BACK TO MAIN  |  ONLINE BOOKSTORE  |  HOW TO ORDER

Financial liberalization hasn't yielded expected results

A Cambridge University study based on the experiences of the OECD countries has shown that financial liberalization has not worked to promote growth in the North. In the absence of a change in policy by Northern governments to promote such growth, the South countries would be well advised to adopt a pragmatic approach to financial liberalization and weigh its benefits against its costs.

by Chakravarthi Raghavan


GENEVA: The liberalization of international financial markets has not yielded the results expected by standard economic theories, has slowed down growth and investment, and seems likely to hinder rather than promote development, according to a just-published study by Lord Eatwell, President of Queen's College, Cambridge University (UK).

Eatwell makes the point that the predominant belief that financial markets are efficient and should be left alone is misguided. Financial markets are prone to irrational swings and asset prices don't necessarily reflect supply and demand; but price distortions however, impact on the real economy.

Without a change of policy to encourage higher growth in the North, says Eatwell, the prospects for successful growth strategies in the South are seriously reduced. But developing countries could adopt a pragmatic stance to see whether benefits of financial liberalization outweigh its costs.

The publication of the Eatwell study by the UN Development Programme (UNDP) in its discussion paper series, appears to be somewhat dated. The foreword to the 66-page publication, by Ms Inge Kaul, Director of the UNDP's Office of Development Studies (the office is said to be on the chopping block under the UN secretariat restructuring), was written in September 1996. And it has taken nearly a year for the 66-page study to be published.

Kaul told a press briefing that the publication had been held back because of political reasons - Eatwell's position as a UK Labour party politician and the impending UK general elections.

The subject of the study, and the inadvisability of developing countries engaging in financial market liberalization, has been carried much further in studies since Eatwell's - and have been more forthright in advising developing countries to undertake financial liberalization only as the last step, and that too, on a step-by-step approach in the sector, and not undertake capital account convertibility (advocated by the IMF management.)

These latter studies, including by several of the authors cited there, as well as by UNCTAD (in its East Asian Development Experience series and in the Trade and Development Reports which are not mentioned in the bibliography), cover the experiences of the developing countries - some of whom liberalized pell mell and are still paying the price - whereas Eatwell's is based on the experiences of the OECD countries, and particularly the G-7.

Deterioration in North's economic performance

Nevertheless, the study's merit lies in pointing out that financial liberalization has not even worked to promote growth in the industrialized countries, which have extensive regulatory institutions, and will cause harm in the former socialist countries.

The study brings out that there has been a deterioration in economic performance of the industrialized countries since the Bretton Woods era of tight capital controls. Per capita output and growth in the major economies have fallen by 30-60% since 1972; and in the 1980s, three-quarters of the OECD and all G-7 economies, save Canada and Japan, had lower investment/GDP ratios than in the 1960s. And so was the experience of 9 out of 10 Latin American countries.

While other factors may also have been at work, the study notes that this deceleration of growth and investment occurred during a period of accelerating financial liberalization.

The UNDP press release notes that similar sweeping liberalization in Southeast Asia is being accompanied now by financial crises in South Korea, Thailand and Singapore.

Contrary to theory, the net flow of financial resources as a result of financial market liberalization has not been from capital-rich developed countries to the developing economies. Between 1983-1992, the largest net transfer was to the US at an average of $100 billion a year, and in 1995, it was to the tune of $119 billion.

Factor scarcity does not hence determine how money is allocated.

And while there has been some dramatic increases in capital flows to developing countries - some $48 billion in 1994 - the benefits of this inflow has been overshadowed by the impact of stock market and foreign exchange volatility, particularly in the aftermath of the Mexican crisis of 1994.

Similarly, the rush to convertibility and relaxation of capital controls in Central and Eastern European economies failed to generate substantial capital inflows: FDI to the entire region between 1992-1994 was just equivalent to the FDI to Malaysia, while some like the Russian Federation became capital exporters.

Rise in real interest rates

The liberalization of financial markets, and the wider range of placement opportunities for savers, has not resulted in similar benefits to borrowers.

In all the G-7 countries, real interest rates have risen since the 1980s, placing an added burden on borrowers (both governments and private agents). And with real interest rates (average of 5.1% over 1981-1993) higher than GDP growth rates, there is an increasing danger of national and international debt rising, Eatwell points out.

An economic environment of liberalized markets, Eatwell says, makes systematic policy-making more difficult, and in particular, biases governments towards deflationary policies.

Any indication of higher levels of activity and employment produce higher interest rates in the bond markets, with dampening effects on the real economy - resulting in a slow-down in output and employment, as well as in fiscal constraints translating into reducing spending on health, education and other social services.

A liberalized, sophisticated financial system, with a premium placed on possibility of exit, is a fragile financial system, Eatwell notes.

That fragility is manifest:

* in liquidity crises, some of which have substantial reverberations in reduced real output;

* in risk aversion in the private sector, which produces a bias towards short-term and corresponding reluctance to invest for the longer-term; l in risk aversion to the public sector, producing a bias towards deflationary policies; and

* in persistent demands for greater "flexibility" to increase the possibilities of exit.

And the development of new derivative products to manage the risk that the liberal financial system has itself created in turn has produced new systemic risks.

All successful examples of the creation of modern industrial economies, from the 19th century Germany to the modern Republic of Korea, Eatwell points out, have been associated with interventionist policies in trade and finance. History suggests that a laissez-faire international regime may well hinder rather than help the process of transformation in Central and Eastern Europe.

The Depression of the 1930s was a product both of loss of international financial control and the fact that governments were convinced of the necessity of deflationary policies. They had no alternative theory which would lead them to act otherwise.

"Without a change of 'theory' by governments, without a willingness to pursue growth-oriented policies," says Eatwell, "no formal structure of financial controls would deliver recovery in the OECD countries."

"And without a change of policy to encourage higher growth in the North, the prospects for successful growth strategies in the South are seriously reduced."

"Developing countries, however, could question this legacy by adopting a pragmatic stance to financial liberalization and by considering whether the benefits of financial liberalization outweigh its costs and help foster the goals of sustainable human development," Eatwell concludes. (TWE No. 167, 16-31 August 1997)

Chakravarthi Raghavan is the Chief Editor of the South-North Development Monitor (SUNS).

 

 

 


BACK TO MAIN  |  ONLINE BOOKSTORE  |  HOW TO ORDER