Full Report - Subregional Office for East and North-East Asia - escap

DEVELOPMENTAL MACROECONOMICS: THE CRITICAL ROLE OF PUBLIC EXPENDITURE CHAPTER 3
Capital flows: managing enhances
policy space and mitigates financial
sector fragility
The opening of the capital account is seen as
essential for encouraging capital flows and the
development of the domestic capital market. These
are expected to enhance both the volume and
efficiency of investment and hence, economic
growth. However, empirical evidence of the growthenhancing
effect of capital account liberalization
(CAL) is mixed. In surveying the empirical literature,
Cobham (2001, p. 5) concluded: “… that the (net)
benefits of CAL for developing countries have not
been established. Indeed … it is more accurate to
say that these benefits may not necessarily exist
for poorer countries”.
There are a number of
shortcomings of capital
account opening
Critics have pointed out a number of shortcomings
of a generalized prescription for capital account
opening for all countries regardless of their level of
development. 27 First, the target of capital account
convertibility is mainly short-term portfolio capital
and not the long-term FDI that developing countries
need the most. FDI is not known to depend greatly
on capital account opening. On the other hand,
capital account liberalization makes it easy for FDI
to leave a country. In order to remain attractive,
developing countries end up offering various tax
concessions – often they race to the bottom. This
means that the burden of raising (or maintaining)
fiscal revenue shifts from capital income to labour
income. As a result, the after-tax income distribution
is likely to become more unequal, which reduces
the growth elasticity of poverty reduction.
Second, the prospect of capital flight forces
Governments to adopt a very conservative fiscal
policy stance (Stiglitz, 2000). Given the limitation of
raising revenues, in most cases, this means cuts
in government expenditure, especially in the social
and infrastructure sectors. Thus, the prospect of
capital flight restricts a country’s ability to use fiscal
and monetary policies to address such issues as
investment in infrastructure, priority sector development
and human development, which are more important
to attract FDI than capital account convertibility.
Third, countries at the lower level of development do
not have an adequate institutional and legal framework
to handle capital flows nor are they attractive for
such flows. Instead, they face the problem of capital
flight. Thus, capital account opening in most cases
is found to increase capital outflows, not inflows. In
order to prevent capital outflows, these countries are
forced to maintain high domestic interest rates, which
adversely affect domestic investment, especially in
SMEs. On the other hand, if the high domestic
interest rate attracts capital inflows, it can adversely
affect a country’s international competitiveness and
the pace of industrialization due to a Dutch diseaselike
syndrome. This happens as a result of a real
appreciation in the value of domestic currency.
Under a flexible exchange rate system, demand for
domestic currency by foreign investors is likely to
lead to nominal and hence real appreciation. Under
a fixed exchange rate regime, the accumulation
of foreign currency by the central bank will cause
monetary expansion and hence, inflation. Therefore,
in either case, there will be real appreciation.
This was exactly what happened in South-East Asian
countries prior to the crisis. If the Government tries
to sterilize the effect of capital flows on money
supply by issuing bonds, it will further push up
the interest rate, causing crowding out of private
investment and fuelling more capital inflows.
In the Asian crisis even countries
at a higher level of development
found it difficult to handle
short-term capital flows
On the other hand, if the Government channels the
inflows through commercial banks, the banks will
have excess liquidity. This may tempt commercial
banks into a more lax scrutiny of loan applications,
which increases the fragility of the banking sector.
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