This second article in this series explores the risks of financial liberalisation and some of the ways to deal with them.
The difficulty in assessing the risks of different financial instruments in different jurisdictions, and of the jurisdictions themselves, makes it almost impossible to calculate with confidence the risk-adjusted returns. This is notwithstanding the gallant (and now much improved) monitoring efforts of the international financial institutions, such as the International Monetary Fund, and the valuable work of the commercial rating agencies. As a consequence, some jurisdictions get more, others get less, capital flows, in either direction, than justified, and financial markets overshoot. They can do so to such an extent as to lead to systemic problems, when, for example, the weaker domestic financial institutions of emerging markets, hampered by their inability to identify and manage risks under the influence of globalisation, collapse. Alternatively, domestic macro-economic problems, considered to be benign on one day, all of a sudden become malignant the next, triggered possibly by some strange events: then sharp, destabilising reversals of capital flow ensue, with debilitating consequences to the financial system and the economy.
All of this, of course, sounds familiar, with the Asian financial crisis of 1997-98 still quite fresh in our minds. And so we all come to realise that for financial liberalisation to produce the desired benefits it has to be accompanied by much greater discipline in pursuing prudent macro-economic policies, and improved robustness in the financial system, including the financial infrastructure. This applies also to those jurisdictions wishing to maintain their current degree of openness, of their financial systems and markets, although it is also possible, and indeed individual jurisdictions have quite successfully chosen, to put up protective shields permanently or temporarily. "If you wish to play major league baseball, you'd better get used to the strong pitching" said a leading central banker in a post mortem of the Asian financial crisis - a telling description of the reality.
And the reality is often harsh, particularly for those who are less well endowed, for example, economies with financial markets that are small relative to the amount of international portfolio capital that could be mobilised by foreign investors but big enough to whet their appetite for profit. These relatively small financial markets may have to tolerate concentrated market positions and lack of transparency, in the hope of retaining foreign interests, but at the expense of increasing their vulnerability to the reversal of flows. Furthermore, the versatility of foreign funds and their higher sensitivity (than domestic funds) to shifts in market sentiment and policy changes, are such that, arguably, the market discipline imposed on macro-economic policies of emerging markets may de facto be more stringent than those imposed on developed markets. Indeed, what is acknowledged by many as unsustainable, the large current account deficit in excess of 5% of GDP in the United States, has been sustained there for some time now, probably a lot longer than if it were run by an emerging market.
But there really is no magic formula or sequence for financial liberalisation. For the sake of argument, in an economy with a domestic savings rate that is already high, where there is no shortage of funding for domestic investment, increasing the efficiency of domestic financial intermediation should arguably receive priority. Freeing up the capital account and allowing international mobility of portfolio capital would, of course, enable foreign savings to come in and would allow financial deepening. But it is important to be clear whether these are needed in the first place, whether the benefits justify the assumption of the associated risks and whether there is adequate risk management capability. In any case, the inflow of foreign savings under liberalisation could well be more than compensated by the outflow of domestic savings. Capital account liberalisation, if the intention is to attract a net inflow of foreign savings, may therefore have to be structured and sequenced accordingly, involving, for a time, asymmetric international mobility of capital biased towards inflows. The fact that, in the financial liberalisation of the Mainland, QFII has preceded QDII is a good example of this approach, although the threat of over-investment now strengthens very much the case for going ahead with QDII as quickly as possible.
In the final analysis, it has to be recognised that net capital inflow, whether in the form of direct investment or portfolio investment, under restricted or free circumstances, must by definition be mirrored by a deficit in the current account of the balance of payments. Long-term dependence on net capital inflow is unrealistic, just as it is unrealistic to sustain significant current account deficits indefinitely. This is not an argument against free and open financial markets. The efficiency gains in financial intermediation arising from foreign participation and competition should not be overlooked. The economic success of emerging markets in Asia, the financial crisis of 1997-98 notwithstanding, would not have been possible if there had been financial repression instead of financial liberalisation. The financial freedom of Hong Kong, furthermore, demonstrates this clearly. But beware of the risks.
Joseph Yam
2 September 2004
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