The text below is composed of short excerpts (abstract, introduction, conclusion) from Jörg Bibow, “Insuring Against Private Capital Flows: Is It Worth the Premium? What Are the Alternatives?” published online by the Levy Economics Institute of Bard College in December 2008. The full text of “Insuring against Private Capital Flows” is available (in PDF) at <levy.org/download.aspx?file=wp_553.pdf&pubid=1107>. — Ed.
Following an analysis of the forces behind the “global capital flows paradox” observed in the era of advancing financial globalization, this paper sets out to investigate the opportunity costs of self-insurance through precautionary reserve holdings. We reject the idea of reserves as low-cost protection against the vagaries of global finance. We also deny that arrangements giving rise to their rapid accumulation might be sustainable in the first place. Alternative policy options open to developing countries are explored, designed to limit both the risks of financial globalization and the costs of insurance-type responses. We propose comprehensive capital account management as an alternative to full capital account liberalization. The aims of a permanent regulatory regime of capital controls, with respect to both the aggregate size and the composition of capital flows, are twofold: first, to maintain sufficient macro policy space; second, to assure a good micro fit of external expertise incorporated in foreign direct investment as part of a country’s development strategy.
Capital account convertibility has been widely advertised as a market-oriented development strategy, with the International Monetary Fund (IMF) acting as a main protagonist in the ideological push for universal capital account convertibility. By permitting developing countries to draw on foreign saving (i.e., capital imports), the argument went, capital account convertibility would set free faster growth and catch-up. In actual fact, the era of advancing financial globalization has witnessed many developing countries running sizeable current account surpluses with massive official outflows into low-yielding U.S. dollar assets. From a mainstream theoretical viewpoint it is truly paradoxical that capital should flow from “South” to “North” rather than the opposite way — thereby even squeezing the developing world’s savings available for domestic investment and development, it would seem.
Following an analysis of the forces behind the so-called “global capital flows paradox” (Summers 2006), this paper sets out to investigate the opportunity costs of rapid reserve accumulation in developing countries and then explore potential alternatives. Apparently, developing countries accumulate reserves as protection against the insecurities inherent in today’s international monetary and financial order. While such a strategy of “self-insurance” was proposed by Martin Feldstein (1999) in the aftermath of the Asian crises, we agree with Rodrik (2006) that the insurance premium involved here may be higher than generally supposed. Related questions concern the effectiveness and sustainability of the supposed self-insurance scheme, as well as its overall economic wisdom compared to potential alternatives. It turns out that these questions pertain to another popular hypothesis put forward in this context, namely the “revived Bretton Woods regime” (BWII) hypothesis (Dooley, Folkerts-Landau, and Garber 2003). After highlighting some crucial shortcomings that question the supposed sustainability of BWII, we deny the ultimate wisdom of capital account convertibility in developing countries and propose an alternative strategy of comprehensive capital account management.
The paper begins with an analysis of the postwar international U.S. dollar standard together with a historical review of the evolution of the U.S. balance of payments in view of the U.S.’s special status as the nth country in the Bretton Woods regime. After offering some reservations concerning the supposed sustainability of the BWII regime in section 3, the analysis in section 4 turns toward assessing the true opportunity cost of self-insurance through U.S. dollar reserve holdings. This is followed in section 5 by a reconsidering of the overall wisdom of financial globalization as contributing toward development. We explore some alternative policy options of developing countries designed to contain the risks of financial globalization and avoid the costs of insurance-type responses. Section 6 concludes.
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6. SOME CONCLUDING OBSERVATIONS
This paper argues that the breakdown of the Bretton Woods system of pegged-but-adjustable exchange rates in the early 1970s has not fundamentally changed the hegemonic position of the U.S. dollar and the U.S.’s nth country role in the global economy. Floating exchange rates together with financial globalization have, if anything, further magnified both the influence of and benefits thereby bestowed upon the issuer of the system’s key currency. Since the early 1980s, U.S. global leadership included acting as lead driver of global demand growth most of the time, resulting in almost continuous current account deficits ever since. While the build-up of the U.S. current account deficit is owed to a number of factors, this paper focuses on the conspicuous turnaround in the developing world’s current account position following the Asian crises of the late 1990s.
The investment and growth performance of developing countries running current account surpluses since then has undeniably undermined the mainstream “chronic saving gap” presumption. But there is also the issue of opportunity costs of self-insurance through bloated precautionary reserve holdings sourced from both current account surpluses and private capital inflows — another paradoxical feature of the global capital flows paradox. The analysis here not only suggests that the opportunity costs of self-insurance may be non-negligible, it also fundamentally challenges the wisdom of insuring the exposure to risks that offer no rewards to developing countries in the first place. Essentially, financial globalization appears like a nifty device for rent extraction working through the defensive behavior of developing countries.
The IMF acted as the main protagonist of universal capital account convertibility. And the Fund’s emergency lending and influence soared in the 1990s as emerging markets, heeding orthodox advice for financial liberalization, frequently got hit by financial crises. The IMF then faced its own crisis as the Fund’s loan portfolio and income plunged when its supposed customers substituted self-insurance for the IMF’s services. The Fund has not changed course on capital account liberalization, peddling its advice on “managing large capital inflows” instead.15 And as some fresh rescue requests arrived at the IMF’s doorstep in the fall of 2008 from countries that were running large current account deficits, this would seem to underline that running a current account surplus offers some safety. Self-insurance is not a free lunch though.
Essentially, private global finance has largely taken over the business of the official international monetary support line. The insurance premium thereby extracted from developing countries for reclaiming part of the policy space lost through financial globalization is significant. Some rationalize the outcome by claiming that the welfare gains of self-insurance outweigh any welfare costs (Aizenman and Lee 2007). Costbenefit analyses of self-insurance are beside the point though when the risk exposure insured against offers no real rewards otherwise unavailable in the first place.
There is another more preferable route out. Instead of full capital account convertibility, we propose comprehensive capital account management, both with respect to the aggregate and the composition of capital flows. The aims of a permanent regulatory regime of capital controls are twofold: first, to maintain sufficient macro policy space and prevent destabilizing hot money; and second, to assure a good micro fit of external expertise incorporated in FDI with a country’s development strategy. This approach would not only avoid the self-insurance premium currently extracted from developing countries for insuring exposures that offer no real rewards in the first place. It should also help them get off a development strategy that might prove less sustainable than suggested by proponents of BWII — a process that seems already well under way. In fact, the financial crisis currently unfolding at the center of the international financial system — much in contrast to the former history of emerging market crises — raises further doubts about the true value of the “insurance scheme” apparently underlying the “global capital flows paradox.”
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15 In its October 2007 World Economic Outlook, the IMF acknowledges the policy challenges posed by capital inflows referring to “their potential to generate overheating, loss of competitiveness, and increased vulnerability to crisis” (IMF 2007: ch. 3, p. 1). Fiscal restraint (i.e., small government) emerges as the best policy response available in the Fund’s view. It is not clear though that curtailing public investment in order to let hot money play its games necessarily offers a favorable trade-off to developing countries.
Aizenman, J., and J. Lee. 2007. “International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence.” Open Economy Review 18: 191-214.
Dooley, M.P., D. Folkerts-Landau, and P. Garber. 2003. “An Essay on the Revived Bretton Woods System.” Working Paper 9971. Cambridge, MA: NBER.
Feldstein, M. 1999. “A Self-help Guide for Emerging Markets.” Foreign Affairs 78(2): 93-109.
Summers, L.H. 2006. “Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation.” L. K. Jha Memorial Lecture, Reserve Bank of India (March).
Jörg Bibow is Assistant Professor of Economics, Department of Economics, Skidmore College. “Insuring Against Private Capital Flows: Is It Worth the Premium? What Are the Alternatives?” was published online by the Levy Economics Institute of Bard College in December 2008. The text above is composed of excerpts from “Insuring Against Private Capital Flows,” reproduced here for educational purposes. The full text of “Insuring Against Private Capital Flows” is available (in PDF) at <levy.org/download.aspx?file=wp_553.pdf&pubid=1107>.