Key Points

• During the last decade there has been a dramatic increase in PI to the world’s emerging economies.
• Many economists claim that PI induces an efficient flow of finance to economies facing capital shortages. But PI is associated with deep structural problems, including increased risk of a financial crisis following a sudden erosion of investor confidence.
• Far from being anomalous, the Asian and Mexican crises illustrate the costs of failing to control PI.

Since the mid-1980s, there has been a dramatic increase in the magnitude of international flows of portfolio investment (PI), especially from countries in the North to emerging market economies across the South. PI entails the purchase of bonds and corporate stock without acquisition of a controlling interest by the investor. North-South PI flows have been heralded as a relatively safe, efficient means of transferring capital to those countries where it is needed most. But this view has been challenged by the series of financial crises across the South, from Mexico in 1994 to Southeast Asia in 1997-98. Many economists have argued that these crises are anomalous, reflecting exceptional circumstances. But a closer look reveals that the unregulated international flow of PI, especially into emerging market economies, is fraught with deep structural problems.

Net PI inflows into emerging market economies totaled $800 million 1987 but soared to $7.2 billion in 1991 and $45.7 billion in 1996. U.S. portfolio investors were drawn to emerging economies for two reasons. First, these investors faced an apparent decline in investment opportunities in the U.S. following the 1987 stock market plunge and the concomitant reduction in U.S. interest rates. Second, at the insistence of the U.S., and especially the IMF during the 1980s, many developing countries deregulated their financial systems through domestic financial liberalization programs, which precipitated a flourishing of new markets and investment instruments and eliminated controls on capital inflows and outflows (through external financial liberalization).

The Southeast Asian financial crisis that erupted in Thailand in July 1997 took investors by surprise. Through late 1996, Southeast Asia experienced huge inflows of private capital. Indeed, in that year Indonesia, Malaysia, and Thailand received the third, fourth, and sixth largest shares of foreign capital inflows (respectively) in the world, for a total of $47 billion.

But IMF economists were equally startled by the crisis. Indeed, this crisis occurred after the IMF had implemented what was regarded as an important new set of safeguards embodied in the Special Information Dissemination Standard in April 1996, following the Mexican crisis. Banking naively on investor rationality, IMF officials embraced the view that better information would suffice to prevent speculative excesses and crises.

The Asian crisis has eclipsed the Mexican financial crisis of 1994 in most respects. The $57-billion bailout of South Korea in December 1997 single-handedly exceeded the Mexican bailout of $50 billion in early 1995, formerly the largest financial rescue in history. In addition, the IMF negotiated relief packages of $4 billion for the Philippines in July, $17 billion for Thailand in August, and $43 billion for Indonesia in November, for a 1997 total of $121 billion.

Of all the types of private capital to enter emerging economies, PI has the greatest potential to destabilize the recipient economy. This is because of the liquidity of PI and the short time horizon associated with such investments. For example, in the current crisis a reversal in conventional wisdom among investors regarding Southeast Asian prospects (initially with regard to Thailand) precipitated the sudden liquidation of portfolios and the dumping of currency holdings. This rapid exit depressed stock prices and undermined the ability of Southeast Asian governments to maintain the value of their currencies. Depreciation, in turn, exacerbated the problem of investor flight and induced a debt crisis as domestic institutions faced rapidly rising costs associated with hard currency-denominated foreign obligations. The lesson of this crisis (and the earlier Mexican crisis) is that while uncontrolled PI flows do not themselves cause financial crises, they render emerging economies vulnerable to a collapse that can be triggered by a large-scale exit of PI.

Moreover, emerging-market financial crises are contagious. The prudent investor, knowing the speed with which a financial crisis can unfold, may flee from all emerging markets immediately when trouble arises in any one of them. The investor who moves too slowly in the face of a general investor flight can suffer catastrophic losses instantaneously.

International PI does introduce the opportunity for an emerging economy to secure more capital than is available domestically. But the excessive liquidity of unregulated PI flows leaves receiving nations vulnerable to rapid financial outflows due to fickle investor sentiments.

Problems with Current U.S. Policy

Key Problems

• U.S. and IMF efforts to open emerging economies to PI have contributed to their vulnerability to financial crises.
• Current IMF bailout conditions, which mandate even greater openness and liberalization, increase the likelihood that current financial history will repeat itself.
• Through U.S. financial support for the IMF, taxpayers are financing bailouts that will not prevent new crises, that socialize the risks of PI, and that may result in U.S. job losses.

Supported by the U.S., the IMF has pressured emerging economies to implement financial liberalization programs to attract foreign PI. These programs were indeed effective, as the data above indicates. These highly liquid flows of “hot money,” as they are called, helped to buoy the financial performance of emerging economies by creating stock and asset market bubbles. But while potentially rewarding to investors, speculative flows of this sort do not provide a stable basis for financing the kinds of economic activities that are necessary to promote long-term, stable, and equitable economic growth in emerging economies.

At present, the U.S. and the IMF are pushing for reforms that will make Southeast Asia again attractive to portfolio investors. But the reform measures (stipulated by the IMF bailouts) require these economies to accelerate external and internal financial liberalization and open their economies further to foreign PI. Paradoxically, then, the success of these reforms will leave the region more dependent on PI inflows and, hence, more susceptible to future financial crises. Moreover, the currency appreciation that is a likely outcome of increased PI inflows (under a system of floating exchange rates) potentially compromises the export performance of Southeast Asian economies that are seeking to export their way out of their present difficulties. Indeed, Mexico—having trod the Southeast Asian reform path under its 1995 bailout—has suffered a deterioration in its trade performance since the bailout, partly as a consequence of the appreciation of the peso and the return of PI to Mexico.

Although U.S. taxpayers provide almost 20% of IMF capital, critics claim that many of them are harmed by its use of these resources. IMF bailouts protect those investors and bankers who simply made bad financial decisions. Furthermore, the specter of stiffer competition with Southeast Asian economies, which have no choice but to try to increase their exports and decrease their imports, introduces the possibility of U.S. job losses. Indeed, the U.S. trade deficit with South Korea has already risen since that bailout was negotiated. The possibility that U.S. consumers may benefit from the ability to purchase low-priced goods from countries in crisis is not sufficient compensation for U.S. employment and economic instability that a rising trade deficit could very well induce. In this economic climate, protectionist sentiments are likely to spread in the United States.

Clinton administration officials are presently urging increased U.S. funding for the IMF and support for IMF-led bailouts across Southeast Asia. U.S. Treasury Secretary Robert Rubin has argued that these IMF bailouts are in the U.S. national interest. He contends that the Mexican bailout was a clear policy success and that bailouts generally promote stability, economic openness, and peace throughout the developing world. Finally, he contends that all U.S. citizens are hurt by financial crises abroad.

But this view is shortsighted. For instance, it entirely neglects the problem of what economists call “moral hazard,” which occurs when investors undertake imprudent actions knowing that they will be insulated from the potential losses. Contrary to Rubin’s claims, in the absence of structural reforms we can expect each bailout to induce greater risk-taking and potentially more instability as investors come to bank on IMF protection. Although bailouts may sometimes be warranted on practical and humanitarian grounds, they must be tied to deep financial reforms that reduce (rather than increase) the likelihood of future crises.

Unfortunately, IMF bailouts are tied to a different kind of reform—austerity measures that primarily punish the impoverished citizens of the developing countries in economic crisis. Such measures have been imposed on developing countries since the debt crisis emerged in the early 1980s—and with devastating effects. IMF reforms feature increases in taxes and decreases in government services and subsidies on vital goods and services. Short-run currency depreciation also spawns rising prices at a time when incomes are falling. It is noteworthy that the IMF’s “crisis resolution through austerity” program in Southeast Asia has received criticism even from prominent mainstream economists Jeffrey Sachs and Paul Krugman and from prominent currency trader George Soros.

It must be emphasized that IMF intervention targets crisis management rather than crisis prevention. The IMF derides policy initiatives that would manage international PI flows as market distortions that undermine economic growth and development. This worldview has prevented the IMF from exploring the diverse array of policy tools at its disposal to prevent crises.

In the immediate aftermath of the Asian crisis, some economists at the IMF—including its First Deputy Managing Director, Stanley Fischer—began to consider PI regulation via the implementation of temporary controls on capital accounts transactions. The IMF is now contemplating amending its Articles of Agreement to include jurisdiction over capital flows. Unfortunately, the IMF (in its March 9-10, 1998, seminar on the issue) has already begun to backpedal, apparently convinced that the crisis has been resolved and that the key to crisis prevention is the maintenance of “good fundamentals.”

Toward a New Foreign Policy

Key Recommendations

• Portfolio investment must be carefully managed to maximize its benefits and minimize its drawbacks.
• There exist promising and economically feasible policy tools for managing PI. These measures include capital controls (like the “Chilean model”) and Tobin transaction taxes.
• The only serious obstacles to the implementation of such management techniques are political and ideological, not technical. These could be overcome through U.S. leadership.

If there is a silver lining to the current crisis, it is that it has created some space for policymakers to consider measures that would prevent the recurrence of financial crises in developing countries. The U.S. should assist emerging-economy governments to establish measures to manage and control highly liquid PI flows. Such measures should be designed to reduce the general reliance of developing countries on short-term private foreign capital (and foreign-denominated obligations), even at the cost of reducing the volume of such inflows. In particular, the U.S. should promote the selective use of capital controls, because such controls can augment other government initiatives to secure sustained, stable economic development rather than the speculative profits associated with unregulated PI inflows.

Volume- and price-based capital controls were key features of the macroeconomic stability achieved by South Korea, Japan, and Brazil during their most successful periods of economic growth. In the view of some economists, capital controls remain a necessary and viable policy tool for emerging economies. Capital controls reduce the ability of investors to flee whenever a government pursues a policy of which they don’t approve. In such cases, capital controls augment policy autonomy and state capacity. More germane to the present discussion, they also reduce macroeconomic instability by damping capital inflows and outflows.

Although they have fallen from favor in economic theory, capital controls remain an important strategy for some developing countries. Measures currently in place in Chile and Colombia (referred to as the “Chilean model”) represent an extremely promising direction for policy. These measures balance the need for capital with the need to protect the economy from instability. In Colombia, foreign investors are free to engage in less-liquid direct investment, such as the construction of new manufacturing facilities, but they are precluded from purchasing debt instruments and are discouraged from purchasing corporate equity. As a consequence, foreign capital is far less able to flee Colombia en masse. In Chile, foreign investors may engage in PI, but they must keep their cash in the country for at least one year. Investors are therefore much more apt to base their investment decisions on a company’s long-term economic prospects than on the opportunity for short-term, speculative gain. To the surprise of many orthodox economists, this model is performing well. Indeed, Chile has not only succeeded in securing large PI inflows, but has also remained relatively unaffected by the “Asian flu” that hit even Brazil in the aftermath of the Southeast Asian crisis.

Many progressive economists and some important organizations like the United Nations Conference on Trade and Development have also proposed adapting economist James Tobin’s proposal for a uniform global transactions tax on foreign currency trading. The Tobin tax is primarily intended to address the problem of foreign exchange market volatility caused by speculation in this market. This approach could also be adapted to offset the instability associated with international PI flows. Short-term traders fleeing assets denominated in a country’s currency could be charged a substantially higher tax on their currency trading. This modified Tobin tax would offset some of the extreme liquidity associated with PI, reduce the profitability of country-to-country transfers in international investment portfolios, and thereby provide developing countries with greater financial stability.

Relying on market incentives such as a Tobin tax represents a simple policy tool for lengthening the time horizon of international PI. It would provide new pools of finance that could be targeted to developing countries to compensate those harmed by financial instability and to finance long-term, real-sector development projects (as economist David Felix has suggested).

Capital controls of various types have played a key role in the successful development of most wealthy countries. The obstacles to capital controls today are political and ideological, and these obstacles could be easily overcome with the support of the U.S. government and the IMF. The U.S. must change course away from its support for unrestricted liberalization and recognize that unregulated PI flows present much greater dangers to emerging economies than to more developed economies.

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