Exchange rates and capital freedom in developing markets.

• Author: Yeager, Leland B.

Merits and Demerits of International Investment

Ideally, resources saved from producing for current consumption are invested where they will create the most value, whether at home or abroad. Savers and investors, dealing with one another either directly or indirectly through financial intermediaries and securities markets, both normally share the gains. Skepticism centers nowadays on hot money, herd behavior, destabilizing speculation, and banking and currency crises. Even as eminent a champion of free trade in goods and services as Jagdish Bhagwati (1998) maintains that capital is different and regrets its unrestrained mobility.

Apart from these current worries, a more general case can be made against the free movement of capital, and particularly against capital export. Arguably, the advantages of investment abroad relative to investment at home appear larger to the individual investor than they actually are for his country, creating a bias in favor of foreign lending or investment. (Murphy 1960 and Jasay 1960 report and assess such arguments.)

First, certain risks borne by a domestic investor are not risks to his country, whereas similar risks of investment abroad impose total or partial losses on the investor and his country. A property confiscated abroad or subjected to adverse regulation or a defaulted foreign debt is simply lost to the investor and his country, whereas a confiscated domestic property or an installation financed by defaulted domestic debt remains within the home country. The supposed answer that a private investor can assess risk better than bureaucrats does not face up to the divergence of viewpoints that forms the core of the argument. (Keynes [1924] 1981 elaborates on this argument in particular.)

Second, taxes on domestic property and property incomes are collected by the home government, whereas taxes collected by a foreign government on the domestic owners' property abroad may be lost, especially if the home government allows credit for foreign taxes paid.

Like these first two arguments, a third is also a kind of externalities argument. Perhaps the most subtle and questionable of all, it also hinges on divergence between individual and national viewpoints. Capital resources are complementary to other broad classes of factors (labor and land) and raise their marginal productivities. Investment abroad leaves such benefits to the foreigner, whereas domestic investment keeps them at home. (But if that aspect of capital export is worrisome, something similar may be true of labor also. There has indeed been worry about "brain drain" from some countries.)

A closely related point hinges on divergence between marginal and average returns to capital and on diminishing marginal returns (a point that could be upset by increasing returns to scale). The individual investor does not consider that his investment abroad tends to reduce returns on the foreign investments of his fellow countrymen to the benefit of foreigners, whereas investment at home depresses marginal returns to capital to the benefit of other home factors of production. This argument is loosely analogous to the terms-of-trade argument for import duties and (if constitutionally permissible) for export duties. Duties could conceivably correct for the externality of the individual importer's or exporter's not taking account of how his activity tends to raise import prices or depress export prices to the disadvantage of the home country. The analogous argument against capital export, like those concerning risk and taxes, focuses on the national interest and neglects the interest of other countries. On purely economic grounds, then, it is ironic that host countries are often reluctant and lending countries eager to expand international investment.

In some ways, of course, foreign investment can serve the national interest. Keynes ([1924] 1981) recognized that in the past, risking capital abroad for high returns in trading, mining, and exploitation had been of great advantage to the national fortunes of the English and Scotch. Relatedly, foreign investment might develop or cheapen sources of raw materials, improving the home country's terms of trade. And it might serve foreign-policy purposes.

Arguments over Capital Controls

The literature about volatility of capital movements has become vast. Attention centers on crises in East Asia in 1997-98, Latin America in the 1980s and 1990s, and Russia in 1998. (1) Several of the countries involved have suffered from corruption, cronyism, insecure property rights, and political influence on industrial and banking decisions. Such chronic ills go far in explaining underdevelopment and financial fragility. Actual crises, however, occur not continuously but in spurts, apparently triggered by discontinuous changes in the perceived probability of disaster (Brown 1992: 295). Explaining such specific events must focus on banking, money, exchange rates, and changing expectations about them. Sometimes political events have been a factor, for example, the assassination of Mexico's leading presidential candidate in 1994 and government turmoil in Russia in 1998.

In the background of many of the crises, expectations of improving economic conditions and relaxation of controls had encouraged heavy capital inflows. (Bartolini and Drazen 1997 explain how decontrol of outflows may seem a good sign and so promote inflows.) Implicit or perceived government guarantees of a steady exchange rate or of the debts of banks or other large enterprises further encouraged inflows (el. Anderson 2004:53-58 and passim). Expectations that the International Monetary Fund would ride to the rescue of troubled countries and their creditors were also a factor. (2) Credit made easy by capital inflows promoted borrowing for purposes that proved overly optimistic. The stage was set for reversal of the flows once some event should trigger a change of prevalent opinion. Oil price increases and the recycling of petrodollars and then anti-inflationary tight money and recession in the United States and the Falklands war all figured in the Latin American debt crises of the early 1980s (Kuczynski 1992).

In East Asia, because several of the emerging economies were stabilizing their exchange rates against the U.S. dollar, its strengthening against the yen after mid-1995 contributed to real exchange-rate appreciation and reduced export competitiveness. In Thailand in 1996 a property and stock-market slump and economic slowdown caused difficulties in the financial sector. High interest rates made the sector more vulnerable but seemed necessary to keep foreign investors willing to finance the large current-account deficit. The baht came under pressure at times in the second half of 1996 and early 1997. To maintain investor confidence and protect an economy with a large foreign debt, the authorities remained committed to their policy of pegging to a dollar-dominated basket (Bank for International Settlements 1997: 40-41, 45, 107-14, written before the crisis actually struck).

Pressures on the exchange rate and the banks often interacted. An exchange depreciation would increase the burden of debts denominated in foreign currency, weakening debtor enterprises and banks that had made loans to them. Currency mismatches were accompanied by maturity mismatches: banks had gone too far in borrowing short to relend long. The central bank's expansion of high-powered money to improve the liquidity of a shaky banking system would further threaten the local currency's exchange rate. The crises had a vicious-circle character as capital ran for the exits. Analysts often mention contagion and herd behavior, although (according to Neal and Weidenmier 2002, anyway, and Schwartz 1998) what looks like contagion may often result from preexisting economic interdependence or shared shocks. Agreed, mindless herding is not the main story, even though, quite plausibly, crisis in one country can raise attention to financial fragility in others. (3)

Anyway, the idea of controls to restrain capital outflows--or volatile inflows in the first place"--has now regained some of its lost respectability. Perhaps a capital-importing country could deter excessively volatile capital movements while leaving the field open to productive international investment. Equity investment, particularly direct investment, might be given preference over other investment and over loans, with the distinction somehow enforced. Controls might be imposed only temporarily in exceptional situations. But suggestions like these are, at worst, mere strings of nice-sounding words.

Sounder advice is to be careful with the sequencing of liberalization measures during a transition from tight regulation to free markets (Edwards 1999: 66-67, 82). Liberalization in process is different from liberalization already accomplished. Capital controls prematurely removed may have been serving as a second-best palliative of harm done by interventions still remaining, including implicit or explicit government guarantee of deposits in government banks or in only recently privatized or inadequately supervised banks, as well as a perceived "too big to fail" attitude toward some banks and other enterprises. A related difference hinges on whether financial freedom has existed long enough to become entrenched or is recent and incompletely adjusted to. (4)

Absent strong financial supervision in lending or borrowing countries, Sebastian Edwards writes, "unregulated capital flows may indeed be misallocated, eventually generating waves of major...