The Consequences of Capital Liberalization

Challenge, Nov, 2000 by Lance Taylor

The world has now experienced a long experimental period with the liberalization of capital flows. What have we learned? There have been surprisingly few balanced studies about its consequences. This economist headed two comprehensive studies and presents his teams' disappointing findings.

AS SEEN from the year 2000, economic policy in developing and postsocialist economies during the preceding ten to fifteen years had one dominating theme--external "liberalization" or the drastic lowering or removal of long-standing barriers to almost all international transactions. This wave of deregulation was the central feature of "globalization" for the nonindustrialized world.

To trace liberalization's effects, it is helpful to think in terms of the standard four-way breakdown of the balance of payments, or the sum of an economy's transactions with the rest of the world (cash inflows counted as positive and outflows as negative).

"Trade" flows are exports and imports of goods and services. "Factor service" payments include interest on outstanding foreign debt, profit repatriation, and remittances from overseas workers, among other items. Trade and factor service payments make up the "current account." There is also a "capital account," which includes increases in foreign debt along with sales of securities. An economy with a capital-account surplus is borrowing and selling assets abroad in net terms--importing capital from borrowing and selling securities on balance. The United States is an obvious example of such an economy.

The sum of surpluses on capital and current accounts equals the change in the fourth component, the economy's "international reserves" or foreign assets held by the central bank. Reserves are part of the money supply. In the 1990s, liberalizing developing countries typically ran current-account deficits--they imported more than they exported. They also typically ran capital-account surpluses--they imported more capital than they exported in the form of loans and purchases of securities abroad. Thus, they generally received capital inflows to cover the excess of their imports over exports (plus net factor service payments sent abroad). Recently, the United States has had the same experience. [1]

Full-scale liberalization of either the current or capital account can have widespread repercussions. When the current account is liberalized, foreign firms can sell their products in the domestic market. This situation immediately confronts local firms with foreign competition in markets for final and intermediate goods and services (the latter via foreign outsourcing to the detriment of domestic suppliers). It drives national relative prices close to those on world markets, with potentially decisive incentive effects on patterns of foreign trade, employment, and production. Liberalizing the capital account allows foreigners to invest. It impacts the financial system directly and may radically shift market-clearing "macro" prices such as the real interest and exchange rates. [2] Combining both forms of liberalization leads to economywide reactions that can create a powerfully stimulating or toxic policy brew. Experience around the world is only now beginning to show whether the stimulants or the toxins will prove more potent.

Two recent research projects were designed to investigate this question through the use of quantified narrative histories for a number of countries. They analyzed changes over time in effective demand, productivity growth, employment, the distribution of income across producing sectors (agriculture, industry, services, etc.), and forms of payments flows (wages by different skill levels, profits, interest, etc.). The studies were carried out by economists from the countries concerned--all highly respected both internationally and at home. [3] One project concentrated on countries in Latin America and the Caribbean, with the other adding detail on the effectiveness of social policies in dealing with the impact of liberalization in Argentina, Colombia, Cuba, India, South Korea (hereafter simply "Korea"), Mexico, Russia, Turkey, and Zimbabwe.

The results are sobering. At their best--and the best cases were infrequent--liberalization packages generated modest improvements in economic growth and distributional equity. At their worst, they have been associated with increasing income inequality and slower growth, even in the presence of rising capital inflows. The obvious implication is that the liberalization strategy needs to be seriously rethought. A good place to start is with conventional views about its likely effects.

The Liberalization Debate

Through the mid-1980s, stabilization and structural adjustment efforts outside the industrialized economies concentrated on fiscal and monetary restraint and realignment of exchange rates.

Then in the late 1980s arid early 1990s came drastic reductions in trade barriers and external financial liberalization, almost simultaneously in most countries. Complementary policies included restructuring domestic financial markets, tax systems, and labor markets. [4] These steps mark close to a 180-degree turn in the course of development policy. It will take time before their full effects can be studied and understood, but one should surely expect serious consequences.