Financial Liberalization: Beyond Orthodox Concerns (International Papers in Political Economy)

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Financial Liberalization Beyond Orthodox Concerns

Edited by Philip Arestis and Malcolm Sawyer

Financial Liberalization

International Papers in Political Economy Series Series Editors: Philip Arestis and Malcolm Sawyer International Papers in Political Economy publishes one annual themed volume per year. Each volume focuses on an important issue in Political Economy. Titles include: Phillip Arestis and Malcolm Sawyer FINANCIAL LIBERALIZATION Beyond Orthodox Concerns.

International Papers in Political Economy Series Standing Order ISBN 1–4039–9936–8 You can receive future titles in this series as they are published by placing a standing order. Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and one of the ISBNs quoted above. Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire RG21 6XS, England

Financial Liberalization Beyond Orthodox Concerns Edited by

Philip Arestis and

Malcolm Sawyer

Selection and Editorial Matter © Philip Arestis & Malcolm Sawyer 2005 Individual chapters © contributors 2005 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2005 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN-13: 978–0333–99759–8 hardback ISBN-10: 0333–99759–X hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Financial liberalization : beyond orthodox concerns / edited by Philip Arestis and Malcolm Sawyer. p. cm. — (International papers in political economy) Includes bibliographical references and index. ISBN 0–333–99759–X (cloth) 1. Finance. 2. Financial crises. 3. Banks and banking. I. Arestis, Philip, 1941– II. Sawyer, Malcolm C. III. Series. HG173.F5137 2005 332—dc22 2005048746 10 14

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Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

Contents Preface

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1 Financial Liberalization and the Finance–Growth Nexus: What Have We Learned? Philip Arestis and Malcolm Sawyer

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2 The Importance of the Gender Dimension in the Finance and Economic Development Nexus Maria S. Floro

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3 Financial Liberalization and Poverty: Channels of Influence Philip Arestis and Asena Caner

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4 Currency Crises and Instability of Global Capitalism Korkut A. Ertürk

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Index

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Preface This is the first volume of the new series of International Papers in Political Economy (IPPE). The new series will consist of an annual volume with four to five chapters on a single theme. The objective of the IPPE will continue to be the publication of papers dealing with important topics within the broad framework of Political Economy. The original series of International Papers in Political Economy started in 1993 and has been published in the form of three issues a year with each issue containing a single extensive paper. Information on the old series and back copies can be obtained from Professor Malcolm Sawyer at the University of Leeds (e-mail: [email protected]). We would like to express our appreciation to Palgrave Macmillan for proposing this new arrangement for IPPE, and particularly thank Amanda Hamilton for her enthusiastic support in the launch of the new series of IPPE. The theme of this first issue is that of the finance–growth nexus, with particular emphasis on what has come to be known as financial liberalization.

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1 Financial Liberalization and the Finance–Growth Nexus: What Have We Learned? Philip Arestis University of Cambridge, Levy Economics Institute

and

Malcolm Sawyer University of Leeds

Abstract The chapter investigates the growth–finance nexus with reference to what has become known as ‘financial markets liberalization’. More precisely, the focus of this contribution will be the removal of Central Bank control over prices charged by banks (notably interest rates), especially in developing countries. The history of banking as the policy makers in both developing and developed countries adopted the essentials of the financial liberalization thesis and pursued corresponding policies, tells a rather sad story: banking crises have been unusually frequent and severe, and they have exacerbated downturns in economic activity, thereby imposing substantial real economic costs. We argue that this experience is not unrelated to the financial liberalization policies pursued by countries. We do this by looking at a number of problems entailed in the financial liberalization thesis and by referring to existing evidence. In so doing this chapter intends to seek an answer to the question of ‘what have we learned?’ from the work undertaken on the issue of financial liberalization and its relevance to the finance–growth nexus. Keywords: Finance, economic growth, financial liberalization JEL Classification: E44 G18 O16 1

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Introduction The purpose of this chapter is to investigate the growth–finance nexus with reference to what has become known as ‘financial markets liberalization’. More precisely, the focus of this contribution will be the removal of Central Bank control over prices charged by banks (notably interest rates), especially in developing countries. This was a fairly common practice in the 1950s and 1960s, which was challenged by Goldsmith (1969) in the late 1960s, and by McKinnon (1973) and Shaw (1973) in the early 1970s. They ascribed the poor performance of investment and growth in developing countries to interest rate ceilings, high reserve requirements and quantitative restrictions in the credit allocation mechanism. Those restrictions were sources of ‘financial repression’, the main symptoms of which were low savings, credit rationing and low investment. They propounded instead the ‘financial liberalization’ thesis, which can be succinctly summarized as amounting to freeing financial markets from any intervention and letting the market determine the allocation of credit. The history of banking, however, as the policy makers in both developing and developed countries adopted the essentials of the financial liberalization thesis and pursued corresponding policies, tells a rather sad story. It actually points to two striking findings (Arestis and Demetriades, 1998). The first is that over the past 30 years or so, banking crises have been unusually frequent and severe. The magnitude of the crises is clearly indicated by the fact that at least two-thirds of the IMF member countries experienced significant banking-sector problems ever since the early 1980s (World Bank, 1989). The second important finding is that beyond the financial costs of banking crises for the local economies involved, they have exacerbated downturns in economic activity, thereby imposing substantial real economic costs (Honohan and Klingebiel, 2000; see also Arestis, 2004, 2006). We argue that this experience is not unrelated to the financial liberalization policies pursued by countries. We do this by looking at a number of problems entailed in the financial liberalization thesis and by referring to existing evidence. In so doing this chapter intends to seek an answer to the question of ‘what have we learned?’ from the work undertaken on the issue of financial liberalization and

Financial Liberalization and the Finance–Growth Nexus

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its relevance to the finance–growth nexus. We explore these issues by concentrating on financial liberalization, the focus of this volume. Given the aim and purpose of this chapter, then, a short review of certain related fundamental issues is in order. When banks are the major lenders to industry, then the level and direction of real investment crucially depends on the decisions of banks as to which projects are to be financed and which not. Projects would live or die by bank decision as to willingness to finance. Banks have lost some of their pre-eminence as lenders, and a range of other financial institutions are involved in the provision of finance and funding to industry.1 We begin with a short review of the history of the growth–finance nexus and the importance of financial liberalization in this relationship. This is followed by an examination of the main theoretical propositions and policy implications of the financial liberalization thesis, before we turn our attention to the problematic nature of the thesis, and to the available empirical evidence. A final long section summarizes the argument and concludes by not only attempting to answer the question of ‘what have we learned?’, but also by highlighting the issues that are explored subsequently in this volume.

A short history of the issue The financial development and economic growth nexus has received a great deal of attention throughout the history of economics. Archaeologists in their excavations over the years in various city sites along the Tigris and Euphrates, have unearthed a great deal of cuneiform blocks, many of which were deposit receipts and monetary contracts. Such simple banking operations were common and widespread in Babylonia (Davies, 1994, pp. 47–50). Copper, gold and silver were used as units of account, but not so much as media of exchange. Even so it was grain that provided the monetary medium. Receipts of lots of grain deposited for safety and convenience became a general method of payment, especially for large amounts. That system of ‘warehouse banking reached its highest peak of excellence and geographical extent in the Egyptian empire of the Ptolemies, (323–30 BC). Private banks and royal banks using money in the form of coins and precious metals had by then long been known and existed side by side with the grain banks, but the former banks were

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used chiefly in connection with the trade of the richer merchants and particularly for external trade’ (Davies, 1994, p. 51). Coinage invention, however, came about later, although some writers would date a form of Chinese coinage in the twelfth century BC, while other writers suggest that they were roughly contemporaneous with the ‘modern’ coin invention of the eastern Mediterranean. The roots of the latter are traced in Lydia and Ionia of Asia Minor in the seventh century BC, where the first coin was in evidence, ‘the birthplace and nursery respectively of coinage’ (Davies, 1994, p. 61).2 The discovery of coinage and its propagation in mainland Greece produced a period of development and growth. Indeed, ‘the development of coinage led directly to the vast increase in trade . . . as the Greeks and others spread their culture and customs throughout the ancient world, creating the civilization which the Romans subsequently made their own’ (Mills, 2002, p. 40). The first signs of public debate, however, on the relationship between finance and growth can be located in Rome in the year 33 AD. In that year there was probably the first classic case of public panic and run on the banks. The Romans debated intensely and fiercely at that time the possibility of placing a hitherto free banking system under the control of the government. Public banks emerged in Europe much later, with the public Bank of Amsterdam, established in 1609, becoming in Adam Smith’s words ‘the great warehouse of Europe for bullion’ (1776, Book IV, p. 422). The years 1694 to 1696 saw the founding of the Bank of England and the Bank of Scotland, and in France the establishment of public banking, which was instigated by John Law (1671–1729), ‘the Keynes of the early eighteenth century’ (Davies, 1994, p. 644).3 France’s first state-chartered bank, with the power to issue unbacked paper currency, began operation in June 1716 (Davies, 1994, p. 554), the year after the death of Louis XIV (whose wars left the French Treasury empty), when the Regent (Duke of Orleans) gave John Law what Kindleberger (1984) described as a case of ‘No other “Keynesian” ever had such a golden opportunity’ (p. 97). That opportunity was to create wealth based on paper money rather than on gold and silver, and it was predicated on the premise that ‘increasing the money supply would not cause inflation provided that the volume of business transactions expanded pari passu with the extra money that was made available’ (Mills, 2002, p. 54). For Law (1705) money is credit and credit is


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determined by the needs of trade, and not by the gold holdings of the central bank or the trade balance. Money is thereby endogenous, determined by the needs of trade. Clearly, this is an early version of the ‘real bills’ doctrine, and probably the earliest statement on the endogenous nature of money. Increasing the money supply for John Law would also increase the demand for money, and thus stimulate output and employment without raising prices. Even beyond full employment, monetary expansion should also raise output through attracting factors of production from abroad (Law, 1705). In fact, John Law created the basis of the banking system – as we know it today. Namely, that a bank need not hold reserves (of commodity money) on a one-for-one basis with the deposits it has accepted nor the loans it has made. Credit expansion can better be implemented through a fractional reserve basis, so long as the system enjoys sound credibility. The notes issued by John Law’s banking were widely acceptable since the bank promised to redeem the notes with the same weight of metal as at the time of issue, unlike the coinage, which had been continually debased through reducing its bullion content. On 2 May, 1716, a private bank, the Bank Générale, was established, which was nationalized on 4 December, 1718, and renamed the Bank Royale. The reserves of John Law’s bank were augmented by a new venture; this was the Mississippi Company rumoured to undertake the mining of large quantities of gold in Louisiana. The John Law experiment prompted Adam Smith to describe it as ‘the most extravagant project both of banking and of stock-jobbing that, perhaps, the world ever saw’ (1776, Book II, p. 283). A speculative boom developed, with the finance of the purchase of the bank’s shares largely provided by the bank itself. However, when credibility is lost, ‘runs’ on the bank can easily materialize with catastrophic consequences. That is exactly what happened in Paris when in January 1720 the bubble burst leading eventually to the complete collapse of John Law’s system in December of the same year. It began with rumours relating to the Louisiana gold discoveries, which never materialized, and ended with the complete collapse of confidence in the bank’s ability to redeem its notes; the Bank Royale simply went bankrupt. That experience produced more than a century of opposition in France to the kind of banking system the country desperately needed. Davies (1994) suggests that French experience ‘provides one of the best examples in history of belated

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industrial experience being to a large extent caused by delay in adopting a modern banking system’ (p. 645). The most important intellectual development, however, came from Bagehot (1873), in his classic Lombard Street. In this contribution, he emphasized the critical importance of the banking system in economic growth and highlighted circumstances when banks could actively spur innovation and future growth by identifying and funding productive investments. Of equal importance is the work of Schumpeter (1911), where the argument is put forward that financial services are paramount in promoting economic growth. In this view production requires credit to materialize, and one ‘can only become an entrepreneur by previously becoming a debtor . . . What [the entrepreneur] first wants is credit. Before he requires any goods whatever, he requires purchasing power. He is the typical debtor in capitalist society’ (p. 102). In this process, the banker is the key agent. Schumpeter (1911) is very explicit on this score: ‘The banker, therefore, is not so much primarily the middleman in the commodity “purchasing power” as a producer of this commodity . . . He is the ephor of the exchange economy’ (p. 74). Keynes (1930), in his A Treatise on Money, also argued for the importance of the banking sector in economic growth. He suggested that bank credit ‘is the pavement along which production travels, and the bankers if they knew their duty, would provide the transport facilities to just extent that is required in order that the productive powers of the community can be employed at their full capacity’ (vol. II, p. 220). In the same spirit Robinson (1952) argued that financial development follows growth, and articulated this causality argument by suggesting that ‘where enterprise leads finance follows’ (p. 86). Although growth may be constrained by credit creation in less developed financial systems, in more sophisticated systems finance is viewed as endogenous responding to demand requirements. This line of argument suggests that the more developed a financial system is the higher the likelihood of growth causing finance. In Robinson’s (1952) view then, financial development follows growth or, perhaps, the causation may be bidirectional. Building on the work of Schumpeter (chiefly 1911), McKinnon (1973) and Shaw (1973) propounded the ‘financial liberalization’ thesis arguing that government restrictions on the banking system restrain the quantity and quality of investment. More recently the


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endogenous growth literature has suggested that financial intermediation has a positive effect on steady-state growth (see Pagano, 1993, for a survey), and that government intervention in the financial system has a negative effect on the equilibrium growth rate (King and Levine, 1993b). These developments can be considered as an antidote to the thesis put forward by Modigliani and Miller (1958) that the way firms finance themselves is irrelevant (their ‘irrelevance propositions’), which is consistent with the perception of financial markets as independent entities from the rest of the economy, so that finance and growth are unrelated. On the other hand, there are still economists who would argue that finance and growth are unrelated. A good example of this view is Lucas (1988) who argues that economists ‘badly over-stress’ the role of the financial system, thereby reinforcing the difficulties of agreeing on the link and its direction between finance and growth. The difficulty of establishing the link between financial development and economic growth was first identified by Patrick (1966) and further developed by McKinnon (1988a) who argued that: ‘although a higher rate of financial growth is positively correlated with successful real growth, Patrick’s (1966) problem remains unresolved: What is the cause and what is the effect? Is finance a leading sector in economic development, or does it simply follow growth in real output which is generated elsewhere?’ (p. 390). The relationship between financial development and economic growth is, therefore, a controversial issue, which could be resolved potentially by resorting to theoretical arguments backed up by convincing empirical evidence. A recent attempt to explore this aspect of the debate has been attempted by King and Levine (1993a) who have argued that Schumpeter (1911) may very well have been ‘right’ with the suggestion that financial intermediaries promote economic development. This is an early attempt to tackle the issue of the strength and causation of the relationship between finance and economic development. It is more ‘aggregate’ and more recent but also refers to the need for further work. The difficulty of establishing the direction of causality between financial development and economic growth was first identified by Patrick (1966) and further developed by McKinnon (1988a) who actually questioned the direction of causation. The causality between financial development and economic growth is, therefore, a controversial issue, which could be

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resolved potentially by resorting to empirical evidence. Arestis and Demetriades (1996) demonstrate that the results of King and Levine (1993a), which are obtained from cross-section country studies, are not able to address the issue of causality satisfactorily, and proceeded to produce two types of evidence in this context. The first is to show that King and Levine’s (1993a) causal interpretation is based on a fragile statistical basis. Specifically, it is shown that once the contemporaneous correlation between the main financial indicator and economic growth has been accounted for, there is no longer any evidence to suggest that financial development helps predict future growth. The second type of evidence demonstrates that cross-section data sets cannot address the question of causality in a satisfactory way. To perform such a task, time series data and a time series approach are required, as for example in Granger (1988) among others. Adopting the latter approach and using cointegration techniques as well as data for 12 representative countries, it is shown that there are systematic differences in causality patterns across countries. It thus emerges that Arestis and Demetriades (1997) were correct in at least voicing those concerns. When summarizing the enormous body of empirical evidence on finance and growth, Levine (2004) distinguishes the following types of evidence: cross-section studies, panel studies, pure time-series investigations, country case studies, and industry and firm level analyses.4 The overall conclusion of this review is that ‘while subject to ample qualifications and countervailing views noted throughout this article, the preponderance of evidence suggests that both financial intermediaries and markets matter for growth even when controlling for potential simultaneity bias’ (p. 85). The problem is that there are still ‘ample qualifications and countervailing views’, which are significant. The same study notes additional problems: the empirical measures do not always account for the functions assigned to them; the determinants of financial development are not well understood; it is the case that ‘political, legal, cultural and geographical factors influence the financial system’, and yet a great deal more work ‘is required to better understand the role of financial factors in the process of economic growth’ (p. 88). Other studies suggest further problems. A recent IMF study (Favara, 2003) fails to establish significant coefficients on financial variables in instrumented growth regressions. Interestingly enough, Rousseau and


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Wachtel (2001) report that in countries with high inflation the possible effects of finance on growth weaken substantially. These contributions add to the unconvincing empirical support of the financial liberalization thesis. With so much emphasis on the financial liberalization thesis in the context of the growth–finance nexus, a brief review of its theoretical premise and its policy implications is in order.

Financial liberalization: theory and policy aspects The financial sector of an economy provides real services, whereby financial instruments, markets and institutions arise to ameliorate market frictions: they can mitigate the effects of incomplete information and transaction costs. In fact, Levine (2004) suggests that the financial system provides the following functions: ‘produce information ex ante about possible investments and allocate capital; monitor investments and exert corporate governance after providing finance; facilitate the trading, diversification and management of risk; mobilize and pool savings; ease the exchange of goods and services’ (p. 5). Even so, Lucas (1988) dismisses finance as an ‘over-stressed’ determinant of economic growth (p. 6) and, as noted above, Robinson (1952) assumed a passive role for finance. At the other extreme, Miller (1998) suggests that ‘financial markets contribute to economic growth is a proposition too obvious for serious discussion’ (p. 14). The middle ground is covered by the idea that the finance–growth nexus cannot be safely ignored without endangering our understanding of development and economic growth (Bagehot, 1873; Schumpeter, 1911; Gurley and Shaw, 1955; Goldsmith, 1969; McKinnon, 1973; Shaw, 1973). No wonder that interest in the finance–growth nexus has been expressed ever since ancient times and continuous abated to today. The recent upsurge of interest in these matters emanates from the fact that a number of writers question the wisdom of financial repression (the practice of administering interest rates), arguing that it has detrimental effects on the real economy. Goldsmith (1969) argued that the main problem with financial repression was its negative effect on the efficiency of capital. McKinnon (1973) and Shaw (1973) stressed two other problems: first, financial repression affects negatively the efficient allocation of savings to investment; and

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second, through its effect on the return to savings, it has a restraining influence on the equilibrium level of savings and investment. In this framework, therefore, investment suffers not only in quantity but also in quality terms since bankers do not ration the available funds according to the marginal productivity of investment projects but according to their own discretion. Under these conditions the financial sector is likely to stagnate. The low return on bank deposits encourages savers to hold their savings in the form of unproductive assets such as land, rather than the potentially productive bank deposits. Similarly, high reserve requirements restrict the supply of bank lending even further while directed credit programmes distort the allocation of credit since political priorities are, in general, not determined by the marginal productivity of different types of capital. The financial liberalization thesis argues for the removal of interest rate ceilings, reduction of reserve requirements and abolition of directed credit programmes. In short, liberalize financial markets and let the free market determine the allocation of credit. With the real rate of interest adjusting to its equilibrium level, low-yielding investment projects would be eliminated, so that the overall efficiency of investment would be enhanced. Also, as the real rate of interest increases, saving and the total real supply of credit increase, which induces a higher volume of investment. Economic growth would, therefore, be stimulated not only through the increased investment but also because of an increase in the average productivity of capital. Moreover, the effects of lower reserve requirements reinforce the effects of higher saving on the supply of bank lending, while the abolition of directed credit programmes would lead to an even more efficient allocation of credit thereby stimulating further the average productivity of capital. Again, however, we point out that these authors have failed to recognize that the core policy combinations of fixed exchange rates and external government debt are themselves inherently repressive, and that liberalizing in these circumstances, therefore, promotes instability. The early experience of countries that went through financial liberalization has been reviewed in a number of studies (see, for example, Arestis and Demetriades, 1997, 1998; Arestis, 2004, 2006; Demetriades and Luintel, 1996; World Bank, 1993). That experience leads to the conclusion that what happened in the relevant economies


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was that financial liberalization typically unleashed a massive demand for credit by households and firms that was not offset by a comparable increase in the saving rate. Loan rates rose as households demanded more credit to finance purchases of consumer durables, and firms plunged into speculative investment in the knowledge that government bail-outs would prevent bank failures. In terms of bank behaviour, banks increased deposit and lending rates to compensate for losses attributable to loan defaults. High real interest rates completely failed to increase savings or boost investment – they actually fell as a proportion of GNP over the period. The only type of savings that did increase was foreign savings, that is, external debt. This, however, made the ‘liberalized’ economies more vulnerable to oscillations in the international economy, increasing the debt/asset ratio and thus service obligations and promoting the debt crises experienced in the recent past. Financial liberalization thus managed to displace domestic for international markets. Long-term productive investment never materialized either. Instead, short-term speculative activities flourished whereby firms adopted risky financial strategies, thereby causing banking crises and economic collapse. Despite the early troublesome attempts at financial liberalization, and the increasing problems and scepticism surrounding the financial liberalization thesis over the years since its inauguration, it nevertheless had a relatively early impact on development policy through the work of the IMF and the World Bank. These two institutions, perhaps in their traditional role as promoters of what were claimed to be free market conditions, were keen to encourage financial liberalization policies in developing countries as part of more general reforms or stabilization programmes. When events following the implementation of financial liberalization prescriptions did not confirm their theoretical premises, there occurred a revision of the main tenets of the thesis. Gradual financial liberalization is to be preferred. In this gradual process a ‘sequencing of financial liberalization’ (for example, Edwards, 1989; McKinnon, 1991) is recommended. Employing credibility arguments, Calvo (1988) and Rodrik (1987) suggest a narrow focus of reforms with financial liberalization left till last. A further response by the proponents of the financial liberalization thesis has been to argue that where liberalization failed it was because of the existence of implicit or explicit deposit insurance coupled with inadequate banking supervision and macroeconomic

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instability (for example, McKinnon, 1988a, 1988b; 1991; Villanueva and Mirakhor, 1990; World Bank, 1989). These conditions were conducive to excessive risk-taking by the banks, a form of moral hazard, which can lead to ‘too high’ real interest rates, bankruptcies of firms and bank failures. This experience led to the introduction of new elements into the analysis of the financial liberalization thesis in the form of preconditions, which should have to be satisfied before reforms are contemplated and implemented. These are due to problems that emanate from differential speeds of adjustment and possible ‘competition of instruments’. This analysis leads to recommendations that include ‘adequate banking supervision’, aiming to ensure that banks have a well-diversified loan portfolio, ‘macroeconomic stability’, that refers to low and stable inflation and a sustainable fiscal deficit, and sequencing of financial reforms. Differential speeds of adjustment are now thought as possible causes of serious problems to attempts at financial liberalization (McKinnon, 1991). There are different speeds of adjustment in the financial and goods markets whereby the latter are sluggish. Thus, financial markets could not be reformed in the same manner and in the same instance as other markets, without creating awkward difficulties. Recognition of these problems has led the proponents of the financial liberalization thesis to suggest the desirability of sequencing in financial reforms. Successful reform of the real sector came to be seen as a prerequisite to financial reform. Thus, financial repression would have to be maintained during the first stage of economic liberalization. Furthermore, there is the possibility that different aspects of reform programmes may work at cross-purposes, disrupting the real sector in the process. This is precisely what Sachs (1988) labelled as ‘competition of instruments’. Such conflict can occur when abrupt increases in interest rates cause the exchange rate to appreciate rapidly thus damaging the real sector. Sequencing becomes important again. It is thus suggested that liberalization of the ‘foreign’ markets should take place after liberalization of domestic financial markets. In this context, proponents suggest caution in ‘sequencing’ in the sense of gradual financial liberalization emphasizing the achievement of macroeconomic stability and adequate bank supervision as preconditions for successful financial reform (Cho and Khatkhate, 1989; McKinnon, 1988b; Sachs, 1988; Villanueva and Mirakhor, 1990). It is also argued by the proponents


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that the authorities should move more aggressively on financial reform in good times and more slowly when borrowers’ net worth is reduced by negative shocks, such as recessions and losses due to terms of trade (see also World Bank, 1989). In their (1994) study, Caprio et al. reviewed the financial reforms in a number of primarily developing countries with the experience of six countries studied in some depth and length. They conclude that managing the reform process rather than adopting a laissez-faire approach is important, and that sequencing along with the initial conditions in finance and macroeconomic stability are critical elements in successfully implementing financial reforms. These post hoc theoretical revisions were thought sufficient to defend the original thesis of a disappointing empirical record. Despite all these modifications, however, there is no doubt that the proponents of the financial liberalization thesis do not even contemplate abandoning it. No amount of revision has changed the objective of the thesis, which is to pursue the optimal path to financial liberalization, free from any political, that is, state, intervention. Sequencing does not salvage the financial liberalization thesis for the simple reason that it depends on the assumption that financial markets clear in a Walrasian manner while the goods markets do not. But in the presence of asymmetric information, financial markets too are marred by imperfections. But even where the ‘correct’ sequencing took place (for example, Chile), where trade liberalization had taken place before financial liberalization, not much success can be reported (Lal, 1987). The opposite is also true, namely that in those cases, such as Uruguay, where the ‘reverse’ sequencing took place, financial liberalization before trade liberalization, the experience was very much the same as in Chile (Grabel, 1995). We argue in the rest of this chapter that there are a number of issues in these arguments that are critical in the development of the financial liberalization thesis. We argue that these propositions are not problem-free. They are, in fact, so problematic that they leave the thesis without serious theoretical and empirical foundations.

Problems with financial liberalization This section deals with the critical issues of the financial liberalization thesis in an attempt to draw conclusions on both its theoretical

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and empirical importance. Arestis and Demetriades (1998) and Arestis (2004, 2006) suggest and discuss a number of them as follows: • the relationship between financial liberalization and economic development; • the relationship between savings and investment; • the role of sequencing; • free banking and the stability of the financial system; • the role of financial policies; • the role of stock markets and speculation; • the magnitude of distributional effects of interest rate changes. The conclusion from these discussions is that there are numerous problems with financial liberalization. In this section we add to the above issues the following: • the relationship between financial liberalization and crises; • the importance of privatizing state banks to financial development and growth; • the role of legal and political factors; • the importance of capital account liberalization to macroeconomic policies; • impact of financial liberalization at the corporate level. We now discuss these critical issues, summarizing the first seven, but full details can be found in Arestis and Demetriades (1998) and Arestis (2004, 2006); however, in some instances we extend the arguments found therein. This summary is followed by a full discussion of the five additional aspects.

The relationship between financial liberalization and economic development In demonstrating that a positive relationship exists between financial liberalization and economic development, the thesis under scrutiny ignores a number of aspects: hedge effects and curb markets; lack of perfect competition, asymmetric information and liquidity constraints; and public finance aspects and low interest rates for development.


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The structuralist theory (Taylor, 1983; Van Wijnbergen, 1983) suggests that the higher interest rates, which follow financial liberalization, might leave unchanged or, indeed, decrease the total supply of funds. This is due to hedge effects, which may not materialize in which case the total supply of funds may not be affected, or to curb effects, which may reduce it. However, it should be readily conceded that both the hedge and curb effects have not been unambiguously empirically validated (Ghate, 1992).5 Futhermore, the McKinnon and Shaw type of models are based on the unrealistic assumption of perfect competition in financial markets. The banking sector departs from perfect competition in at least two respects. First, banking sectors are rather oligopolistic, and the result of financial liberalization could very well be the monopoly result whereby the decrease in loans and the increase in the real interest rate are higher magnitudes than that under perfect competition. Second, perfect competition involves the assumption that economic agents can borrow or lend as much as they wish at the prevailing rate of interest, and in contrast credit rationing is a pervasive feature of the banking sector. The degree of competition in the financial sector and its impact on growth have been the focus of much theoretical and empirical work. Theoretical contributions have emerged from questions concerning the extent to which competition enhances the efficiency of the production of financial services and whether it can improve the quality of financial products and the degree of innovation in the financial sector. Indeed, increased financial sector competition can ‘lead to lower costs and enhanced efficiency of financial intermediation, greater product innovation and improved quality’ (Claessens and Laeven, 2004, p. 69). At the empirical level the focus has been on the potential impact competition may have on banking systems and growth. A summary of the debate is provided in, for example, Vives (2001) and Claessens and Laeven (2004). The latter study concludes that the theoretical contributions suggest ‘an ambiguous relationship between degree of competition and access to financing and, in turn, growth’. At the same time, the empirical contributions show that ‘some relationships between market structure and growth, the link from structure to degree of competition is not clear’ (p. 80). Claessens and Laeven (2004) also provide further empirical findings, which suggest that the structural measure of banking competitiveness utilized in the study ‘is negatively associated with countries’

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growth, suggesting that less competitive banking systems are better at providing financing to financially dependent firms’; consequently, market power in banking may be beneficial to accessing finance. However, they also find that ‘the effects of banking system competitiveness on growth vary with the level of countries’ financial sector development’ (p. 68). More precisely, they find ‘that in only countries with less developed financial systems do financially dependent industries grow faster if the financial system is less competitive while in more developed financial systems they grow faster when the financial system is more competitive’ (p. 68). It follows that less competition may be desirable in countries with underdeveloped financial systems, where banks extend financing to borrowers who are more informed. However, in countries with developed financial systems, competition enhances growth. Although a large cross-section of countries is utilized, there are problems with this approach. These are the problems associated with the use of cross-section data as we have stressed above and demonstrated elsewhere (see, for example, Arestis and Demetriades, 1997). Moreover, variables that have been shown to affect financial sector development are not always accounted for in the empirical part of the Claessens and Laeven (2004) study. It is worth noting in this sense that the results and their interpretation are tentative, since no detailed investigation is undertaken of the channels through which competition may affect the functioning of the financial sector. The authors are, thus, forced to concede that their results ‘suggest that competition policy in the financial sector is complicated and can not be evaluated independently from the overall development of the financial system’ (p. 68). Further problems can emanate from asymmetric information, which could very well produce monopolistic tendencies in view of restrictions on competition among banks. The problems of adverse selection and moral hazard are acute in the financial sector and have important implications for the effects of financial liberalization. These problems suggest that the existence of operators in the financial markets who are prepared to take excessively high risks implies higher interest rates than otherwise and, presumably, a lower total supply of funds thereby inducing financial instability. A related problem is that of ‘liquidity constraints’, both firms and households can be faced with, which can arise as a result of financial


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market imperfections. There is actually considerable evidence that households face liquidity constraints in developing countries caused by the presence of incomplete information in credit markets (for a very good example, see Rosenzweig and Wolpin, 1993). These imperfections may be caused either by asymmetric information in liberalized markets, which can lead to equilibrium credit rationing (Stiglitz and Weiss, 1981), or by government regulations of, for example, interest rates. Jappelli and Pagano (1994) demonstrate that to the extent financial liberalization can relax or eliminate liquidity constraints for the household, it may then lead to a reduction in savings. The final aspect is that of public finance. Financial liberalization may limit government ability to raise revenue through monetary base creation. Another destabilizing effect in this context is that financial liberalization by producing higher interest rates is likely to be accompanied by destabilizing consequences for the macroeconomy. In addition, the thesis ignores the advantages of using low interest rates and, thus, credit selection for development purposes.

The relationship between savings and investment In the McKinnon/Shaw model savings is seen to take place prior to investment. But savings can only fund investment ex post, and it would be more accurate to perceive as investment occurring prior to savings (though, of course, ex post, in national accounts terms, savings and investment are equal). Savings cannot finance capital accumulation; this is done by the banking sector, which provides loans with which investment expenditure is financed, without necessitating increases in the volume of deposits (Studart, 1995). A second problem with the McKinnon/Shaw model is the assumption that deposits create loans. In modern banking systems, including most LDCs, loans create deposits not the other way round (see also Arestis and Howells, 1996). It is worth noting in the context of the arguments just advanced that the liquidity preference of the banks is a paramount dimension of the argument (Chick and Dow, 2002), as well as the ability of the banking sector to innovate, with liability management being a good example in this context (Arestis and Howells, 1996).

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The role of sequencing Sequencing does not salvage the financial liberalization thesis for the simple reason that it depends on the assumption that financial markets clear, while the goods markets do not. This is a strange assumption, since given the well-known Walras Law in which excess demand in markets sum to zero, suggests that if the financial market clears, then so will the goods market. In any case, in the presence of asymmetric information, financial markets too are marred by the so-called imperfections. But even where the ‘correct’ sequencing took place (for example, Chile), where trade liberalization had taken place before financial liberalization, not much success can be reported (Lal, 1987). The opposite is also true, namely, and as noted above, that in those cases such as Uruguay, where the ‘reverse’ sequencing took place, financial liberalization before trade liberalization, the experience was very much the same as in Chile (Grabel, 1995). Stiglitz (2000) highlights the difficulties with the sequencing literature in explaining the South East Asian crisis, where strong macroeconomic fundamentals, along with sound systems of banking regulation and supervision, and reasonable economic policies along with sound financial institutions were in place. Still the South East Asian financial crisis of 1997–98 was not prevented. Kaminsky and Schmuckler (2003) when discussing relevant findings conclude that ‘the ordering of liberalization does not matter in general. Opening the capital account or the stock market first does not have a different effect than opening the domestic financial sector first’ (p. 31).

Free banking and the stability of the financial system The proponents of free banking refer to a number of examples to demonstrate the advantages of free banking, and thus provide support for it. Arestis and Demetriades (1998) refer to the three cases that have been most frequently discussed to show that in reality the situation was far from what is normally alleged as ‘successful’ free banking cases. In the USA during the period 1837–63 and in 18 states (including New York) where there was free banking, there were serious problems with bankruptcies and issue of ‘too much money’ being the most serious ones. In free banking systems the equality of


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marginal revenue and marginal cost, with the latter being zero, may very well produce these problems in money creation (the relevant arguments advanced in Friedman (1959) are particularly pertinent in this context). Scotland during the years 1695–1845 experienced a period of free banking. There was no central bank and Scottish commercial banks issued their own banknotes backed by their own holdings of gold specie and were not under any legal supervision; nor were there any restrictions on entry to the banking industry. But the Scottish system depended upon the English banks whenever problems arose. Indeed, and as Dow (1996) observes, the experience of Scottish commercial banks during that period could not be isolated from the presence of the Bank of England throughout the UK. Furthermore, even in that era of Scottish free banking the system evolved its own form of central banking. The two ‘old banks’, the Bank of Scotland and the Royal Bank of Scotland, in effect performed that function. Canada over the period 1820–1935 experienced allegedly free banking. However, the period was characterized by the fact that the Bank of Upper Canada and the Bank of Montreal were not as ‘free’ as it is alleged. They were actually owned to a significant extent by politicians of Upper Canada and Lower Canada respectively (Dow, 1996). Clearly, then, even in the most frequently discussed cases of free banking, the system may either have worked because of support emanating from outside the system itself, or it was simply marred by serious problems. There are further serious theoretical drawbacks. Asymmetric information, which leads to two types of problems: adverse selection and moral hazard (Stiglitz and Weiss, 1981). These problems can lead to a situation where financial distress becomes widespread, developing into financial fragility.6 Under these circumstances financial institutions may very well collapse, leading to a financial crisis. The existence of a lender-of-last-resort or explicit deposit insurance schemes enables economies to avert financial crises. Even so, financial fragility may contribute to serious macroeconomic instability when governments are forced to intervene, which makes it impossible for them to maintain fiscal and monetary discipline as traditionally defined.7 Financial liberalization has actually been at the root of many recent cases of financial fragility and crises (Diaz-Alejandro, 1985; Burkett and Dutt, 1991; Gibson and Tsakalotos, 1993).8 Financial reforms in many countries allowed real interest rates to reach

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levels exceeding 20 per cent per annum in some cases. National governments either abandoned attempts at financial liberalization or were forced to intervene by nationalizing banks and guaranteeing deposits. Consequently, a free banking system is unlikely to be in a position to tackle financial crises. If anything, under free banking circumstances the system itself is at the centre of the financial crisis and as such encourages it; the situation is bound to deteriorate under a free banking system. Bank regulation and central banks to regulate the system become paramount. Indeed, and as Dow (1996) argues, what is required is not deregulation, but better regulation.

The role of financial policies A broad literature has established that the financial sector in an economy can be important in determining the average productivity of capital, itself being one of the main channels of economic growth. However, the causal nature of this relationship is now known to exhibit considerable variation across countries, which indicates that institutional factors or policies may play a critical role in determining how the process of financial development affects economic growth (Arestis and Demetriades, 1997). The importance of institutional factors is confirmed by Demirgüç-Kunt and Detragiache (2001), who demonstrate that institutional quality is inversely related to the incidence of financial fragility that usually follows episodes of financial liberalization. The relevance of financial liberalization policies is highlighted in Arestis et al. (2002), who demonstrate that the direct effects of financial repression in some developing countries are much larger than, and in some instances opposite to, those emanating from changes in the real interest rate. Arestis, Demetriades and Fattouh (2003) provide a further assessment of the effects of several types of financial policies on the average productivity of capital in 14 countries, including both developed and developing countries. Specifically, they utilize a new data set on financial restraints, capital adequacy requirements and restrictions on capital flows in these countries, for a period of 40 years. Modern panel-time series methods are employed to examine the effects of these policies on the productivity of capital, controlling for financial development, employment and capital. Their findings suggest that the effects of these policies vary considerably across countries, probably reflecting institutional


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differences. They also demonstrate that the main predictions of the financial liberalization literature do not receive adequate empirical support, a result that may reflect the prevalence of financial market imperfections. In contrast, their findings provide significant support to the thesis, currently gaining increasing support among international policy makers, that some form of financial restraints may indeed have positive effects on economic efficiency.

The role of stock markets and speculation These are two interrelated aspects and we take them together. There has been an enormous growth of stock markets over the last 10 to 15 years (Arestis and Demetriades, 1977; Singh, 1997). Well-developed stock markets may be able to offer different kinds of financial services than banking systems and may, therefore, provide a different kind of impetus to investment and growth than the development of the banking system. Atje and Jovanovic (1993), Levine (1996), and Levine and Zervos (1995, 1996), provide empirical evidence of a strong and positive relationship between stock market developments and economic growth. They argue that stock markets may affect growth through liquidity, which makes investment less risky. Companies enjoy permanent access to capital through liquid equity issues. This argument leads to the conclusion that ‘stock market development explains future economic growth’ (Levine, 1996, p. 8). The studies of Levine and Zervos (1995, 1996) and of Atje and Jovanovic (1993) differ in two respects: Levine and Zervos use indexes of stock market development just as Atje and Jovanovic do, but unlike the latter, their indexes combine a number of characteristics; and, unlike Atje and Jovanovic, Levine and Zervos control for initial conditions and other relevant factors that may influence economic growth. It is worth noting, though, that Zhu, Ash and Pollin (2004) demonstrate that the results of Levine and Zervos (1995, 1996) are not robust in that they are driven by their choice of outlier countries. Once more appropriate outliers are utilized, it is no longer the case that a statistically significant relationship can be detected between economic growth and liquid stock markets. Furthermore, Arestis, Demetriades and Luintel (2001) offer a critique of the positive relationship between stock market development and economic growth; stock market volatility is an important variable

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that should be carefully considered. Once this is properly undertaken, unsupportive empirical evidence to the ‘stock market development explains future economic growth’ thesis is derived. However, speculation is an important aspect of stock markets, and represents a source of macroeconomic instability in that stock market financial assets are highly liquid and volatile (Grabel, 1995; Keynes, 1936, chapter 2; Federer, 1993). They thus make the financial system more fragile rather than less fragile (Arestis, Demetriades and Luintel, 2001; Weller, 2001; Arestis and Glickman, 2002), consequently encouraging short-termism at the cost of long-term growth. Financial liberalization, therefore, is less likely to enhance the long-term growth prospects, especially of developing countries. Additionally, dependence on the external inflows, which have produced the stock market expansion particularly in developing countries, erodes policy autonomy and forces monetary authorities to maintain high interest rates to sustain investor confidence and greed. There is also the argument that external financial liberalization may lead to a reduction in the rate of return as a result of increased capital flows, which reduces the domestic saving rate. Domestic institutions may face so much competition from foreign institutions, which may cause excessive pressure on domestic institutions and eventually to their bankruptcy.

The magnitude of distributional effects of interest-rate changes Financial liberalization and the ensuing freeing of credit markets improves income distribution and decreases industrial concentration, owing to widened access to finance and a decreased degree of credit market segmentation. This benefits small firms because it avoids subsidizing priority sectors, which leads to market segmentation. This is the implied hypothesis put forward by the proponents of the financial liberalization thesis (Fry, 1995, for example). There are, however, further important and significant distributional effects that are ignored by the financial liberalization thesis. There are the effects that emanate from the distinction between ‘demand determined’ and ‘cost-determined’ price sectors (Kalecki, 1971). In the ‘demand determined’ competitive sector, essentially agriculture and raw materials, prices are determined by supply and demand. In the


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‘cost-determined’ price sector, manufacturing and services, prices are set at some stable mark-up over average variable costs, and prices are administered on the basis of some expected normal rate of capacity utilization through a mark-up process over normal average variable costs, sufficient to cover fixed costs, dividends and the internal finance of planned investment expenditures. The price leaders effectively set the market price as just described, so as to yield their targetprofits. The rest follow the price leaders and they may have higher or lower average costs and so lower or higher mark-ups and net profits. Interest is a cost and must be passed on if firms are to achieve their profit targets to finance their investment plans. The bigger the size of the firm, the easier it is for it to pass on the increase in interest rates. It follows that increases in interest rates hit the ‘demand-determined’ price firms, since they absorb interest rate changes in the case of these firms in the short-run. In the long-run interest rate changes may be expected to be passed on in prices if the profit rate is to remain unchanged. A further important redistributional effect is present. ‘Demanddetermined’ price firms, normally small firms, save small amounts, which are deposited with the commercial banking sector. Small firms, therefore, are very sensitive to interest rate changes. By contrast, ‘Cost-determined’ price firms that are big firms, possess a preponderant amount of their own savings. They prefer to have too much rather than too little savings, which gives them independence from lenders and it enables them to substitute capital for labour, if need be. These are internally created funds that are utilized for investment purposes, so that these firms are insulated from capital markets. It follows that high interest rates hit the small firms rather harshly, but leave the big firms fairly unscathed. The weak, therefore, are victimized. An undesirable distributional effect is thus created, which promotes sectoral inequalities. It also retards socially desirable sectors, as for example the case with the housing sector, which has a high propensity to borrow. This analysis clearly corroborates Keynes’s (1973) argument that increases in interest rates enhance the degree of income inequality significantly. This inequality suggests that monetary policy that aims to sustain high levels of interest rates entails a certain degree of moral responsibility about it. In the case of developing economies there is the additional problem that emanates from the external

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debt. Higher interest rates at a global level are accompanied by an increase in third world debt, which implies redistributional effects across countries. The importance of the ethical issues that arise from this analysis cannot be exaggerated (Arestis and Demetriades, 1995). It is also for this reason that interest rate policies, which aim at a stable and permanently low level of interest rates, should be supported. We turn our attention next to the five additional aspects as suggested above.

The relationship between financial liberalization and crises The study by Arestis and Glickman (2002) is a good example that clarifies this relationship. It draws on the financial crisis in South East Asia (1997–98) and focuses on the role of financial liberalization in the process. The analysis suggests that the treats to growth and employment emanating from the financial sector, which Minsky (1986) identified in the closed economy setting are greatly intensified in open, liberalized economies. Financial liberalization is demonstrated to be a key factor in this process. The gist of the argument is that ‘financial liberalization produces an upward step-change in the intensity of the domestic drive towards financial innovation, as it sweeps away the rules and conventions which previously governed the way banks related to one another and their customers. It thereby speeds up the process by which debt ratios of commercial concerns and financial institutions rise, escalating financial fragility, and it hastens the day when banking and financial crises loom’ (Arestis and Glickman, 2002, pp. 244–5). Proponents of financial liberalization favour ‘sequenced’ programmes of ‘free’ market reforms as elaborated earlier in this chapter. But such reforms only serve to weaken the barrier of financial conservatism, which acts to contain pressures leading to fragility of the financial system. This, however, raises the feeling of invulnerability, weakening inhibitions against speculation and reinforcing the tendency towards euphoria (Minsky, 1986). In an open economy, this mood will spread rapidly beyond the confines of the country concerned. In the absence of capital controls, speculators will turn their attention to the domestic economy, especially so the higher interest rate differentials may be in their favour.


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Capital flows will offset any tendency for the domestic upswing to push interest rates higher. The exchange rate may be pegged without much difficulty, or allowed to appreciate. In either case, the external position is interpreted as evidence of ‘economic’ health, fuelling optimism further. Success is an endogenous factor driving financial innovation forward, and openness extends the scope of achievable success. Sooner or later the economy can be led to one of the following: a crisis that is domestic in origin but impacts on its external situation; or to a crisis that is external in origin but impacts on its domestic situation; or to a crisis that is a combination of these two factors. Under these conditions, the exchange rate becomes a source of further uncertainty. Speculators begin to doubt the ability of the state to support its currency, and they may very well move against the currency concerned, possibly on a massive scale as in the case of the South East Asian crisis. This analysis clearly suggests that financial liberalization should be expected to lead to crisis. The experience of countries with financial liberalization discussed above and in Arestis and Glickman (2002) clearly testify to this real possibility. Consequently, Minsky’s (1986) view that the instability of the financial system threatens high growth rates and low unemployment is validated by these experiences. Financial liberalization, as a key euphoria-inducing factor, ‘intensifies this threat by adding further major stresses to the financial infrastructure’ (Arestis and Glickman, 2002, p. 258).

The importance of privatizing state banks to financial development and growth This issue may be closely related to the free banking aspect: if free banking leads to stability of the financial system, as the proponents of the financial liberalization thesis still hold, then government ownership of banks should not be contemplated. We suggest that the privatization issue, however, is a separate item and one that is related more closely to the endogenous growth literature as argued above. The endogenous growth literature suggests that ‘state’ banks provide an effective means to politicians to interfere with the normal workings of the banking market system. Politicians can thereby influence the allocation of credit on grounds that have little to do with an efficient way of allocating it. Privatization of state banks, therefore,

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would improve the efficiency of credit allocation, and also enhance both the quantity and quality of investment; private banks would also promote financial development, since the more efficient private banks would attract funds into the banking system in a better way than the inefficient state banks. La Porta et al. (2002) provide empirical evidence based on crosssection data, which supports the contentions of this thesis. Activities of state banks are robustly and negatively correlated with both growth and financial development. The same study also reports results that show government ownership of banks being higher when institutional factors, such as property right and government efficiency, are weak. Demetriades and Andrianova (2004) interpret the latter finding as a possibility of inverse causation: ‘if government ownership of banks is the result of institutional weakness, then lower growth rates and financial under-development may be the result of the same institutional weakness. Thus, privatizing state banks without addressing the institutional deficiencies that brought them about may not have the positive effects of growth predicted by La Porta et al. (2002)’ (p. 6). Furthermore, Andrianova et al. (2003) in a model with three types of banks (private banks of ‘honest’ type and ‘opportunistic’ type, and a state type of bank), and in a variety of empirical tests in the case of 83 countries, produce results that are not in agreement with the financial liberalization thesis. Demetriades and Andrianova (2004) summarize these results and conclude that ‘the privatization of state banks is, at best, unnecessary, since it is better to build institutions that foster the development of private banks and remove subsidies from state banks. At worse it is detrimental, since when institutions are weak it will almost certainly lead to financial disintermediation’ (p. 57).

The role of legal and political factors Legal factors Goodhart (2004) suggests that ‘the most important determinant of growth is good governance. Good governance is linked in turn with the establishment and maintenance of the rule of law, and with monetary stability . . . By the same token the ability of financial intermediation and development to help general long-term sustainable


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growth depends sensitively on these same underlying conditions’ (p. 253). An efficient and effective legal system involving respect for property rights, contract laws, bankruptcy laws etc., is thus paramount to economic growth and financial development. In fact, La Porta et al. (1998) draw on the distinction between civil law and common law in their study of the significance of law factors to financial development and growth.9 They find in their sample of 49 countries that civil-law countries have the weakest shareholder and creditor protection, while the common-law countries have the strongest shareholder and creditor protection. Legal origins also significantly influence legal enforcement with the common-law countries (and Scandinavian civil-law countries) being endowed with the best quality of law enforcement; the French civil-law countries have the worst. But the main determinant of legal enforcement is per capita GDP so that rich countries with civil-law tradition offer better law enforcement than poor common-law countries. In a different paper but utilizing the same sample, La Porta et al. (1997) offer evidence suggesting that although no significant difference can be established in terms of banking development, civil-law countries have lower levels of capital market development than common-law countries. These findings can be compared with those of Rajan and Zingales (2003) who find that in civil-law countries of the French variety financial development was higher than in common-law countries in the pre-Second World War period. It was after the Second World War when civil-law countries began to lag behind common-law countries. Furthermore, legal origins ‘may themselves be determined by historical, cultural, socio-economic and political factors’ (Demetriades and Andrianova, 2004, p. 58), many of which influence financial development. Zingales (2003) adds to the difficulties by suggesting that legal origins are also correlated with a number of quality indicators, such as efficiency of the judiciary, bureaucratic quality, and many other factors. The upshot of the argument is then that the purported link between all these factors and legal factors is very difficult, if not impossible, to gauge. A further difficulty with the relationship between legal origins and financial development and growth, is that there is little variation in legal origins, since most countries have a civil-law tradition, but a great deal of variation in financial development and growth. The example of Rajan and

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Zingales (2003) that in general terms financial development peaked before the First World War, declined in the inter-war period and well after the Second World War, before growing to a new peak at the end of the twentieth century, is very relevant to the argument. This U-shaped pattern suggests that other more important variables affect financial development and growth besides legal origins. The same authors stress political factors. Political factors The importance of political factors is located in the observation that there is a serious variability in the level of financial development in industrialized countries at the same stage of economic development. The political power of incumbents is invoked to explain this disparity (Rajan and Zingales, 2000, 2003). It is thereby argued that this disparity can be justified by the existence of interest groups or insiders (primarily incumbent managers and owners as well as trade unions) that are inherently opposed to financial openness. Financial openness promotes greater competition from new entrants thereby threatening the interests of the elite who possess a privileged position in obtaining finance. In times of crisis or conflict, the elite gains a firmer grip over its political influence and can thereby push through legislation protecting their interests. In more normal time, or indeed when greater prosperity is in place, these interest groups lose out in terms of their political influence, so that ultimately new legislation is introduced that encourages development in the financial markets. Under these circumstances, financial liberalization, however objectionable it may be to the elite, would force both them and the rest of economic agents to innovate. In fact, if trade and financial liberalization were introduced together, then the interests of both the elite and the rest of the economy are aligned and the drive to financial development ensues. This hypothesis explains the U-shaped pattern of financial development in the twentieth century referred to above. In fact, Rajan and Zingales (2003) produced empirical evidence that supports their contentions. The trouble is that although this thesis may offer an acceptable explanation in terms of the role played by interest-group politics, the empirical evidence is marred by data unavailability and, thus, sample-size problems – in some of the regressions in Rajan and Zingales (2003) the size of the sample is less than 20 observations!


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There is also a serious conceptual problem with this thesis. The resolution to which we have referred assumes that resolving the problem of financial openness leads to alignment of group-interests in the economy. This is a highly questionable hypothesis. There is also the rather obvious problem that a score of other factors could potentially explain the U-shaped pattern of financial development in the twentieth century than the Rajan and Zingales (2003) hypothesis. All in all, a great deal more research is needed to resolve the problems to which we have just alluded. The discussion of legal and political factors is closely related to the role of institutions in the finance–growth nexus. In this context, it is the case that little is known about how institutions interact with each other and their path of development and transformation. Indeed, the relevant literature is not very helpful to policy since it does not provide much guidance on what institutions to transform, how to transform them or what form they should take. Clearly, strong property rights and legal systems are important to a country, but the real challenge is the design and transformation of institutions to provide high quality services. The real challenge is how to transform institutions so that secure property rights and well-functioning legal and political systems can be guaranteed. In this context the study by Arestis, Nissanke and Stein (2006) is important in that it offers a holistic approach to viewing factors that should be taken into account when considering accessibility to international financial flows. They suggest that norms, incentives, regulations, capacities and organizations are crucial elements in the design of institutions that would promote robust economic growth.

The importance of capital account liberalization to macroeconomic policies The financial liberalization thesis suggests that capital account liberalization has positive effects on economic growth. Capital account liberalization, through rising global linkages via cross-border financial flows, can increase economic growth through various channels, and these are summarized in Arestis and Caner (2005, Chapter 3, this volume). In terms of the impact of removing controls over foreign investment on GDP growth, it is expected to vary depending largely on the nature of the initial restrictions. Removing restrictions on foreign

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direct investment flows are likely to have a positive impact on GDP growth. Other than the fact that they may encourage foreign investors to come forward, thereby increasing the flow of ideas and technology transfer, removing restrictions that aim at prohibiting capital from flowing to certain sectors may lead to a better allocation of resources. It may very well be the case that there could be more costs associated with short-term capital inflows than benefits. While short-term capital inflows may, in principle, supplement domestic savings and lead to higher levels of investment and growth rates, this benefit is likely to be small in economies with already high saving and investment ratios. The financial crisis in East Asia demonstrated that where it is not possible to invest short-term capital inflows in productive activities, they could end up creating asset price bubbles, especially when they are channelled into the stock market or the property market. During the early stages of this process capital inflows lead to unsustainable asset price increases, fuelling the euphoria of investors and leading to incorrect investment decisions (Arestis, Demetriades and Fattouh, 2001, 2003). Relative price distortions and resource misallocations of this type are likely to impact GDP growth negatively. Consequently, removing restrictions on short-term capital flows may well promote this occurrence. The literature casts a great deal of doubt on the effect of capital account liberalization on growth. Arestis and Caner (2005, this volume) when summarizing the relevant contributions conclude that ‘It is, therefore, not surprising to discover that this is another aspect of financial liberalization that has not produced supportive causal evidence’. Stiglitz (2004) is even more scathing in the critique of capitalmarket liberalization of rules affecting short-term capital flows and speculative hot capital. Capital-market liberalization ‘inhibits the use of counter-cyclical monetary policy’ and ‘leads to more overall economic volatility, and more volatility of consumption’; it also ‘exposes the country to new shocks, and weakens the built-in shock absorbers in the economy, provided by the price system’ (p. 63). The overall conclusion is that capital-market liberalization does not lead to faster growth or higher investment; it might, indeed, affect growth and investment adversely. Stiglitz (2004) goes beyond the theoretical problems of capital-market liberalization and argues that the evidence is also weak. It demonstrates that that capital-market liberalization has not been beneficial to countries that introduced it.


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In fact, the evidence clearly implies a systematic association between capital-market liberalization and instability (Demirgüç-Kunt and Detragiache, 2001; Honohan, 2001). In the same study, Stiglitz suggests that the IMF in supporting and promoting capital-market liberalization, ‘did not believe that policy should be based on theory or evidence; either it had an agenda that was different – perhaps promoting the interests of the financial markets – and/or policies were based more on ideology, not economic science: an ideology which coincided with interests’ (p. 58).

Impact of financial liberalization at the corporate level Proponents argue that financial liberalization has positive effects on corporations. Johnson and Mitton (2002) argue that external financial liberalization exposes cronyism and enhances market discipline. They refer to evidence from Malaysia where the imposition of capital controls in September 1998 primarily benefited firms with strong ties with the politicians. Capital controls in this view provided the shield for favoured firms to be supported, thereby causing inefficiencies. Rajan and Zingales (1998) argue that capital controls are necessary to allow a ‘relationship-based’ system to function. Informal relationships between politicians and banks help to channel lending to approved firms, a system that works when a country is protected from international capital flows. Under such a system, removing capital controls can lead to over-borrowing and financial collapse – as in certain parts of Asia in the 1990s.10 Stiglitz (2004) argues that to the extent capital-market liberalization causes greater consumption and output instability, it then ‘increases the risk premium firms require for investment, thereby discouraging investment’ (p. 63). Bekaert and Harvey (2000) argue that capital market liberalizations that integrate local economies with world capital markets reduce primarily expected equity returns – the cost of equity capital – but by less than expected, along with a small growth effect. This is explained in the case of 20 emerging countries by the finding that local market volatilities tend to be large while the covariances with world factors are low; and yet a small increase in correlation with the world market returns is reported. Furthermore, a small but insignificant increase in the volatility of stock returns is found, following capital market liberalization. Two further papers are of related interest.

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Bekaert, Harvey and Lundbland (2005) find a link between equity market liberalization and economic growth in a number of countries, while Bekaert, Harvey and Lundbland (2004) show that equity market liberalization is associated with a greater reduction in consumption growth volatility in countries with more open capital account. Laeven (2003) concentrates on the financing constraints aspect of firms in the case of 13 countries, and for the period 1988 to 1998, and shows that financial liberalization affects small and large firms differently. It has positive effects on the financing constraints of small firms, which are constrained before financial liberalization, but adverse effects on large firms, which are not so constrained before financial liberalization, essentially because they enjoy preferential treatment. Forbes (2004) also finds that financial liberalization can help smaller companies to raise financing and, also, can remove financial constraints for publicly traded firms. Another relevant result is that financial liberalization has a positive impact on the investment activity of multinationals. Desai, Foley and Hines (2004) study foreign affiliates of US multinational firms over the period 1982–97 to conclude that they are 13–16 per cent smaller in countries with capital controls than they are in comparable countries without capital controls. Countries that impose capital controls have higher interest rates than comparable countries without capital controls. These effects are reversed when capital controls are removed. Lipsey (2001) examines three financial crises, the Latin America crisis of 1982, the Mexico crisis of 1994, and the East Asia crisis of 1997, to conclude that direct investors are much more able to ride out economic problems than those involved in foreign bonds, equities, bank loans and other similar investment forms. The reason for this difference is the ability of direct investor to redirect sales from home to overseas markets in time of crises, with this being particularly true for US firms operating abroad. Studies of external financial liberalization, however, are disadvantaged by the imprecise measurement of capital controls in particular, which are typically blunt (Edison et al., 2003). They can also induce financial fragility and distress that lead to cycles of growth and crises that can affect the corporate sector severely and halt its economic growth. We have discussed several possibilities in this chapter, but three further ways can be mentioned (see also Johnson and Mitton, 2002): domestic firms switch borrowing from local to international


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lenders, who are either not aware or cannot assess risks appropriately; domestic banks become less willing to bail out firms once they have lost their monopolies; and domestic financial institutions respond to financial liberalization by adopting more risky strategies.

Summary and conclusions We have considered in this chapter the theoretical premise that has come to be known as the financial liberalization thesis. We have identified a number of theoretical propositions, which we have examined closely. We suggested that these critical issues of the thesis are marred by serious difficulties. We looked at the available evidence and found that it is not of much help to the thesis either. It is clear from this excursion in the literature that no convincing evidence has been provided in support of the propositions of the financial liberalization hypothesis. On the contrary, the available evidence can be interpreted as indicating that the theoretical propositions of the thesis are at best weak, and as such they ought to be abandoned. We may, therefore, conclude by agreeing with Stiglitz (1994) that the financial liberalization thesis is ‘based on an ideological commitment to an idealized conception of markets that is grounded neither in fact nor in economic theory’ (p. 20). When financial liberalization is viewed in this way, it falls under the rubric of ‘innocent fraud’, as used in Galbraith (2004). Namely, the current structure is somehow a ‘natural’ phenomenon, rather than the direct result of specific laws, institutions, and policies of government. Therefore, the debate begins with assumptions regarding institutional structure that are in fact policy options subject to review. Or, as Galbraith (2004) argues, there is ‘a continuing divergence between approved belief – what I have called elsewhere conventional wisdom – and the reality’. Ultimately, and unsurprisingly, though, what really emerges is that ‘it is the reality that counts’ (p. ix). The question posed in the title of this chapter can now be answered quite simply. Despite the enormous amount of literature in the area of financial liberalization and the finance–growth nexus, what we have really learned is not very much and the little we have learned is negative; that is not very much. The little we have learned may be summarized briefly: neither the extreme views of Lucas (1988) and Robinson (1952), nor those of Miller (1998) can

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be sustained. We have shown that the finance–growth nexus is important to our understanding of economic development and growth, but a great deal more is needed to clarify fully its role in this process. Indeed, there are still issues relating to the finance– growth nexus, which either need to be explored or in desperate need for further elaboration. Three such issues are of particular relevance in this context: the gender dimension, poverty and the changing nature of financial crises in the era of financial liberalization. Despite the significant developments discussed in this chapter, there has been little work conducted on the direct relationship between finance and gender. Raising the critical role of gender relations in determining development outcomes is not important to the financial liberalization view. It is true that the effects of economic and financial policy decisions on the well-being of people transmitted through the market and non-market sectors of the economy are complex to say the least. The manner in which gender inequalities and income and wealth differentiation are likely to be affected significantly within and between countries is an issue that has already begun to attract the interest of economists working outside the financial liberalization paradigm. Maria S. Floro in Chapter 2 attempts to fill a great deal of this gap in the literature on the relationship between financial liberalization and poverty. Turning to the poverty issue, we note that the small amount of research that has been undertaken on the question of the impact of financial liberalization on poverty has been extremely simplistic. It is based on the view that financial liberalization mobilizes savings and allocates capital to more productive uses, both of which help increase the amount of physical capital and its productivity, thereby increasing economic growth; so that economic growth caused by financial liberalization reduces poverty. Nonetheless, one would expect the economic and institutional changes brought about by a financial liberalization package to have a more complex effect on the living conditions of the poor than merely through the presumed growth channel and this simplistic view. Philip Arestis and Asena Caner take on board this issue in Chapter 3. We have noted above in the introduction that over the last 30 years or so, the degree of severity of recent financial crises has increased substantially in terms of their frequency. We have


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also made the point there that these financial crises exacerbate downturns in economic activity, thereby imposing substantial real economic costs not only to the countries involved but to other countries as well, beyond the financial costs of banking crises for the affected local economies. Korkurt A. Ertürk, in Chapter 4, discusses the changing nature of financial crises as a result of the experience of this era.

Notes 1. There is the interesting question of the distinction between banks and other financial institutions. For the purposes of this chapter, suffice to say that a bank is a financial institution whose liabilities are counted as part of the money stock; the rest of financial intermediaries would be classified as other financial institutions. 2. The first coinage in the kingdom of Lydia was made of electrum, an amalgam of gold and silver, and was produced by King Croesus. 3. Other observers, however, regard John Law ‘as a monetary crank’, while others ‘as a precursor of modern schemes of managed money and Keynesian full-employment policies’ (Bordo, 2004, p. 143). 4. There is another type of evidence that relies on the elasticity of the savings and investment relationships, which are, of course, at the heart of the thesis. The elasticity of the savings relationship is either insignificant or when significant, it is rather small. Fry (1995) suggests that ‘the real interest rate has virtually no direct effect on the level of saving, but may exert an indirect effect by increasing the rate of economic growth’ (p. 188). The investment relationship with respect to the real rate of interest is also questionable. Demetriades and Devereux (1992), using data on 63 developing countries for the period 1961–90, find that the negative effect of higher domestic interest rates on investment, working through the cost of capita, outweighs the effect of an enhanced supply of investible funds on investment, so that interest rate liberalization has, on balance, a negative effect on investment. Greene and Villanueva (1991) find a statistically significant negative effect of real interest rates on investment in 23 developing economies over 1975–87 (for a comprehensive review of the literature, see Fry, 1995). 5. Hedge effects are due to substitution of hedge assets (gold and land are the most obvious examples) for bank deposits brought about by higher interest rates. Curb effects refer to those emanating in the informal sectors that prevail in developing countries. 6. In the 1980s more than 25 governments had to intervene to help distressed financial institutions. The number of countries included developing as well developed. The latter category contained EU countries and the USA. 7. However, there are always policy responses to allow the real economy to continue to function as desired. With a floating exchange rate system, and

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on the assumption that interest rate changes do not have an impact on the economy, the financial ‘cost’ for the government is a distributional issue, and an important one at that, but not one of helping real economic activity and sustaining total output as desired. 8. There are many examples one could mention to make the point. Argentina, Chile, Turkey, Philippines and Uruguay are the most frequently discussed relevant cases. 9. Civil law has its origins in Roman law, and relies on formal rules, statutes and comprehensive code in settling disputes. Three types of such law, French, German and Scandinavian, are based on the Roman law with varying degrees of dependence. Common law, which originates from the law of England, is based on precedents from judicial decisions and on the views of judges in resolving disputes. 10. There is also the more macroeconomic argument that capital controls in Malaysia enabled the country to ride out of its economic difficulties as a result of the South East Asian crisis (Arestis and Glickman, 2002; Krugman, 1998; UNCTAD, 1998).

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2 The Importance of the Gender Dimension in the Finance and Economic Development Nexus Maria S. Floro American University

Abstract Using an open developing economy case, this chapter presents a conceptual framework for understanding the significant genderrelated, equity and welfare implications of domestic and international resource mobilization. This conceptual framework builds upon the notion of economic development as a process of structural transformation and changes in production and distribution processes involving the two sectors of the real economy engaged in human provisioning namely, the market and non-market, domestic sectors. It highlights the role of gender, along with class, as an important analytical category; not only does it serve as a basis for fundamental division of labour in societies, but also for socially defining one’s role in economic life. Both class and gender are constitutive bases of power. The chapter also explores the interaction between the financial sector and the real sector in terms of the allocation of resources by governments in order to mobilize foreign savings vis-à-vis foreign investment. It serves to illustrate the underlying power structure of market liberalization policies and current dominant economic growth strategies. Any analysis of financing strategies aimed at promoting sustainable, human development needs to highlight the interlinkages Keywords: Gender, finance and development, foreign capital flows, financial liberalization JEL Classification: O11, O16, O23, J16 43

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between these sectors and to demonstrate that the choice and terms of financing strategies affect not only capital formation and GDP growth, but also the distribution of welfare gains (and associated costs) among the population and the long-term process of social reproduction. Gender inequalities and income and wealth differentiation are likely to be affected significantly within and between countries.

Introduction1 This chapter highlights the gender-based equity and welfare dimensions of the development financing strategies.2 Its premise is that the overarching goal of development is to provide an enabling environment that permits each and every person to have command over resources sufficient to develop his or her capabilities for an adequate standard of living and for active participation in all aspects of human life – political, economic and social (UNIFEM 2000, Sen and Dreze 1995). This means that the social objectives of human development such as gender equity, freedom from poverty and discrimination, social inclusion, and the development of human capabilities – must serve as the central guiding principles in governments’ and multilateral institutions’ efforts to achieve sustained economic growth and improvements in human well-being (UNIFEM 2000, UN 1995, Nussbaum 2002). Hence, any financing strategy including mobilization of foreign resources via foreign direct investment must be examined by taking into account the totality of the economy’s engagement in the provisioning for human life and social reproduction of labour (Cagatay, Elson and Grown 1995). A careful examination of the effects of such financing strategies cannot focus exclusively however, on the monetized, market-based activities as traditional models of foreign resource mobilization or investment typically do. Markets, households, firms and other economic institutions are social constructs. Those that wield power have influenced the actions of governments and rules setting of international institutions; they in turn have played an active role in the construction of markets and market rules of engagement, better known as economic policies and development strategies. Gender, alongside class, is an important analytical tool for understanding development processes and their welfare outcomes; not only does gender serve as a basis for fundamental division of labour in societies, but it also socially defines roles and identities in the

Importance of Gender Dimension in the Development Nexus

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material practices of ‘making a living’. Both class and gender are mutually constitutive bases of power that can be reproduced and reshaped by the social organization of production and manner of distribution. The effects of economic policies and development strategies on the well-being of children, men and women are overwhelmingly complex and are transmitted through changes that take place both in the market and non-market sectors of the economy by means of various channels. Any analysis of policies aimed at sustainable, human development needs to highlight the interlinkages between these channels and to demonstrate that the choice and terms of financing strategies affect not only capital formation and economic growth but also the distribution of welfare gains (and associated costs) among the population and the long-term process of social reproduction. These benefits and costs are reflected in new patterns of wealth and poverty creation emerging from the resulting changes in the social organization of labour and financial markets and the non-market domestic economy. Therefore, financing strategies and patterns of financial sector growth, as this chapter will argue, can lead to a development process that may be characterized either as a) sustainable, b) uneven and unequal, or c) stagnationist. The chapter is organized in the following manner. In the section that follows we review the different perspectives of the relationship between gender, finance and development. It explores some key interlinkages between gender, finance and development and highlights the totality of women and men’s contributions to the economy by means of their participation in both market (productive) and non-market (reproductive) activities. A simple conceptual framework is presented in the next section, which illustrates the mechanisms through which development financing strategies can affect the ability of women, men and children to develop their capabilities. It also examines the means by which development financing strategies can affect these individuals’ command over resources and commodity bundles. The penultimate section makes use of developing countries’ experiences to illustrate the transmission mechanisms in the case of mobilizing international capital flows and the resulting diverse pattern of development processes. The chapter concludes with a summary and conclusions.

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Gender, finance and development Various perspectives of finance and development Since the 1970s, financial policies and the emphasis on market solutions to resource mobilization have muted any substantive discussion on alternative processes of growth and structures of power relationships. The overwhelming dominance of the neoliberal paradigm and the imposition of market liberalization policies have discouraged serious discussion, at least in key policymaking circles, on the connection between financial resource mobilization and the distribution of incomes, risk and bargaining power. This dominant policy paradigm is supported by an array of studies on the role of finance in economic development that focus exclusively, if not overwhelmingly on the following: how can the financial sector be developed so that investment is enhanced and hence (market) economic growth is promoted?3 The central concern is to mobilize domestic and foreign savings in order to promote (market) economic growth via an increase in investment. The models of financial repression led by McKinnon (1973) and Shaw (1973) emphasize the role of government failure in the sector. Accordingly, financial sector reforms need to occur in order to reverse this ‘repression’. Hence, the key policy prescriptions for developing countries are to’ ‘widen and deepen’ their financial markets and to deregulate them in order to mobilize internal sources of finance as well as to tap the global markets for external sources.4 This perspective is further reinforced by financial growth models that emerged in the 1980s and 1990s incorporating both endogenous growth and endogenous financial sector development.5 Financial markets and financial market expansion are viewed to be fundamental in a complex world of increased market integration, risk, competition, high information and monitoring costs. Stock markets, banks, money markets and the development of new financial assets including derivatives such as future/forward swaps are seen to be positive developments in enhancing the accumulation of capital by allowing diversification of portfolio and allocating risk. In so doing, they not only reduce transaction costs but also liquidity and productivity risks. The dominant neoliberal thinking has not remained unchallenged in the academic and civil society circles. A growing literature on


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financial instability and financial crises by Keynesians, post-Keynesians, neostructuralists and institutionalists raised serious questions on the underlying premises, methodology and the weak foundations for the predicted outcomes of the neoliberal models and theories.6 The experiences of developing countries in the 1980s and 1990s exposed the underlying volatility and market excesses as they adopted financial and trade liberalization policies and as they became increasingly integrated into the global financial markets. These experiences, particularly in the form of financial crashes and crises, provided an important backdrop to these growing critical evaluations and challenges. Using markup pricing approach, cost-push inflation models, Keynesian-based adjustment mechanisms, theories of risk and uncertainty, and market failures, this body of studies demonstrates the excesses of financial crises and heightened instability as well as the adverse, negative effects of unregulated capital flows on savings, investment, market output and growth, both in the short term and long term. The missing gender dimension Until recently, little work has been conducted on the direct relationship between finance, gender and distribution. Much of the research in the area of finance and distribution examines mainly the effects of financial flows or policies on (market) economic growth and the impact of (market) growth on income distribution.7 The transmission mechanisms are found to consist of price effects through inflation, interest rate, wage rate, profit rate and exchange rate movements and of non-price effects through output, capital formation and employment. While the expansion of human capabilities can clearly be enhanced by (market) economic growth, there are many determinants other than growth that work towards (or against) this development objective. Besides, the impact of financial resource flows and financial sector growth can be extremely variable, depending on the terms at which the financial resources are obtained and the accompanying pattern of growth. They can bring about more opportunities such as new jobs, technologies or industries, and also more risks in terms of higher market fluctuation and greater economic insecurity. It is in this sense that financing strategies and pattern of financial sector growth can lead to a development process that may be characterized as any of

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the following: a) sustainable, b) uneven and asymmetric, or c) stagnationist. It is therefore important to examine the distributional implications of financing strategies – across countries, classes, and gender. A growing number of feminists such as Erturk and Cagatay (1995), Singh and Zammit (2000), Braunstein (2000), Seguino (2000), Elson and Cagatay (2000), Fontana and Wood (2000) and Floro (2001) have begun to explore these issues by raising the critical role of gender relations in determining development outcomes. They point out that the effects of economic and financial policy decisions on the wellbeing of children, women and men in these countries are transmitted through the market and non-market sectors of the economy in complex, often contradictory ways. Rapid integration of markets, for example, has brought about shifts in resource distribution, reorganized production processes, altered prices including wages, interest rates and exchange rates and affected household production of goods and services that are needed for human maintenance and social reproduction. Gender and class become major axes of differentiation around these processes of adjustments. The way in which owners and managers of capital/ firms restructure the organization of the production process and adjust their workforce have serious implications on how the costs of adjustment and risks associated with market instability and cyclical fluctuation are distributed between labour and capital and also across the working population. For example, the institutionalization of investors’ social responsibility, code of conduct and effective rule of law that respect citizens’ and workers’ rights as human rights can lead to better sharing of costs as well as benefits of market expansion among those who provide inputs in the production process. Likewise, the forging of a rule-of-law-based, social contract between governments, investors and the affected community can create the basis for mutually beneficial partnership in productive endeavours. On the other hand, the absence of such institutions can heighten the vulnerability of certain groups of workers, particularly those who experience job casualization and joblessness. For instance, with the increase in outsourcing and subcontracting generated through the increase in foreign capital flows in India and China, both contracted professionals and piece rate homeworkers have their centre of gravity in the main


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headquarter firm that generate them. Other Indian and Chinese workers remain’ ‘excluded’ or’ ‘marginalized’ in the growth process, operating in the market fringes (in the form of informal sector activities) to meet the demand among the growing middle and low-income classes for more affordable food, basic commodities and services ranging from haircuts to food vending. This is not to say that financial resource mobilization is not important, but it is useful to clarify the means and the end. Financing strategies that facilitate the mobilization of savings, efficient administration of payments mechanisms, diversification and pooling of risk, non-discriminatory allocation of credit and provision of other financial services play a crucial role in furthering human development. They should, however, be achieved on terms that do not compromise the basic functioning and the development of the capabilities of the vulnerable segments of the population. Intersection of gender and financing strategies for development Financing development – whether it is through the mobilization of domestic resources, international resources, exploiting gains from trade, promoting international financial cooperation or tapping external borrowing – involves the transfer of funds between countries, sectors, institutions, households and individuals. This is done through a wide range of institutions and structures that serve as channels, intermediaries and/or facilitators. Financial, monetary, trade and fiscal policies that direct the operation of the economy and govern the actions of these institutions and structures do not only influence the mobilization of resources and their allocation to various uses: they also determine the terms on which these funds are obtained and the degree of control over these resources by different social groups of individuals. Resource mobilization and allocation raise the questions of ‘for whom?’ and ‘for what?’ are these funds used. They can alter the way production is organized as well as the structure of power relationships by shifting the command of resources between groups, say between governments and the private sector, between investors and host countries, between investors, capitalists and workers, women and men and so forth. It is in this sense that financing strategies have social content (Elson and Cagatay 2000). The intersections of gender and the strategies for financing development are often neglected in most academic and policymaking

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circles. This neglect overlooks the crucial interaction between non-market and market-based activities. Indeed, non-market activities are as important to the functioning of markets as markets are for the performance for non-market activities vis-à-vis resource transfers, labour allocation and the complementarity between goods and services produced in these two sectors. The non-market sector of the economy (also referred to as the reproductive sector) is a significant aspect of economic life that provides a wide array of goods and services produced by the household and communities for their own consumption.8 Caring of young children, mentoring and tutoring, the day-to-day tasks of preparing meals and other daily household tasks both sustain and develop managers, workers, doctors, computer programmers and farmers. These activities rely on unpaid labour, which is contributed overwhelmingly by women. In the following section, we examine the processes of allocating and utilizing resources to mobilize domestic and foreign savings and the resulting growth and distributional impact. The manner in which gender inequalities and income and wealth differentiation are likely to be affected significantly within and between countries is addressed in the conceptual framework discussed below.

A conceptual framework of finance and distribution The key elements of an analytical framework are introduced in this section, utilizing the real and financial sectors of the economy. Taking a small, open developing economy as an example, we highlight the interaction between these two sectors in terms of the allocation of real resources to mobilize savings (both domestic and foreign) and of the likely impact on the real sector. This conceptual framework builds upon the notion of economic development as a process of transformation and changes in production involving two areas of the real sector of the economy namely, the market and the non-market (reproductive). Furthermore, we assume that the end goal of development is to enhance each person’s capabilities.9 That is, we take into account the fact that well-being and human capabilities are influenced not only by access to market consumption goods and services but also those goods and services produced in the non-market sector by households and communities for their own consumption.10 These goods and


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services are critical for health, knowledge, literacy, esteem, social interaction, all necessary for human development and the social reproduction of labour. With this objective in mind, we focus our story on the changes brought about in the real sector, both market and non-market, by the financial flows. The real sector involves the activities and exchanges among three units, namely the government, firm and household. Within the financial sector, we focus on those activities that mobilize both domestic and foreign savings, particularly in terms of foreign capital flows. In our story, the extent of equality or inequality of opportunities that a person faces, and what he or she can or cannot achieve, depends not just on incomes but also on socially ascribed characteristics and prevailing institutional rules and economic policies that set the parameters in which incomes are earned. The way a person is viewed or treated in society with racial or ethnic disparity may be influenced by his or her racial or ethnic characteristics. Gender, as will be shown in our analytical framework, similarly has influence of its own in societies. Moreover, the differences in individuals’ abilities to achieve certain basic functioning have much to do with their access to incomes as with policies regarding provisioning of health services, basic education and protection of their natural environment and financial, trade and investment policies. Basic capabilities lie in the use of public goods and services as well as in access to stable employment opportunities and decent working conditions.

Real sector We represent the real sector of an open, developing country economy in terms of production of goods and services produced for exchange in the market sector, and those that are produced for own consumption (non-market economy). The market economy production takes place in both the private (firm) sector and the public (government) sector. Market production involves resources, particularly capital investment and labour paid with wages and profit returns respectively. While there are a host of institutional, technological, economic and social factors that affect the production structure and decision-making processes in the market economy, we emphasize in our story the effect of prevailing social and gender norms. In other words, the economic

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activities and roles performed by market agents – men and women – are a reflection of existing gender relations. For example, gender role perceptions that women specialize in household production activities and men in market production activities may influence the responses and decisions of employers. In this manner, the pattern of hiring, promotion and salary decisions become ‘bearers of gender norms’ (Grown, Elson and Cagatay 2000, p. 1148). At the same time, the level and form of labour market participation, for example, the type of occupation, location of work and amount of time spent in market activities are decisions made by men and women within the context of their socially ascribed roles and obligations. Non-market production, on the other hand, takes place mainly within the household sector. It involves unpaid labour time and non-labour resources, the latter referring to that portion of consumption goods and services bought from the market that are further processed within the household. Similarly, institutional and social factors such as gender norms influence household decisionmaking, for example, expenditure allocation and loan borrowing; they also determine the division of labour within the household. Women provide the bulk of unpaid labour in their roles as household managers and childcare providers. Each of the three sectors is described next. The household sector Households (and their members) are diverse and a key question one confronts in developing a conceptual framework is how to classify them and on what manner are they differentiated. Here we proceed in terms of grouping households (and their members) on the basis of their main source of livelihood or money incomes and their wealth endowments (in the form of past savings). The representative household sector in our story consists of two types of household, each with male and female working members.11 Poor households possess no assets except their labour while the wealthy households have accumulated past savings as well as possessing labour. Development of human capabilities and social reproduction is the objective of these households and their members and this is achieved by their access to public goods and services as well as by allocating their labour time between non-market and market production activities.


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It should be noted that household production technology of non-marketed goods and services is not uniform across countries nor even among households within a country. For poor households with little command over market-based resources, some basic necessities for social reproduction have to be either met by household-produced substitutes using unpaid labour or else their consumption is reduced.12 Next we examine the incomes earned by the two sets of households. We consider here two types of earned income, namely wage earnings of men and women and asset earnings (when accumulated savings are converted into capital investment). Although the income constraint on purchasing goods and services faced by each household set is denoted by its earned net incomes, the individual earnings and household incomes do not convey adequate information on the well-being of its household members. The market/non-market sector linkages in terms of time allocation are crucial in determining the overall well-being outcome. While access to an independent source of income tends to be highly valued by women not only for what it buys but also for the greater dignity it brings, it may also have serious welfare costs that counter these positive effects. This is highlighted in the decisionmaking regarding time allocation and the division of labour among the household members. The total time available to women and men can either be spent working in the market economy, working in the non-market sector, or engaging in social, sleep and leisure activities that directly enhance a person’s well-being. Household members, particularly women, allocate their working time between these sets of economic activities. The prevailing gender norms may be such that most of the unpaid labour is contributed by women including those who earn wages. Increased women’s participation in the labour market, therefore, may be at the cost of longer workdays or more intensification of work. Women, particularly in poor households, therefore tend to juggle their working time between the market and the non-market sectors. They continue to perform most of the unpaid labour in household work, childcare and care of the sick even as they serve as income earners. On the other hand, women in wealthy households may command the use of resources such as nannies or consumer durables to reduce their household work, thereby freeing more time devoted to paid work and/or leisure time.

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The well-being of members in the two types of households depends not just on the purchased goods and services that their money incomes command but also on the goods and services provided by the government.13 In general, human functioning and development of capabilities are adversely affected when government provision of social services and public goods are reduced. The effect on the well-being and human capabilities are likely to differ between poor and wealthy households, it being greater for the former since poor households are more likely to use public health services, public transport and public education than wealthy households. The effect is also likely to differ among members within the household as well. The decrease in public support for health care, for example, falls hard on women household members who are the primary caregivers. The firm sector The firm sector engages in the production of domestic consumption goods and services and exports.14 Capital used in market production can be augmented by means of various financing strategies to mobilize both domestic savings and foreign savings. The composition of output produced in the market sector can be altered or affected by a development financing strategy. This can be illustrated by a case of trade policy that promotes trade liberalization. Export promotion strategy under trade liberalization can change the manner in which overall market production is organized and the allocation of resources between tradable (particularly exports) and non-tradable production sectors. For instance, shifts from the production of subsistence food crops to export crops, for example, cut flowers, are likely to take place in agriculture. Manufacturing enterprises particularly those producing ‘import-competitive goods’, for example, local utensils, food, and footwear products, are likely to decline while export-oriented goods such as garments, cocoa, rubber or lumber logs increases. Trade liberalization has an extensive impact on the structure and scale of employment in the market sector also. The turnover rate of labour and thus the number of workers in transition expands. Those workers whose skills become obsolete lose their jobs in the formal market sector; many re-enter the labour force as informal sector workers. The transformation of the firm sector does not yield genderneutral results; it is likely to have differential impact on men and


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women workers in terms of earnings, levels and terms of employment. The promotion of exports, for example, can have potential benefits in terms of increased employment and increased earnings, along with more foreign exchange.15 But this requires a careful assessment of the manner in which the reallocation of resources occurs and the accompanying effects on employment and earnings and on non-market production activities. The quality of employment refers to the regularity of employment, working conditions, the rights to worker representation (through trade unions or other means), social protection, occupational risks, measures and the possibility of career advancement or skill-upgrading. It is also possible that trade liberalization leads to a dramatic expansion of imports rather than an increase in export production, thus bringing about higher trade deficits. Unregulated import liberalization can threaten domestic firms or farm enterprises in formerly protected areas of the domestic economy leading to the displacement of workers in local industries that are unable to compete. The gender balance among the displaced would depend on the job distribution between men and women in the affected sectors (UN 1999, Floro 2001). Without any public action in terms of skillsretraining, employment generation and credit provision as well as provision of social protection, households that suffer drastic decline in wage incomes as a result trade-led job displacement are likely to feel the adverse effects in their functioning and in the development of human capabilities. Poor households are likely to be more vulnerable than rich households since their money incomes depend solely on wage earnings. Women household members are likely to increase their unpaid work burden more than their male counterpart. The government sector In our story, we focus on three related activities of the government. First, the government raises revenues through taxation policies and can also engage in public borrowing. Secondly, it provides public goods and social services that directly affect well-being and social reproduction as well as provide infrastructure goods and extension services that help augment incomes, particularly those of poor households, by increasing their productivity. The latter include labour retraining or re-skilling programmes, agricultural extension services and so forth. Thirdly, the government actively mobilizes foreign

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savings by providing direct and indirect government subsidies to investors. For example, the government can allocate spending on building infrastructure such as export processing zones or road projects primarily aimed to attract and benefit foreign investors or multinational firms. These public sector activities can help boost the rate of return received by investors. Government revenues are derived from a range of taxes but in our story we focus on indirect taxes (for example, sales tax and value added taxes or VAT), direct taxes (for example, income and corporate taxes) and foreign trade taxes.16 Taxation policies divert control over economic resources from taxpayers (e.g., individuals, firms, households, foreign investors, etc.) to the state for its own desired use and for transfers to others. While the level of taxation is undoubtedly important, equally so is the structure of taxation.17 Foreign trade taxes, particularly import duties, used to serve as a traditional major source of revenues. These, however, decline under trade liberalization regimes and to offset this revenue source, domestic sales taxes on goods and services are increased.18 With trade liberalization this substitution between forms of taxes has increased and government has become more reliant on indirect taxation as well as on government borrowing.19 The question of which source of revenue to tap – indirect, direct tax, etc. – have important distributional consequences. In fact, tax policy is at the heart of policy debate on the level of public services that should be provided and who should pay for them.20 For example, governments can decrease the proportion of total tax collection from corporate or capital gains taxes if they decide to support the business sector and investors’ interest by broadening the tax base and adopting a regressive tax system. The issue of the structure of taxation is relevant to women and low-income households because of its implications on the distribution of incomes and on relative prices. For each type of tax, gender bias may exist explicitly in tax laws or implicitly through its differential impact on men and women (Barnett and Grown 2004; Stotsky 1997). Since poor households tend to consume a higher proportion of their incomes than do high-income households, it can be assumed that the former would have a higher effective average tax burden than wealthier households if most taxes were indirect. This impact will be reduced if taxes are imposed selectively on luxury


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consumer goods and basic food and other consumption items are exempt. Gender biases therefore can result from men and women’s differential consumption and expenditure patterns.21 Additionally, the unit of taxation can affect the incentive for women to work in the labour market. For example, if wage earnings of men and women are the same and these earning are pooled within the household, then their tax rate is uniform. If on the other hand, wage earnings of women are less than men, the effective marginal tax rate on women in pooled income households is higher than that of men’s. This is not the case, however, in non-pooled income households or when individual income taxation policy is adopted. Women wage earners are also likely to benefit when a higher proportion of tax revenue is raised from corporate taxes and also from direct income taxes. They represent roughly half the population but provide about less than that of taxable income. The type of tax exemptions – which categories, institutions, individuals and activities are affected – can have gender implications as well. Tax deductions for such expenses as childcare costs, for example, have a bearing on women’s labour force participation. When a woman works at the labour market, not only does she pay a portion of her income to taxes but she (or her household in cases of income pooling) must also pay for those costs resulting from her decision to work. In general, taxation policies can alter the distribution of incomes or economic resources as well by altering the incidence of taxes directed at wage earnings, taxes directed at profit or returns to capital investment earnings, indirect taxes, and import duties.22 Government budgets serve not only as tools in smoothing out macroeconomic fluctuations but also as a means to correct any market failures and inadequacies of market operations particularly in the provision of public goods and social services. As with taxation, the pattern of government spending can affect women and men in different ways. Government programmes that help improve the access to and quality of social services are likely to relieve women of physical stress and prolonged time of caring for the sick. Likewise, public sector projects that enhance the security of jobs and the productivity and earnings of working members of poor households are likely to result in these households’ increased command over market purchased goods and services (expanded internal market). This

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also leads to a reduction in non-market activities and reduce the demand for women’s unpaid work. Governments, together with public and private sector support, can also address the need for microcredit and microfinance. These provide loans to women as well as men entrepreneurs whose capital needs are not met through bank financing. The financial sector The financial sector in our story consists of an array of bank and non-bank financial institutions and markets that mobilize savings flow from two sources, domestic and foreign, and that facilitates the transfer of savings into alternative uses by means of different financial instruments. The sources of savings are described briefly but the focus of our story is in terms of foreign capital inflows. Domestic saving flow Domestic savings is drawn from that portion of the market income, which is not consumed in a given period and is determined by both the propensity to save rate and level of earned income. Financial policies have been used to influence saving behaviour of households in order to increase the national savings rate. Financial institutions can and have chosen to ration their financial services, for example, savings and credit facilities, and provide services only to certain individuals, households or businesses (Germidis et al. 1991; Floro and Yotopoulos, 1991; Ghate, 1992). Indeed, many formal financial institutions – pension funds, investment companies, commercial banks, development banks and other financial institutions – can fail to serve whole social groups including poor households and women. Inadequate information, high transaction costs as well as prevailing gender norms tend to make these financial institutions bypass many financial services needs of households with members engaged in flexible or irregular forms of employment as well as the needs of women – as entrepreneurs, farmers, wage workers and household managers. Given their divergent social and economic circumstances within and outside the household, women and men are likely to have different savings patterns as well as needs for financial services. Although the literature on gender dimensions of saving is sparse, a small but


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growing literature strongly suggests that there are gender differences in saving decisions as well as in risk attitudes (Seguino and Floro 2003; Bajtelsmit and Bemasek 1997; Sunden and Surette 1998; Hungerford 1999). The options and constraints that women face differ from those of men and hence their saving behaviour may also differ. For example, men, who by their position in the labour market are more likely to be beneficiaries of social insurance policies, may have less need to fall back on savings for consumption smoothing purposes. Women are likely to outlive men, a factor that propels them to save at higher rates. In addition, the need to raise funds for a dowry may lead women to save more than men of the same age cohort in those countries where the dowry system still prevails.23 Although the capacity of poor households to save is clearly limited, there are reasons why they may have a strong propensity to save.24 This tends to occur during times of periodic surpluses, but when they do the actual amount saved can be significantly large, relative to income. Yet bankers and policymakers, for example, typically assume that the interest paid on savings serves to be the major incentive for savings. Available evidence argues that for many women, particularly in poor households, privacy of accounts, proximity and easy access to funds and access to credit are more important savings inducements (Fong and Perrett 1991; Manning and Graham 1999). External sources of finance The mobilization of foreign savings can take the form of revenues from net trade flows, equity capital flows, foreign aid, and loans. These different forms of savings from abroad are transmitted either through global markets or through government-instituted channels including international financial institutions. Mobilization of financial resources via loans, money and capital markets requires payment in the future either in the form of expected interest rate or expected capital gains or earnings. Note that in the case of equity capital flows and loans, there is an expected, additional outflow of foreign exchange in future periods. Inflow of capital into the country leads to an outflow to service foreign public and private debt and interest payment or in the form of repatriation of foreign equity, capital gains and earnings.25 Moreover, international bank lending, through their subsidiaries,

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tend to have certain biases. They focus more on lending to large companies and are less oriented to lending to small and medium firms. In some cases, they may attach more priority to consumer lending especially to higher income households and less through lending for long-term capital investment. Capital outflows require that the market sector generate a large surplus on the current account of the balance of payment or else rely on foreign aid. For instance, the adverse impact of foreign capital outflows can be overcome through access to other markets, particularly those of developed countries. Yet access to these markets can be highly uneven, depending on political ties, and with significant non-tariff as well as tariff barriers including many of the areas relevant to developing countries’ exports (Griffith-Jones 2002). There are also capital inflows and outflows effects on fiscal behaviour so that shifts in the primary budget deficit consistent with solvency can shift dramatically with investor sentiment, forcing large fluctuations in public investment expenditure.26 In recent decades, foreign direct investment is the dominant form of private capital flow to developing countries, accounting for about 70 per cent of the total private flows (Griffith-Jones 2002). A substantial portion of these flows are increasingly hedged. Multinational firms, especially those producing for the market economy of host countries, can hedge foreign exchange risk either for their profit remittances or even their level of capital. This may be done by purchasing US dollars or dollar-dominated government bonds in the host country or by hedging off-shore. The resulting impact on the foreign reserves and the exchange rate is likely to be no different than that of speculative forms of capital. Whether or not foreign savings increase overall investment and, by extension, the growth of market output by expanding the pool of resources available, depends on the structure of the economy and on the terms of which foreign direct investment (FDI) enters a country. The conditions of entry as well as the extent of economic planning and coordination also determine whether foreign investment will encourage or crowd in domestic investment. Enhanced domestic investment occurs whenever strong backward or forward linkages with domestic firms exist or are created by new foreign firms. On the other hand, FDI could crowd out domestic investment whenever foreign firms compete with domestic firms and drive them out of business.


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The employment effects of foreign capital flows including FDI are difficult to gauge given the lack of or feeble monitoring efforts on this issue, although recent studies have attempted to partly overcome this difficulty. This is also due in part to the increasing prevalence of subcontracting and informalization. Such jobs are often directly connected to specific foreign companies via local intermediaries, thus weakening the distinction between foreign and local ownership (Balakrishnan 2002; Benería and Floro 2004; Benería 2001).

Link between financial sector mobilization and real sector changes Not all financial resource flows are converted into capital formation, however. There are several factors that influence the link between finance and real sectors of the economy, particularly the portion of financial flows that is converted into capital investment. First, the form of financial asset, and the terms by which the flows are obtained, matters (Singh and Zammit 2000; Arestis et al. 2005). The conversion rate between financial flows and capital formation is likely to be low if they are in the form of speculative or ‘hot money’ types of financial derivatives that mainly take advantage of arbitrage opportunities, or they are used to servicing outstanding debt obligations. Secondly, the manner of operation of financial institutions and markets, especially in allocating resources among alternative productive uses, also affects this conversion rate. If mobilized savings are used to extend consumers’ credit backed by these financial resources, whether foreign or domestic, then financial flows into the productive sector of the market economy is likely to be small. Inadequate risk pooling, asymmetric sharing of investment and risk information (transaction costs inefficiency) and inefficiency in fundamental valuation can lead to a lower conversion rate. Additionally, discrimination on the basis of gender and other forms of distortion reduces it. For instance, women entrepreneurs’ lack of access to credit is widely recognized as one of the key constraints that limit women’s performance in productive activities. The nature of their productive activities and their lack of access to and command over assets that serve as collateral are often cited as reasons for their limited access to credit.

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But the issue is more complex with other factors appearing to have significant influence in the allocation of credit as well. The prevailing gender norm that women are supplementary income earners, even when contributing a substantial portion of the household income, appears to permeate decisionmaking in many financial institutions. Because of this attitude and because of the social and economic devaluation of women’s productive work, women have only limited use of the funds mobilized through financial intermediation. Even when women do apply for loans and their financial characteristics are the same as men’s, discriminatory attitudes and practices on the part of lenders create barriers. Although scarcity in data and methodological issues limit the number of empirical studies in this area, available evidence indicates that gender-based biases tend to permeate financial sector lending rules and operation (Manning and Graham 2000). Thirdly, the share of savings channelled into investment is influenced by central bank initiatives and financial policies. Without requisite rules, demand for transparency and accountability and appropriate monitoring mechanisms enforced by the state and rule of law, foreign capital flows can lead to a net reduction of capital investment available to a country by means of speculative behaviour of investors, transfer pricing, royalties and licensing fees. It can also crowd out domestic investment by encouraging foreign borrowing from local banks. An understanding of the vital interaction between financial and real sectors as well as between market and non-market segments of the real sector is crucial for a full assessment of the distributional implications of financing strategies of development. This is examined more carefully in the following section in the case of mobilizing foreign capital.

Distributional effects: the case of mobilizing foreign capital Throughout the 1980s and 1990s, developing countries witnessed a bipolar trend in foreign capital flows: on one hand, there was steady inflow of these financial resources in a handful of selected countries, primarily in East Asian and Latin American regions. On the other hand, there had been only a trickle (in the case of sub-Saharan African countries) and even dramatic collapse in other countries


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(in the case of Argentina and Indonesia). Countries with low capital mobility and increasing current accounts deficits face the critical decision on how and in what manner to reverse this trend. First, the extent to which government incentives and central bank initiatives are made in order to attract capital flows directly impinge on government expenditure allocation and taxation issues. If the country uses tax-based incentives such as capital gains tax exemption, then this may increase other taxes such as indirect taxes that would disproportionately burden women. The study by Barnett and Grown (2004) shows that reliance on indirect taxes in both developed and developing countries has raised concerns against regressivity. The study also provides empirical evidence that shows an increase in tax burden of lower and middleincome groups and a reduction in the burden of the highest income groups. There is also an increase in the relative tax shares paid by individuals through personal income taxes compared with those paid by businesses through corporate income taxes. Overall, there has been reduction in tax revenues resulting in what is called a ‘fiscal squeeze’ which means a reduction in public services. Secondly, increases in government spending on projects that would primarily benefit foreign investors may either constrain the resources available to other budget expenditures such as provision of public goods and social services or provision of skills retraining, employment assistance and microfinance programmes (Floro 2001). We now examine these varied transmission mechanisms in which foreign capital flows affect the market and non-market sectors of the economy. The predicted outcomes in mainstream economic models are that access to international resources (foreign savings) allows the rate of investment and (market) output and income growth to be raised.27 The discussion in the preceding section demonstrates that this does not automatically take place. The resulting development process and outcomes depends on the terms, timing and forms by which foreign investment enters the country. It also depends on how these financial flows affect prices, wages and employment in the market sector and unpaid labour use in the non-market sector. There are important gendered consequences in terms of real incomes and well-being of households and their members that need to be given serious consideration. These gendered consequences are further explored under three possible

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outcomes, namely 1) sustainable development, 2) unequal or uneven development, and 3) stagnationist. The effect of foreign direct investment on the market sector is often transmitted through changes in interest rates, bank credit and demand for government bonds, as well as in exchange rates. Secondary effects also occur through changes in net trade flows and domestic savings mobilization, which then feed onto the market economy. If the increase in foreign investment flows leads to a net increase in capital investment over a sustained period of time, then there are potential benefits of international private capital. A sustainable development takes place when: a) there is an increase in stable employment opportunities for women and men, higher real wages and access to technical skills and training; b) household incomes across the board are increased so that domestic savings and tax revenues are increased; c) foreign investment does not crowd out domestic investment particularly among small and medium enterprises; d) these are increases in domestic credit leading to better access by poor households and women; e) it does not lead to cyclical instability; and f) foreign investors interests do not compromise human rights including those of workers, other development imperatives of preserving cultural heritage and protection of the environment and attaining gender equality. Braunstein and Epstein (2004) point out that this would largely depend on the institutional context, particularly on the ability of governments and citizens of countries or regions to exert their bargaining power over foreign investors including multinational corporations. Milberg (1999) argues that it is the country’s ‘absorptive capacity’, or those factors which promote domestic economic growth through investment, infrastructure and human capital development, that serves as the main factor in attracting foreign investment. For example, during the 1960s and 1970s, South Korea and Taiwan became economically dynamic countries through their selectively strategic financial and trade policies and careful economic planning. Contrary to the market-centred studies that emphasized the free play of market forces, Cho and Kim (1998) argue that state intervention and decisive industrial planning in Taiwain, for example, during this period allowed and enabled a developmental state to produce rapid economic development. Fiscal policies played a critical role in developing a well-educated, highly skilled workforce, well-developed


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physical and technological infrastructure thereby attracting foreign investors. In Korea, the government invested heavily in the expansion of education at the primary and secondary levels. The provision of universal primary education and wide access to secondary and higher education contributed substantially to expanding economic opportunities for its citizens. There was also support for small and medium enterprises (SMEs) as evidenced in the case of Taiwan. Recognizing that these enterprises generally have difficulty getting credit to finance capital improvements, obtain better technology and break into markets, the government gave them support in the 1960s in terms of preferential credit and specific support services (Kim and Nugent 1993, Wade 1990). As a result, SMEs in Taiwan accounted for at least 90 per cent of enterprises in the 1980s, providing the main backbone for its exports (World Bank, 1993). Even with these targeted public expenditures to support education, housing and small businesses, the governments of Korea, Taiwan and Singapore experienced both positive public as well as private savings rates during the same period. In Malaysia, the high levels of public consumption reflected the explicit redistributional goals of its New Economic Policy and yet it achieved a public savings rate of 3.2 per cent of GDP in 1961–80. Malaysia also had a relatively high level of taxation during this period; its tax–GDP ratio averaged 21.45 per cent in 1979–88 particularly on its oil industry (World Bank 1993, p. 229). Likewise, Singapore’s tax regime included a moderate tax structure, like those in Korea and Taiwan, to support these public provisions of social and educational services. Since the 1980s, however, the government discontinued the process of attracting foreign direct investment by promoting political and social stability and human resources development and instead, introduced a valueadded tax and a more neutral overall tax regime, which reduced overall the more progressive forms of taxation in order to support financial and trade liberalization policies. Nevertheless, we need to examine both the longer-term macroeconomic and social conditions as well as gender dimensions of those policies adopted by the East Asian countries during their period of high economic growth in the 1960s and 1970s before concluding that a sustainable development process has been achieved. The need for such studies may seem obvious but many have not been forthcoming until recently.

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Anthropological and ethnographic studies of Taiwan’s small and medium enterprises reveal that the government’s export promotion policies made use of the ‘Living Room as Factories’ programme and ‘Mothers’ Workshops’ programme to encourage married women to work in their own ‘living rooms’ as factories that were outside the purview of labour laws and monitoring standards (Hsiung 1996). Designed to bring the ‘surplus labour of communities and families’, namely married women, into the labour market, the ‘Living Room as Factories’ programme was launched during the 1970s in order to help promote Taiwan’s satellite manufacturing system using subcontracting and outsourcing based on married women’s low wages (Hsiung 1996, p. 54). The statistical data collected by the government show that, in 1988, an average of 11.6 per cent of the gross profit of the manufacturing industry was created by workers labouring under subcontracting arrangements. Through the Mothers’ Workshop programme, the Taiwanese government helped emphasize women’s moral obligation to the country as both mothers and as homeworkers, thereby reinforcing their subordinate and dependent status in the family and society. The participation of Taiwanese mothers in the two programmes may have been a significant turning point for women’s engagement in the market economy but it may be at the cost of longer workdays and more intensification of work at home particularly if they continue to perform most of the unpaid labour in household work, childcare and care of the sick. As one homeworker puts it: ‘When I go to work, I have to take my daughter with me. At home, my husband either watches TV or takes a nap after he finishes a day of work. To me, leaving the factory doesn’t mean my work is done. After dinner, I have to take care of the kids, bathe them and wash clothes’ (Hsiung 1996, p. 102). Hence, an increase in women’s time in the labour market (or paid) work does not fully inform us about the resulting changes in women’s (or their families’) welfare. While access to an independent source of income tends to be highly valued by women, not only for what it buys but also for the greater dignity it brings, it may also have serious costs on their health and well-being that counter these beneficial effects. Recent studies show that much of the export-led growth experienced by the ‘miracle growth’ economies including Taiwan and South Korea have relied on the wage aspect of gender inequality.


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In particular, the offering of low wages that discriminate against women and the gendered wage gap in the East Asian countries have served as stimuli to investment (Seguino 2000a; Erturk and Cagatay 1995). Seguino (2000b) empirically investigates the relationship between gender inequality, investment and economic growth using 1975–95 panel data set on semi-industrialized countries where women provide the bulk of labour in the export sector. Her results show a positive and significant correlation between total FDI (measured as FDI inflows plus outflows) and gender wage differentials in Korea and Taiwan. Other studies show that firms, including multinational corporations, increasingly engage in subcontracting of women homeworkers at very low wages, thus replacing core, full-time workers and allowing the persistence of gendered wage gaps (Benería 2001; Prugl 1999; Chen et al., 1999). Studies examining the relationship between foreign direct investment and women’s employment also argue that while foreign direct investment may have helped bring about the feminization of the labour force, this feminization trend can be reversed. As export sectors mature and begin to use more technologically or administratively intensive production methods, women’s share of total employment in these sectors decline, which is what happened in Ireland, Mexico and Singapore (Elson 1996; Fussell 2000). Heightened tensions between workers and management/employers began to surface during the 1970s in Taiwan as well as in South Korea over wages and working conditions. The labour movement gained momentum during the period and the governments responded with varied forms of institutionalized repression (Cho and Kim, 1998). The government in South Korea enforced policies that suppressed expansion of trade unions. The ‘Temporary Special Law on Trade Unions and Arbitration of Labour Disputes in Foreign Investment Companies’ was then enacted in the early 1970s, which resulted in major setbacks in workers’ rights. The Taiwanese government, on the other hand, encouraged trade unions to organize but then attempted to control the workers through co-optation of the unions and to discipline them through the mobilization of ‘living room-factory’ women who were outside the purview of trade unions and thus often serve as substitutes. Regardless of whether men or women gain more from faster economic growth fuelled by foreign capital flows, there are good

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reasons, as well as evidence, to suggest that women are more disadvantaged by cyclical instability and economic crises than are men (Singh and Zammit 2000). The experience of South Korea illustrates how a government’s decision to follow the path of market liberalization in the 1980s and 1990s made the country more vulnerable, leading to the severe financial crisis of 1997–98. Although the country experienced moderate savings rate, it was not sufficient to meet the high rate of investment activities during the period of high economic growth. As a result, South Korea started relying on foreign capital and on foreign and domestic bank loans even as early as the late 1960s (Basu 2002). As the economy continued on its high growth path and expanded its export base to include heavy industries, it became more and more a debt-financing investment economy. In 1991, the government lifted its control over interest rate, the credit allocation of the banking sector as well as its control over foreign capital. It was only a matter of time before the domestic and foreign investors’ aggressive and risky ventures under such financially fragile conditions would lead to massive firm and bank failure and to financial crisis. The extent to which free mobility of capital exacerbates economic instability and increases the risk of economic downturns has been a subject of much academic debate, but there is growing evidence that financial crises are likely to disproportionately hurt women and girls (World Bank 2001; UN 1999). In the absence of social services and safety nets, women become subject to increased economic and social pressures. If formal domestic employment collapses, household production is likely to increase. These tasks place added burdens on women who must also manage the increased stresses that inevitably emerge within households. The unpaid labour of caring increases during times of economic crisis, but this work primarily falls on women and intensifies serious emotional and psychological stress. In South Korea, for example, the recent economic crisis caused shifts in employment patterns that affected women household workers severely. First, female workers are dismissed and replaced by male workers because many employers and government agencies believed that employment should be provided to the ‘male family breadwinner’. Second, young women supplanted older women workers in the formal sector because employers could pay lower wages. Finally,


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female employment in the more precarious informal sector grew as female employment in the formal sector declined. In response to the financial crisis, governments of East as well as South East Asian economies were under pressure from the World Bank and the International Monetary Fund to raise foreign exchange and liberalize their markets. As a result, they encouraged flexible industrial restructuring which rapidly transformed the production sectors (Deyo 1998). One obvious outcome is a growing dualism within and across sectors in terms of employment structures and production arrangements. On one hand, industrial restructuring has sharply reduced employment opportunities for low-skilled and especially women workers in large firms in garment and other labour-intensive industries. Firms that continued to compete in these wage cost-focused areas end up with increasingly casualized portions of the workforce. Women have figured more prominently in casualization and informalization strategies, especially in subcontracting to small workshops. At the same time, the larger firms have created new, although limited, employment for higher skilled and technical workers, predominantly male, in engineering, design, marketing and other core functions. A study on the employment effect of the 1997–98 financial crisis in the Philippines shows that women increased their labour force participation and their work hours as male unemployment worsened considerably, more than female unemployment (Lim, 2000). It appears that an important coping mechanism during crisis periods is that women increase their market work hours by taking two or even more jobs. In short, the crisis has effected more idleness for men because of unemployment and shorter work days. A study of the Philippine households’ response to the crisis also shows that a greater proportion of households in the lower income group withdrew their children from school, which likely increased the level of childcare activities and child workers (Balisacan and Edillon 2001). The same study also pointed out that there were more female-heads of households who have opted out of the labour force in the aftermath of the crisis than their male counterparts. This probably included many discouraged workers who were forced to spend more time in managing the households and performing domestic chores themselves instead of hiring help. Unfortunately, the resulting change in the non-market work burden among women has not been

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measured systematically nor taken into account in most economic evaluations of the financial crisis. There are two other development outcomes that can occur. An unequal development occurs when market growth resulting from foreign capital flows increases but the total wage bill – whether through price, employment and/or wage effect – remains constant or even declines. This is brought about by any of the following events. First is the occurrence of a jobless growth or the encouragement of more capital-intensive production that supplant labour-intensive techniques leading to a decline in wage employment. There may also be a restructuring of the labour market that affects women or men workers severely. It may be that male workers are substituted for female workers in the firm and government sectors because employers believe that employment should be provided to the ‘male breadwinner’. Another form of labour market restructuring is when young women and men supplant older women and men workers because they could be paid lower wages. A second mechanism of unequalizing development is a decline in relative wages even as profit rates and/or interest rates increase. This situation can occur when increased capital flows reinforce or maintain labour cost minimization schemes involving the intensified use of contingent labour and the related promotion of casual work arrangements to enhance its global competitiveness. As shown in the case of the East Asian countries, this can lead to precarious forms of employment and lower wages for those who belong to this occupational category.28 Thirdly, foreign investment can crowd out domestic investment particularly in small and medium enterprises, leading to an overall decline in credit available to domestic firms and to an increase in interest rates. Unless gender-based and other forms of discrimination are explicitly addressed, financial institutions will ration credit in favour of large enterprises and wealthy clients and further restrict credit access to poor households, small and micro-enterprises as well as women borrowers. The case of China, the developing world’s largest recipient of foreign direct investment and also one of the world’s fastest growing economies is illustrative of the above points. Its enormous consumer market (1.3 billion consumers) and the abundant supply of cheap, mostly skilled labour serve as key attractions to foreign


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investors. In addition, the Chinese government has a strong regulatory apparatus in place to manage and supervise foreign investors. All these factors suggest that China has the potential to steer foreign investment that it attracts towards sustainable and even development. Yet a closer look at China’s experience in attracting foreign direct investment suggests that the government has not been able to take advantage of its relatively strong bargaining power and tap into the potential benefits of foreign direct investment in promoting sustainable development. With the passage of the ‘Wholly Foreign Owned Enterprise Law’ in 1986 and the adoption of more market-oriented policy reforms in the 1990s, particularly the opening of the domestic market to foreign-owned firms, the Chinese government has embarked on a multi-pronged strategy to attract foreign investment in its labour-intensive, export-oriented manufacturing sector. This strategy involved reduced fees for labour and land use, extended the maximum duration of joint venture agreements beyond 50 years and, in 1997, giving exemption from import duties and value added taxes on capital goods imports to foreign investors and foreign companies. The overall effect was an increase in FDI flows to China from under $5 billion in 1986 to over $41 billion by 1999 (Braunstein 2002). At the same time, China’s accelerated push for market reforms in the late 1990s tends to seriously undermine existing modes of cooperative behaviour as well as increase interregional inequalities (Liew 1997). In his study of the transition process of China’s economy, Liew (1997) argues that, on balance, these modes of cooperative behaviour have helped bring about improvements in the productivity of enterprises, both at the state and township-village levels and have contributed to economic reform. He points out that there is need for the continued role of the state as the Chinese economy undertakes the difficult task of economic transformation away from central planning towards a market-oriented economy. Unfortunately, discussions on this topic have often been dominated by neoliberal prejudice against government regulation and intervention and against any form of cooperative and collective action. ‘Until recently, moderating the degree of uncertainty for individuals and the ability to maintain a modicum of cooperative behaviour have been essential ingredients in China’s comparative success in economic

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reform’ (Liew 1997, p. 163). The drive to attract foreign direct investment, however, has weakened the ability of the Chinese central government to take on necessary steps in maintaining macroeconomic stability and in reducing the degree of economic insecurity especially among workers as the economy takes a plunge in the market. It has also made it more difficult to keep the balance between competition and cooperation. At the same time, a growing gap in interregional growth and incomes has appeared. A two-level pricing policy that maintained planned prices for raw materials but allowed market prices for processed goods were adopted in the early 1990s. This favoured the coastal regions at the expense of the inland, agricultural provinces because the former have a higher proportion of export processing zones. Moreover, special economic zones and coastal provinces were granted economic privileges that were denied inland provinces. For example, special economic zones could retain 80–100 per cent of their foreign exchange earnings, but provinces like Guangdong and Fujian could retain 30 per cent (Wu 1994, p. 17). This resulted in so-called ‘commodity wars’, tax avoidance and economic plan evasion by the inland provinces, increased income disparities and uneven development. At best, the direct impact of FDI in China on employment and wages are relatively modest and less strong than that of domestic investment and exports (Braunstein and Epstein 2004). There is also evidence that it crowds out domestic investment and is associated with decline in provincial tax revenue.29 The increasing prevalence of subcontracting by many foreign companies in China leaves even fewer incentives for wage increases and improvements in working conditions. The study by Mehmet and Tavakoli (2003) on China as well as the Philippines, Singapore, and Thailand found evidence that FDI has caused a race to the bottom in the sense that overall labour demand has become more responsive to wage increases, thus lowering labour’s bargaining power. Furthermore, while wages may be higher in the short-run, studies have found that these export-oriented firms do not necessarily narrow the gender wage gap (Seguino, 2000). Braunstein (2002) added that if higher wages are a result of regulatory concessions given to foreign companies in China’s coastal export-processing zones such as exemption from labour laws and the illegality of


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unions, these higher wages may be accompanied by poor working conditions. The erosion of workers rights allowed by many governments of developing countries and indirectly endorsed by multilateral institutions, continues to serve as one of the main building blocks for increased competitiveness in the world market. In the absence of any effective monitoring and accountability, the working conditions in many domestic as well as foreign-owned firms are likely to remain poor. This seems to be the case for China as well. Long hours, congested dormitory living conditions and exposure to hazardous substances, for example, have become common in the case of many women workers in the factories along its coastal regions. Unless female-intensive FDI is part of a longer-term industrial policy that seeks to promote forward and backward linkages through coordination and that reduces economic insecurity among its working population, countries like China could get caught on a low-road development path based on low wages and deterioration of workers’ rights. Such an approach, together with the rapid breakdown of the modes of cooperative behaviour, is likely to create an increasingly unequal distribution of the gains from China’s economic growth. An unequal development process can therefore lead to increased income disparities among households and greater differentiation among women and men. Those who benefit from market growth by having control over additional financial resources experience increase in their well-being as in the case of asset-based earning households. Those who are excluded or marginalized in the process experience bare subsistence and even deprivation.30 Concomitantly, unpaid labour is likely to be reduced for those women in wealthy households who stand to benefit from increased market growth through purchases of ‘labour-saving consumer durables’ such as microwaves, washing machines, and hired house-cleaning services. The opposite occurs for those women who face unemployment or reduced wage earnings and/or a decline in their spouse’s wage earnings. It appears that an important coping mechanism is for women to increase their market work hours by taking two or even three jobs. At the same time, they may take on a mounting share of caring and unpaid household duties that compete both for their time and energy. A third scenario, that of a stagnating development process, can arise if policy reforms are undertaken to reverse the low levels of

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foreign direct investment flows, thereby bringing about adverse fiscal response and problems associated with short-term macroeconomic management and long-term development outcomes. It can also arise if foreign direct investment leads to increased net capital outflows so that a net decrease in capital formation in the market sector occurs, prices rise and governments are compelled to borrow more loans and implement fiscal austerity. The resulting inflow of capital in the current period presumably leads to an outflow in later periods when the repatriation of foreign equity, capital gains and earnings occurs. In fact, the reversal of outflows can be so severe that it drastically reduces capital formation and employment.31 This leads to a general decline in individuals’ capabilities and social reproduction is threatened. Stagnation also results from heightened financial instability and accompanying contraction of the formal (market) sector due to the temporality of foreign capital flows and their characteristic volatility.32 Such is the case for many sub-Saharan African countries, which made use of tax-based incentives such as low capital taxes, provisioning of infrastructure for foreign companies and maintenance of cheap labour in order to attract foreign capital. The levels of foreign direct investment flows to Africa are extremely low and often concentrated within a small number of export enclaves such as the mining and other natural resource extractive sectors. The decline in official development assistance (or foreign aid) to many African countries in recent years has raised the interest on mobilizing foreign capital. It is however the case that the decision on how and in what manner to reverse the trend of low foreign capital inflows has gendered and distributional implications. Proponents of financial liberalization reforms have argued that financial repression of African economies throughout the 1970s and 1980s has hindered the resource mobilization role of the financial institutions and hence brought about limited competition and economic inefficiency. Although the development of financial sectors in African countries varied widely, they were nonetheless characterized by low or negative interest rates, directed credit allocation to certain ‘favoured’ sectors on the basis of political rather than efficiency considerations, and heavy government ownership and management of financial institutions. As a result, the financial sectors in many African countries are segmented,


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fragmented, oligopolistic and only served the short end of the market (Geda 2002). Kenya’s experience, with its financial system dominated by a few commercial banks (predominantly foreign-owned), illustrates how stagnation can result from the mobilization of foreign capital through market liberalization.33 Kenya adopted financial sector reforms in 1989 as part of the $170 million World Bank adjustment credit. In addition to interest rate liberalization, which was achieved fully in 1991, the government liberalized the bond markets and capital markets, abolished credit guidelines that favoured agriculture in December 1993, and allowed partial privatization of parastatal banks (Mwega 2003). As a 1994 World Bank report pointed out, these reforms have been undertaken in the context of ‘pervasive macroeconomic instability’ (World Bank 1994).34 Interest rate liberalization in Kenya, as with Malawi, Tanzania and Zimbabwe, seems to have only a small or non-significant impact on private or aggregate saving rates (African Development Bank 1994; Mwega 1995). Some studies found a positive and significant relationship between real deposit interest rates and financial savings (Lipumba 1997; Nissanke et al. 1995).35 The latter suggests that interest rate liberalization in Africa only encouraged the substitution of other forms of savings for financial savings with very little effect on total savings.36 Nissanke et al. (1995) conducted several econometric tests to examine the responsiveness of net foreign savings inflow as well as aggregate saving rate to financial liberalization policy by using 1970–93 data for Kenya and Tanzania. Based on the results he argues that financial liberalization policy has not been sufficient to generate a strong response in terms of increased savings mobilization and financial intermediation and increased private investment. This finding supports the view expressed by Milberg (1999), and Braunstein and Epstein (2004), that investors, whether domestic or foreign, are unlikely to be responsive to interest rate changes; instead the institutional environment such as credibility of government policies, steady growth in absorptive capacity and in aggregate demand (market size) are factors that usually dominate investors’ decisions. Furthermore, the unregulated capital mobility under the adoption of financial liberalization has promoted a deflationary fiscal and monetary bias by creating the expectation that there is unlimited

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supply of private capital and, as a result, public investment rates decline. This was the case in Kenya whereby the decline in the gross domestic saving rate between 1980 and 1993 was caused mainly by a reduction in public savings (Mwega 2003, p. 368). There are different avenues through which the decline in savings takes place. First, the government’s effort to levy or collect taxes is adversely affected as it sought to mobilize foreign capital by providing tax privileges or exemptions. This is supported by the findings of Geda’s (2002) econometric study of fiscal response to foreign capital using a panel data for 21 African countries.37 The study shows that private capital inflows, as with foreign aid, have led to a decrease in direct tax revenues and have no short-run impact on indirect taxes. They are found, however, to have a significant negative impact in the long term on indirect taxes and such effect is explained by the resulting change in the level of private consumption and external trade. A second avenue is the likely negative effect of capital inflows on private savings. Moreover, high interest rates have contributed to stagflation by increasing the cost of working capital and reducing real wages and aggregate demand. Overall, financial liberalization policies in Africa did not result in steady economic growth; in fact, they contributed to a statistically significant drop in the investment ratio. Despite the adoption of financial liberalization policies and fiscal-based incentives, foreign capital inflows to the African countries remained sporadic at best throughout the 1990s – with the exception of Nigeria (because of its oil resources) and South Africa. Many of the private capital inflow surges during the 1990s in Kenya, Ghana, Zambia and Zimbabwe, among others, took the form of the so-called ‘Ugandan disease’.38 Most appeared as trade credits and investment in Treasury bills and were short term in nature. This brought about not only a real appreciation of the currency but also created associated macroeconomic management problems as well as development concerns. Irregular surges in portfolio capital flows permitted substitution out of the local currency and thus losses in seignorage to already fiscally stressed governments. Thus, although any private capital inflows to Africa were conditional upon deficit reduction or maintaining a balanced budget, these inflows have an inherent tendency to aggravate the deficit. Geda’s study of the government’s fiscal response in 21 African countries to private capital inflows


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shows a strong positive impact on current government expenditure (Geda 2003, p. 226). Any increase in overall government expenditure in the case of several African countries did not necessarily translate into budget allocation for public goods provisioning, however. Budget priorities have been such that infrastructure projects primarily benefiting foreign investors end up constraining resources available to other expenditure items such those for social services provision. In general, there was a negative trend in the social allocation ratio (for education and health) between 1981 and 1990 in many African countries including Kenya, Mali, Tanzania, Nigeria, Gabon, Burkina Faso, Zaire and Zimbabwe, to name a few (Stewart 1995). Until recently, the governments’ response in the form of reduced public social spending, particularly in the treatment of HIV/AIDs, has brought about severe consequences for the entire population, poor and wealthy households alike, and especially for women workers. As with government cuts in social services, the introduction of marketdetermined user fees have posed an increased work burden for women in households that are too poor to pay them. Such an approach towards financing development implicitly assumes an unlimited supply of female labour available to make good any shortfalls in the provisioning of affordable basic services. At the same time, corruption didn’t dissipate but rather took the form of government–private sector alliances and crony forms of rent seeking activities. Moreover, the efforts of the Bretton Woods institutions-sponsored stabilization programmes to keep debt payments flowing and maintain solvency of the international financial institutions has led to the stifling of human development in these African countries. Many of the public services including water and primary health clinics that are essential for the advancement of human development have been abandoned to the poor allocative mechanisms of the market. Nowhere is the debt problem starker than in the heavily indebted poor countries (HIPC) in the sub-Saharan African region. Total debt service in 2001 ranging from 13.4 per cent (Zambia), 36.3 per cent (Burundi) to 74.3 per cent (Sierra Leone) of total exports has created obstacles to development that are almost insurmountable (UNDP 2003). The high rate of debt servicing in Africa has channelled savings out of the continent during a time of devastating public and reproductive health crises that should have led to a significant infusion of

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resources from the international community. Perhaps no other single indicator can show the severity of the problem than the decline in the human development index (HDI). This occurred between 1990 and 2001 for the following countries: Botswana, Burundi, Zambia, Cameroon, Congo, Lesotho, Cote d’Ivoire and Swaziland, to name a few (UNDP 2003). The index usually moves steadily upwards, though slowly, because three of its key components – literacy, enrolment rates and life expectancy – take time to change. Thus when the HDI index falls it indicates a severe crisis in terms of human resource depletion and stagnating development process. The 1990s saw unprecedented stagnation and deterioration even as these countries continue to maintain their market liberalization policies in the hope of attracting foreign capital. A stagnating development process therefore leads to the reversed substitution effect for those who stand to lose when per capita market growth stagnates or declines including unhedged domestic investors, workers and care-providers.39 When incomes decline, households and communities are compelled to engage in more nonmarket production activities that depend mainly on unpaid labour in order to replace market purchases or government services that are previously available. This lengthens the person’s (typically a woman) working day, taking on multiple jobs or by intensifying work effort through the performance of overlapping work activities. If one took into account the manner in which people function, particularly the way they perform their work and spend their time as an essential element of well-being, then serious welfare implications of very long work hours and work intensity must be considered as well.

Summary and concluding remarks A careful examination of the effects of financing strategies cannot focus exclusively on the monetized, market-based activities as traditional models of savings mobilization, trade or investment typically do. Gender, alongside class, is an important analytical tool for understanding development processes and their welfare outcomes; not only does gender serve as a basis for fundamental division of labour in societies, it also socially defines roles and identities in the material practices of ‘making a living’. Both class and gender are mutually constitutive bases of power that can be reproduced and


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reshaped by the social organization of production and manner of distribution. The effects of mobilizing resources on the well-being of children, men and women are complex and are transmitted through changes that take place both in the market and non-market sectors of the economy. Any analysis of policies aimed at sustainable, human development needs to highlight the interlinkages between these channels and to demonstrate that the choice and terms of financing strategies affect not only capital formation and market output but also the distribution of incomes, risks and access to public goods among the population and the long-term process of social reproduction through their effects on the non-market sector. The key elements of a conceptual framework are also introduced in this chapter. Using an open, developing economy case, we highlight the interaction between the financial and real sectors in terms of the allocation of resources to mobilize savings (both domestic and foreign) and of the likely impact of foreign capital flows on the real sector. This conceptual framework builds upon the notion of economic development as a process of transformation involving two sectors of the real economy, namely, the market and the nonmarket, reproductive sectors. It highlights the dynamic interaction between these two sectors particularly in terms of class-based identities and gender roles. Household members, particularly women, allocate their working time between these sets of economic activities. Moreover, the development of human resources and social reproduction of labour crucially depends on both non-market and market sectors. The terms, timing and form in which private foreign capital enters the country, for example, critically determine whether it will support or undermine social objectives and sustainable development. This requires the need for consistent and transparent rules, appropriate monitoring and, above all, a comprehensive genderaware framework that enhance the social development impact of direct foreign investments and contribute towards gender equality and sustainable economic growth. The exclusion of the non-market sector – particularly the unpaid work performed – and of the economic and social costs and benefits from monetary, investment and financial policy debates, including financial liberalization, can lead to a seriously erroneous assessment of their development impacts.

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While there maybe potential benefits of international private capital, there are also large risks and potential long-term costs. The case of China and Taiwan illustrate how global corporations and local businesses are increasingly engaged in labour cost minimization schemes involving the intensified use of contingent labour and the related promotion of casual work arrangements. This has led to precarious forms of employment and lower wages. Many women (particularly those with dependants) have engaged in household production that is integrated in the global chain of production processes (Chen et al., 1999; Standing 1999). Such employment has provided income earning opportunities for women, but they are poorly paid, have no benefits and are highly unstable. Whether foreign capital flows will be positive or negative for women in terms of employment opportunities depends on the organization and structure of production that these flows support, the stability of employment created, and the workplace conditions, training and education provided. Therefore, the expected gains from free flows of foreign capital are never matched with the true costs of accompanying higher market volatility and adverse macroeconomic consequences. The terms and nature of financing strategies affect not only capital formation and economic growth but also the distribution of benefits (and associated costs) among the population and the long-term process of social reproduction. Gender inequalities and income and wealth differentiation are likely to be affected significantly within and between countries.

Notes 1. The author would like to thank Nilufer Cagatay, Tom Hungerford, Philip Arestis, Matthew Forstater and John Willoughby for their insightful comments and constructive suggestions. All views (and errors) in this chapter are solely those of the author. 2. This chapter extends the discussion in Floro (2001) and Floro et al. (2003) on the gender dimensions of the 2002 International Conference on Financing for Development. The main agenda that emerged from the conference and as expressed in its outcome document (called Monterrey Consensus) put the primary responsibility and emphasis on the domestic mobilization of resources within developing countries and on the greater role of markets (and market liberalization policies) in promoting foreign capital flows and trade to meet the internationally agreed commitments and goals.


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3. See McKinnon (1973), Shaw (1973), Prescott (1986), Kapur (1983), Pagano (1993), to name a few. 4. Financial widening and deepening include policies promoting the entry of foreign banks, introduction of off-shore banking and development of stock/equity markets. 5. See, for example, Lucas (1988), King and Levine (1993) and Greenwood and Jovanovic (1990). 6. This is represented by works of Singh (1997), Diaz-Alejandro (1985), Taylor (1983, 1991), Fitzgerald (2000), Arestis and Demetriades (1993), Arestis et al. (2005), Blecker (1998), Pollin (1997), Griffith-Jones (2002) and Stiglitz (1994), to name only but a few. 7. See, for example, Fitzgerald (2001), Bulir (2001) and Birdsall (2000). 8. Non-market economic activities include subsistence crop production, water and fuel gathering, food preparation and house cleaning, care for the children, sick and elderly, and the management of community services. 9. The conventional view of standard economic or financial growth models is that goods and services produced in the market economy directly affect a person’s well-being and capabilities. 10. The latter refer to cooked meals, cleaned house, gathered water, care of children, sick and elderly and so forth. Additionally, the manner in which people make use of their time also affect directly their well-being. This includes socially necessary time or time spent on social/cultural activities, personal care (including sleep) and leisure activities. 11. This characterization of household clearly falls well short of definitive. It ignores the increase in female-headed households, single person households, as well as multi-generational, extended families in many societies. These omissions are made owing to our focus on gender-differentiated outcomes. 12. Washing clothes, for example, would require more unpaid labour time with the use of purchased laundry soap (a cheaper market good) than with the use of a purchased washing machine (a more expensive market good). The alternative would be to wash clothes infrequently so that the standard of cleanliness is compromised. 13. These are social services or public goods such as child immunization, public education, public transport, counselling of domestic violence victims, garbage and waste management, etc. 14. Consumption goods and services are comprised of those that are directly consumed by household members, and those that are further processed within the household using unpaid labour. 15. Among the newly industrializing countries where the manufacturing sector is heavily oriented towards exports, the share of women workers in this sector has substantially increased (Berik 2000; UN 1999). In fact, women have provided the bulk of labour in the manufactured, labourintensive, export sector. 16. There are different forms of taxation ranging from income taxes, domestic taxes on certain goods and services, taxes on foreign trade, currency taxes, and other taxes including social security and property

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17.

18. 19. 20. 21.

22.

23.

24.

25.

26.

27.


or inheritance taxes but in this analysis, we focus only on a few of them. Until the 1980s, foreign trade taxes are traditionally seen to be more important in developing countries than income taxes, accounting for 5% of GDP and 30.6% of total tax revenues. Import duties, contributing 4.2% of GDP and 25% of total tax revenues were the most important revenue sources, particularly for least developed countries with per capita income below $350 dollars and least important for countries with much higher per capita incomes. Countries that make extensive use of import duties are found by several studies generally not to resort to indirect taxes such as general sales levy. This is true for example in many developing countries including the Philippines and many parts of sub-Saharan Africa. For a detailed analysis of the gender dimension of taxation, see Barnett and Grown (2004). Hoddinott, Alderman and Haddad (1998) have shown that women, in their roles as household managers and primary carers, consume goods that benefit family health, nutrition and education while men consume more of their incomes on personal items. Barnett and Grown (2004) also argue that commodity taxes are likely to alter relative prices between market and non-market sectors and in so doing affect the allocation of work between them. While this story is worth pursuing, a careful examination of the effects of changes in taxation policies is outside the scope of this chapter. Instead, we highlight the effects of government action (increase in government spending) in order to mobilize international resources by attracting foreign capital inflows. In South Korea, for example, where young women are the primary source of labour in export industries, Kim (1997) found that, among their highest priorities in the decision of how to allocate earnings were the goals of saving for a dowry and financing their siblings’ education. The existence of informal savings clubs and organizations in many countries, particularly among women, indicate the positive savings rate even among the poor (Fong and Perrett 1991; Ghate 1992). In fact, recent data trends show that for several developing countries, international bank lending has not only declined but has become negative. The impact of short-term capital flows on firms through the availability of bank credit is also analysed in Fitzgerald (2001). He demonstrates that the impact on output and investment is not only considerable, but also asymmetric. There is a plethora of studies and research purportedly demonstrating that the benefits to developing economies of their integration to international capital markets are clearly substantial. In particular, access to international savings allows the rate of investment (and thus industrial progress and income growth) to be raised and the effect of exogenous shocks to be dampened on the one hand, and of the gains in efficiency


28.

29.

30.

31.

32.

33.

34.

35.

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from transfers of competitive technology and financial skills on the other. The rapid integration of national economies through trade and financial market liberalization and the accelerated competition among firms, domestic as well as foreign, for increased share of the market require a flexible labour force that can be redeployed, and contracted quickly during periods of expansion, and can be maintained ‘at arms length’ at little or no cost during periods of slump (Elson, 1996). Many women (particularly those with dependants) have engaged in household production that is integrated in the global chain of production processes. Such employment has provided income-earning opportunities for women, but they are lowly paid, have no benefits and are highly unstable. This differs from the finding of the study by Agosin and Mayer (2000), which demonstrates the crowding in of domestic investment in Asia and the crowding out in Latin America. Weeks (2003), on the other hand, makes use of a simulation approach to show that financial liberalization policies have lead to a greater propensity for crowding out in Latin America during the 1980s and 1990s. This is assuming the absence of any redistributive government transfers such as unemployment compensation and other social protection measures. For example, in some developing countries in Asia, Africa and Latin America, the reversal of capital flows was so dramatic in 1998 that more than half of all official assistance to these countries in 1999 was absorbed by repayments to private banks and bond holders (Griffith-Jones 2002). Following the argument of Fitzgerald (2001) and Singh and Zamit (2000), the volatility of international capital flows is not attributed in this chapter merely to investor irrationality or even to ‘speculation’ except in the technical sense of international or intertemporal arbitrage. Rather it is the scale of these flows in relation to the size of the domestic capital market – in terms of both the proportion of the domestic capital stock that is effectively ‘on the market’ and the size of the local market in relation to the international market in which the non-resident investors operate – and the high covariance between asset prices within a given developing economy or even region, which renders them problematic. Mwega (2003, p. 357) expressed concern regarding the possibility of collusion among the top commercial banks in determining the interest rates following financial sector liberalization reforms at the end of the 1980s. The resulting inflow of capital into the country in the current period presumably leads to an outflow in later periods when repatriation of foreign equity, capital gains and earnings occurs. In fact the reversal of outflows can be so severe that it drastically reduces capital formation and employment. Some neostructuralists argued that an increase in financial savings may be at the expense of the informal credit sector and adversely affect the supply of credit to small businesses and poor households. Wijnbergen

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36.

37.

38. 39.


(1983) and Buffie (1984), for example, argue that financial saving need not be interest elastic, and even if they are, may not be translated to increased credit to the private sector if they are used to raise the cash and foreign asset reserves held by these institutions, or to finance fiscal deficits. These results are consistent with those found for other African countries as well. An econometric analysis by Oshikoya (1992) found nonsignificant gross private investment coefficient for Kenya after controlling for terms of trade and financial repression. Geda (2002) makes use of an Error Correction model, which estimates several sets of equations that are derived from a stylized fact-based government decision making framework specific to Africa. The results show that the impact of capital inflows on taxes varies across the types of inflows, the nature of taxes and between different regions in Africa. In 1993–94, private capital inflows to Uganda reached an extraordinary 8 per cent of GDP (Kasekende and Martin 1997). The growing informalization of jobs alongside stagnant growth or decline of regular, core, protected jobs in the last three decades means that employment adjustments under a changing economic environment concentrate the burden of shift on those workers who become either unemployed or part of the ‘periphery’ or contingent worker force as casual, part-time or subcontracted labour. They also shift some costs of adjustments associated with market volatility and fluctuation onto the unpaid workers engaged in household maintenance and reproduction of both the ‘reserved’ unemployed and ‘periphery’ workers.

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Balicasan, Arsenio and Rosemarie Edillon (2001), ‘Socioeconomic Dimension of the Asian Crisis: Impact and Household Response in the Philippines’, in Yun-Peng Chu and Hal Hill (eds), The Social Impact of the Asian Financial Crisis, Cheltenham: Edward Elgar, pp. 167–192. Barnett, Kathleen and Caren Grown (2004), Gender Impacts of Government Revenues, Commonwealth Economic Paper Series, London: Commonwealth Secretariat. Basu, Santonu (2002), ‘Financial Fragility: Is it Rooted in the Development Process? An Examination with Special Reference to the South Korean Experience’, International Paper in Political Economy, 9 (1), 1–32. Benería, L. (2001), ‘Shifting the Risk: New Employment Patterns, Informalization, and Women’s Work, International Journal of Politics, Culture and Society, 15(1), 27–53. Benería, L. and Floro, M. (2004), Deconstructing Poverty, Labor Market Informalization, Income Volatility and Economic Insecurity in Ecuador and Bolivia (co-authored with Lourdes Beneria), Geneva: UNRISD Background Paper. Berik, Gunseli (2000), ‘Mature Export-led Growth and Gender Wage Inequality in Taiwan’ Feminist Economics, 6 (3), November, 1–26. Blecker, Robert (1998), ‘The Globalization of Finance and the Limits on National Policy Autonomy: A Survey of the Debate’, paper prepared for the Economic Policy Institute Project on Global Finance and Domestic Economic Policy, July. Bouton, L., C. Jones and M. Kiguel (1994), ‘Macroeconomic Reforms and Growth in Africa: Adjustment in Africa Revisited’, World Bank Policy Research Working Paper No. 1394, Washington DC: World Bank. Braunstein, Elissa (2000), ‘Engendering Foreign Direct Investment: Family Structure, Labor Markets and International Capital Mobility’, World Development, 28 (7), 1157–72. Braunstein, Elissa and Gerald Epstein (2004), ‘Bargaining Power and Foreign Direct Investment in China: Can 1.3 Billion Consumers Tame the Multinationals?’, in William Milberg (ed.), Labor and the Globalization of Production. Basingstoke: Palgrave Macmillan. Buffie, E.F. (1984), ‘Financial Repression: The New Structuralists and Stabilization Policy in Semi-Industrial Countries’, Journal of Development Economics, 14(3), 305–20. Bulir, Ales (2001), ‘The Impact of Macroeconomic Policies on the Distribution of Income’, Annals of Public and Cooperative Economics, 72 (2), 253–70. Cagatay, Nilufer, Diane Elson and Caren Grown (1995), ‘Introduction to the Special Issue on Gender, Adjustment and Macroeconomics’, World Development, 23(11), 1827–36. Chen, Martha, Jennifer Sebstad and Lesley O’ Connell (1999), ‘Counting the Invisible Workforce: The Case of Homebased Workers’, World Development, 27(3). Cho, Hee Yeon and Eun Mee Kim (1998), ‘State Autonomy and Its Social Conditions for Economic Development in South Korea and Taiwan’, in Eun Mee Kim (ed.), The Four Asian Tigers: Economic Development and the

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3 Financial Liberalization and Poverty: Channels of Influence Philip Arestis University of Cambridge, Levy Economics Institute

and

Asena Caner Levy Economics Institute

Abstract This chapter examines the channels of influence on poverty of financial liberalization policies. Financial development and its effects on the economic development of a country has recently been one of the most prolific areas of research in the fields of development, finance and international economics. However, so far, very little work has been done to analyse comprehensively the relationship between financial liberalization and poverty. There is still controversy about the exact role and the effectiveness of financial liberalization on improving economic conditions in developing countries. This chapter aims to contribute to this debate by critically reviewing the relevant literature and looking closely at the channels through which financial liberalization can affect poverty. Keywords: Economic development and growth, financial liberalization, poverty, channels of influence, policies JEL Classifications: O16, I32

Introduction It is undeniably the case that financial development and its effects on economic growth and development has been one of the most 90

Financial Liberalization and Poverty

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prolific areas of research in the fields of development, finance and international economics. Despite these developments, though, there has been little work on the relationship between financial liberalization and poverty. Related literature has been, to a great extent, based on the neoclassical view that financial liberalization mobilizes savings and allocates capital to more productive uses, both of which help increase the amount of physical capital and its productivity. By this means, financial liberalization increases economic growth. The logic follows that economic growth caused by (or accompanied by) financial liberalization increases incomes and therefore reduces poverty. It is actually the trickle-down effect of growth that helps reduce poverty. A distant exception may be Fry (1995), who in surveying the limited work on this issue, concludes that ‘financial repression and the ensuing credit rationing worsen income distribution and increase industrial concentration’ (p. 205). By implication, then, financial liberalization and the ensuing freeing of credit markets improve income distribution and poverty. Nonetheless, one would expect the economic and institutional changes brought about by a financial liberalization package to have a more complex effect on the living conditions of the poor than merely through the presumed growth channel and the simplistic view summarized by Fry (1995). In this chapter, we investigate two further channels of interest, in addition to the growth channel: the crises channel and the access to credit and financial services channel. Many economists agree that financial sector reforms have produced disappointing results and have failed to meet expectations. In some countries financial markets were liberalized prematurely because of the failure to recognize their imperfect characteristics; indeed, in many cases all those attempts led to financial crises (Arestis and Glickman, 2002). It is possible that the poor might be more severely affected by such crises. The second channel we investigate, the crisis channel, works via the changes in the macroeconomic dynamics, increasing volatility and vulnerability to financial crises following liberalization. In the third channel we study, we evaluate the evidence regarding changes in poverty caused by better access to credit and financial services that financial liberalization is expected to yield. To the extent that a liberalization programme increases the financial resources available to the previously disadvantaged and to the extent that the poverty problem is related to lack of

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consumption smoothing mechanisms, there is room for financial liberalization to help alleviate poverty. The main message that we get from reviewing the literature is that there is still no clear understanding of the mechanisms underlying the way moving from financial repression to a liberalized regime influences different segments of the population and, in particular, the poor. A straightforward application of the standard liberalization policies without taking any measures to protect the initially disadvantaged groups of the population from potential losses can worsen the living conditions of these groups. The chapter is organized into the following sections: in the next section, we describe the definition of financial liberalization that we adopt. This is followed in the subsequent three sections by an investigation of the three channels through which financial liberalization is expected to have an effect on poverty. A final section summarizes and concludes.

Defining financial liberalization The term financial liberalization takes various meanings in the literature. In this chapter, we adopt the multidimensional definition given in Kaminsky and Schmukler (2003). Financial liberalization consists of the deregulation of the foreign sector capital account, the domestic financial sector, and the stock market sector viewed separately from the domestic financial sector. The liberalization of the capital account is captured by the regulations on offshore borrowing by financial institutions and by nonfinancial corporations, on multiple exchange rate markets and on capital outflow controls. In a fully liberalized capital account regime, banks and corporations are allowed to borrow abroad freely. They may need to inform the authorities but permission is granted almost automatically. Reserve requirements might be in place but are lower than 10 per cent. Also, there are no special exchange rates for either the current account or the capital account transactions; nor are there any restrictions to capital outflows. A fully liberalized domestic financial system is characterized by lack of controls on lending and borrowing interest rates and certainly by the lack of credit controls, that is, no subsidies to certain sectors or certain credit allocations. Also, deposits in foreign currencies are permitted. In a fully liberalized stock market, foreign investors


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are allowed to hold domestic equity without restrictions and capital, dividends and interest can be repatriated freely within two years of the initial investment. According to Kaminsky and Schmukler (2003), full financial liberalization occurs when at least two of the three sectors are fully liberalized and the third one is partially liberalized. A country is partially liberalized when at least two sectors are partially liberalized. This way of defining financial liberalization follows the experience of countries, both developed and developing, since the early 1970s. Kaminsky and Schmukler (2003) provide indexes that help to shape the pattern of financial liberalization for both developed and developing countries. Broadly speaking, two episodes of financial liberalization can be identified: the first took place in the 1970s and the second in the late 1980s. Stock markets in developed countries were liberalized in the early 1970s, while the domestic financial sector and capital account were ‘repressed’ until the early 1980s. Liberalization of the domestic financial sector predates the opening of capital account in the rest of the 1980s. So that by the mid-1980s developed countries liberalized, at least partially, their domestic financial sector. By the late 1980s and early 1990s capital account liberalization had taken place in all developed countries. In developing countries, domestic financial sector was liberalized along with capital account in the 1970s. However, the stock market was out of reach for foreign investors over the period. That epoch came to an end with the 1982 debt crisis, when controls were re-imposed and remained in place until the late 1980s (especially capital account controls) when a liberalization wave took place in Asia and then in Latin America. By the early 1990s, the domestic financial sector and stock market had been jointly deregulated in developing countries. This predates capital account liberalization, which only commences in the early 1990s. These are, of course, generalizations. Looking more closely at the dates of financial liberalization (see Kaminsky and Schmukler, 2003, Table 1), further differences emerge. All the G-7 countries deregulated the stock market first. European countries adopted a more mixed approach (25 per cent liberalized the domestic financial sector first, with the rest deregulating the stock market first). Latin American countries liberalized the domestic financial sector first. Asian countries followed a mixed strategy: some deregulated the domestic financial sector, while some others the stock market. Capital account liberalization in all Asian countries took place subsequently.

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The economic growth channel One channel through which financial liberalization can affect poverty is through economic growth. Obviously, the existence and strength of the link between financial liberalization and poverty depends on the existence and strength of the links between, first, financial liberalization and growth and, second, between growth and poverty. Proper understanding of this channel requires, therefore, full analysis of the two links to which we have just referred. As we describe below, there are problems associated with the soundness of both links. We discuss in the rest of this section both the theory and the empirical evidence when evaluating these two relationships. This particular channel can be thought of as relying on the theory of financial liberalization as developed originally by McKinnon (1973) and Shaw (1973). We begin with the relationship between financial liberalization and economic growth and/or economic development. Financial liberalization and economic growth In financial liberalization theory, financial repression, that is, distortions of financial prices such as interest rates, reduces the real size of the financial system relative to the non-financial, which leads to slow real rate of economic growth (McKinnon, 1973 and Shaw, 1973). The theory rests on the assumptions that saving is an increasing function of real rate of interest on deposits and real rate of growth in output and that investment is a decreasing function of the real loan rate of interest and an increasing function of the growth rate. At the initial repressed stage, the nominal interest rate is administratively fixed, and thus the real rate is kept below its equilibrium level. Low interest rates encourage current consumption and discourage saving. Ceilings on loan rates reduce the average efficiency of investment projects since investments with lower returns that would not be profitable under the higher equilibrium interest rate, are now profitable. Removing the ceiling on interest rates leads to an increase in saving, as rising real interest rate traces the saving curve. The average return to investment increases as the low-yielding projects are no longer profitable. Rising efficiency of investment leads to increased output, which further increases saving. Therefore, according to this theory, in an environment where investment opportunities are plentiful but the financial system is repressed, the key to higher and


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more efficient investment is to raise the return to savers, that is, the real interest rate. Liberalizations of the stock market and the capital account, two important dimensions of financial liberalization, are also thought to have positive effects on economic growth. Stock markets can promote long-run growth through encouraging corporate control, speculation, acquisition and dissemination of information. Indeed, stock markets can reduce the stock of mobilizing savings and facilitate investment in the process; financial assets traded in stock markets are more liquid than otherwise because savers can buy and sell quickly when they wish to alter their portfolios (Arestis et al., 2001, pp. 17–19, discuss these aspects at length with relevant references). Turning to the capital account liberalization, we may note that rising global linkages via cross-border financial flows can increase economic growth through various channels. First, financial integration of a poor country, in terms of its capital endowment, to the rest of the world results in higher investment in the country as capital flows in to earn higher returns (Prasad et al., 2003). Second, improved risk allocation reduces risk premium, thereby lowering the cost of raising capital (Prasad et al., 2003; Bekaert et al., 2000, 2001). Global diversification of risk can increase investment in riskier but higher expected return projects that were shunned before (Obstfeld, 1994). Third, transfer of technology and managerial know-how can raise aggregate efficiency and productivity and in turn help increase economic growth (Prasad et al., 2003; see, also, Agénor, 2002b). Fourth, integration can help the domestic financial sector by increasing incentives for improving the regulatory and supervisory framework for banking, by letting foreign banks introduce a variety of new financial instruments and techniques or by increasing competition which can improve the quality of domestic financial services (Prasad et al., 2003). Fifth, financial openness though potentially mitigating asymmetric information and reducing costs associated with small-scale lending, can enable the poor to have access to the formal sector of the financial system (Agénor, 2002b).1 It has also been shown in the literature that it is possible for the financial liberalization process to have a negative effect on growth. In terms of stock market liberalization three channels have been shown to be important: all three relate to the enhanced liquidity property of stock markets (Demirgüç-Kunt and Levine, 1996): (i) greater stock

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market liquidity may reduce saving rates; (ii) less uncertainty accompanied by enhanced liquidity may decrease precautionary savings; and (iii) highly liquid stock markets may act as ‘disincentive to exert corporate control’. A further characteristic of stock markets is that of ‘excess’ price volatility, which can lead to undesirable effects: casino-type speculation (Keynes, 1936); ‘excessive’ volatility that reflects independence of stock-market-asset values from underlying fundamentals (Shiller, 1989), which can induce ‘noise’ into the market (DeLong et al., 1989) and lead to inefficient allocation of resources (Federer, 1993). Devereux and Smith (1994) study the effect of international risk sharing (portfolio diversification) in a multi-country world in which growth is based on the spillover effects of human capital accumulation. Their assumption of constant relative risk aversion preferences generates a positive relationship between the country-specific income risk and the average growth rate of the economy through the saving rate. Financial openness, by eliminating country-specific income risk, eliminates the impact of this risk on saving and therefore on growth. In other words, when countries share endowment risk via international capital markets, saving and growth rates can be lower in financial openness than in autarky. The main result of the Devereux and Smith (1994) model holds when countries differ in their productivity risks instead of in their income risks. However, this model has been criticized in that the results hold only when there is only one investment technology available (Agénor, 2002a). When there is more than one technology available, financial openness may increase the growth rate (although it can reduce saving rate as before) via a reallocation of savings to higher risk but higher return projects. Much criticism of the financial liberalization theory has been conducted on the dubious assumption that markets, if left on their own, will work efficiently. Another important critique has been launched on one of the critical assumptions of the thesis that for the financial liberalization and growth link to work savings would increase following financial liberalizations. However, there is no unanimous agreement on this issue. The relationship is complex, not only because there are short-term and long-term effects involved, but also financial liberalization is a process with many dimensions. Here are some of the channels mentioned in the literature: first, financial deregulation, by increasing competition among the providers of


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financial intermediation, boosts borrowing by agents that were constrained before in the financially repressive regime; financial deregulation would thus affect savings negatively (Bayoumi, 1993). Furthermore, financial development should alleviate credit constraints for poorer households, thereby enabling them to make productive investment, such as in human capital (Li et al., 1998). Indeed, a developed and healthy financial system can be a powerful antimonopoly means that enable the poor households and small firms to escape the tyranny of exploitative monopolists. By contrast, an underdeveloped financial system can be ‘clubby, uncompetitive, and conservative’ (Rajan and Zingales, 2003). Second, if financial liberalization involves the foreign exchange market, it may induce large capital inflows, which may result in a surge in real income and a positive direct but transitory effect on saving. Third, the liberalization of interest rates encourages saving, if the substitution effect dominates the income effect. Fourth, the liberalization of the stock market could provide a wider range of saving instruments and help channel funds into the formal financial sector from the informal sector. The effect on total saving is, however, ambiguous (Bandiera et al., 2000). Gibson and Tsakalotos (1994) group the critique on the financial liberalization thesis into two main areas. The first critique includes the Keynesian and neo-structuralist critiques. The second critique emphasizes the microeconomic failures that are prevalent in financial markets. These critiques show how much the outcome of the financial liberalization hypothesis depends on the assumptions made. The Keynesian models stress the role of effective demand. In these models a rise in the deposit interest rate increases the marginal propensity to save and therefore reduces aggregate demand. If aggregate demand and output fell, then the rate of profit would be reduced and, thereby, investment would decrease. As a result, investment in a financially liberalized economy could be lower than that in a repressed one (Burkett and Dutt, 1991). This outcome stands in sharp contrast to that of the financial liberalization thesis. The neo-structuralist view agrees with the Keynesian view in that, following the removal of deposit interest rate ceilings, an increase in the desire to save reduces aggregate demand and makes contraction more likely than growth. It adds that as the rate of interest and bank deposits increase, the availability of credit may or may not increase. If deposits come from assets that were previously unproductive (such

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as jewellery) then total availability of credit increases. But if deposits flow to the banking system from the informal sector, then the total supply of credit in the economy could contract, since banks are subject to reserve requirements while the informal market is not (Taylor, 1983). Within such a framework, the overall outcome is far from beneficial; output and investment fall and inflation rises as rising interest rates increase the cost of capital. Therefore, financial liberalization is stagflationary, which is very much similar to the experience of some developing countries. Stiglitz and Weiss (1981) made an important contribution to the critique of financial liberalization. Their work showed that credit rationing is not special to repressed financial regimes and is not necessarily eliminated in financial markets after interest rate liberalization, as the literature on financial liberalization usually assumes. Information failures in loan markets may lead to credit rationing by banks. The argument is as follows: at higher interest rates, the overall riskiness of bank portfolios becomes higher since the less risky projects are not profitable at the ongoing interest rate and thus firms switch to riskier projects. Moreover, using high interest rates as a screening device may attract bad loans, since borrowers who are willing to pay high rates may be less worried about whether they will be able to pay back the loan or not. As a result, banks prefer rationing credit to raising loan interest rates. According to this imperfect information view, a free interest rate regime alone may not be sufficient for allocative efficiency of capital. In such an environment government intervention in the form of financial repression may be preferable to liberalization. Criticizing this conclusion, Fry (1997, p. 760) notes that there is ‘such a small range of real interest rates over which financial repression could be appropriate, if it is appropriate at all’. Moreover, Fry (1997) appears to agree with Arestis and Demetriades (1997) in their contention that ‘market failure does not necessarily imply government success. . . . [T]he effects of financial liberalization depend upon the institutional context of the economy in question and, particularly, the existence or otherwise of good governance’ (p. 796), a view that ironically does not exclude the possibility of credit rationing. An interesting contribution that makes the point that financial development can be regressive and thereby affect adversely the poor is the prediction of the widely cited model of Greenwood and Jovanovic (1990). A set-up cost is required when


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getting involved in the financial sector and benefiting from the screening and risk-pooling that it offers. Poor households may not be able to incur this cost, hence falling even further in the distribution of income and wealth. Empirical literature testing the relationship between financial liberalization (or one dimension of it) and growth is quite sizable. The findings, however, are mixed and inconclusive. The general agreement is that a higher level of financial sector development is associated with a higher rate of economic growth (see, for example, Beck et al., 2000 among many).2 However, the experiences of various countries reveal that financial liberalization may be neither a necessary nor a sufficient condition for achieving a high growth rate. Indeed, there may be ‘reverse causation’ too: it could very well be the case that faster growing economies are more likely to choose to liberalize their economies, rather than financial liberalization causing economic growth (Arestis and Demetriades, 1997). It is also stressed that there is a need to carefully manage and sequence the integration of an economy with the global market as part of the financial liberalization package. However, sequencing does not appear to be vindicated in empirical work. A recent study concludes that ‘the ordering of liberalization does not matter in general. Opening the capital account or the stock market does not have a different effect than opening the domestic financial sector. But one exception exists; crashes seem to be larger in emerging markets if the capital account opens up first’ (Kaminsky and Schmukler, 2003, p. 31). Prasad et al. (2003) reach similar conclusions when dealing with the developing world. They conclude that ‘the available evidence does not . . . provide a clear road map for the optimal pace and sequencing’ in financial liberalization and integration. Indeed, ‘there is the unresolved tension between having good institutions in place before undertaking capital market liberalization and the notion that liberalization can itself help import best practices and provide an impetus to improve domestic institutions’ (p. 5). Even when ‘capital flows have been associated with high growth rates in some developing countries, a number of countries have experienced periodic collapse in growth rates and significant financial crises over the same period, crises that have exacted a serious toll in terms of macroeconomic and social costs’ (p. 6). But even if sequencing were to prove effective there would still be the problem of sound macroeconomic framework

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and institutions in more general terms. For it is the case that the current view on financial liberalization is that the quality of macroeconomic policies and institutions, along with that of governance, appears to play an important role in financial liberalization policies (Prasad et al., 2003, especially pp. 10–11). Bekaert et al. (2000) study emerging equity markets before and after they dropped barriers to foreign participation in equity markets and report that many of them exhibit higher average growth rates after the official liberalization dates, without making any statements about the cause and effect relationship. After controlling for various factors that contribute to a country’s economic performance, the authors find that the effect of liberalization on economic growth is small but still positive at about 0.7 to 1.4 per cent and that the effect is stronger in countries with higher levels of secondary school enrolment. In a later study, the same authors find that equity market liberalizations lead, on average, to a one per cent increase in annual real per capita GDP growth over a five-year period and that this effect is not spuriously accounted for by macroeconomic reforms or by business cycles (Bekaert et al., 2001). They also find that investment to GDP ratio rises after capital market liberalizations, whereas the consumption to GDP ratio falls, the trade becomes more negative and the size of the government sector remains about the same. Therefore, they disagree that capital flowing in after liberalization is channelled mainly to consumption. Returning to stock markets, Arestis et al. (2001) provide evidence suggesting that the link between stock market volatility and growth is significantly strong and negative in a time series context; thereby improving substantially on the findings of Levine and Zervos (1998), who utilizing crosssection data conclude that the relationship between stock market volatility and growth is not statistically robust (and positive in some cases). Rodrik (1998) casts doubt on the effect of capital account liberalization on growth. In a sample that includes almost 100 countries, developing as well as developed, he finds no significant effect of capital account liberalization on the percentage change in real income per capita over the period 1975 to 1989. Edwards (2001) finds that the positive relationship between capital account openness and productivity performance only manifests itself after the country in question has reached a certain degree of development. At very low


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levels of domestic financial development a more open capital account may have a negative effect on performance. Edison et al. (2002) find mixed evidence that capital account liberalization promotes long-run economic growth and that the positive effects are most pronounced among countries in East Asia. 3 A further possibility is the impact capital account liberalization may have on macroeconomic policies. Governments in their attempt to promote capital inflows may use capital account liberalization to register their commitment to a broader diet of reforms, thereby signalling good economic policies (Bartolini and Drazen, 1997). The possibility of capital account liberalization ‘forcing’ governments to pursue better macroeconomic policies, through the ‘discipline effect’, has also been suggested. It is argued that ‘if international capital flows become more important for national economic development, and if they respond negatively to bad monetary and fiscal policies, governments may be induced to conduct better macroeconomic policies (Tytell and Wei, 2004, p. 3; see, also Stiglitz, 2000). However, although ‘when the market’s judgment is right, this discipline is valuable, rewarding good policies and penalizing bad’, it is the case nonetheless that ‘markets are not always right’ (Fischer, 1998). It is, therefore, not surprising to discover that this is another aspect of financial liberalization that has not produced supportive causal evidence. Capital account liberalization may induce countries to pursue low-inflation monetary policies, but do not appear to encourage low budget deficits (see, for example, Tytell and Wei, 2004). Rodrik (2001) is even more critical of the ‘discipline effect’: ‘In practice . . . the discipline argument falls apart. Behavior in international capital markets is dominated by mood swings unrelated to fundamentals’. Empirical work on financial liberalization and saving gives no support to the financial liberalization hypothesis. Bayoumi (1993) examines the effect of financial deregulation on personal saving in the United Kingdom. He finds that household saving showed a decline associated with financial innovation; and that saving became more sensitive to wealth, real interest rates, current income and demographic factors. He attributes a fall of 2.25 per cent in the personal saving rate to deregulation alone. Bandiera et al. (2000) find no evidence of positive effect of the real interest rate on saving in eight developing countries. In most cases the relationship is

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negative. Furthermore, the effect of the financial liberalization index on saving is mixed: negative and significant in some countries, positive and significant in some others. One possible reason for the ambiguity of findings in the empirical literature on financial liberalization and growth may arise from the difficulty in identifying and quantifying liberalization in a consistent manner across a wide group of countries. Consequently, different studies have applied different empirical measures. Another reason may be that, while most studies start with essentially the same benchmark cross-country growth model, there is divergence with respect to the set of countries included in the analysis, the sample period that is investigated, the dataset employed, and the estimation technique applied. Another explanation as to why empirical studies do not find the strong effect mentioned in the theoretical papers, is provided by Prasad et al. (2003). Most of the differences in income per capita can be explained by differences in total factor productivity, explained by ‘soft’ factors such as ‘social infrastructure’ (i.e. governance, rule of law, respect for property rights, etc.), and not, as might be expected, by differences in the capital–labour ratio. Under these circumstances, financial liberalization and integration is unlikely to increase growth by itself. It is also true that there are costly crises that many developing countries have experienced in the process of financial integration. As we will discuss further in this paper, a flawed sequencing of domestic financial liberalization, when accompanied by capital account liberalization, increases the chance of banking or currency crises, which are often accompanied by huge output losses.4 Economic growth and poverty We now turn to the discussion of the link between economic growth and poverty. Although economic growth represents increased output for a country in general, there is no guarantee that the gains from growth will be distributed evenly among the various groups. World Bank (2001) puts it very aptly: ‘For a given rate of growth, the extent of poverty reduction depends on how the distribution of income changes with growth and on initial inequalities in income, assets, and access to opportunities that allow poor people to share in growth.’ (p. 52). Broadly, there are two ways in which economic growth can benefit the poor (Klasen, 2001). First, there are direct benefits in which


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economic growth favours the sectors and regions where the poor exist, and the factors of production that the poor own. Although policies designed to work through the direct channel appear more reliable in reducing poverty, they carry the risk that the poor will probably suffer more in times of recession. Second, there are indirect benefits that operate through redistributive policies, especially taxes, transfers and government spending. Economic growth can provide opportunities for redistributing the gains from growth. Growth can generate the fiscal resources to expand investments in the assets of the poor or to expand transfers and safety nets for the poor. Empirical evidence on the relationship between economic growth and poverty has one clear message: as countries get richer, on average the incidence of income poverty falls. Furthermore, the poor in developing countries share in the gains from rising aggregate affluence and in the losses from aggregate contraction (Ravallion, 2001; World Bank, 2001). Using a sample of 80 countries covering four decades, Dollar and Kraay (2002) find that the income of poor (i.e. bottom fifth of the population) rises one-for-one with overall growth in per capita GDP. Moreover, they find that contrary to some popular views, the effect of growth on the income of poor is no different in poor countries than in rich ones; and that the poverty–growth relationship has not changed from the 1960s and 1970s to the 1980s and 1990s. An interesting recent study that builds on Dollar and Kraay (2002) attempts to identify the potential sources of pro-poor growth (Kraay, 2004). Three sources are proposed: ‘(a) a high rate of growth of average incomes; (b) a high sensitivity of poverty to growth in average incomes; and (c) a poverty reducing pattern of growth in relative incomes’ (p. 3). Using a large sample of developing countries, it is found that most of the variation in poverty changes is accounted by growth with the remainder due to poverty-reducing patterns of growth in relative incomes.5 Although in general growth reduces poverty, there is also considerable churning under the aggregate outcomes; for example, some people lose during spells of growth even when poverty goes down on average. Therefore, one has to look ‘beyond averages’ (Ravallion, 2001). The empirical literature presents different findings on what makes growth pro-poor (i.e. which institutions and policies influence the extent to which growth benefits the poor). One common finding is that inflation has a negative effect on poverty. Dollar and Kraay

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(2002) test the impact of a set of institutions and policies (that have been identified as pro-growth in the literature) on the income of the poor and find that openness to international trade and improved rule of law raise incomes of the poor by raising overall incomes and that their effects on the distribution of income is very close to zero. Improving fiscal discipline and stabilizing inflation not only raise overall incomes, but they appear to have an additional positive effect on the distribution of income, further increasing incomes of the poor. Easterly and Fischer (2001) use data from an international poll of 31 869 respondents in 38 countries to find that inflation tends to lower both the share of the bottom quintile of the income distribution and the real minimum wage; it also tends to increase poverty. Datt and Ravallion (1999) find evidence that inflation is a significant determinant of poverty using data for Indian states. Although there seems to be an agreement in the literature on the negative effects of inflation on poverty, the evidence on the effects of social spending, such as health and education, is mixed due to different methodologies or samples. Dollar and Kraay (2002) find that public spending on health and education has no systematic effects on incomes of the poor. They attribute this to the inability of governments in many countries to design social services that are well targeted towards the poor. Filmer and Pritchett (1997) also find little relationship between public health spending and health outcomes such as infant mortality, raising questions about whether such spending benefits the poor. In contrast, Bidani and Ravallion (1997) do find a statistically significant impact of health expenditures on the poor (which they define in absolute terms as the share of the population with income below one dollar per day) in a cross-section of 35 developing countries, using a different methodology. Gouyette and Pestieau (1999) find a simple bivariate association between income inequality and social spending in a set of 13 OECD economies. We have examined in this section so far the strength between financial liberalization and poverty in an indirect way, namely how financial liberalization can affect growth, and whether growth in its turn can affect poverty. There is, however, a noteworthy study (Jalilian and Kirkpatrick, 2002) that attempts to test econometrically the relationship between financial liberalization and poverty through the growth channel in a more direct way. These authors build their work on the assumptions that finance exerts a positive


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and significant influence on growth and that growth of average income leads to growth of incomes of the poor. They then make an attempt to estimate the contribution that financial development makes to poverty reduction in low-income countries, using panel data for 42 countries, including 26 developing and 16 developed countries. The authors estimate two equations: a growth and a poverty regression. In the growth regression, they are interested mainly in the coefficient on the financial development indicator, the estimate of which has a positive sign but a low degree of significance. They try a variety of proxies for financial development, including bank deposit money assets over GDP, which is the preferred indicator in Beck et al. (2000), and net foreign assets over GDP. They control for primary school enrollment, trade regime, change in the rate of inflation, change in the share of trade in GDP, initial real per capita income, change in manufacturing value added over GDP and public expenditure on education. They also include a developing country dummy to test the hypothesis that it is developing countries that benefit most from financial development, for which they find positive evidence. The poverty regression that the authors run is inspired by the work of Dollar and Kraay (2002), which finds that growth has been beneficial for the poor. Here, the growth rate of the incomes of the poor (the lowest quintile) is regressed on the growth rate of the average income in the country. The main finding is that growth benefits the poor at least as much as it benefits the average. Control variables in this regression include the change in the Gini coefficient and the change in the rate of inflation, both of which have negative and significant coefficient estimates, and also the change in government expenditure, initial real income per capita and a developing country dummy variable. Having run these two regressions, the authors combine the estimates in an equation that expresses the effect of financial development on poverty: the first effect is the indirect (trickle-down) effect, which works through economic growth. The second one is the possible direct effect of financial development on poverty. However, the authors assume that the second effect is zero, on the grounds that the measures of financial development, utilized for the purposes of their study, are correlated with the growth rate of GDP and, therefore,

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cannot be included separately in the poverty regressions. Consequently, the impact of financial development on poverty is only expressed as the product of two derivatives; the rate of change in the growth of income of the poor with respect to one per cent change in the growth of average income of population and the change in growth of average income with respect to a unit change in financial development. The estimation of the two regressions as described above yields an average value of 1 for the first term in the product and 0.4 for the second term. Hence, the authors conclude that one unit change in financial development leads to a 0.4 per cent change in the growth rate of the incomes of the poor. A more recent study that attempts to study the link between financial liberalization and poverty is Honohan (2004). A cross-section of ‘some 70-odd’ developing countries is utilized to empirically test the hypothesis that ‘deep financial systems appear to be associated with lower poverty’. With the poverty dependent variable defined as ‘the share of population below $1 a day’, and independent variables that include GDP per capita, inflation, governance variables, and non-government (private) credit as the financial variable, Honohan (2004) concludes that ‘Taken literally – and we should not do this except as a rough indication of the size of the effect – the estimates imply that a ten percent point in the ratio of private credit to GDP should (even in the same mean income level) reduce poverty ratios by 2.5 to 3 percentage points’ (pp. 9–10). Using the higher poverty threshold of ‘$2 a day’ produces results, that are not as strong for the private credit variable (it is even insignificant in some instances) as they are in the ‘$1 a day’ case. When stock market capitalization and/or market turnover, or bank concentration, are employed as independent variables instead of private credit, the results are not even significant for these variables. Honohan (2004) is very careful to warn that these results are merely suggestive than conclusive. Indeed, ‘The analysis is at too aggregative a level to be fully convincing. Additionally, the ways in which financial development is being measured, based mainly on size, are clearly rather weak ones’ (p. 10), and that ‘though useful and readily available, banking depth is unlikely to be a wholly reliable summary indicator’ (p. 15). We would add the further problematic nature of cross-country regressions, especially that of heterogeneity of coefficients across countries, and the possibility of cross-section estimates not corresponding to country-specific


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estimates, among many other problems of the kind dealt with in Arestis et al. (2004). What we learn from the literature on financial liberalization, growth and poverty is that there is more agreement on the existence and strength of the link between economic growth and poverty than that between financial liberalization and economic growth. That financial liberalization brings economic growth is a strong assumption in many cases. The growth and poverty reduction effects of financial liberalization depend on the distributional changes induced by growth and the set of institutions and policies that accompany liberalization.6

The financial crises channel The positive view about financial liberalization in the tradition of McKinnon (1973) and Shaw (1973) has been clouded by the substantial increase in financial fragility experienced in many countries in the 1980s and 1990s in the aftermath of pursuing financial liberalization policies (see, for example, Arestis and Glickman, 2002). In some countries, banking sector problems started soon after the deregulation of the financial sector (see, for example, Diaz-Alejandro, 1985). Fast growing economies in Latin America and East Asia all of a sudden faced recessions and the booming capital flows faded away; in fact, ‘the process of capital account liberalization appears to have been accompanied in some cases by increased vulnerability to crises. Globalization has heightened these risks since cross-country financial linkages amplify the effects of various shocks and transmit them more quickly across national borders’ (Prasad et al., 2003, p. 5). These developments sparked discussions among economists about ways of preventing and alleviating crises. Some criticized financial liberalization policies and suggested putting some limits on capital flows to moderate the boom–bust patterns (see, for instance, Stiglitz, 1999; Arestis and Glickman, 2002). In terms of the issue in hand, these developments raise the related issue of the impact of financial crises on poverty and of policies to alleviate them. It has actually been argued that financial crises are the most important cause of large increases in poverty, which are also associated with rising income inequality. Policies in response to financial crises have tended to ignore possible implications on poverty. But

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even in those rare occasions when governments attempted to account for the impact of financial crises on the poor ‘their efforts are frustrated by the lack of institutional capacity to implement specific programs in the heat of a crisis and by severe information problems’ (Lustig, 2000, p. 3). We begin our discussion in this section by first attempting to deal with the issue of the way(s) financial liberalization can lead to financial crises. This is then followed by a discussion of how financial crises may affect poverty. A relatively early contribution on the issue of how financial liberalization can lead to financial crises is the study by McKinnon and Pill (1997), where a simple two-period model of borrowing and investing is employed. It is shown that capital markets could go wrong when uncertainty about payoffs to new investments increases as a country moves from repression to reform. When there is moral hazard in the capital market and international financial flows are unrestricted, with the presence of deposit insurance, banks lend exuberantly, which sends over-optimistic signals to firms about the outcome of the reforms. Thus, overborrowing and overinvestment occur. Savings decline and the current account deficit grows rapidly. If the outcome of the reform turns out to be less favourable than expected, firms have trouble repaying investment loans and this puts the banking system in serious trouble. Bacchetta and Wincoop (1998) study capital flows in recent years and contend that the wave of financial liberalization and structural reforms is the fundamental factor behind the increase in capital inflows to some developing countries. The authors show that it is possible to reproduce some main features of capital inflows to emerging markets, such as overshooting of asset prices, volatility of financial markets and contagion by using a rather simple model and without relying on irrational or herding behaviour. Arestis and Glickman (2002) are also concerned with the impact of financial liberalization on financial crises, in a study based on Minsky’s (1986) ‘financial instability’ hypothesis that is extended to the open economy, ‘liberalized’ case. The thrust of the explanation in this study is located in the endemic instability of financial markets. High growth and low unemployment are threatened by this instability. Financial liberalization intensifies this threat by acting as the key euphoria-inducing factor. Under financial liberalization, economies are forced to bear a greater degree of ‘ambient’ risk (Grabel, 1995)


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than otherwise, so that the euphoria promulgated by financial liberalization produces financial crises. Empirical work on the impact of financial liberalization on macroeconomic volatility and crises provides evidence of an increased likelihood of eventually being hit by financial crises for countries that have gone through financial liberalization (see below where financial crises are defined). According to Kaminsky and Schmukler (2003), although equity markets stabilize in the long run (i.e. in five years or longer) if financial liberalization persists, the amplitudes of booms and crashes substantially increase in the immediate aftermath of financial liberalization. That is, financial liberalization tends to trigger larger financial cycles. The authors also find that the short-run effects of financial liberalization vary across mature and emerging markets. In emerging markets, the short-run effects are more pronounced. Booms and crashes increase in the immediate aftermath of financial liberalization by about 35 per cent over their size during repression. In mature markets, even when financial liberalization triggers more volatile stock markets in the short run, booms and busts do not increase as much as in the case of emerging markets. Moreover, mature markets experience larger bull markets but less pronounced bear markets in the aftermath of financial liberalization, which supports the view that financial liberalization is beneficial for them even in the short run. However, the experience of emerging markets suggests that larger booms and crashes emerge immediately following financial liberalization. How do financial crises affect poverty? Before we attempt to deal with this question, it may be fruitful to define financial crises, which comprise for this purpose both currency and banking crises. Eichengreen and Bordo (2002) define these crises as follows: ‘For an episode to qualify as a currency crisis, we must observe a forced change in parity, abandonment of a pegged exchange rate, or an international rescue. For an episode to qualify as a banking crisis, we must observe either bank runs, widespread bank failures and suspension of convertibility of deposits into currency such that the latter circulates at a premium relative to deposits (a banking panic), or significant banking sector problems (including but not limited to bank failures) resulting in the erosion of most or all of banking system collateral that are resolved by a fiscally-underwritten bank restructuring’ (p. 16). This way of defining banking and currency crises means that between

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1980 and 1998 there were 128 currency crises (they peaked in 1982, 1986 and 1992, with more than 10 crises in each year), and 53 banking crises (and in the years 1981, 1987, 1994 and 1998 there were more than five crises in each year). There were also five ‘twin crises’ (that is, banking and currency crises in the same year) over the same period. We may return to the channels through which financial crises affect poverty, and begin by making the important point that financial crises may not only affect the current living standards of the poor, but also their ability to grow out of poverty. There are a variety of channels through which crises affect poverty and income distribution (Baldacci et al., 2002; Ferreira et al., 1999). First, crises typically lead to a fall in earnings of both formal and informal sector workers because of job losses in the formal sector and a decline in the demand for services in the informal sector. These changes may have different impacts on workers with different skills and different levels of job security. Second, changes in relative prices caused by a crisis will have some effects on the distribution of income. Currency depreciation leads to a decline in the price of non-tradeables relative to tradeables, leading to a fall in the earnings of those working in the non-tradeables non-sector. If an increase in demand for exports follows the currency depreciation, then higher employment and earnings in the exporting sectors may follow, which offsets some of the income loss. However, if food is imported, then the exchange rate change can easily hurt those of the households that are net consumers of imported food.7 Thirdly, contractionary fiscal policy that is traditionally implemented in response to a crisis leads to cuts in social programmes. This may limit the access of the poor to some essential services at a time when their incomes are falling. Fourthly, changes in interest rates as well as changes in asset and property prices affect different sections of the income distribution differently. Especially higher interest rates, which are normally associated with financial liberalization, have significant redistributional effects that affect the poor harshly, but reward the rich handsomely. Additional reasons why crises may affect the poor more include the ‘labour hoarding’ hypothesis, highlighted by Agénor (2002a) and the asymmetric effects of increased rate of inflation on the poor. The ‘labour hoarding’ hypothesis indicates that unskilled workers (typically poor people) are often the first to lose their jobs as firms


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‘hoard’ their trained labour force. This is related to the existence of high costs of hiring, training and firing skilled labour and the more the shock is perceived to be temporary, the greater the incentive to ‘hoard’ skilled workers. The increased rate of inflation that tends to accompany the shocks and their resolution may also affect the rich and the poor differently (Easterly and Fischer, 2001). As the poor normally hold a greater proportion of their wealth in cash than the non-poor, they tend to be more affected by the increased rate of inflation (which is a tax on money holding). Also, as nominal wages are not perfectly linked to the price index, inflation leads to a decline in real wages. This affects the poor more than the rich because poor people do not have capital rents. Moreover, labour earnings constitute a much larger share of their total income. There are also other reasons, which relate specifically to the Latin American countries, although they would be applicable in the case of other countries. Lustig (2000) shows that crises not only result in higher poverty rates, but also may cause irreversible damage to the human capital of the poor. In Latin America, the poor are vulnerable to negative shocks for a variety of reasons. They have little or no access to public social insurance schemes because they are largely either self-employed or unpaid family workers. Even when they are wage earners, they often work for employers who have difficulties in complying or are unwilling to pay their share in a contributory system. Since enforcement mechanisms tend to be weak for smaller and micro firms, non-compliance can be large. Also, the poor may be precluded from access to social insurance because of legal restrictions, such as is the case with domestic workers. Most of the empirical evidence on the effects of crises on poverty supports the argument that crises have an aggravating effect on poverty. Lustig (2000) shows that out of 20 crises in Latin America, all were followed by an increase in the poverty headcount ratio, and 15 of them by a rise in the Gini coefficient. Baldacci et al. (2002) estimate the impact of financial crises on the incidence of poverty and find that both macro and micro data show an increase in poverty due to a financial crisis. Studying the particular case of Mexico, they find that poverty rates soared and the poverty gap widened, relative to pre-crisis period, owing to increase in formal unemployment, notably in urban areas, and the insufficient adjustment of the level of social safety net in a period of rising inflation. In contrast, Dollar

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and Kraay (2002) discard the idea that crises are particularly hard on the poor. Defining a crisis as an episode of negative per capita GDP growth of at least five years, they find that income of the poor (i.e. the poorest one-fifth of the population) does not decline more than the mean income does in crisis episodes. Yet, they acknowledge that the same proportional decline in income could have a greater impact on the poor if the safety nets are weak, thus making crises harder on the poor. Levinsohn et al. (1999) find that the poor in Indonesia have been hit the hardest by the dramatic price increases that resulted from the recent financial crisis. Therefore, the notion that the very poor are insulated from international shocks is not right, at least in the Indonesian case. A closely related issue is whether output contractions normally associated with financial crises have an asymmetric effect on poverty.8 Lustig (2000; see, also, De Janvry and Sadoulet, 2000) argues that financial crises and the consequent loss of real income may have an irreversible impact on the human capital of the poor. Consequently, temporary negative shocks are thought to have persistent effects. The evidence on this issue, however, appears to be pretty mixed (Agénor, 2001). Agénor (2001) conducts further investigation and examines four channels in an attempt to uncover possible effects on poverty: the expectation and confidence channel; credit rationing at the level of the firm; the household borrowing constraint channel; and the ‘labour hoarding’ hypothesis channel. Agénor (2001) employs the VAR approach in the case of Brazil over the period 1981–99, using annual data and also employing an impulse response analysis, to conclude in favour of significant asymmetric effects: ‘the response of the poverty rate to output shocks is state dependent; when output is initially above trend, any positive shock tends to lower poverty. By contrast, in a recession or in a period of severe contraction, output shocks have no discernible effect on poverty – and neither do they affect unemployment’ (p. 21). One may generalize the state of current evidence on this issue by suggesting that financial liberalization can affect a country’s vulnerability to financial crises, which are likely to hurt the poor disproportionately. Financial crises affect not only the current position of the poor, but they also lead to a reduction in the limited human capital of the poor, thereby affecting their ability to grow out of poverty. The challenge for policy makers then is primarily to take appropriate


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measures to avoid crisis situations if the decision to liberalize the financial sector has already been made. The roles of exchange rate policy, capital controls and counter-cyclical fiscal policy in generating or avoiding crises should be seriously taken into consideration, along with relevant policies (see Lustig, 2000, pp. 6–11, for a detailed discussion). Lustig (2000) summarizes the relevant policies that include: (i) improved prudential regulation and supervision of financial intermediaries; (ii) new standards of data dissemination; and (iii) implementation of corporate bankruptcy reforms. It is equally important to choose pro-poor responses to crises in those cases when they cannot be avoided. The incomes of the poor should be protected in the face of macroeconomic adjustment by using appropriate policy options, such as by maintaining safety nets and by carefully selecting the composition of fiscal adjustment. For it is the case that ‘Socially responsible macroeconomic policy in crisis avoidance and crisis response can contribute simultaneously to lower chronic poverty and higher growth’ (Lustig, 2000, p.18).

The access to credit and financial services channel The financial liberalization process may have some profound effects on the availability of credit and financial services for the poor. The proponents of financial liberalization argue that it leads to financial deepening and better access to credit for previously marginalized borrowers and savers. Reduction of reserve requirements increases the supply of credit for a given level of deposits. A rise in the rate of interest increases savings and bank deposits thereby allowing banks to supply more loans. Furthermore, the removal of barriers to entry increases competition among the providers of financial intermediation and motivates banks to extend their services to traditionally excluded sections of the population (Chigumira and Masiyandima, 2003). This opens up new financial options for savers and borrowers. Bayoumi (1993) finds that the saving function of households in the United Kingdom changed noticeably as a result of widespread domestic financial deregulation; however the effects on the poor are not investigated. Nonetheless, it is not clear that financial sector reforms will increase the supply of loans to small firms and the poor. As noted by Chigumira and Masiyandima (2003), from the banks’ point of view, it is generally more costly to lend to

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the poor than to large and established companies, because of higher processing, administrative and monitoring costs and higher risk of default. One fundamental distinction between conventional banks and development financial institutions is that bank lending emphasizes profitability rather than other lending criteria, such as the viability of the project or social outreach. Thus, banks may naturally prefer doing business with established companies rather than providing loans to the poor even after financial sector reforms. The poor in developing and transition countries may be offered little or no financial services or access to credit and private market insurance for a number of reasons (Holden and Prokopenko, 2001). First, the demand for deposit facilities may be low, owing to macroeconomic instability or deficiencies in the regulation and supervision of financial institutions. Also, the supply of saving facilities may not be adequate because of high fixed costs or low economies of scale associated with opening bank branches, especially in rural areas. Second, credit risk assessment may be difficult in developing countries, owing to either macroeconomic instability, poor accounting practices that distort the real financial situation of borrowers or inadequate management of the financial institution itself. It may also be that the lack of a strong judicial system and difficulties in bankruptcy procedures limit the lenders’ ability to obtain repayment of their loans. The third reason may be due to the regulation and supervision of financial institutions. In some countries, extremely liberal licensing policies lead to a large number of weak institutions. In other countries, very restrictive requirements reduce competition and increase the power of existing institutions, resulting in a widening of the spread between lending and deposit rates. Inadequate regulation of conduct may effectively tolerate insider lending, thus increasing the credit risk exposure of the financial system. Two further reasons relate directly to restrictions in the access by the poor to these markets, and another to the weak position of the poor as a force in the economy (Lustig, 2000). The first of the two reasons is due to asymmetric information and high transaction costs that restrict access of the poor to credit and other markets. The second reason relates to the limited assets held by the poor, which restricts substantially their ability to have access in these markets. The other reason is due to the little or no voice of the poor to expect and demand protection in the form of pro-poor measures and the introduction


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and implementation of safety nets when necessary. This is particularly serious in times of fiscal and other policy retrenchment. The impact of financial liberalization on the availability and allocation of credit to the poor could also work through the effect of liberalization on the interaction between formal and informal financial markets. In fact, thinking of developing countries, one cannot possibly ignore the formal and informal market interaction, since the informal financial sector has usually a more important role in these countries and paying attention only to the formal sector is misleading. Although the size of the informal sector cannot be assessed accurately, the sector is widely diverse. Floro and Ray (1997) venture a description of the informal sector as follows: ‘At one end of the spectrum is the highly personalistic system of reciprocity among relatives and friends’, which involves transactions that ‘do not carry interest charges. . . Then there are cooperatives, credit unions . . . and other self-help organizations which are owned and operated by their members . . . At the other end is the complex structure of trade and production credit provided by input suppliers and output buyers to their client-producers. Other examples of linked transactions, such as those between a landlord and a laborer or tenant, are also common’. There are also the marketing agents ‘consisting of paddy traders, or commission agents . . . wholesalers and retailers. These agents usually are engaged in moneylending as a means of having a claim over the produced output and of securing the trader’s share in the output . . . market’ (p. 37). In the same study, it is shown that there is considerable link between the financial institutions in the formal and the informal sectors, even in the absence of government intervention. The flow of funds is thought to be from the formal to the informal credit sector. The point, however, to make is that financial liberalization that expands the formal sector at the detriment of the informal sector, can hurt the poor in a big way in view of the fact that the poor operate mainly in the informal sector as the quote above clearly testifies. The point needs further elaboration. Lensink (1996) argues that financial liberalization of the formal sector may lead to a decline in savings and hence in the quantity of investment by reducing the overall allocative efficiency of capital. In a number of sub-Saharan African countries savings and the efficiency of investments failed to improve following financial reform programmes that focused strongly on the formal banking sector.

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What the liberalization programme failed to recognize is that the formal banking sector in sub-Saharan Africa is relatively unimportant for the financing of investment projects. The bulk of the population makes little or no use of the formal savings and lending institutions, as Miracle et al. (1980) make clear: ‘the great bulk of the African population makes little or no use of financial savings and lending institutions. There are few banks in most areas, and those that are found are either not available to, or if available not used by, the majority of the population for a variety of reasons’ (pp. 701–2). In contrast, a flourishing informal financial sector exists (see, for example, Taylor, 1983). Moreover, information problems (imperfect information, moral hazard and enforcement problems) can be severe in the formal financial sector, in a way that these problems are not in the informal sector. The lenders in the informal sector solve these problems by lending to a particular group of clients with whom they usually work and live in the same village. Since the informal lender has better knowledge of the borrower than the formal lender, it has better opportunities to discriminate among borrowers with high and low risks and is better able to charge appropriate interest rates. This informational advantage applies particularly to rural investment projects, since in rural areas only a few formal banks exist. In such an environment, financial liberalization can shift funds from the better informed informal to the poorly informed formal sector. This will reduce the overall efficiency of capital allocation process. Therefore, a financial liberalization programme that ignores the existence of the informal sector may eventually lead to a worsening of resource allocation and investment quality (Lensink, 1996). Obviously, the poor will not be the winners. But the poor would lose even if the informal sector were to be supported directly, through the creation, for example, of ‘rural credit centres’ to act as agents of the formal sector banks. Clearly, the informational problems of the informal sector are solved as suggested above, but only by lending to ‘a small number of borrowers, mainly large farmers and other rural agents who can provide collateral’ (Floro and Ray, 1997, p. 34; see, also, Lensink, 1996, p. 165). This small group is unlikely to include a significant percentage of poor borrowers. Consequently, even if financial liberalization caused funds to flow into the informal sector, it is not certain that the poor would necessarily benefit.


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Floro and Ray (1997) discuss the complex links between formal and informal financial institutions in developing countries. The lack of information about borrower characteristics, collateral requirements etc. in the formal credit sector constrains its ability to meet effectively the credit needs of small enterprises, who turn to the informal credit sector. Informal financial institutions usually operate both in rural and urban areas, representing a major source of credit for many borrowers. One way of interaction between the two is horizontal: individuals first try the formal market; excess demand spills over to the informal market. The other is vertical: informal lenders have access to formal sources of lending; they re-lend the funds they borrow from the formal market. In the case of vertical integration, one question is whether the terms of credit for informal borrowers will improve when an expansion in formal credit is created. We have argued above that this is unlikely to benefit the poor, unless of course there is significant government intervention. This may take the form, for example, of specifically designed loan policies at below-market interest rates, with the single-minded objective of targeting the poor. The authors claim, quite rightly, that the answer to the question posed towards the end of the last paragraph depends on the market structure of the informal credit system. In the case of the Philippines, they argue that there is evidence of noncompetitive behaviour among rice millers (the highest rank of the informal credit hierarchy) supported by accounts of comprehensive information sharing, collective monitoring, price setting and substantial capital requirements that set barriers to entry. Rice millers lend funds to traders in the form of cash advances for buying the output of rice farmers. The authors observe that millers have some influence on the terms offered to the farmers by the traders, that is, that the effect of noncompetitive behaviour among the millers is transmitted down the ladder. The kind of noncompetitive market structure envisioned by the authors is collusive behaviour in a repeated game setting. Each rice miller (lender) has a particular niche of borrowers; therefore each has an incentive to undercut activities of another lender in his niche. These incentives are balanced by a threat of a credit war in which deviant lenders are punished by a retaliatory expansion of credit in their territory. The greater the access to credit of lenders, the bigger the threat and the easier it may be to sustain collusion. In such an environment, an expansion of formal credit to informal

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lenders may not be used but held only as a potential threat, facilitating collusion. Therefore, credit expansion by the formal sector to rice millers, for instance, as part of a financial reform package, does not necessarily increase the availability or improve the terms of credit to small farmers and the poor in more general terms. In any case, under the conditions examined in both the Lensink (1996) and the Floro and Ray (1997) studies, the nature of the interaction between the formal and informal financial sectors has to be kept in mind when designing liberalization programmes. For the impact on the poor can be considerable. Empirical research on whether financial liberalization improves access to credit by the poor and the marginalized is so far rather limited. The findings are usually not very optimistic. The results from Euler equation estimations by Bandiera et al. (2000) suggest that financial liberalization has had little impact on the availability of credit to consumers through the formal financial sector in eight developing countries: Chile, Ghana, Indonesia, Korea, Malaysia, Mexico, Turkey and Zimbabwe. Chigumira and Masiyandima (2003) report that in Zimbabwe financial sector reforms begun in 1991 had some positive effects. Removal of controls on interest rates and credit along with easing of financial sector entry restrictions resulted in increased financial depth as entry into the financial sector went up and a wider variety of financial products became available for the majority of the population. After the early years of reform real incomes increased, leading to higher savings. Both total domestic credit and private credit increased. However, high and unstable inflation starting from the late 1990s dampened savings as savers tended to switch back to physical inflation hedges as opposed to financial savings. Further problems were also evident in Zimbabwe. Chigumira and Masiyandima (2003) suggest that ‘Much of the increase in the private sector credit was mainly for established borrowers as opposed to the small and medium scale enterprises (SMEs), which got on average less that 5% of the total domestic credit supply even if their proportion of savings in the economy’s total financial savings is high’ (p. 52). Two main reasons were put forward to explain that experience. First, banks continued to use conventional lending methodologies, which focus on collateral security, capacity, character of borrower, initial capital outlay and business track record, which commonly lack among the SMEs and the poor. Second, the implementation of reforms in an


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unstable macroeconomic environment led to high lending rates. With high and uncertain inflation rates, nominal interest rates were pushed to significantly high levels, even though real interest rates were low. The excessive lending rates discouraged SMEs and the poor from borrowing. Amonoo et al. (2003) provide some evidence on the effects of financial liberalization in Ghana. Specifically, they study how rises in interest rates that come with the adoption of financial liberalization affect the demand for credit and loan repayment by the poor and the SMEs in a rural region of Ghana. They find a negative relationship for both cases. Hence, they infer that lowering interest rates would increase the demand by the poor and SMEs for credit and loan repayment at banks and non-bank institutions. Consequently, available evidence suggests that financial liberalization can have consequences for access to the financial market by small customers and the poor. Whether these consequences are adverse or beneficial is far from clear. On the one hand, increased competition and improved distributional efficiency will lead financial institutions to seek markets normally rationed out, that is, small borrowers with good business prospects and insufficient collateral. In doing so they may extend financial services to a larger share of the population and contribute to financial innovation. On the other hand, financial sector reforms may also leave the basic structure of the banking system unchanged, thereby protecting or reinforcing the oligopolistic position of banks. In this case, the customers usually excluded from financial transactions will not benefit from greater access. Some marginal customers may even be excluded. In many countries, financial sector reforms so far have not embraced the broad agenda of developing the institutional structure and new instruments to satisfy the financial needs of small enterprises and the poor. The focus has mainly been on liberalizing interest rates and encouraging entry into the formal financial institutions. These are not sufficient to improve access to credit and financial services by the poor, given the empirical evidence on the experience of some developing countries with financial liberalization. Even if credit and financial services are extended to small customers and the poor, it is unlikely that improved access by itself will eradicate poverty; indeed, and as Morduch (1999) suggests, ‘Alleviating poverty through banking is an old idea with a checkered past. Poverty alleviation through the provision of subsidized credit was a centerpiece of many

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countries’ development strategies from the early 1950s through the 1980s, but these experiences were nearly all disasters’ (p. 1570). The evidence produced by Morduch (1999) points to the conclusion that ‘the greatest promise of microfinance is so far unmet, and the boldest claims do not withstand close scrutiny’ (p. 1571), and still ‘The best evidence to date suggests that making a real dent in poverty rates will require increasing overall levels of economic growth and employment generation. Microfinance may be able to help some households take advantage of those processes, but nothing so far suggests that it will ever drive them’ (p. 1610). Therefore, although the highly motivated and entrepreneurial candidates probably use the new set of opportunities well and benefit from access to credit, those who lack the skills or the determination to manage their finances are destined to end up in bankruptcy. Ultimately, it would appear to be the case that it is on the employment/unemployment front that the battle against poverty may be won. Policies to enhance access to credit by the poor If the financial liberalization process by itself does not improve the access to credit and financial services by the poor, then policy makers should satisfy some requirements to make sure financial services are more readily available to all segments of the society. Holden and Prokopenko (2001) emphasize that the first requirement is the establishment of macroeconomic stability, yet it is not a sufficient condition. Another requirement is establishing a basis for adequate regulation and supervision of financial institutions. Unless constrained by regulation, the managers of financial institutions may not have sufficient incentives to keep risk within acceptable limits. Effective regulation and supervision may be especially important in developing and transition countries because of a greater need for building public confidence in the financial system. However, excessive constraints on financial institutions may increase the costs of operating in some areas and, therefore, may reduce the probability of promoting financial services to the poor. Holden and Prokopenko (2001) also mention the need for financial institutions that are specialized in certain industries or certain types of lending, such as factoring and leasing companies or mortgage finance companies. They argue that these institutions are in a better position than large multi-purpose institutions to assess financial and investment


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plans in their field of expertise. They can help small and medium size enterprises with their financing needs in cases where commercial banks that dominate the financial sector lend only to large and wellestablished firms. To alleviate credit risk assessment problems, financial institutions in developing and transition countries may also consider using some simple credit scoring models (Holden and Prokopenko, 2001). In cases where poor accounting records prevent these institutions from using traditional methods of credit assessment, these simple models can work well enough to satisfy the need. Along similar lines, the authors also recommend establishing credit information bureaus (centralized databases that include financial information on enterprises), which can help reduce financial constraints resulting from underdeveloped financial markets. They also recommend strengthening property rights in developing and transition countries. Effective and secure property rights allow the development of financial markets by reducing adverse selection and moral hazard problems. Chigumira and Masiyandima (2003) recommend that the lending criteria of conventional financial institutions be revised to make them more appropriate for micro-borrowers. New approaches, such as the use of solidarity groups, village banking or group lending where group members guarantee each other, can be implemented. Such risk-sharing schemes may encourage banks to lend to the poor at low cost, low risk and without any form of traditional collateral. Last, but not the least, the role of micro-finance institutions should be emphasized. These institutions have the advantage of proximity to the market they serve and, therefore, enjoy better knowledge of the community. They complement the formal financial system by providing services to the parts of the society that have limited access to the formal system (Holden and Prokopenko, 2001). Chigumira and Masiyandima (2003) report that the emergence of micro-finance institutions in the late 1990s in Zimbabwe helped narrow the loan gap of the poor. Owing to their more appropriate and effective lending methodologies and their strategic locations, these institutions have managed to service the poor and the SMEs with more success than conventional banks. The authors maintain that the promotion of linkages between the formal and informal financial institutions would facilitate the design of diversified savings instruments that take into account the investment needs of the

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poor. The authors would like to see a consolidation of micro-finance institutions into the conventional banking sector by regulating these institutions and allowing them to collect savings as well as provide credit.

Summary and conclusions The experience with financial liberalization in the past two decades has shown that the process has a complex relationship with respect to changes in the living standards of the poor. It is usually assumed in the literature that an economic expansion brought about by the liberalization of interest rates, removal of barriers to entry to financial markets, opening up borders to capital flows and letting markets determine exchange rates will eventually benefit the poor via a trickle-down effect. Evidence tells us that this is not always the case. Although financial repression may not be desirable, its alternative is not traditional liberalization. When financial liberalization is applied without first maintaining macroeconomic stability and establishing the supporting institutions and policies, even when it brings economic expansion, it often comes at the cost of devastating crises and increasing economic inequality. Without adequate regulation and supervision, financial institutions may take excessive risks. The poor appear to pay a higher price than the rich in the aftermath of these crises. It is important to provide the poor with sufficient access to consumption smoothing mechanisms to alleviate poverty. For this purpose, various measures have to be taken. Revising the credit evaluation and lending criteria of financial institutions to make them more appropriate for small-scale borrowers is one such measure. Setting the legal and institutional framework for alternative lending practices, such as group lending, is another one. Equally important as providing access to credit and financial services is providing the poor with education, safety nets and basic health services. Unless they are equipped with the proper skills to take advantage of the financial services and to manage the debt, the poor may not benefit at all from the new set of prospects. The core of the discussion is that if financial liberalization were to be introduced, it must be designed with poverty reduction as its thrust in order to benefit the poor. Otherwise, the market by its nature


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will benefit those who already have access to economic resources or to information and those who are strategically positioned to take advantage of the opportunities offered by the market.

Notes 1. The empirical evidence produced by Agénor (2002b), however, suggests that ‘there appears to be a reasonably robust, non-monotonic . . . relationship between poverty and globalization . . . at low degrees of globalization, globalization does not hurt the poor. However, at higher levels, globalization leads to a decline in poverty’ (p. 3). 2. A recent IMF study (Favara, 2003) fails to establish significant coefficients on financial variables in instrumented growth regressions, contrary to the evidence produced by Levine et al. (2000). Interestingly enough, Rousseau and Wachtel (2001) report that in high inflation countries the possible effects of finance on growth weaken substantially. 3. An interesting question on the issue of capital account liberalization is how to measure it. One measure is based on the official restrictions on capital flows as reported to the IMF by national authorities, the so-called de jure measures. This, however, does not measure the intensity of capital controls. To capture this effect, the measure used is based on the estimated gross stocks of foreign assets and liabilities in relation to GDP, the so-called de facto measure (Tytell and Wei, 2004). 4. This argument in the text is particularly relevant in the case of developing countries. Theory and evidence (see, for example, Prasad et al., 2003) suggest that this can be explained by a number of factors, most important of which may be the following. International investors tend to engage in ‘momentum trading and herding’, and thereby speculative attacks on developing country currencies. The risk of contagion is always a real threat given that international investors initiate withdrawal of capital for reasons that are normally not related to domestic fundamentals and factors. 5. There are differences between Dollar and Kraay (2002) and Kraay (2004) in two respects. The first is that Kraay (2004) focuses on absolute poverty measures, while Dollar and Kraay (2004) concentrate on relative poverty measures. The second difference is that while Dollar and Kraay (2002) look at common summary statistics (i.e. Gini coefficient and quintile shares), Kraay (2004) utilizes measures of distributional change for poverty. 6. Interestingly enough, the reverse causality possibility in the relationship between finance and poverty has been discussed in the literature (Honohan, 2004). It is readily recognized, however, that in view of the fact that the poor hold only a very small fraction of aggregate financial assets, poverty rates are highly unlikely to have a causal role in terms of financial development in a significant way. 7. Ma and Cheng (2003) distinguish sharply between banking and currency crises in their study of the effects of financial crises on international trade.

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They conclude that banking crises have a negative impact on imports but a positive impact on exports in the short run. Currency crises negatively impact imports in the short run, but stimulate exports in the long run. 8. The empirical evidence on the costs of financial crises is quite revealing. We may refer to the South East Asian crisis to make the point, and to figures reported in Agénor (2001; see, also World Bank, 2000). Over the period 1997 to 1999, which mostly coincides with the South East Asian crisis, the incidence of poverty (as measured by the national poverty line) increased from 11% to 18% in Indonesia; the urban poverty headcount rose from 8.5% to 18% in South Korea, while in Thailand the incidence of poverty increased from 11.4% to 12.9%. The income of the poor fell as a result of both lower real wages and higher unemployment: in Thailand real wages fell by 4.5% (and unemployment increased from 2.2% in 1997 to 5.3% in 1998); in South Korea real wages fell by 10.6% (and unemployment increased from 2.6% in 1997 to 8.4% in early 1999); and in Indonesia real wages fell by 44% (and unemployment increased less dramatically than in the other two cases referred to in this note, but ‘disguised’ unemployment rose). 9. IFLIP (the Impact of Financial Sector Liberalization on the Poor) is a research-capacity building programme coordinated by the ILO. It aims to contribute to the debate on financial liberalization by generating active research on the effects of financial sector reforms in selected African countries, currently Benin, Ghana, Senegal and Zimbabwe and by integrating research findings into policy making at national and regional levels.

References Agénor, Pierre-Richard (2001), ‘Business Cycles, Economic Crises, and the Poor: Testing for Asymmetric Effects’, Mimeo, Washington, DC: World Bank. Agénor, Pierre-Richard (2002a), ‘Macroeconomic Adjustment and the Poor: Analytical Issues and Cross-Country Evidence’, Policy Research Working Paper No. 2788, Washington, DC: World Bank. Agénor, Pierre-Richard (2002b), ‘Does Globalization Hurt the Poor?’, Policy Research Working Paper No. 2922, Washington, DC: World Bank. Amonoo, E., P. Kojo Acquah and E. Ekow Asmah (2003), ‘The Impact of Interest Rates on Demand for Credit and Loan Repayment by the Poor and SMEs in Ghana’, IFLIP9 Research Paper 03–10. Arestis, Philip and Panicos Demetriades (1997), ‘Financial Development and Economic Growth: Assessing the Evidence’, Economic Journal, 107(442), 783–99. Arestis, Philip, Panicos Demetriades and Kul B. Luintel (2001), ‘Financial Development and Economic Growth: The Role of Stock Markets’, Journal of Money, Credit and Banking, 33(1), 16–41.


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Arestis, Philip and Murray Glickman, (2002), ‘Financial Crisis in Southeast Asia: Dispelling Illusion the Minskyan Way’, Cambridge Journal of Economics, 26(2), 237–60. Arestis, Philip, Ambika, D. Luintel, and Kul B. Luintel (2004), ‘Does Financial Structure Matter?’, Working Papers Series No. 399, Levy Economics Institute of Bard College, Annandale-on-Hudson, New York. Bacchetta, Philippe and Eric van Wincoop (1998), ‘Capital Flows to Emerging Markets: Liberalization, Overshooting and Volatility’, NBER Working Paper, No. 6530, Cambridge, MA: National Bureau of Economic Research. Baldacci, Emmanuel, Luiz de Mello and Gabriela Inchauste (2002), ‘Financial Crises, Poverty and Income Distribution’, IMF Working Paper, WP/02/4, Washington, DC: International Monetary Fund. Bandiera, Oriana, Gerard Caprio, Patrick Honohan and Fabio Schiantarelli (2000), ‘Does Financial Reform Raise or Reduce Saving?’, Review of Economics and Statistics, 82(2), 239–63. Bartolini, Leonardo and Allan Drazen (1997), ‘Capital Account Liberalization as a Signal’, American Economic Review, 87, 138–54. Bayoumi, Tamim (1993), ‘Financial Deregulation and Household Saving’, Economic Journal, 103(421), 1432–43. Bekaert, Geert, Campbell R. Harvey and Christian Lundbland (2000), ‘Emerging Equity Markets and Economic Development’, NBER Working Paper, No. 7763, Cambridge, MA: National Bureau of Economic Research. Bekaert, Geert, Campbell R. Harvey and Christian Lundbland (2001), ‘Does Financial Liberalization Spur Growth?’ NBER Working Paper, No. 8245, Cambridge, MA: National Bureau of Economic Research. Beck, Thorsten, Ross Levine and Norman Loayza (2000), ‘Finance and the Sources of Growth’, Journal of Financial Economics, 58, 261–300. Bidani, Benu and Martin Ravallion (1997), ‘Decomposing Social Indicators Using Distributional Data’, Journal of Econometrics, 77, 125–39. Burkett, Paul and Amitava Krishna Dutt (1991), ‘Interest Rate Policy, Effective Demand and Growth in LDCs’, International Review of Applied Economics, 5(2), 127–54. Chigumira, Gibson and Nicolas Masiyandima (2003), ‘Did Financial Sector Reform Result in Increased Savings and Lending for the SMEs and the Poor?’, IFLIP Research Paper 03–7. Datt, Gaurav and Martin Ravallion (1999), ‘When is Growth Pro-Poor? Evidence from the Diverse Experiences of India’s States’, Mimeo, Washington, DC: World Bank. De Janvry, Alain and Elisabeth Sadoulet (2000), ‘Growth, Poverty, and Inequality in Latin America: A Causal Analysis’, Review of Income and Wealth, 46, 267–87. DeLong, J. Bradford, Andrei Schleifer, Lawrence H. Summers and Robert J. Waldmann (1989), ‘The Size and Incidence of the Losses from Noise Trading’, Journal of Finance, 44(3), 681–96. Demirgüç-Kunt, Asli and Ross Levine (1996), ‘Stock Markets, Corporate Finance and Economic Growth: An Overview’, World Bank Economic Review, 10(2), 223–39.

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Devereux, Michael B. and Gregor W. Smith (1994), International Risk Sharing and Economic Growth’, International Economic Review, 35, 535–51. Diaz-Alejandro, Carlos F. (1985), ‘Good-Bye Financial Repression, Hello Financial Crash’, Journal of Development Economics, 19 (1–2), 1–24. Dollar, David and Aart Kraay (2002), ‘Growth is Good for the Poor’, Journal of Economic Growth, 4, 239–76. Easterly, William and Stanley Fischer (2001), ‘Inflation and the Poor’, Journal of Money, Credit, and Banking, 33(2), 160–78. Edison, Hali J., Michael W. Klein, Luca Ricci and Torsten Sloek (2002), ‘Capital Account Liberalization and Economic Performance: Survey and Synthesis’, NBER Working Paper No. 9100, Cambridge, MA: National Bureau of Economic Research. Edwards, Sebastian (2001), ‘Capital Mobility and Economic Performance: Are Emerging Economies Different?’, NBER Working Paper No. 8076, Cambridge, MA: National Bureau of Economic Research. Eichengreen, Barry and Michael D. Bordo (2002), ‘Crises Now and Then: What Lessons From the Lase Era of Financial Globalization?’, NBER Working Paper No. 8716, Cambridge, MA: National Bureau of Economic Research. Favara, Giovanni (2003), ‘An Empirical Reassessment of the Relationship Between Finance and Growth’, IMF Working Paper, No. 03/123, Washington, DC: International Monetary Fund. Federer, J. Peter (1993), ‘The Impact of Uncertainty on Aggregate Investment Spending’, Journal of Money, Credit and Banking, 25(1), 30–45. Ferreira, Francisco, Giovanna Prennushi and Martin Ravallion (1999), ‘Protecting the Poor from Macroeconomic Shocks: An Agenda for Action in a Crisis and Beyond’, Policy Research Working Paper No. 2160, Washington, DC: World Bank. Filmer, Deon, and Lant Pritchett (1997), ‘Child Mortality and Public Spending on Health: How Much Does Money Matter?’, Policy Research Working Paper No. 1864, Washington, DC: World Bank. Fischer, Stanley (1998), ‘Capital Account Liberalization and the Role of the IMF’. Available on the Internet at: . Floro, Maria Sagrario and Debraj Ray (1997), ‘Vertical Links Between Formal and Informal Financial Institutions’, Review of Development Economics, 1(1), 34–56. Fry, Maxwell J. (1995), Money, Interest and Banking in Economic Development, London: Johns Hopkins University Press. Fry, Maxwell J. (1997), ‘In Favour of Financial Liberalisation’, Economic Journal, 107(442), 754–70. Gibson, Heather D. and Euclid Tsakalotos (1994), ‘The Scope and Limits of Financial Liberalisation in Developing Countries: A Critical Survey’, Journal of Development Studies, 30(3), 578–628. Gouyette, Claudine and Pierre Pestieau (1999), ‘Efficiency of the Welfare State’, Kyklos, 52, 537–53. Grabel, Ilene (1995), ‘Speculation-led Economic Development: A Post Keynesian Interpretation of Financial Liberalization Programs’, International Review of Applied Economics, 9(2), 127–49.


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Greenwood, Jeremy and Boyan Jovanovic (1990), ‘Financial Development, Growth and the Distribution of Income’, Journal of Political Economy, 98(5,1), 1076–107. Holden, Paul and Vassili Prokopenko (2001), ‘Financial Development and Poverty Alleviation: Issues and Policy Implications for Developing and Transition Countries’, IMF Working Paper, WP/01/160, Washington, DC: International Monetary Fund. Honohan, Patrick (2004), ‘Financial Development, Growth and Poverty: How Close are the Links’, chapter 1 in G.A.E. Goodhart (ed.), Financial Development and Economic Growth: Explaining the Links, Basingstoke: Palgrave Macmillan. Jalilian, Hossein and Colin Kirkpatrick (2002), ‘Financial Development and Poverty Reduction in Developing Countries’, International Journal of Finance and Economics, 7, 97–108. Kaminsky, Graciela Laura and Sergio L. Schmukler (2003), ‘Short-Run Pain, Log-Run Gain: The Effects of Financial Liberalization’, IMF Working Paper WP/03/34, Washington, DC: International Monetary Fund. Keynes, John Maynard (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Klasen, Stephan (2001), ‘In Search of the Holy Grail: How to Achieve Pro-Poor Growth?’, Mimeo, University of Munich. Kraay, Aart (2004), ‘When is Growth Pro-Poor?’, Cross-Country Evidence’, IMF Working Paper WP/04/47, Washington, DC: International Monetary Fund. Lensink, Robert (1996), ‘The Allocative Efficiency of the Formal versus the Informal Financial Sector’, Applied Economics Letters, 3(3), 163–5. Levine, Ross and Sara Zervos (1998), ‘Stock Markets, Banks and Economic Growth’, American Economic Review, 88(3), 537–58. Levine, Ross, Norman Loayza and Thorsten Beck (2000), ‘Financial Intermediation and Growth: Causality and Causes’, Journal of Monetary Economics, 46, 31–77. Levinsohn, James, Steven Berry and Jed Friedman (1999), ‘Impacts of the Indonesian Economic Crisis: Price Changes and the Poor’, NBER Working Paper No. 7194, Cambridge, MA: National Bureau of Economic Research. Li, Hongyi, Lyn Squire and Heng-fu Zou (1998), ‘Explaining International and Intertemporal Variations in Income Inequality’, Economic Journal, 108(1), 26–43. Lustig, Nora (2000), ‘Crises and the Poor: Socially Responsible Macroeconomics’, Poverty and Inequality Advisory Unit Working Paper No. 108, Brazil: Inter-American Development Bank (Sustainable Development Department). Ma, Zihui and Leonard K. Cheng (2003), ‘The Effects of Financial Crises on International Trade’, NBER Working Paper No. 10172, Cambridge, MA: National Bureau of Economic Research. McKinnon, Ronald I. (1973), Money and Capital in Economic Development, Washington, DC: Brookings Institution. McKinnon, Ronald I. and Huw Pill (1997), ‘Credible Economic Liberalizations and Overborrowing’, Papers and Proceedings, American Economic Review, 87(2), 189–93.

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Minsky, Hyman P. (1986), Stabilizing an Unstable Economy, New Haven: Yale University Press. Miracle, Marvin P., Diane S. Miracle, Laurie Cohen (1980), ‘Informal Savings Mobilization in Africa’, Economic Development and Cultural Change, 28, 701–24. Morduch, Jonathan (1999), ‘The Microfinance Promise’, Journal of Economic Literature, 37(4), 1569–614. Obstfeld, Maurice (1994), ‘Risk Taking, Global Diversification and Growth’, American Economic Review, 84, 1310–29. Prasad, Eswar, Kenneth Rogoff, Shang-Jin Wei and M. Ayhan Kose (2003), ‘Effects of Financial Globalization on Developing Countries: Some Empirical Evidence’, IMF Board Document, Washington, DC: International Monetary Fund. Rajan, Raghuram G. and Luigi Zingales (2003), Saving Capitalism from the Capitalists, New York: Crown Business. Ravallion, Martin (2001), ‘Growth, Inequality and Poverty: Looking Beyond Averages’, World Development, 29, 1803–16. Rodrik, Dani (1998), ‘Who Needs Capital-Account Convertibility?’, Essays in International Finance, No. 207, Princeton: Princeton University Press. Rodrik, Dani (2001), ‘The Developing Countries’ Hazardous Obsession with Global Integration’, Mimeo, Kennedy School of Government: Harvard University. Rousseau, Paul L. and Paul Wachtel (2001), ‘Inflation, Financial Development and Growth’, in T. Negishi, R. Ramachandran and K. Mino (eds), Economic Theory, Dynamics and Markets: Essays in Honor of Ryuzo Sato, Boston: Kluwer, pp. 309–24. Shaw, Edward S. (1973), Financial Deepening in Economic Development, New York: Oxford University Press. Shiller, Robert J. (1989), Market Volatility, Cambridge, Mass.: MIT Press. Stiglitz, Joseph E. (1999), ‘Bleak Growth Prospects for the Developing World’, International Herald Tribune, 10 April. Available on the Internet at: . Stiglitz, Joseph E. (2000), ‘Capital Market Liberalization, Economic Growth and Instability’, World Development, 28(6), 1075–86. Stiglitz, Joseph E. and Andrew Weiss (1981), ‘Credit Rationing in Markets with Imperfect Information’, American Economic Review, 71(3), 393–410. Taylor, Lance (1983), Structuralist Macroeconomics: Applicable Models for the Third World, New York: Basic Books. Tytell, Irina, and Shang-Jin Wei (2004), ‘Does Financial Globalization Induce Better Macroeconomic Policies?’, IMF Working Paper WP/04/84, Washington, DC: International Monetary Fund. World Bank (2000), Global Economic Prospects 2000, Washington, DC: World Bank. World Bank (2001), World Development Report 2000/2001, Oxford University Press: New York.

4 Currency Crises and Instability of Global Capitalism Korkut A. Ertürk University of Utah

Abstract The chapter argues that currency crises are best explained as episodes of asset price bubbles that emerge under conditions of economic liberalization. Three destabilizing processes which correspond to different phases of an asset price bubble are underscored as general features of a currency crisis: overborrowing, overinvestment and capital flow reversals. The relative importance of these processes varies as currency crises have evolved over time. Excessive credit expansion and overborrowing were the destabilizing processes that have played a decisive role in current account driven crises, where capital inflow was predominantly governed by arbitrage opportunities and its reversal tied to rising devaluation risk associated with reserve depletion. Starting with the late 1980s, capital account driven crises have come to predominate as variable price assets, such as bonds and stocks, as opposed to fixed price assets in the form bank loans, became the main conduits of the capital inflow. In these crises, portfolio dynamics driven by speculative expectations on variable price assets, along with the increased predictability of asset prices, set the stage for destabilizing trend speculation on the part of international investors. Foreign investors chased a rising trend of asset prices, and capital flow reversed when they begin to think that asset prices have peaked. Keywords: Currency crises, asset price bubbles, overborrowing, capital flows, volatility JEL Classification: E12, E44, F41 129

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Introduction Currency crises have become a common occurrence around the world in the era of capital account liberalization. Following numerous crises in Latin American in the 1980s, speculative attacks on currency wrecked havoc in the Scandinavian countries in the late 1980s, the European Monetary System in 1991–92, in Mexico in 1994–95, in East Asia in 1997–98, in Russia in 1998, in Brazil in 1999, and in Argentina and Turkey in 2000–2001. And, now (February 2005), we may soon be faced by a dollar crisis that can have severe repercussions for the US and the whole world economy. After each major episode, a new generation of crisis models emerged and a different question or set of questions became the centre of attention, pointing to a new layer of determination that superimposed itself on those that came before. Arguably, we still lack a clear understanding of what has remained the same and what was novel in different episodes of crises. In the 1980s, the traditional view held that countries ran into crisis when they began to experience a steady decrease in their foreign exchange reserves as a result of monetizing rising fiscal deficits. Once the decline in reserves fell below some critical threshold a speculative attack ensued on the fixed exchange rate (Krugman, 1979).1 On the eve of a crisis, countries experienced rising prices, real exchange rate appreciation and an increasing current account deficit, all of which were thought to be the harbingers of a coming débâcle. In the European crisis of 1991–92, speculators perceived a conflict between the fixed parity and the change of direction in macroeconomic policy that appeared likely in the light of unexpected economic developments, triggered mainly by the German unification. Once speculators sensed that countries in question would do better by abandoning the fixed exchange rate parity than defending it, a speculative currency attack ensued. In the academic literature, these crises gave rise to the so-called second-generation models, which emphasized new themes such as multiple equilibria, self-fulfilling nature of speculators’ expectations and governments’ utility functions, among others.2 Both the Mexican (1994–95) and especially the East Asian crises (1997–98) seemed different from what had come before. It was a source of intense disagreement whether the Mexican crisis was essentially

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the same as the earlier Latin American crises because it also involved an unsustainable increase in aggregate demand (Edwards, 1996), or something quite different, caused by a self-fulfilling run on the currency triggered by an array of unexpected foreign and domestic shocks (e.g. Gil-Diaz and Carstens, 1996). But, little ambiguity existed in the Asian crisis. It clearly did not fit the mould of the earlier, so-called first generation crises, as none of the countries involved was running government budget deficits of any significance, nor experiencing any significant depletion of foreign exchange reserves at the time of the crisis. The Asian crisis was also different than the European crisis in that it was followed by a severe recession rather than an expansion of output, as was the case in Europe.3 Of the two main explanations of the Asian crisis, one held that the governments in South East Asia were responsible for the private sector profligacy because of their misguided interventions in the economy, even though they might not have been over-spenders themselves. They gave sweeping guarantees to large corporations and underwrote much of the banking sector in the name of industrial policy, which led to a reckless binge of overinvestment on the part of businesses who knew well that their governments would not let them go under if they failed. According to the second view, the main cause of the Asian crisis was financial panic that was caused by irrational herd behaviour on the part of international investors. Thus, the crisis was caused neither by the problems in the real economy, nor the inconsistent government policies. Abrupt and unpredictable reversals in capital flows, caused by self-fulfilling expectations, were a result of the imperfections in international capital markets. The financial panic thesis did not address why the decline in output was so severe in East Asia. Conventional theory led one to expect devaluations to have an expansionary effect, and that was indeed what seems to have had happened in Europe after its crisis in 1991–92. The question was one of the main issues taken up by what Krugman (2000) called the ‘third generation’ models, where the adverse effects of devaluations on output were tied to problems caused by currency mismatch on the balance sheets of domestic firms that were credit constrained.4 Firms’ net worth fell with devaluation and their ability to access credit suffered, impairing

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their ability finance production even when the devaluation created lucrative opportunities for exports (Aghion et al., 2000, 2001).5

What have been the common features in different crises? Despite their many differences, the successive generations of currency crisis models can be thought to revolve around a similar set of questions. At one level, currency crises appear as a problem of overborrowing made possible by an excessive expansion in bank credit. Often, capital inflow is stimulated by financial liberalization and leads to a credit expansion in the recipient country that is followed sooner or later by a debt problem. Depending on the country, the debt pile up could be either private or public, and owed to either domestic or foreign investors, but the destabilizing dynamics set off appear to be the same. At yet another level, these crises are seen to have resulted from a new breed of speculative attacks where expectations turn into self-fulfilling prophecies. The main stumbling block here has been the abrupt capital flow reversals caused by capricious shifts in investor sentiment. In the ‘first-generation’ models, both problems, overborrowing and the capital flow reversal, were explained by the same mechanism. Monetization of government deficits fuelled an explosive rise in credit supply, giving rise to an unsustainable increase in expenditures and rising prices. A fixed nominal exchange rate led to real currency appreciation and usually went hand in hand with a rising current account deficit. As a result, the devaluation risk steadily rose and brought an end to the capital inflow re-imposing the foreign exchange constraint. The beginning of the ‘end’ came when the depletion in foreign exchange reserves set off a rush among speculators to get out of the domestic currency before the inevitable maxi-devaluation struck. In the crises of the 1990s, the destabilizing processes that needed explanation were still the same. Explosive increases in bank credit gave rise to overborrowing, leading to excessive debt and capital flow abruptly reversed. But to the reserve depletion caused by monetized government deficits was no longer an explanation that seemed applicable. As mentioned earlier, excessive credit expansion took place even when there were no government budget deficits, and


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capital flow reversals could no longer be predictably tied to rising devaluation risk caused by a rising current account deficit and foreign exchange reserve depletion. Instead, financial ratios of various kinds – such as the size of the short term foreign debt relative to foreign exchange reserves – were now thought to foretell capital flow reversals that were self-fulfilling in nature; and, the excessive supply of credit was tied to banks’ unwillingness to hedge against currency risk. Explosive increase in domestic bank credit was often tied to a rising currency mismatch in banks’ balance sheets between their assets and their liabilities.6 Banks were lending internally what they borrowed from outside at a much lower interest rate. As long as the fixed parity held, this was very lucrative for the banks, but it meant that they were exposed to exchange rate risk. The failure to hedge against this risk also meant that their vulnerability to adverse exchange rate movements was increasing along with their open positions. This was thought to be yet another example of excessive risk taking caused by moral hazard, except now it also had a bearing on capital flow reversals. For the rising currency mismatch in banks – that is, when short term liabilities to foreigners exceeded reserves – explained why the international investors would have the jitters; and, that, in turn, could turn into panic whenever some unexpected shock struck, explaining why the crisis broke out when it did.7 Thus, moral hazard began to replace monetized government deficits as the overarching explanation not only of excessive credit expansion and debt build-up, but eventually also of capital reversals. The alternative was to explain capital flow reversals by emphasizing the unpredictability of international investors by referring to ‘irrational herd behaviour’ and contagion effects. Though not very satisfactory from a theoretical point of view, this was at least politically innocuous as it did not lend support to grandiose schemes of remaking the crisis-stricken countries in the image of the US, as it placed much of the blame on the imperfections in international capital markets rather than those in developing countries. But, again, in either view some market imperfection was seen as the ultimate source of the problem. One emphasized the distortions within the domestic economy in developing economies, while the other put the emphasis on the vulnerabilities caused by a malfunctioning international capital market.

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The objective of this chapter is to develop an alternative explanation that seeks to explain currency crises as episodes of asset price bubbles that come into existence not as a deviation from market rationality but as its very expression.8 I argue that the conditions of economic volatility brought about by financial and capital account liberalization can give rise to currency crises even in the absence of the type of imperfections that are mentioned. According to this view, financial liberalization can lead to an explosive increase in bank credit quite independently of moral hazard problems. At the same time, the fact that asset price movements often become fairly predictable stimulates destabilizing ‘trend’ speculation by ‘foreign’ investors. Capital inflow continues as long as asset prices are expected to rise, and asset prices keep rising as long as the capital inflow continues. Capital withdraws once speculators begin to think that asset prices have peaked, leaving behind an exposed banking system and a private sector laden with excessive debt. The levels of debt that seem reasonable when asset prices are high, become excessive when the asset price bubble deflates. This implies that erratic capital flows can be a manifestation of profit taking and market rationality rather than irrational herd behaviour. Thus, the argument that currency crises are but episodes of asset price bubbles that burst can explain both of the two main destabilizing processes, mentioned above, that need explanation in a currency crisis, that is, overborrowing following excessive expansion in bank credit and erratic shifts in capital flows. A defining characteristic of asset price bubbles is that they give rise to overinvestment of capital. In those instances where much of the capital inflow involves investment in industrial capacity, an understanding of currency crises as asset price bubbles also helps to put in perspective the ‘real economy’ causes of these crises. For instance, in the countries that were affected by the Asian crisis, private sector overinvestment and overcapacity were acute (Greider, 1997). Their terms of trade with their richer trading partners had been deteriorating,9 an outcome arguably of overaccumulation of capital in the export sectors of these economies. From this point of view, the Asian currency crisis can be seen as a manifestation of the fallacy of composition problem inherent in a generalized strategy of export-led growth (Ertürk, 2001–2). However, not all asset price bubbles involving currency crises are associated with overinvestment of ‘real’ capital. In many instances, as we shall see, asset price bubbles were associated


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with overinvestment of portfolio investment that had little repercussions for capacity investment. The following section begins with a Kaldor-inspired discussion that provides a simple working conception of overaccumulation in developing country exports, helping us understand how capital flows in the context of an asset price bubble can preclude a stable market adjustment at the most general level. The Asian crisis is discussed next as an example of a case where a connection can be made between the currency crisis and capacity overinvestment. In the following two sections, the discussion turns to more proximate causes of currency crises, focusing on the two main destabilizing processes mentioned above, the overborrowing and spending and erratic shifts in capital flows. The former predominate in ‘current account’ driven crises while the latter does in the case of crises that are ‘capital account’ driven. The chapter ends with a discussion of what the increasing weakness of the US dollar portends for developing countries and the world economy.

A Kaldorian conception of overaccumulation The stylized picture of world trade that had emerged in the early post-World War II era was one where developed countries sold manufactured goods to developing countries and bought raw materials in exchange. At the time, many economists recognized that this particular pattern of trade was fraught with pitfalls for both groups of countries. It not only posed a potential threat to industrialization efforts in the developing world, but also to economic prosperity in the developed countries by making the growth of manufactures dependent on an inelastic supply of primary goods from the South. Kaldor (1996) tried to conceptualize the latter problem that developed countries faced by thinking of the world economy as consisting of two sectors producing manufactured goods and primary goods, situated respectively in the developed and developing countries. This enabled him to pose the question in terms of intersectoral balance, or lack thereof, for the world economy as a whole between the manufactures and primary goods. By expressing the respective growth rates of the two goods as, respectively, a positive and a negative, function of the terms of trade between them, he posited a simple balance condition in terms of the particular price ratio at which the

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two growth rates equalled each other. Kaldor used his analysis to argue for the institution of buffer stocks of raw materials as a remedy against the potential disruption of production of manufactures which used the former as inputs (Kaldor 1996, Third Lecture). In a similar vein, we can think of the world economy as comprising two sectors, again situated respectively in the advanced and newly industrializing countries (NICs), but now producing respectively smart and dumb chips instead of manufacturing versus primary goods. Advanced countries import from NICs standardized, lower technology ‘commoditized’ inputs (dumb chips), while the NICs buy high-tech goods (smart chips) as capital inputs from advanced countries. Assuming an initial situation of balanced trade, the two growth rates are equal when in balance. The growth rate of high-tech goods in the advanced countries is related positively, and that of low-tech goods negatively, to the price ratio of high-tech goods over low-tech goods, expressed in terms of the advanced country’s currency. The point at which the two schedules intersect gives the price ratio ( p) for which the two growth rates are in balance (see point A in Figure 4.1). In the abstract, this equilibrium point can be thought of as stable. If the price ratio is higher than its ‘equilibrium’ value the production of high-tech goods grow faster than that of low-tech goods, giving rise to an excess supply of high-tech goods which pushes down

p gH

p2

C

D B

p1

gL′

A gL gH1 , gL1 Figure 4.1

gL2

gL , gH


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the relative price of high-tech goods in terms of low-tech goods. Likewise, if the p is less than its equilibrium value, the price ratio is pushed up by an excess supply of low-tech goods. However, the crucial point about currency crises is that asset price bubbles, which are prone to emerge in an environment characterized by liberalized capital flows, as will be argued, prevent a stabilizing price adjustment that would close the gap in the respective growth rates. In this example, the capital inflow to developing countries has two effects. On the one hand, it expands the potential supply of output by expanding the industrial capacity in the recipient countries. This can be thought of as causing an upward shift in the growth rate schedule for low-tech goods. On the other hand, the capital inflow also fuels an asset price bubble and a currency appreciation, which prevents a smooth upward adjustment in relative prices in terms of the advanced country currency.10 Thus, rather than smoothly moving to the new equilibrium point at C, we end up at B, i.e. which indicates a global overaccumulation of low-tech goods. Because asset price inflation prevents a stabilizing price response the imbalances caused by overinvestment in the South only gets worse over time, setting the stage for an eventual collapse in the exchange rate. The meltdown of currency can be thought of as a belated price response that overshoots, indicated in our diagram in Figure 4.1 as an abrupt jump from point B to D. What triggers an abrupt reversal of capital flows that actually sets off the crisis will of course have more proximate causes, and some unexpected event – such as revelations of problems in the banking sector, a well-publicized bankruptcy of a major exporter or the collapse of some speculative investments in real estate – can be the actual trigger of the capital flow reversal. But, it is instructive to note that even in the absence of an abrupt reversal in capital flows and thus a currency meltdown, the exporters in developing countries still suffer from a steady deterioration in their terms of trade (as an adjustment to point C in our diagram indicates). At a more general level, this is the deeper problem faced by developing countries that are trying to industrialize by means of promoting exports. Incidentally, the higher growth rate in the advanced countries, which the jump to point D implies in our diagram, is fuelled by the

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deflationary trend in the NICs. However, higher growth in the North at point D involves overaccumulation of high-tech goods as well, implying economic trouble down the line for the developed countries also. The discussion returns to this at the end of the chapter in connection with the current impasse in the world economy, when the connection between the bursting of the high-tech asset price bubble and the currency troubles in the US is discussed.

Overaccumulation and the Asian crisis Was the Asian crisis fundamentally a result of overinvestment in the export sectors of the countries involved in the crisis, and was the problem of over-capacity in the region a sign of intersectoral imbalance in the world economy as suggested in the previous section? It has been argued that economic liberalization, which amounted to the abandonment of state guidance of private investment in countries such as Korea has led to overinvestment and misallocation of resources in these economies. Perhaps, more importantly, it can also be added that economic liberalization has at the same time disrupted the flexible division of labour and the mutual ‘consistency’ of industrial policies – called at times the ‘flying geese’ model of economic development – among individual countries in the region, which had hitherto prevented overaccumulation of capital and onerous competition among them. In the mainstream literature, the prevalence of overcapacity in various East Asian economies was recognized as a moral hazard problem. Since much of the capital spending in these countries was thought to be ‘misguided’ because of state intervention, a falling profitability and rising incremental capital output ratios were seen as the inevitable outcome (Krugman 1994, 1998).11 With excessively high rates of investment (approaching 40 per cent of GDP ) that relied more on the extensive use of inputs rather than gains in productivity, diminishing returns were bound to set in. Thus, from this point of view, it is not surprising that the return on investment would tend to diminish over time. Instead, how the pace of investment could be kept so high for so long was the real question that needed an explanation. The obvious answer of course was ‘moral hazard’. This however is hardly a convincing argument, for it fails to explain the long duration of unprecedented success East Asian


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economies had. As Singh and Weisse (1999) argue, any explanation of the Asian crisis must also be capable of explaining the successes of these economies as well. Thus, an explanation based on the complications caused by the abandonment of the so-called Asian model of development appears more plausible. According to this argument the two crucial components of the model that were relinquished with liberalization mattered the most: (a) control over external borrowing and (b) state coordination of private investment (UNCTAD, 1998; Singh and Weisse, 1999; Singh, 1995; Chang et al., 1998; Chang, 1998). While the abandonment of the latter was the ultimate cause of overinvestment, that of the former acted as the more proximate cause of the crisis itself.12 The focus of this line of argument can fruitfully be expanded to underscore the regional impact of the abandonment of industrial policy within individual countries. For, arguably, it is plausible that the main adverse effect of economic liberalization that mattered most was the disruption of the regional division of labour and the mutual consistency of private investment trajectories of individual countries in the region. The initial success of East Asian economies, according to this argument, had much to do with the viability of this regional division of labour which was instrumental in preventing overinvestment and deteriorating terms of trade even when their developmental state was not up to par. Once this regional cohesion unravelled, The South East Asian countries ended up overinvesting to early-exit from labour and resource intensive exports and move onto the low-tech end of capital intensive industries, with dire results for the regions as a whole. On theoretical grounds, one cannot help but be sceptical about the chances of success of a generalized strategy of export-led growth. As Singer (1950) and Prebisch (1950) warned long ago, a development strategy based on the export of income inelastic goods is bound to lead to deteriorating terms of trade. Indeed, the price of developingcountry manufacturing exports have steadily been falling since the 1980s in relation to developed country exports of machinery, transport equipment and services (Wood, 1997).13 Within a given region the parallel export expansion of cheap exports collectively facing less than infinitely elastic world demand can give rise to ‘immiserizing growth’ (Bhagwati, 1958). That is, with export expansion the barter terms of trade could fall to such an extent that per capita income would

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diminish as economic activity increased.14 For instance, between 1996 and 1998 the fall in the $US price of its exports was such that Korea’s export revenue rose only by 2 per cent while the volume of its exports increased by 38 per cent.15 Likewise, in 1996 prices, the 1998 US import bill for all non-oil imports from ‘East Asia’ (Hong Kong, Indonesia, Korea, Singapore, Taiwan and Thailand combined), which amounted to $107.9 billion, would have been worth $143 billion (Barth and Dinmore, 1999). Thus, the real question is how East Asian countries could escape the trap of deteriorating terms of trade and overcome the threat of immiserizing growth, at least until very recently. An important part of the explanation seems to be the viability of the ‘flying geese’ model, that is, the regional division of labour and the mutual consistency of industrial policies and export structure of individual countries, and perhaps the advantage of being the ‘early exporters’. In the so-called ‘flying geese’ model, groups of countries that constitute discreet cohorts in terms of their technological ability (as well as skill level of their labour force and overall level of development) engage in different types of productive activity.16 While countries at the bottom of the rung produce labour and resource intensive goods, those that have developed greater technological abilities move on to producing relatively more capital-intensive and technologically sophisticated goods. The newly initiated begin in sectors with the lowest barriers to entry into international markets and move their way up one step at a time as the sophistication of their economies increases. Thus, as Japan began moving on to higher technology sectors in the early 1970s, Korea and Taiwan moved into positions of leadership in apparel and textiles. Within a decade the latter were moving on to electronics, automobiles and auto components, while apparel and textiles were being taken over by the South East Asian newcomers. Though the nature of regional economic integration in East Asia has been more complex than the simple ‘flying geese’ analogy suggests,17 the regional pattern of division of labour nonetheless appears to have prevented onerous competition among individual countries, enabling them to upgrade production in a relatively orderly fashion. The threat of deteriorating terms of trade could thereby be kept at bay and the fruits of productivity improvements retained largely within the economy. As economic liberalization


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intensified the competitive pressures East Asian countries faced towards the end of the 1980s, the ‘flying geese’ model of development appears to have begun to unravel. First, opportunities for export penetration were diminishing (especially for the more advanced producers in the second tier) at a time when world economic growth was at best anaemic. The per capita income of trade partners of all countries in East Asia have steadily been falling. Second, exchange rate volatility and uncertainty, caused by large swings in the dollar–yen rate, was disruptive for making long-term investment plans and the smooth evolution of the regional division of labour. In 1985 one $US was worth 240 Japanese yen in exchange markets. By 1988 the $US value of yen had almost doubled, rising from 0.0042 to 0.0078. For the following two years yen had depreciated against the $US by 12 per cent, only to appreciate again by 50 per cent between 1990 and 1995 – which in turn was followed by another 30 per cent slide in its value between 1995 and 1998. Third, China’s entry into international markets, together with that of a host of other low-income countries, had threatened the market position of the East Asian countries, especially in labour intensive manufactures. In general, the exports of low-income countries to developed countries increased almost four times in merely six years, between 1987 and 1993, while imports from middle-income countries rose less than 50 per cent during the same period (Wood, 1997). In East Asia, Chinese exports began to outperform the exports from other countries in the region in the latter half of the 1980s, reaching a quarter of the regional total by 1995 after rising steeply from 20 per cent in 1990. During the same five-year period, the ratio of Chinese exports to the total combined value of exports from Thailand, Malaysia and Indonesia increased from about 60 per cent to little above 70 per cent, while this ratio was less than 30 per cent in 1980. During the period 1988–96, the world share of Chinese exports also outstripped by a multitude the shares of Indonesia, Malaysia and Thailand in their respective ten top exports of manufactures (World Bank, 1998, p. 24). Finally, producers in the second-tier countries in the region were becoming more and more competitive among themselves and with Japanese firms, competing increasingly on the basis of cost by investing in low-wage countries in the thirdtier and beyond (especially in China). In the 1980s, Korea ran a large trade deficit with Japan and a large surplus with the US. Its trade

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surplus with the US, which reached almost $10 billion by 1987, evaporated by 1992 as the US, fearing yet another Japan in the making, unleashed a trade offensive that brought pressure to bear upon Korea to revalue its currency, among other measures. At the same time, Korea’s trade deficit with Japan soared, eventually reaching $15 billion in 1996, reflecting its failure to lower its technological dependence. Many firms moved their operations to South East Asia in an effort to continue to compete on the basis of lower labour costs. These challenges notwithstanding, economic liberalization had eased access to credit and accelerated the capital inflow into the region, making it both possible and desirable for producers in each country to step up investment in a scramble to maintain market share by moving up the production chain.18 Many of the third-tier countries tried to emulate Korea’s narrow specialization in niches of standardized production in capital intensive, high-tech industries with relatively low barriers to entry in international markets. The result for the region as a whole was disastrous as the investment boom of the early 1990s, by the second half of the decade, gave rise to a severe overcapacity problem in the low-tech end of capitalintensive industries.19 The export prices fell precipitously in electronics, computers, semiconductors and telecommunications equipment (World Bank, 1998, p. 22) as many capital-intensive exports became ‘commoditized’ (UNCTAD, 1998; pp. 59–61; World Bank, 1998, ch. 2). In much of the literature on currency crises, the discussion begins past this point, focusing initially on how an increased credit expansion makes an unsustainable increase in aggregate demand possible and the complications that causes. It then becomes immaterial that private investment expenditures were the leading component of aggregate demand in East Asia (and that a large part of the capital inflow directly or indirectly financed capacity investment), while in many other episodes the increase in aggregate demand was led by a private consumption boom and that the share of portfolio investment in the capital inflow was much more significant. In both situations, the general pattern is recognized to involve a ‘spending’ spree made possible by a period of excessive credit expansion (and thus overborrowing) that followed, though not always, economic liberalization.


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The part played by capital flow reversals was initially relatively straightforward, and thus less of a puzzling question, when the devaluation risk stemming from current account deficits caused by the spending spree, and reserve depletion seemed to be the decisive factors. This appeared to be the case in the 1980s. Towards the end of this decade, perhaps beginning with the crises in Nordic countries, this appears to have changed. Fixed price assets in the form of bank loans were still the main conduit of financial capital flows into developing economies during much of the 1980s, whereas variable price assets, such as bonds and stocks, appear to have begun to take their place by the end of that decade. The explosive expansion of secondary asset markets in developing countries during this period (Grabel, 1996; Singh, 1997, 2003; Singh and Weisse, 1998) meant that portfolio dynamics driven by speculative expectations on variable price assets, and thus the very dynamics of asset price bubbles, could become the driving force behind erratic capital flows. Once capital inflows into developing countries began to finance speculative asset positions first and foremost, the capital account dynamics rather than those associated with the current account started to become decisive. This typology differs from Krugman’s (2000) influential classification of different generations of models that are thought to reflect the transformation of these crises. In his classification, as already mentioned above, first generation models refer to reserve depletion caused by monetized government budget deficits, while the second generation models focus on governments’ willingness to devalue to avoid reserve depletion, and the third generation models emphasize financial balance sheet problems stemming from currency and maturity mismatch. In what appears to be an alternative classification, Krugman also makes a distinction between fundamentals driven, firstgeneration models and expectations driven, second-generation models (Williamson, 2001), which might at best imprecisely correspond to the contrast drawn here between ‘current account’ versus ‘capital account’ driven crises. As we shall see, the current account driven crises need have little to do with monetized government budget deficits and lax public finance, and the capital account driven crises’ salient characteristics would have little to do with the complications caused by currency (and maturity) mismatch, nor how governments prefer to react when faced with the threat of a speculative attack.

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Current account driven crises When currency crises first broke out in the Southern Cone countries in Latin America in the late 1970s, disinflation was being attempted for the first time in context of a liberalized capital account. Also, because belt tightening was not thought to be sufficient in itself to bring down the inertial part of inflation, the nominal exchange rate functioned as an anchor in all these stabilization programmes. The main objective was to reduce domestic inflation by decreasing incrementally the rate of devaluation. In later years, similar disinflation programmes with the exchange rate as the nominal anchor were also used in many other countries in different parts of the world. Often, inflation did not fall in tandem with the incremental reduction in the rate of devaluation of currency, causing the exchange rate to appreciate in real terms. Initially, it was thought that this would have a contractionary effect as it would tend to reduce net exports. But, time after time, the result was invariably the opposite: a private consumption-led boom in output that eventually went bust in a few years. For instance, in both Chile and Argentina, where these types of programmes were first implemented, private consumption rose by more than 10 per cent within a year the programme had been implemented, and the GDP increase was also close to double digits. With such rapid expansion of output, it was not long before the current account deficits began to balloon as well, reaching for instance as high a ratio as 14 per cent of GDP in Chile within two years (Calvo and Vegh, 1999). A private consumption-led explosive increase in output that went bust in a few years was the common pattern repeatedly experienced in many other countries that implemented disinflation programmes with a nominal exchange rate anchor. The boom phase of the cycles seemed to be explained by the discrepancy in the speeds with which rate of devaluation and inflation declined.20 Just as the very credibility of the disinflation programme brought down the expected rate of devaluation, the domestic nominal interest rate also fell in line with the uncovered interest rate parity condition. The decrease in the real rate of interest was even greater because the decline in the rate of inflation often lagged behind (Rodriguez, 1982). Moreover, the real wages also often rose, because the decline in inflation, though not as fast as the decrease in the rate of devaluation, was nonetheless faster


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than the decrease in the rate by which nominal wages continued to increase. Thus, falling real interest rates, coupled possibly with rising real wages was a part of the explanation of the consumption led boom in output.21 But what is perhaps more important was the increased ease of access to credit throughout the economy. As economic liberalization, of which the adoption of a credible disinflation programme has often been a part, set the stage for an increase in the capital inflow, a steep increase in borrowing usually ensued. Whether in fact their real income rose or not, the consumers’ and firms’ willingness, as well as their ability, to borrow increased. Likewise, the banks’ ability, and the willingness, to provide credit rose as well. Taylor (1998) argues that credit expansion and overborrowing begin with the adoption of a credible economic liberalization programme as it gives rise to a positive interest rate spread, because the nominal interest rate usually falls less than the decrease in the expected rate of devaluation. This fuels a steady capital inflow, causing the domestic money supply to increase. If the central bank sterilizes, a further increase in the domestic interest rate leads to an even higher interest rate spread, stimulating even a greater inflow. The capital inflow in fact induces domestic banks to raise the volume of credit they supply, which in turn raises both the money supply on the one hand and prices and output on the other. As long as the real exchange rate continues to rise, banks can indeed make easy profits by lending inside the country what they borrow from outside at a much lower rate of interest. The positive interest rate spread emphasized above can explain why foreign investors would be willing to continue to lend, but not necessarily the willingness to borrow on the part of the domestic banks. Banks find what they do profitable because they ignore the devaluation risk and the possibility that the trend of real appreciation of currency can reverse itself. Is this then prima facie evidence of the moral hazard problem? Indeed, the large open positions banks took in many of the East Asian countries were blamed for setting the stage for the crisis by the proponents of the moral hazard argument. Thus, in McKinnon and Pill’s view (1997, 1999) the problem in East Asia was too rapid financial liberalization that did not allow the time needed to develop the institutional infrastructure for prudential regulation of banks and the financial system. Corruption, cronyism and lack of transparency

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were thus thought to be the ultimate causes of the large open positions banks took and overborrowing throughout the economy. A number of arguments can be made against this moral hazard view. First, in any episode of an asset price bubble, one finds excessive borrowing based on optimistic expectations that look like ‘irrational exuberance’ after the fact when the bubble bursts. Even in economies with a well-established tradition of prudential regulation and welldeveloped financial system, a period of rapid profit growth fuels overconfidence and gives rise to a climate of financial exuberance. This was in fact one of Minsky’s salient points about business cycle dynamics in an advanced capitalist economy such as the US, where the most recent episode of irrational exuberance is too well-known to recount. But, lest the US is dismissed as an argument against moral hazard, because it has been rife with corruption – as it now turns out – to a degree more than ever thought possible, the Nordic countries – not known for their corruption and cronyism – also experienced an explosive increase in bank credit on the heels of financial liberalization in the late 1980s that eventually ended in a banking and currency crisis. The speculative fervour that develops in episodes of asset price bubbles stimulates corruption rather than the other way around. Thus, it is more plausible that corruption is more the effect than the cause. Second, independently of moral hazard, other compelling reasons exist why one would expect bank credit to be procyclical under conditions of economic liberalization, which can explain bouts of overborrowing. Among these that have already come under extensive scrutiny is the strong pro-cyclical effects of the Basel Accords that set minimum capital requirements for banks (Isenberg and Phillips, 2005; Griffith-Jones and Spratt, 2002; and Rude, 2005). Yet another reason, not yet as well recognized, is the fact that liquidity preference and currency substitution become intertwined under conditions of financial and capital account liberalization. This acts as a built-in macroeconomic destabilizer, as it affects procyclical variations in the liquidity position of banks. Because of various problems – high inflation, credibility, exchange rate risk, etc. – currency substitution is unsurprisingly quite extensive in many developing countries around the world.22 Thus, it is not unusual for people in these economies to try to keep a large part of their idle balances in foreign currency. Financial and capital account liberalization, when


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successful, embed currency substitution within the local banking system and lower transaction costs, channelling thereby these inactive balances into foreign exchange deposits in domestic banks. As a result, under normal conditions, changes in the liquidity preference entail currency substitution, causing first and foremost quantity rather than price changes in the form of shifts in the composition of total bank deposits between active and inactive balances. This, in turn, acts as a built-in macroeconomic destabilizer because domestic banks’ reserve requirements are invariably much higher for foreign exchange denominated accounts than for those denominated in local currency. When inactive balances swell in the banking system at a time of rising liquidity preference and economic slowdown, the effect is to lower banks’ liquidity by redistributing deposits within the system from low-to high-reserve accounts. Likewise, banks’ liquidity situation is improved during times of rising economic activity and falling liquidity preference when the relative size of active balances in domestic currency accounts increase in relation to inactive balances that mainly consist of foreign exchange deposits. Given all this, policies that aim at eradicating practices thought to give rise to moral hazard are likely be counterproductive not only because there might be other causes that are at least as important as suggested above, but also stamping out such practices can have adverse unintended consequences if these happen to be ‘second best’ solutions to other ‘distortions’ in the economy. For instance, deposit insurance and lender of last resort practices of central banks can create moral hazard problems, but they have also been quite effective in containing systemic risks such as bank panics since the 1930s (Eatwell and Taylor, 2000, p. 47). Thus, the cost of getting rid of such practices can plausibly outweigh the moral hazard problems themselves. When it comes to the ‘bust’ phase of the cycle, the argument is more straightforward. The output expansion fuelled by the excessive credit creation is unsustainable, mainly because the real exchange rate appreciation and rising output give rise to a ballooning current account deficit, causing a steady increase in the devaluation risk. This means that the domestic nominal interest rate now needs to keep increasing in order to maintain a positive interest rate spread to ensure that the capital inflow continues. As a result, rising interest rates and the current account deficit first slow down, and eventually

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reverse, the economic expansion. Depending on the level of the foreign exchange reserves and the rate of their depletion, a run on the currency can occur at anytime. In capital account driven crises, discussed next, what is fundamentally different is essentially the modality of the capital inflow and its reversal. In what has so far been discussed in connection with Lance Taylor’s analysis above, the capital flow has been linked to arbitrage opportunities created by a positive interest rate spread. A contention of mine in this chapter is that the growing importance of variable price financial instruments as conduits of capital flows in the 1990s has created a potential for destabilizing trend speculation on the part of international investors. This suggests a state of the world where expectations of asset price capital gains rather than arbitrage opportunities emerge as the predominant motivation behind capital flows. Similarly, once the expectations of asset price increases cease, for whatever reason, capital flow reverses regardless of whether devaluation risk and foreign exchange reserves are high or low. This is the sense in which currency crises become ‘capital account’ driven.

Capital account driven crisis Under conditions of capital account liberalization, the exchange rate becomes just another asset price that can be subject to speculation. This means that just like in the case of any other forward-looking asset price, rumours, noise and investor sentiment, at least in the short run, are likely to be more important than what is happening in the real economy in determining movements in its price. Yet, ever since Friedman (1953) argued that destabilizing speculation would be unprofitable, and, thus, unsustainable in the long run, most mainstream economists have assumed that speculation as a rule could not be destabilizing. Asset price bubbles were considered highly unlikely if not impossible in a ‘normally’ functioning market. The rise of the ‘efficient market hypothesis’ in the 1960s had bolstered the influence of Friedman’s argument, as it gave credence to the idea that actual market prices of assets must be the best estimates of their true values at a given point in time.23 The intuition behind Friedman’s (1953) argument rested on a simple view of arbitrage in which the market comprises smart traders who know the true values and misinformed noise traders. If securities are undervalued, as the argument


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goes, then the smart traders would continue to buy them until their prices are bid up to their true value. Likewise, if securities are overvalued, smart traders would sell them, bringing their price down to their true value. Indeed, under these conditions, speculation is always stabilizing and profitable. Misinformed noise traders thus create riskless arbitrage opportunities that smart traders profit from, while making losses themselves. Undoubtedly, the assumption that smart traders or speculators know with certainty what is the true value is exceedingly unrealistic. But, even under this strong assumption, it does not follow that the deviation of the current price of an asset from its true value creates a riskless arbitrage opportunity. Because traders in general have a finite time horizon, a speculator who sells overvalued assets short can find that by the time s/he is supposed to close his/her position, the true value has increased, or, that the assets in question have become even more overpriced.24 In both situations, the speculators who have sold securities short would be making losses. Even if the true value is known, it does not follow that it would be equal to the expected future price. Thus, because the fear of making losses would cause smart traders to limit the initial positions they take in an over or undervalued asset, current price might not smoothly adjust to its true value. Needless to say, if we drop the assumption that speculators know what the true value is, the risk of loss they perceive is likely to be higher, and the compensatory shift in demand for the undervalued asset smaller. That is why the modern ‘noise trader’ or the ‘behavioural’ approach to finance holds that riskless arbitrage is not effective in relation to the prices of shares or bonds as a whole, and severely limited even when it comes to the relative prices of individual assets (Shleifer and Summers, 1990; Shleifer and Vishny, 1997). In this setting, unlike what Friedman (1953) foresaw, successful (read rational) speculators are those who engage in ‘trend’ speculation, where they act like noise-traders themselves in the short run, trying to feed the bubble rather than help deflate it (Delong et al., 1990).25 In other words, they chase asset price trends to jump on the bandwagon of noise traders and know when to get off while the rest rides on. In a similar manner, the asset price bubbles that have emerged in the aftermath of economic liberalization have created ample opportunities of trend speculation for international investors. Depending on the special conditions of each country, asset

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price bubbles have emerged in different asset categories. In some countries it was the real estate market, in others the equities, corporate bonds or government debt instruments. In the following, the simplest type of a debt instrument such as a short term government bond is assumed. In order to draw a contrast between capital flows motivated by expectations of capital gain in asset prices from those that are driven by arbitrage opportunities, a useful starting point might be the uncovered interest rate parity condition, which, as shown below, simply states that the difference between the domestic nominal interest rate and the international interest rate must be equal to the sum of the devaluation risk (DR) and the country (or sovereign) risk (SR).26 i− i* = DR + SR

(1)

where i is the domestic nominal interest rate and i* the international interest rate. The change in foreign exchange reserves is in turn the sum of the current and capital accounts; ΔF=T(Y, E)+C(i, i*)

(2)

where T is trade balance, Y is output, E the real exchange rate (where an increase means a fall in the value of the domestic currency). As it is commonly assumed, TY < 0, TE > 0 and Ci > 0, holding i*, DR and SR constant. In Taylor’s (1953) argument discussed above, the first equation turns into an inequality once a developing country adopts a credible stabilization programme. The interest rate differential on the lefthand side exceeds the sum of SR and DR, and the greater the interest rate spread the higher is the magnitude of capital inflow. Over time, output expansion and real exchange rate appreciation cause the trade deficit to rise and that eventually pushes up the DR. Under these circumstances, a positive interest rate spread can only be maintained with a higher domestic interest rate. Because the domestic interest rate cannot be increased indefinitely, it becomes harder to check the decrease in the foreign exchange reserves by raising the interest rate past a threshold, causing a further increase in the DR. This is the beginning of the end, and once reserves begin to fall


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steadily the actual mechanism of the speculative attack need not be different from Krugman’s (1979) account. In its present form, Equation (1) implicitly assumes that arbitrage works only through assets that are held to maturity for their interest yield, since expectations of asset price changes are not part of the arbitrage condition. If, instead, the prospect of capital gain is the motivating factor behind capital flows, asset price expectations would need to be introduced into the interest parity condition. One simple way this can be done is by defining – for want of a better term – the total exchange rate risk (TER) as the difference between the devaluation risk (DR) and the expected increase in asset prices (ΔAPe),27 TER = DR − ΔAP e,

(3)

and rewriting Equation (1) as, i − i* = TER + SR.

(4)

Note that in Equation (1) the total exchange rate risk is simply assumed equal to the devaluation risk because the expected change in asset prices is implicitly set equal to zero. Now, let us assume a situation where a credible disinflation programme with a nominal exchange rate anchor is about to be implemented in some developing country, and that this gives rise to the expectation that the nominal rate of interest on government bonds will decline in the near future. The adoption of the stabilization programme, again, as assumed before, leads to a decrease in the devaluation rate (crawling peg), giving rise to a positive spread. But, in addition, the expected asset price change turns positive as well, as it is now expected that the implementation of the stabilization programme will attract capital which will push down the nominal interest rate in the near future and thus raise the value of old issue bonds. Thus, in this case, the total exchange rate risk falls not only on account of the lower expected devaluation risk, but also because of the expected increase in asset prices. Again, capital flows in, the supply of bank credit expands and spending and output rise. But now, in contrast to the earlier case, the TER begins to rise as soon as the expected increase in asset prices peters out – as the interest rate levels off after its initial rapid decline following the first implementation of the disinflation

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programme – even when the current account deficit might still be insignificant and reserves are high. To the extent that foreign hedge fund managers begin to believe that domestic asset prices have peaked, they might simply close their positions and move elsewhere. Provided the SR is still low, an increasing number of ‘local’ speculators who might also think that asset prices have peaked would switch to foreign currency denominated bank accounts within the country. In either case, whether the foreign hedge funds leave the country or bank deposits shift to foreign exchange denominated accounts in domestic banks, there is an unexpected weakness in the value of the home currency, that is, a slowdown at the rate at which the devaluation rate is decreasing (crawling peg), or a fall in reserves. This can shake the market confidence in the stabilization programme, causing the DR to rise unexpectedly as well. At this point, it is possible that the current account deficit, that might until then be seen as a normal corollary of the capital account surplus, might all of a sudden be deemed unsustainable and thus a problem. In other words, it becomes a problem because the capital inflow falters as the expected asset price increases peter out. In the end, the TER ends up rising on account of both the initial fall in the expected asset price increases and the eventual rise in the devaluation risk. Even if the exchange rate survives the initial capital outflow, with the TER rising the nominal interest rate begins to rise steeply. Unlike the situation discussed in the previous section, the higher interest rate is unlikely to succeed in keeping the interest rate spread positive and thus buy much time for the country in question. First, to the extent that rising interest rates signal to investors that negative asset price changes are ahead, they are likely to stimulate a net outflow rather than an inflow of capital. In the stylized world of the Mundell–Flemming model, this means that the capital flow is a negative function of the expected rate of change of the interest rate. Within a certain range involving higher time frequencies, this effect is likely to be much stronger than the conventional positive relationship that is postulated in Equation (2) between the level of the interest rate and the capital inflow. Most if not all of the IMF-backed stabilization programmes in force at the time a currency crisis erupted in one or the other developing country barred the central bank from acting as an intermediary and


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as a lender of last resort.28 The objective of these stabilization programmes was instead to rely on market forces to maintain liquidity, where two self-correcting mechanisms were often presumed (Ekinci and Erturk, 2004). First, because the private banking sector often held a large portfolio of government debt instruments – mainly because some private banks became the primary dealers in these assets after financial liberalization – they would have a stake in maintaining the value of these assets and be inclined to buy what the speculators wanted to unload. Second, the capital outflow would self-correct by pushing interest rates higher, which would then reverse the outflow. More often than not neither mechanism worked as the two tended to clash with each other. As remarked above, the expectation of further increases in interest rates initially stimulated an outflow as investors tried to avoid capital losses by exiting sooner than later. Thus, interest rates had to reach exorbitantly high levels before the capital outflow could at all be stopped, let alone reversed. The excessively high interest rates in turn raised prohibitively the cost of short-term borrowing for the primary dealer banks who were supposed to absorb the portfolio speculators were unloading. The result often was a chain reaction of bank failures where exorbitantly high interest rates pushed them over the edge even if the banking system was strong enough to weather the shock of the initial bursting of the asset price bubble. Moreover, once banks were forced to default on their foreign debts they also threatened the solvency of the public sector, causing the SR to unravel as well (Corbett and Vines, 1999). The solvency of the public sector was also threatened when the public debt was high to begin with, since with very high interest rates it did not take very long before it began to look out of control. Thus, quite often, government guarantees that were meant to reduce the devaluation risk for foreign investors during the good times, whether explicit – as with the dollar-indexed bonds (tesobonos) in Mexico – or implicit, came back to haunt the solvency of the public sector.29 Once the SR unravelled, which was likely to happen one way or another, no interest rate increase, no matter how big, could stem the outflow of capital and a complete meltdown became inevitable. A stark asymmetry often exists in the policy response to banking cum currency crises as to whether it takes place in an advanced or

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developing country. Prompt lender of last resort intervention, which in general is very effective (Allen and Gale, 1999), has only been the common reaction only in the former (Rude, 2005), while its practice in the latter often seemed to require at least a partial default on debt and controls on capital flows. Thus the fear of being shut off from international credit markets has militated against its use in developing countries in general, even though in those instances where a debt default (Russia and Argentina) or the imposition of capital controls (Malaysia) made it possible, the economic outcome was surprisingly positive – even embarrassingly so, given that the conventional wisdom held all along that the cost of shunning international capital markets would be catastrophic and thus unthinkable in this day and age. Rude (2005) argues that in the current neoliberal era the holding back of the lender of last resort provision in the periphery is functional from the point of view of how the world economic system reproduces itself because contractionary adjustment to periodic crises are the means by which market discipline is instilled where political resistance is weakest. While this appears convincing, it need not follow that no limit exists to how far the lender of last resort and aggressive monetary easing can be used to contain crises in the centre, and most notably in the US, without complications beginning to arise for the world economy as a whole. Two such complications that directly bear upon the foregoing discussion are the following. First, if the bursting of the high-tech bubble in the US was ultimately tied to deeper problems, the type of global ‘real’ imbalances the oversimplified picture drawn in Figure 4.1 above describes, the question then is whether preventing the economy from slipping into a depression comes at a price. Do the financial imbalances in the centre that are thereby compounded prevent a return to robust growth under current conditions? Moreover, it needs to be further explored if the failure to restore growth in the centre, in turn, puts the international reserve currency in jeopardy. Because, even to muddle through if financial imbalances in the US – and most notably its net indebtedness to the rest of the world – steadily worsen, anxiety about the fragility of the reserve currency and the world financial order is bound to rise. Second, an extended period characterized by increasing unease about the weakening dollar, and heightened uncertainty about other


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major currencies, is bound to blunt their attraction to the wealth owners in the rest of the world. Once the dollar ceases to be the magnet it has been until recently in the era of financial liberalization – with no other currency yet ready to fully replace it – not only hot money flows out of the centre but also ‘local’ wealth returns home in the periphery. For developing countries this holds the promise of at least a partial respite from the effects of the kind of vulnerability they have developed towards international capital markets, discussed above in this section. The juggernaut Rude’s thesis describes can now be escaped to a degree, because the threat of assured massive capital flight lest fiscal rectitude be compromised might no longer be as menacing. Thus, if the current trends continue unabated, the developing countries might begin to discover that they can cautiously reflate their economies without triggering a run on their currencies. Some of the current attempts at establishing regional economic and financial networks, if they bear fruit, can help entrench this relative expansion of breathing space in the developing world.30 The following section focuses on the future of the dollar in connection with increasing uncertainty about the ability of the US to be the engine of world growth, and speculates on whether the world is about to enter a new era that will spell the end of globalization as we know it.

Will the centre (dollar) hold? Ever since the bursting of the high-tech stock market bubble, the US economy has been riddled with overcapacity and a high level of indebtedness. But, a massive fiscal stimulus and aggressive monetary easing has been successful in pushing bond and real estate prices to unprecedented levels, inducing a credit boom that prevented private consumption from falling. While it might still be too early to say that it worked, the strategy has indeed prevented the US economy from slipping into a severe depression after the collapse of the stock market at the turn of the century. But, in the meantime, the aggregate macroeconomic imbalances have clearly worsened (Papadimitriou et al., 2005). The budget deficit has risen steadily every year in the last four years and is estimated to exceed $400 billion in 2004, and the current account deficit is already well in excess of 5 per cent of GDP. The net value of assets owned by foreigners in the US has by

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now reached $3.3 trillion, about 30 per cent of GDP, which is double the share of four years ago. This is the amount by which what foreigners own exceeds what Americans own in the rest of the world, and thus the net investment income – interest plus dividend payments – will increasingly turn negative for the US as interest rates go back up again in the future. There has been some improvement in level of indebtedness in the corporate sector in the last few years, but the households’ rate of indebtedness remains at an all time high. The savings rate out of household disposable income is barely positive, and overall national saving rate is slightly above a miniscule one per cent of GDP. The weakening of the dollar, about 16 per cent on a broad trade-weighted basis since its peak in February 2002, shows no sign of having any real impact on the current account deficit, making one wonder how much further the dollar can go on decreasing without triggering a sharp rise in US interest rates. Technically, an even weaker dollar could possibly allow the US economy to expand at the expense of the Asian and European economies (Godley et al., 2004). But, if that meant higher interest rates, the level of private consumption in the US could not possibly be maintained at its current level and a severe recession would surely result. Given the high level of indebtedness of the household sector, the negative impact of sharply higher interest rates on private consumption would be considerably stronger than the increase in exports the lower dollar would stimulate. What happens to interest rates in the US as the dollar continues to lose value depends on the degree to which foreign demand for US financial assets slackens. A drawn out, gradual, weakening of the dollar makes the US assets less and less attractive for foreign investors, sooner or later pushing up their yields to a level that can more than compensate for the higher devaluation risk they now possess. In fact, within the last year the net private capital flows have almost consistently remained below $57 billion, the current average monthly US current account deficit, requiring official purchases to make up the difference. To all intents and purposes, the US is now dependent on a handful of foreign (mostly East Asian) central banks to attract enough capital to cover its foreign deficit. Arguably, a sharp and steep dollar devaluation rather than a slow downward drift would be better for the US economy as it would wipe out the devaluation risk of US assets in one fell swoop, making them cheap and attractive to foreign buyers once again. Moreover, the net


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asset balance of the US vis à vis the rest of the world would also improve considerably after a maxi devaluation. But, it is doubtful that the US would be able to bring that about even if it wanted to, short of causing a complete financial breakdown. Barring cataclysmic events, it appears that what will happen to the dollar and the US interest rates in the near future will increasingly be dictated by the interests of foreigners, such as the Chinese and the other Asians who are already in possession of a massive cache of US dollars. This would mean that the US will find it increasingly difficult to have any real control over its financial and economic destiny. Given this structural bind, it might be possible to speculate about three distinct possibilities in relation to what might happen in the near future. First, against all odds, the economic recovery takes hold in the US and the world economy settles on a path of sustainable growth. The US would then resume being the engine of world growth as the importer of last resort, and aggregate demand in much of the rest of the world can plausibly continue to be export led. The twin deficits would then cease to be a problem as the current account deficit would be equity-financed by private foreign investors, and the budget deficit would simply shrink over time – in ratio to GDP if not in absolute level – with the higher output growth. The second possibility is that of a complete collapse of the dollar and cataclysmic turmoil in financial markets world-wide. This can happen if for some unexpected reason financial panic overwhelms the ability of world central banks to absorb a massive worldwide dollar sell off. Thus, even if no one wants it to happen there can still be a run on the dollar. One can even think of it as gradually snowballing out of control as the temptation to break rank first and diversify out of the dollar before it loses more of its value gains momentum among especially the smaller central banks around the world. An unstable process can thus be set in motion, which the bigger players might not be able to stop.31 No matter how it exactly happens, the ultimate effect would be to abruptly raise the US savings by sharply curtailing spending and output, with disastrous effects on the rest of the world as well. Thus, the net effect would be very similar to a situation where the US administration abruptly tried to get rid of its budget deficit. By now, the first possibility looks increasingly far-fetched, if not impossible. The housing price bubble is the single most important

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obstacle the US economy will face in the next couple of years. The US personal saving rate could be kept so low mainly because households could tap into the overvalued equity in their houses through refinancing their mortgages. That clearly will not continue. When housing prices begin to fall, the effect can potentially be much worse than the bursting of the stock market bubble. For not only is the household property holdings currently almost twice as big as the aggregate size of stock portfolios in the US (Financial Times, 12/9/2004), but also the Fed will have much less room for monetary easing while fiscal stimulus will be hard to administer by yet another significant increase in the budget deficit. Moreover, the recent news reports about financial irregularities and undeclared losses at Fannie Mae, while not surprising at all, are yet another sign of serious trouble ahead. It appears, though, that just as financial markets lose all faith in the viability of this first possibility, the pieces are increasingly being held together by the fear of the second, which is indeed too frightening even to contemplate. Hence the term, ‘the balance of assured mutual financial destruction’, coined recently by Larry Summers (Roubini, 2005), captures the knife-edge quality of the unstable equilibrium that is now struck – though everyone knows it cannot last. The first possibility is but a chimera and the second a nightmare. That alone, one would think, makes a third option desirable for the world as a whole. Only time will show if it emerges and in what shape if it does.

Summary and conclusion I have argued that currency crises are best explained as episodes of asset price bubbles that emerge under the conditions of economic liberalization. My objective has been to show that economic volatility need not be the result of market imperfections, but rather an expression of profit-seeking behaviour on the part of the agents in both local and international markets. The three destabilizing processes I have underscored as general features of currency crises – overborrowing, overinvestment and capital flow reversals – correspond to different phases of an asset price bubble. In current account driven crises, excessive credit expansion and overborrowing are the destabilizing processes that play the decisive role. Capital inflow is predominantly governed


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by arbitrage opportunities, where its reversal is tied to rising devaluation risk associated with reserve depletion. Starting with the late 1980s, capital account driven crises have come to predominate as fixed price assets in the form of bank loans are increasingly dwarfed by variable price assets such as bonds and stocks, giving rise to portfolio dynamics driven by speculative expectations on variable price assets. This, combined with the increased predictability of asset prices, in turn, sets the stage for destabilizing trend speculation on the part of international investors. Typically, the capital inflow continues as foreign investors chase a rising trend of asset prices, and reverses when they begin to think that asset prices have peaked. Once the asset price bubble deflates, the threshold of sustainable debt is drastically reduced and a chain of bank failures is triggered. Once a crisis breaks out, the single most effective policy response is whether the provision of lender of last resort is made available or not, which is rarely (commonly) the case in the periphery (centre). But, even in the US, the effectiveness of lender of last resort intervention is not without limit if financial imbalances that are thereby compounded prevent a return to robust growth. Anxiety about the world reserve currency is bound to rise if lacklustre growth in the US is accompanied with a steady rise in its net indebtedness.

Notes 1. See also Flood and Garber (1984). 2. Obstfeld (1994) is considered the classic example of this class of models. See, also, his earlier, Obstfeld (1986) and Eichengreen et al. (1997). 3. The conventional view holds that real economic activity has improved in Europe following its devaluation in 1992. See Gordon (2000) for an argument that takes an exception to this view. 4. In some other papers, the focus has been on problems caused by maturity mismatch rather than currency mismatch (Chang and Velasco, 1999). 5. Thus, it was argued that if firms are highly indebted in foreign currency, tight monetary policy can possibly be helpful to the extent that it bolsters the value of the currency, but a contractionary fiscal stance is unambiguously harmful, increasing the likelihood that the economy gets bogged down in a bad equilibrium (Krugman, 1999). 6. ‘Maturity mismatch’ has also been emphasized as another problem. 7. For instance, Furman and Stiglitz (1998) offer the excessive buildup of short-term debt as the single most important explanation of the sudden shift in market sentiment in the Asian crisis.

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8. This is broadly consistent with the approach other heterodox economists have taken, such as Arestis and Glickman (2002) and Grabel (1995), among others. See also, Allen and Gale (1999). 9. See note 13, below. 10. For ease of exposition, it is assumed that currency appreciation is just sufficient to keep the price ratio constant. 11. Krugman (1999, 2000) has since come to believe that the Asian crisis was caused by self-fulfilling financial panic. 12. This argument seems to apply best to a country like Korea, which, it is argued, successfully practised the Asian model (Amsden, 1989; Wade, 1990; Johnson, 1995; Singh, 1997), and where the matrix of political power that had underpinned it began to unravel with economic liberalization. However, its general validity for the region as a whole perhaps remains to be established. While the ‘developmental state’ is in centre stage in most explanations of the crisis in Korea, in the case of Thailand, Indonesia and Malaysia it is often suggested that the problem was its absence or limited nature (Henderson 1999). See also Booth (1999) and Reynolds (2001) for a discussion of the institutional differences of South East Asian countries. 13. Also see, Maizels et al. (1998); Sapsford and Singer (1999); Sarkar and Singer (1991). 14. For discussion on immiserizing growth and the fallacy of the composition problem inherent in export-led growth, see Kaplinsky (1993, 1999); Sapsford and Singer (1999); Cline (1982). 15. Author’s own calculations based on World Bank NIPA statistics for Korea. 16. The term ‘flying geese model’, coined by a Japanese economist, Kaname Akamatsu (1932, 1945), in the 1930s, is controversial in East Asia because it was used by the Japanese to legitimize the infamous ‘Greater East Asian Co-prosperity Sphere’ during World War II. However, Akamatsu’s ideas were developed long before, and continued to gain in influence after the war (Korhonen, 1994). Yet the charge that it is a cover for Japanese imperialism has survived (Steven, 1990). For a more evenhanded history of regional cooperation and integration in (South) East Asia, see Korhonen (1998). Akamatsu’s flying geese analogy was later recast by Cummings (1984), in the context of the product cycle theory for East Asia. See also Petri (1988) and Kuznets (1985). 17. South East Asian countries today are far from replicating the early industrialization experiences of Japan or even that of Taiwan and Korea (Reynolds 2001). Rather than establishing backward linkages and indigenous industries, the diffusion of manufacturing capacity in these countries has been linked to transnational production networks that are hierarchically organized with Japanese corporations at the apex in control of strategic technologies and Korean and Taiwanese firms dependent on the latter. The spatial separation of innovation and product assembly with the transnational reorganization of production has meant that transfer of industry from one country to another no longer has the same propensity to create the multitude of backward linkages in the


18.

19. 20.

21.

22.

23.

24. 25.

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domestic economy Akamatsu envisaged in his writing about the Japanese textile industry before World War II (Bernard and Ravenhill, 1995). See Blomqvist (1996) for a discussion of how the ‘flying geese’ model can be extended to account for foreign direct investment. Between 1990 and 1996, the composition of East Asian exports shifted towards more skill and capital intensive goods with amazing speed. In comparison, for instance, Mexico’s export structure changed very little during the same period (World Bank, 1998, p. 23). Expressed as a ratio of national output, investment exceeded levels that were already quite high, especially, in Korea, Thailand and Malaysia. Interestingly, in neither the detailed individual country studies nor the literature on disinflation programmes do excessive public spending and monetized government budget deficits get the top billing (Taylor, 1999, 2001). Another view argues that the rapid increase in private consumption is caused by the disinflation programme’s lack of credibility in the eyes of the public. Because the consumers do not think that the fall in inflation will be permanent, they increase their expenditures especially on big ticket consumption items and expensive imports with the idea of buying what they can before inflation begins to go back up (Kiguel and Liviatan, 1992; Calvo and Vegh, 1999). However, this argument does not explain where the extra income to spend comes from. See, among others, Rodriguez (2003) for Mexico, Bahmani-Oskooee and Techaratanachai (2001) for Thailand, Komarek and Melecky (2003) for Eastern Europe, Prock et al. (2003) for Latin America, Civcir (2003) for Turkey. The ‘efficient market hypothesis’ has gained currency among economists with Samuelson’s (1965) ‘proof’ that in a market that is efficient in appropriating all available information, stock prices should exhibit a random walk, and Fama’s (1965) ‘demonstration’ that the stock market almost actually does. But, it turns out neither proposition is valid. Empirically it is shown that stock prices do not exhibit a random walk, and theoretically it is now known that unforeseeable prices are neither necessary nor sufficient for rationally determined stock prices. See, among others, Shleifer and Summers (1990), Shleifer (2000), Lo and MacKinlay (1999), Bossaerts (2002) and Shiller (2000). In light of these developments in the finance literature, Friedman’s contention now appears far from persuasive, if it ever was. Among the early criticisms of Friedman (1953), see Kemp (1963) and Baumol (1957). Shleifer and Summers (1990) call these, respectively, the fundamental value and noise trader risk, In the modern finance literature on asset price bubbles the emphasis, until recently, was on rational traders’ risk aversion which was thought to prevent them from eliminating noise driven price movements. However, the focus has been shifting to ‘trend’ speculation as the winning strategy for speculators, a fact well known to market participants all along (Soros, 1987; Temin and Voth, 2004).

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26. The devaluation risk in turn can be decomposed into two components: a major devaluation risk (MD) and exchange rate drift (ERD), which entails relatively predictable incremental changes in the peg. In a fixed exchange rate regime ERD is insignificant or zero while MD is positive; and in the case of floating regime it is exactly the opposite: ERD is significant while MD is zero or negligible (McKinnon and Pill, 1998). 27. This is discussed in more rigorous terms in Ekinci and Erturk (2004). The devaluation risk and expected asset price increase can be expressed respectively as: ΔAPe = Δ ln Pt + 1 and DR = Δ ln et + 1 (where Pt + 1 is the price of the asset at time t + 1 and e is the nominal exchange rate), and the modified interest parity condition where assets are held for the expected increase in their price is given by: Δ ln Pt + 1 = i* + Δ ln et + 1 + SR. In the case of a simple discount instrument with a face value of X, the price of the instrument is Pt = X/(1 + it ) at time t, which gives, ln Pt = ln X − ln(1 + it ) = ln X − it , with the reasonable approximation . ln(1 + it ) = it. Likewise, because Pt + 1 = ln X − ln(1 + Ei t + 1) =ln X − Eit + 1 (where E is the expectations operator), it follows that: Δ ln Pt + 1 = it − Eit + 1 = i* + Δ ln et + 1 + SR, or it = Eit + 1 + dt , where, dt = i + Δ ln et + 1 + SR. This means that, in a Keynesian spirit, asset prices (interest rate) follow a forward-looking unit root process (with respect to the expected rate) with drift (dt). In other words, with given expectations about the drift, the current interest rate is governed by its expected future value. Thus, what speculative investors expect about the future determines what happens in the current period. 28. In general, the failure to provide lender, of last provision appears to have caused the greatest harm in transmitting the financial débâcle to the ‘real’ economy. 29. In fact, the link between the initial fall in the DR and the eventual increase in the SR might be more immediate. A strict anti-inflationary policy stance – as was the case, say, in Cavallo’s plan in Argentina – that is designed to reduce effectively the DR, at the same time can have the effect of raising the default risk on the stock of outstanding domestic debt (and thus the SR) because it thwarts the ability of the country in question to inflate its domestic debt if need be. McKinnnon (1994) explains in a similar vein why the risk premium on Italian and Spanish debt increased after the Maastricht Treaty as the member countries in the Europe Union effectively gave up their ability to inflate their debt. See also Vives (2002). 30. This might indeed prove to be an opportune time for experimentation in setting up regional networks. Especially important is the Asean Plus Three (APT), which brings together the member countries of the Association of South East Asian Nations with China, Japan and South Korea. As it might be recalled, the US and the IMF had strongly opposed any idea of setting up an Asian Monetary Fund at the time of the East Asian Crisis. Thus, the growing cooperation among APT countries is a diplomatic failure for the US, which has been promoting the Asia–Pacific Economic Co-operation forum instead to prevent the development of Asian economic regional cooperation at its expense.


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31. The financial press is already awash with stories about central bankers making plans to diversify their reserves in order to reduce their exposure to the dollar, and oil producers parking an ever smaller amount of their proceeds in dollar denominated accounts.

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Index

absorptive capacity, 64 adverse selection, 16 Argentina, 154 Asian crisis, 18, 24, 32, 130, 131 overaccumulation, 138–43 Asian economies, 107 Asian model of development, 139 asset earnings, 53 asset price bubbles, 134, 148 Babylonia, banking systems, 3 balance of assured mutual financial destruction, 158 Bank Générale, 5 Bank of Montreal, 19 Bank Royale, 5 Bank of Scotland, 19 Bank of Upper Canada, 19 banks history of, 3–9 privatization, 25–6 Botswana, 78 Bretton Woods, 77 Burkina Faso, 77 Burundi, 77, 78 Cameroon, 78 Canada, free banking, 19 capital account driven crises, 143, 148–55 capital account liberalization, 29–31, 93 effect on growth, 100–1 effect on macroeoconomic policies, 101 capital gains tax exemption, 63 capital outflows, 60 Central Bank, 1, 2 Chile, 118

China, 70–3 coinage, 4 commodity wars, 72 foreign direct investment, 71 Wholly Foreign Owned Enterprise Law, 71 coinage, invention of, 4 commoditization, 142 commodity wars, 72 competition, 15–16, 119 competitions of instruments, 12 Congo, 78 contagion effects, 133 corporate effects of liberalization, 31–3 cost-determined pricing, 22–3 Cote d’Ivoire, 78 country (sovereign) risk, 150 credit access, 113–20, 118 policies enhancing, 120–2 credit expansion, 129, 145 credit rationing, 98 credit scoring models, 121 crises see financial crises cronyism, 31 currency substitution, 146 current account driven crises, 143, 144–8 demand determined pricing, 22–3 depreciation, 110 devaluation risk, 150, 151 developing countries, 99, 106, 114 credit access, 113–20, 118 see also poverty dollar, stability of, 155–8 dollar-indexed bonds (tesobonos), 153 domestic saving flow, 58–9 dumb chips, 136 169

170

Index

economic development, 14–17 economic growth, 47–9, 94 and financial liberalization, 94–102 and poverty, 102–7 economic policies, public effects, 45 efficient market hypothesis, 148 Egypt, banking systems, 3 equal opportunities, 51 equity capital, 59 excess price volatility, 96 expectations driven models, 143 external debt, 11 external finance, 59–61 feminism, 48 finance and distribution, 50–1 financial crises, 24–5, 107–13, 129–68 Asia, 18, 24, 32, 130, 131 capital account driven, 143, 148–55 common features of, 132–5 current account driven, 143, 144–8 Latin America, 32 Mexican, 32, 130 and poverty, 109–10 financial instability, 108 financial liberalization corporate effects, 31–3 and crises, 24–5 definition of, 92–3 and economic development, 14–17 and economic growth, 94–102 problems with, 13–14 sequencing of, 11, 12 theory and policy, 9–13 financial markets liberalization, 1, 2 financial policies, 20–1 financial repression, 2, 9 financial sector, 58 mobilization, 61–2 financial stability, 18–20 firm sector, 54–5 first-generation models, 132, 143 fiscal squeeze, 63

flying geese model, 138, 140, 141 foreign capital, mobilization of, 62–78 foreign direct investment, 60, 71 foreign trade tax, 56 free banking, 18–20 fundamentals driven models, 132, 143 Gabon, 77 gender issues, 43–89 domestic saving flow, 58–9 finance and development, 46–50 finance and distribution, 50–1 financial sector mobilization, 61–2 gender and financing strategies, 48–9 real sector, 51–62 wage gap, 54–5, 67 see also women Ghana, 76, 118 Gini coefficient, 105, 111 global capitalism, instability of, 129–68 global diversification of risk, 95 globalization, 107 government budgets, 57–8 government sector, 55–8 grain banks, 3–4 gross domestic product growth, 100 growth regression, 105 heavily indebted poor countries, 77 historical aspects, 3–9 household sector, 52–4 human development index, 77 immiserizing growth, 139 import duties, 56 import expansion, 55 import-competitive goods, 54 Indonesia, 118 inflation, 105, 144 interest rates, 150 changes in, 22–4, 152 liberalization, 75 low levels, 24

Index 171

International Monetary Fund, 11, 69 investment, 17 irrational herd behaviour, 133 irrelevance propositions, 7 Kaldorian conception of overaccumulation, 135–8 Kenya, 75, 76, 77 Keynes, John Maynard, A Treatise on Money, 6 Keynesian model, 97 Korea, 67–8, 118 export revenue, 140 labour hoarding, 110, 112 Latin America, 107, 111 Latin American crisis, 32 Law, John, 4, 5 legal factors, 26–8 Lesotho, 78 liquidity constraints, 16 Living Room as Factories programme, 66 loans, 59 Lombard Street, 6 low-income households, 56 McKinnon–Shaw model, 15, 17 macroeconomic policies, 29–31 and capital account liberalization, 101 macroeconomic stability, 12 Malawi, 75 Malaysia, 65, 118, 154 Mali, 77 market integration, 48 Mexican crisis, 32, 130 Mexico, 118 dollar-indexed bonds (tesobonos), 153 micro-finance, 121 missing gender dimension, 47–9 Mississippi Company, 5 monetized government deficits, 133 moral hazard, 16, 133, 146, 147 Mothers’ Workshops, 66

multinational companies, investment activity, 32 Mundell–Flemming model, 152 neo-structuralist model, 97 newly industrializing countries, 136 Nigeria, 76, 77 non-market economy, 51 overaccumulation Asian crisis, 138–43 Kaldorian conception, 135–8 overborrowing, 129, 145 Philippines, 69, 117 political factors, 28–9 portfolio diversification, 96 poverty, 90–128, 114 credit access, 113–20, 118, 120–2 and economic growth, 102–7 financial crises affecting, 109–10 regression, 105 privatization, 25–6 real bills doctrine, 5 real sector, 51–61 changes in, 61–2 financial sector, 58 firm sector, 54–5 government sector, 55–8 household sector, 52–4 reverse causation, 99 risk country (sovereign), 150 devaluation, 150, 151 global diversification, 95 total exchange rate, 151 Rome, banking systems, 4 Royal Bank of Scotland, 19 rural credit centres, 116 Russia, 154 sales tax, 56 savings, 17, 58–9, 101 Scotland, free banking, 19 second-generation models, 143 sequencing, 11, 12, 18

172

Index

Singapore, 65 small and medium enterprises, 65, 118–19 smart chips, 136 Smith, Adam, 4, 5 social infrastructure, 102 Southern Cone, 144 speculation, 21–2 stagflation, 76 stagnation of development, 73–4, 78 stock markets, 21–2, 100 liberalization, 95–6 structuralist theory, 15 sub-Saharan Africa, 74–8, 115–16 Summers, Larry, 158 sustainable development, 64 Swaziland, 78 Taiwan, 65, 66, 67 Living Room as Factories programme, 66 Mothers’ Workshops, 66 Tanzania, 75, 77 taxes, 56 tesobonos, 153 third generation models, 131 total exchange rate risk, 151

trade balance, 150 trade liberalization, 54 transaction costs inefficiency, 61 transition countries, 114 Turkey, 118 Ugandan disease, 76 unequal development, 70, 73 US economy, 155–8 value added tax, 56 wage earnings, 53 wage gap, 54–5, 67 Walras Law, 13, 18 women employment patterns of, 68–9 provision of unpaid labour, 50 savings patterns of, 58–9 wage earners, 57 wage gap, 54–5, 67 see also gender issues World Bank, 11, 69 Zaire, 77 Zambia, 76, 77 Zimbabwe, 75, 76, 77, 118

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