Project Syndicate - Despite recent financial market turbulence, the underlying dynamic of the world economy remains essentially unchanged. The big issue is not how to deal with a downturn, but rather how to sustain today’s global boom and the capital flows that go with it. With the world expected to continue growing rapidly, there are excellent investment opportunities that will be funded only if capital continues to move into countries that can use it productively.
The good news is that some countries have large savings that they want to invest in other countries, and are not put off by short-run market gyrations. In fact, our projections show that gross (or total) capital inflows to emerging markets will increase from US$400-500 billion just before the Asian crisis of 1997 to US$800-900 billion both in 2007 and 2008. These inflows are expected to top US$1 trillion in the not-so-distant future.
With 20-20 hindsight, it is clear that in 1997-98, weak bank regulation and corporate governance aggravated the depth of the economic contraction that followed the “sudden stop” of capital flows. But what exactly does this imply for how middle- and low-income countries today should set their capital-account policies amid the current flood?
Should a country with weaknesses in its financial system simply avoid letting capital in? While this has become more difficult, countries can still choose – at least to some degree – how open they are to capital inflows.
But capital controls are not the only variable that determines financial openness. The evidence suggests that other factors such as the quality of economic and political institutions are at least as important in determining how much capital a country will attract. But what determines the extent to which countries benefit from financial globalization?
A recent study by the IMF’s research department, using data from the past 30 years to assess the effects of financial globalization, conveys two messages. First, countries should be cautious about external financial liberalization when financial sector development and institutional quality are below key thresholds. In other words, don’t jump into the water unless you can swim.
Second, caution has costs: financial openness may itself catalyze improvements in fundamentals that enhance the benefits of globalization. Capital controls, whatever their benefits in terms of mitigating the risks associated with volatile capital flows, are costly in a variety of ways. In other words, everyone really should learn to swim.
The first message will resonate with those who believe that a key lesson of the Asian crisis a decade ago is that countries opened themselves to certain types of flows – especially foreign currency debt – before they were ready. The implication is that countries should first strengthen their domestic financial sectors and corporate governance, and only later open the capital account.
But even if capital controls could still fully insulate a country from the forces of financial globalization, such a goal would not be desirable. Opening up to foreign direct investment and other non-debt capital flows may serve to boost economic growth without adverse side effects on macroeconomic volatility or a risk of crisis. This is the case for countries with both relatively weak and strong fundamentals.
One conclusion, therefore, is for countries to be cautious about removing capital controls when they have not yet reached the relevant “safety” thresholds, but equally to stress the sizable net benefits for countries that exceed the thresholds. The latter, in turn, provides strong incentives for countries to address institutional shortcomings so that they can reap the potential benefits of external financial liberalization.
Of more pressing immediate concern is the fact that capital is currently flowing to many countries regardless of whether they are ready to receive it. There are large current-account surpluses among emerging markets (a big change from 1997, when most emerging markets had deficits). Indeed, several large oil exporters and Asian manufacturing exporters will have sizable surpluses for as long as we can forecast.
This capital has to be invested somewhere. We think that capital from these countries is increasingly flowing not so much “uphill” to developed countries (as it did over the past five years), but rather “around the hill” to other emerging markets and poorer developing countries. But is everyone really ready to receive such large amounts of capital and to carefully manage its macroeconomic impact?
The risk today is not imminent crisis, but rather that the capital flows arising from the global boom will not be well managed, leading to the buildup of vulnerabilities. So the danger is that, when the party ends – and it is hard to know when that will be – a lot of mopping up will need to be done.
Simon Johnson is Economic Counselor and Director of Research at the International Monetary Fund; Jonathan D. Ostry is the IMF’s Deputy Director of Research.
Copyright: Project Syndicate, 2007.