Emerging
markets are back in the spotlight. Investors and banks are suddenly
unwilling to finance current-account deficits with short-term debt.
South Africa, for example, has had to increase interest rates, despite
slow economic growth, to attract the funding it needs. Turkey’s rate
increase has been dramatic. For these and other emerging countries, 2014 may prove to be a turbulent year.
If
volatility becomes extreme, some countries may consider imposing
constraints on capital outflows, which the International Monetary Fund
now agrees might be useful in specific circumstances. But the fundamental question is how to manage the impact of short-term capital inflows.
Until
recently, economic orthodoxy considered that question invalid.
Financial liberalization was lauded because it enabled capital to flow
to where it would be used most productively, increasing national and
global growth.
But
empirical support for the benefits of capital-account liberalization is
weak. The most successful development stories in economic history –
Japan and South Korea – featured significant domestic financial
repression and capital controls, which accompanied several decades of
rapid growth.
Likewise,
most cross-country studies have found no evidence that capital-account
liberalization is good for growth. As the economist Jagdish Bhagwati
pointed out 16 years ago in his article “The Capital Myth,” there
are fundamental differences between trade in widgets and trade in
dollars. The case for liberalizing trade in goods and services is
strong; the case for complete capital-account liberalization is not.
One
reason is that many modern financial flows do not play the useful role
in capital allocation that economic theory assumes. Before World War I,
capital flowed in one direction: from rich countries with excess
savings, such as the United Kingdom, to countries like Australia or
Argentina, whose investment needs exceeded domestic savings.
But
in today’s world, net capital flows are often from relatively poor
countries to rich countries. Huge two-way gross capital flows are driven
by transient changes in perception, with carry-trade opportunities
(borrowing in low-yielding currencies to finance lending in
high-yielding ones) replacing long-term capital investment. Moreover,
capital inflows frequently finance consumption or unsustainable
real-estate booms.
And
yet, despite the growing evidence to the contrary, the assumption that
all capital flows are beneficial has proved remarkably resilient. That
reflects the power not only of vested interests but also of established
ideas. Empirical falsification of a prevailing orthodoxy is disturbing.
Even economists who find no evidence that capital-account liberalization
boosts growth often feel obliged to stress that “further analysis”
might at last reveal the benefits that free-market theory suggests must
exist.
It
is time to stop looking for these non-existent benefits, and to
distinguish among different categories of capital flows. Some are
valuable, but some are potentially harmful.
Foreign
direct investment (FDI), for example, can aid growth, because it is
long term, involves investment in the real economy, and is often
accompanied by technology or skill transfers. Equity portfolio
investment may involve price volatility as ownership positions change,
but at least it implies a permanent commitment of capital to a business
enterprise. Long-term debt finance of real capital investment can play a
useful role as well.
By
contrast, short-term capital flows, particularly if provided by banks
that are themselves relying on short-term funding, can create
instability risks, while bringing few benefits.
Read more: Adair Turner: In Praise of Fragmentation
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