The Bangladesh cabinet has endorsed lifting of an embargo in place since independence, on investments in foreign countries by local businesses and individuals, under a liberalised foreign exchange regime. A daily reported that the “preferred sectors in the new investment criteria includes deposits in banks and investments in stocks, real estate and other industrial units in foreign countries.”
The report quoted a senior Finance Ministry official as saying that the blanket changes are needed “to keep pace with changed world economic order and modernise investment outlook as decades [of] long restrictions on capital account convertibility makes no financial sense given the country’s current buoyant reserve position.”
Alas, the senior official seems to be unaware of an increasing volume of evidence that capital account liberalisation lies at the heart of most financial crises. Both frequency and depth of financial crises increase with the capital account liberalisation. There is now a great deal of consensus that capital account liberalisation together with rapid financial sector deregulation played a large role in the Asian financial crisis of 1997-98 that punctured more than three decades of rapid growth of East Asian economies under a regime characterised by financial restraint and control. Malaysia could come out of the crisis only after it introduced restrictions on foreign capital transactions.
Countries, such as China and Viet Nam that remained unaffected by the contagion, had restrictions on capital account. The same is true of India who could largely insulated itself from the 2008-9 global financial crisis.
Countries with liberalised capital account also are vulnerable to monetary policy changes in advanced countries. For example, in recent years, countries that have liberalised their capital account in the hope of overcoming their structural balance of payments deficit or savings-investment gap through short-term capital flows, experienced sharp fluctuations in financial markets, including sudden depreciation of their currencies when the market anticipated a shift in the US Federal Reserve’s monetary policy.
This means the Bangladesh Bank has to have strong macro-prudential regulation to protect our financial sector from external shocks. It must also have “very large” foreign exchange reserves to withstand storms hitting our shores arising from changes in macroeconomic policies abroad. But keeping large foreign exchange reserves has an opportunity cost as this could have been invested in socially desirable sectors. Moreover, as some countries in the region with large accumulated foreign reserves (e.g. South Korea) have found out in the wake of the 2008-9 crisis and during the volatility caused by changes in the US monetary policy, that their “large reserves” may also quickly disappear.
Furthermore, if the Bangladesh Bank is not extra-vigilant, the blanket deregulation of the foreign exchange regulations act is likely to open the door for large-scale capital flight through “legalised” channels. One just hopes that the Bangladesh Bank has the capacity to bear this huge prudential regulatory and policy-making- as well as vigilance- burden.
It is understood that “a group of influential businessmen had long been pressing the government to lift the ban on current capital account convertibility so that they could invest outside the country.” However, apparently the decision was “largely dictated by the International Monetary Fund” (IMF), a source at the Bangladesh Bank told the daily.
This, in fact, is contrary to IMF’s Article of Agreement VI (Section 3) which explicitly states, “Members may exercise such controls as are necessary to regulate international capital movements …”
Under the leadership of IMF Managing Director, Jacques de Larosiere, the Fund stayed away from financial globalisation or internationalisation until 1987. Jacques de Larosiere has famously said, “We had our catechism: Thou must give freedom to current payments, but thou must not necessarily give freedom to capital.” He further noted, “I was comfortable with the idea that the Fund would not move toward compulsory freedom of capital. By the time I left the Fund in 1987, I was not aware of any discussions of changing the Articles to bring the capital account within our jurisdiction.”
Only during the 1990s, the IMF became an enthusiastic advocate of capital account liberalisation, and its Executive Board, led by Managing Director, Michel Camdessus, sought to amend its Articles as the status quo was portrayed and increasingly seen as anachronistic and naïve. Thus, the IMF under his leadership began to encourage the staff to give greater emphasis to capital account issues in Article IV consultations and technical assistance and to promote capital account liberalisation more actively.
However, the Asian financial crisis from mid-1997 forced the Interim Committee at the Annual Meeting in September 1997 in Hong Kong to ask for caution in the implementation of capital account liberalisation. Although the Asian financial crisis dealt a blow to the supporters of capital account liberalisation, it did not diminish their enthusiasm. Despite the deepening of the Asian financial crisis and the financial crises in Russia and Brazil in 1998, the Interim Committee renewed its call for capital account liberalisation at the 1998 Spring Meeting of the Board.
It is argued that capital account liberalisation would see capital outflows from capital abundant developed countries to capital-scarce developing countries. This sounds very logical, as water flowing downstream. This is also consistent with economic theory which states that marginal returns decline with higher stock of capital. Therefore, as capital competes or rushes in seeking opportunities for better returns where the stock of capital is low, the cost of capital should decline.
Paradoxically, developing countries are financing large current account deficit of the richest country in the world, the US. With some exceptions, opening up the capital account has facilitated capital flight, rather than inflows, especially of a long-term nature, to develop new economic capacities. Developing countries continue to provide net financial resources to developed economies, peaking with an all-time high of $883 billion in 2008. The lost decade of the 1980s in Latin America, the lost two decades at the end of the 20th century in Africa, and protracted stagnation in post- ‘shock’ transition economies have accompanied financial liberalisation. And when capital has flowed to emerging markets, such episodes have often been temporary and eventually reversed with devastating consequences, as in the 1997-1998 East Asian, 1998 Russian, 2000 Turkish and 2002 Argentine crises.
Not surprisingly, recent IMF research acknowledges that financial liberalisation has not ensured higher growth. In fact, one of its recent publications attributed the rise in inequality worldwide to capital account liberalisation (“Who Let the Gini Out?” Finance & Development, December 2013, Vol. 50, No. 4).
Capital account liberalisation has also not ensured significantly cheaper finance. Instead, the cost of finance rises sharply during economic downturns (forcing real interest rates to rise) and falls during booms (involving low real interest rates). More rents have accrued to finance in the OECD economies in recent decades. Meanwhile, financial liberalisation has led to financial deepening which has increased the levels of intermediation and corresponding claims to financial rents.
One can explain politicians’ enthusiasm towards the idea of local investors investing overseas. This may be seen as a sign of maturity or progress towards becoming a developed or capital exporting country! They can presumably take the credit for this progress. But juxtapose this with our begging for foreign aid and loan. If we do have surplus capital that needs invested overseas, then why not encourage our local investors to invest here to overcome our huge deficits in infrastructure, energy and other essential services instead of looking for foreign investors?
Why are our investors not attracted to domestic opportunities and instead pressing for deregulating our capital account? Is that not one sure way of saying that “we do not have confidence or stake in this country. So, we need ‘legalised’ channels to take our assets and money to a safe-haven.”
Anis Chowdhury, is a former Professor of Economics from the University of Western Sydney, Australia.