Palma said, included:

* the crawling peg regime that several countries of the region adopted has generated more satisfactory results than fixed nominal exchange rate regimes;

* there is a need for pragmatic approach to treatment of foreign capital inflows -- with some capital control over the capital account, if an independent monetary policy is to be combined with exchange-rate targeting;

* economic policy measures have to be designed so as to provide stronger incentives for savings and investment;

* industrial policy is required to increase the manufacturing-value added in exports.

"A more general, but important point," Palma stressed, "is that in implementing policies governments need to be sensitive to the shifting nature of the actual environment in which they have to operate, thus avoiding reliance on abstract, general rules".

The Latin American economist added: "Compared to the debt crisis of the 1970s, which was largely due to external factors that could not be controlled by the Latin American governments, the current crisis in some countries in Latin America is mainly of an endogenous nature".

Palma had a lively exchange of views with some of the Latin American delegations, including Argentina, which thought his assessment was heavily pessimistic.

The Argentine delegate cited some recent data, suggesting a sharp rise in exports, despite fixed nominal exchange rate regime - Argentine peso parity with US dollar - increase in reserves and capital inflows.

Palma noted that there were two factors explaining this.

Past experience in Latin America had shown that countries could be in domestic recession, yet the exports could be rising. This was because domestic producers finding no market internally, turn to exports.

The second factor was the Brazilian market. In the first six months of the Real plan, from July 1994 until the Mexican crisis - the Brazilian currency had appreciated by 30%. Brazil thus proved an ideal market of Argentine exports. And while the Argentine peso remained pegged at parity to the US dollar, the US dollar itself was devaluing against the other currencies, particularly the German DM and the Japanese yen. As a result the Argentine peso was devaluing against other currencies, thus benefiting Argentina in some third markets.

But this situation of the depreciating dollar had been reversed over the last few weeks, though it was difficult to say how long this would go on and how far the Argentine exports would be helped. Also, Brazil, as a late-starter in the "reform" process was learning quickly from the experience of others in Latin America, and was changing its policy. Brazil had hence avoided an over-valuation of the Real. It was difficult again to predict its effects on Argentine exports.