Tue, Jan 16, 2007 - Page 9 News List

The false promise of financial liberalization in emerging markets

By Dani Rodrik

Something is amiss in the world of finance.

The problem is not another financial meltdown in an emerging market, with the predictable contagion that engulfs neighboring countries. Even the most exposed countries handled the last round of financial shocks in May and June of last year relatively comfortably.

Instead, the problem this time around is one that relatively calm times have helped reveal: The predicted benefits of financial globalization are nowhere to be seen.

Financial globalization is a recent phenomenon. One could trace its beginnings to the 1970s, when recycled petrodollars fueled large capital inflows to developing nations. But it was only around 1990 that most emerging markets threw caution to the wind and removed controls on private portfolio and bank flows. Private capital flows have exploded since, dwarfing trade in goods and services. So the world has experienced true financial globalization only for 15 years or so.

Freeing up capital flows had an inexorable logic -- or so it seemed. Developing nations, the argument went, have plenty of investment opportunities, but are short on savings. Foreign capital inflows would allow them to draw on the savings of rich countries, increase their investment rates and stimulate growth. In addition, financial globalization would allow poor nations to smooth out the boom-and-bust cycles associated with temporary terms-of-trade shocks and other bouts of bad luck. Finally, exposure to the discipline of financial markets would make it harder for profligate governments to misbehave.

But things have not worked out according to plan. Research at the IMF, of all places, as well as by independent researchers documents a number of puzzles and paradoxes. For example, it is difficult to find evidence that countries that freed up capital flows have experienced sustained economic growth as a result. In fact, many emerging markets experienced declines in investment rates. Nor, on balance, has liberalization of capital flows stabilized consumption.

Most intriguingly, the countries that have done the best in recent years are those that relied the least on foreign financing. China, the world's growth superstar, has a huge current-account surplus, which means that it is a net lender to the rest of the world. Among other high-growth countries, Vietnam's current account is essentially balanced, and India has only a small deficit. Latin America, Argentina and Brazil have been running comfortable external surpluses recently. In fact, their new-found resilience to capital-market shocks is due in no small part to their becoming net lenders to the rest of the world after years as net borrowers.

To understand what is going on, we need a different explanation of what keeps investment and growth low in most poor nations. Whereas the standard story -- the one that motivated the drive to liberalize capital flows -- is that developing countries are saving-constrained, the fact that capital is moving outward rather than inward in the most successful developing countries suggests that the constraint lies elsewhere. Most likely, the real constraint lies on the investment side.

The main problem seems to be the paucity of entrepreneurship and low propensity to invest in plant and equipment -- what Keynes called "low animal spirits" -- especially to raise output of products that can be traded on world markets. Behind this shortcoming lay various institutional and market distortions associated with industrial and other modern-sector activities in low-income environments.

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