Should developing countries pursue capital mobility and integration with the world financial system?
Free Capital Mobility has been one of the main points pushed for by the market fundamentalist view that dominated the global consensus in the 1980s and 1990s. However, by the late 1990s Asian Financial Crisis, and certainly by 2008’s Great Recession, cracks in this view had arisen and become more mainstream, leading to a debate over the desirability of capital mobility. In this brief essay, I go over the arguments for and against capital account liberalization and answer the question of whether developing countries should pursue financial integration.
To start, I’ll go over the arguments in favor of financial liberalization, which are based on the Neoclassical beliefs of perfectly efficient and competitive markets. This view is known as the Washington Consensus, and was pushed heavily by the Fed and international institutions like the IMF from the late 1980s through the early 2000s, often forcing developing countries to adopt liberalization reforms to receive IMF loans. The primary theoretical benefit is that liberalization will lead to growth. With investment no longer constrained by domestic savings (which would likely be low in less developed countries), foreign investors chasing higher returns would invest in developing countries, propelling growth. The other main theoretical benefit is that liberalization promotes consumption smoothing and countercyclical capital flows. During recessions, investors would chase higher returns from developing countries and capital would flow in, while the opposite would occur in good times, allowing developing countries smoother consumption paths. There are two other more “paternalistic” arguments for liberalization, namely that it will teach economic discipline (bad domestic policies will lead to capital flight to other emerging markets) and it will lead to positive learning-by-doing externalities in the banking sector (increased financial market development and efficiency).
As mentioned, this view hinges on the unrealistic assumptions of the Neoclassical school. In reality, there are plenty of disadvantages to liberalization. First, Fuceri et al. (2019) show that liberalization doesn’t lead to statistically significant growth, yet does lead to increased inequality in the form of a reduced share of labor income. They explain that this is exacerbated by countries with less development in the financial system (which describes many developing countries). Stiglitz (2004) re-affirms that liberalization doesn’t lead to growth (citing former IMF Chief Economist Kenneth Rogoff’s admission that when controlling for political factors, liberalization doesn’t have a statistically significant effect on growth), while also explaining that it leads to output and consumption volatility. Based on real-world evidence, capital flows are often procyclical, which makes sense because in times of recessions investors generally move investments away from “risky” assets like developing-country investments, despite higher returns, and into “safe” assets like US dollars or gold. This destroys the traditional hypothesis that liberalization allows for smooth consumption, showing that it in fact leads to the exact opposite. The procyclical nature of capital flows described by Stiglitz, doesn’t just mean countries miss out on the positive benefits of consumption smoothing, but also leads to the negative effects of what are known as Sudden Stops. Korinek & Mendoza (2014) classify sudden stops as sharp reversals in capital accounts (large outflows after periods of expansion), which lead to deep recessions and real asset price depreciations. They describe a cycle where an emerging market economy borrows in the presence of a collateral constraint: economic expansion leads to a leverage buildup, and when leverage is high the constraint is binding, so spending is reduced, thus reducing aggregate demand, which reduces asset prices, thus reducing the value collateral, further tightening the constraint, leading to further spending reductions, and so a vicious cycle arises. They explain that the defining characteristic is that borrowers are subject to a financial constraint that is a function of aggregate macro variables, which play a role in determining market prices, which are used to value collateral (basically if the borrowing limit tightens during a shock, the debt level remains the same which is the crux of the issue leading to the vicious cycle). A final rebuttal of the traditional argument for capital mobility comes from Rodrik and Subramanian (2009) who refute the assumption that developing countries are savings-constrained, which is the main argument for foreign investment promoting growth. They explain that developing countries are rather investment-constrained, and that foreign investment worsens this by appreciating the developing country’s exchange rate, lowering potential investment profitability and growth in the long run. They also show that countries that grow more rapidly rely less on foreign capital, have better financial institutions, and see growth correlated with exchange rate depreciations. Exchange rate appreciations are another problematic side-effect that diminishes growth for developing countries. Guzman et al. (2018) explain that the free market results in an inefficient exchange rate that doesn’t internalize externalities, whereas as a managed stable & competitive (low) Real Exchange Rate has a positive impact on macro-stability and growth. An important complementarity of exchange rate interventions is that they create breathing room for countercyclical monetary policy and smooth investment volatility. This means that interventions to maintain a SCRER would have a positive impact on growth and stability, which completely contradicts the Neoclassical argument. Ultimately, the evidence points not only to the theoretical benefits of capital mobility not materializing, but also to it having significant drawbacks. It doesn’t lead to more growth and does lead to inequality, it doesn’t lead to consumption smoothing and does lead to sudden stops, and developing countries being investment-constrained rather than savings-constrained leads to RER appreciations that have negative effects on growth and stability.
This leads us to the question of whether developing countries should pursue integration with the global financial system. I would hesitantly, and somewhat contradictorily, say yes but with strong caveats. Considering the fate of a country like North Korea (DPRK), I’d say financial integration is better than the alternative of complete autarky. Assuming you are at least a slightly open economy, that puts us in the realm of International Economics, meaning countries are confronted with what is known as the Mundellian Trilemma, which explains that you can have at most two of the following three: capital mobility, exchange rate flexibility, and domestic monetary policy autonomy. However, Rey (2014) explains that this really amounts to a dilemma because by integrating financially (even slightly), you open yourself up to the US exporting its monetary policy, even if you adopt a flexible exchange rate regime (and certainly for a fixed one). The solace in these findings, however, is that capital controls are the best tool at mitigating these spillovers. Capital Controls are defined as any interventions into the capital account, and can be distinguished according to the following categories according to Erten et al. (2019): (1) what the controls are imposed on (inflows or outflows), (2) whether they’re price or quantity based (taxes or government’s implementing of transaction quotas), (3) ex-ante or ex-post timing (to prevent crisis from happening beforehand or whether they’re enacted during crises to mitigate them), (4) long-standing structural or episodic controls, and (5) who they restrict (foreigners from investing or citizens from borrowing). These controls work through direct and indirect channels. The direct channel either changes the cost of international borrowing (taxes) or limits the flow (quotas). The indirect channel works by signaling to foreign investors how accommodating/hostile policymakers are to investment (leading to bias against capital controls as a measure last resort) or by providing information about the expectations of an economic environment (if liberalization suddenly occurs, it can be perceived as evidence that country’s economy may be on the brink of crisis). Erten et al. find that ultimately capital controls reduce the ratio of short-term to long-term flows but not the total amount of flows, inflow controls are more effective than outflow controls, and that capital controls do reduce financial vulnerability to shocks. Some other interesting findings from include that more capital account openness leads to more exchange rate overvaluation, and that regulating capital flows allows for more monetary policy independence minimizing the tradeoff with interest rate stability arising from the trilemma. Erten et al. note that even in good times, total capital mobility can lead to overheating and excessive borrowing & risk. These findings on capital controls dovetail nicely with our previous discussion of the negative aspects of free capital mobility. So while I argue in favor of integration with the world financial system, I do so while advocating for developing countries to actively pursue capital controls and real exchange rate management.
When Keynes was engineering the Bretton Woods Agreement Post WWII, he believed free capital movement was a source of major financial instability and was a cause of the Great Depression, and that it shouldn’t interfere with the ability to make domestic monetary policy. In spite of Keynes’ pleas, it took over 60 years for his views to gather acceptance again. A new consensus has seemed to emerge that acknowledges capital flows have externalities (private return doesn’t equal the social return), government intervention to mitigate these externalities is in fact welfare enhancing, and adopting ex-ante tax-based macro-prudential capital controls are effective and beneficial for developing countries’ growth and stability. Finally, in 2012 the IMF’s new Institutionalist View of Capital Account Liberalization & Management went as far as to state that capital flows should be somewhat regulated to offset surges and sudden stops, and that full liberalization was is in fact not good for all countries at all times. From all of this, it seems as if there is now broad consensus that capital account liberalization is irrefutably bad for developing countries in terms of growth, stability, and equality. However, the fact that the market fundamentalist agenda was pushed so hard by the US and IMF for so long without evidence in favor and with strong evidence against, seems to be politically motivated, as it benefitted developed nations while causing real economic harm for developing countries.
