SUNS  4335 Tuesday 1 December 1998



FINANCE: UNFETTERED CAPITAL FLOWS AREN'T ALWAYS OPTIMAL

Geneva, 30 Nov (Chakravarthi Raghavan) -- Whatever else Malaysia may or  may not have achieved by instituting capital controls and restricting foreign transactions in its currency, it has changed the parameters of the debates on international capital flows.

The Bank of International Settlements, in its quarterly review of international banking and financial market developments, notes that "whereas earlier discussions on these issues had often been biased by ideological considerations, there has more recently been a greater willingness to re-examine the hypothesis that unfettered international capital flows are optimal".

It is now increasingly acknowledged, notes the BIS, that a certain number of pre-requisites, have to be fulfilled before countries liberalise their capital accounts. These include robust banking
systems, adequate financial supervisory and regulatory standards and transparent rules and practices.

A premature opening could expose the domestic economy to volatile capital inflows that exceed absorbtion capacities. And in the sequencing of capital market liberalization, preference should be given to direct investment, followed by portfolio and long-term capital investments.

But in the area of short-term capital flows that the debate has become most controversial. Controls on outflows are generally rejected on grounds that they are ineffective in preventing capital flight.

And there has been growing support for some restrictions on inflows, by measures such as those introduced by Chile in 1991 (a one year compulsory deposit at the central bank for all non-equity inflows). These are considered as an implicit form of taxation and, as such, considered not inconsistent with capital convertibility.

But the short-terms benefits need to be balanced against long-term costs, including higher borrowing rates, administrative requirements and competitive distortions. They also involve the difficult task of differentiating between speculative flows, on the one hand, and trade financing and long-term investment, on the other.

All these have strengthened the views about better supervisory arrangements, and better international standards and mechanisms for not only greater transparency on the part of countries, but also on the lending side. The recent crisis has also revealed important weaknesses in the risk management systems of intermediaries and in financial disclosure, "bringing to the fore weaknesses in the world financial system itself."

In particular, regulatory oversight has lagged the globalization of markets and advances in technology, and "a clearly defined international framework for handling financial crises is lacking."

However, longer-term efforts to resolve such issues have been superseded by events. The financial turbulence unleashed by the Russian decision to float the ruble, and then declare a partial debt
moratorium, threatened to reach a systemic dimension. This prompted official actions - including the recapitalization of a hedge fund (LTCM), and discussions on contingent financing for Brazil.

Since restoring overall market confidence has become critical, resort to rigid foreign exchange controls and moratoria would have detrimental effects and might heighten market concerns about a more generalized resort to controls and withdrawal from all emerging markets, and would add to the difficulties of coordinating a fair sharing of costs and delay an orderly resolution of the present crisis.