The International Monetary Fund Deters free capital flow.

• Author: Krol, Robert
• Position: Economics

RECENT FINANCIAL problems in Turkey along with the debt crisis in Argentina provide ammunition for critics of globalization. They claim that free markets cannot be trusted to allocate capital across the globe. Some argue that the solution is to give the International Monetary Fund an expanded role in the world financial system. They are wrong. The free flow of capital is critical to economic development. Faith in the IMF is unfounded; time after time, it has bailed out countries without creating incentives for substantive reform. Financial crises represent government failure, not market failure.

Access to the global capital market provides an economy with a number of important benefits, including lower borrowing costs for businesses and greater returns to savers, the ability to smooth consumption when faced with adverse economic shocks, improved risk management, and greater financial sector efficiency due to increased competition from foreign financial institutions. Open capital markets subject both business and government to greater market discipline.

To understand how the free flow of capital helps businesses and savers, imagine what happens in an economy completely cut off from global markets. The supply of funds available to finance business investment is limited to domestic sources. If total saving in this economy is low, borrowing costs will be high. The high cost of borrowing will deter all but the most lucrative business projects; other productive projects will go without funding.

Now imagine a second economy that is also cut off from global markets. This time, however, total saving is high, resulting in low borrowing costs, which, in turn, increase the number of business projects that are financed. Although investment and capital formation are high, the abundance of capital means that some funds are funneled into projects that provide a low return.

The problem with closed capital markets is that the high-saving country is financing some projects that pay a return below what could be earned on projects that remain without funding in the low-saving nation. Both countries can gain from opening their capital markets to one another.

With open markets, capital will flow from the high-saving economy to the low-saving one. More high-return projects will be financed in the low-saving country, promoting economic growth and a higher standard of living. Although investment in the high-saving nation declines as funds are invested abroad, the higher return on international loans results in greater consumption over time. Individuals living in both countries are made better off.

The low-saving case just described characterizes many of today's emerging economies. By allowing international capital flow, emerging economies can lower the cost of capital and increase investment. One study estimated that the cost of capital in emerging markets declines between five and 75 basis points (a basis point equals one-hundredth of one percent in yield of an investment) following capital market liberalization. As the cost of equity capital falls, higher stock market prices allow private firms to expand, increasing investment. Another analysis of 11 emerging economies found average growth in private investment increased by 22% above the sample average in the three years following the opening of their stock markets to international investors.

Open capital markets allow investors and banks to diversify their portfolios internationally, lowering total portfolio risk. Improved risk management lowers the frequency of financial crises.

Few investors hold only one stock. The typical portfolio contains stocks, bonds, and real estate. They understand that, through diversification, total portfolio risk declines because the returns on assets are not perfectly correlated. For example, when a few companies have bad years and pay a low return, other firms have good years and offer a high return. As a result, a diversified portfolio's overall return is more stable. The risk in a portfolio comprised of 20 U.S. stocks is reduced by about two-thirds, compared to owning a single stock.

Further portfolio risk reduction can be gained through international diversification. Because business cycles are not perfectly correlated across nations, the stock and bond market returns across countries do not move in perfect unison. The negative impact of a recession in one nation may be offset by the impact of an expansion in another. An...