International Finance: From Globalization to Crisis

By Chakravarthi Raghavan,
Third World Network Features
25 February 1995

The Mexican peso crisis underlines the case for rethinking the current policy advice to the developing countries—on a uniform development model, complete withdrawal of the state from the economy and financial liberalisation.

Geneva:—The Mexican ‘peso crisis’ and the reactions to it from the Northern centres and the international financial institutions (IFIs) underline the case for rethinking the current orthodox policy advice to the developing countries— a uniform development model, complete withdrawal of the state from the economy and financial liberalisation.

This was a major thrust of discussion, from panel UNCTAD (United Nations Conference on Trade and Development) economists and other participants at a seminar on ‘International Finance: From Globalisation to Crisis.’

Argentine academic and leading Latin American economist, Roberto Frenkel, said that if there was any lesson to be drawn from the Mexican experience it was that national measures were needed to control short-term capital flows, and that these had to be supported by international agreements.

The Frenkel view is shared by economists and experts elsewhere who suggest that just as the International Monetary Fund-World Bank policy advice changed in the late 1980s and early 1990s, and developing countries were pressed to open up their financial sectors and capital markets to suit the interests of the US and Europeans, when the latter find that 'rescue' operations as for Mexico would involve asking the tax-payer to meet the bills, there will be another reversal of policy and developing countries would be advised to regulate capital markets and impose restrictions.

UNCTAD's Officer-in-Charge, Carlos Fortin, who chaired the seminar, in a brief opening comment noted that in 1994 (when the Trade and Development Report had raised some of the issues about global finance and role of the state in the economy), the Wall Street Journal had called the UNCTAD economists Rip Van Winkles, but it has now run a story on the first page as to how the economists had been warning for years about the likelihood of the kind of crisis that overtook Mexico.

Shaheen Abrahamian, heading the Global Interdependence Division of UNCTAD (and one of the principal authors of its annual Trade and Development Report), said the developing countries were told that they should not depend on debt for development but on non-debt creating capital flows and that when things were left to the market, those following correct policies would be rewarded and those not doing so would be punished. On this basis, Latin America got the go-ahead, and they liberalised their domestic economy and trade, and short-term capital flew in.

Now suddenly, over the past few days, there is talk of these countries having become over-exposed to short-term capital, Abrahamian said.

Mexico did not go out to attract short-term capital. The inflows were the result of its economic policy and till the crisis Mexico was being held out as exemplar. The question that has to be asked is how did the examplar policies result in a serious flaw in the economy? How did the rewards of the market become the seeds of a crisis . . . . The real question to be asked is whether the current orthodox paradigm is right, whether the pendulum has swung too far (over the state role in the economy) and whether the current paradigm needs to be corrected.

Andrew Cornford, another senior economist dealing with banking and financial services, cited the earlier UNCTAD reports where there had been repeated cautionary views over the opening up of the financial sectors and dangers of short-term capital flows.

Mexico got into the crisis not because of wrong policies or mismanagement, but because it succeeded too well in following the orthodox policy line and advice, Yilman Akyuz, another senior economist and head of UNCTAD’s macro-economic policy unit, said. Mexico had cut its public deficit, brought inflation under control (annual 9% rate in November 1994) and undertook trade liberalisation, including in the financial sector.

The conventional analysis (the British Chancellor of the Exchequer, Nigel Lawson’s view) is that if the public sector deficit is taken care of, the deficit of the private sector does not matter because the market knows what to do; and that capital is scarce in developing countries and provides a high rate of return. Therefore, if the Third World opened up its capital account and encouraged investment from abroad, capital would come into the country. Countries would get into trouble only if there were problems elsewhere: high budget deficit, high inflation and unliberalised trade. If these were right, all problems and difficulties would disappear.

The problem with this analysis was that in Latin America, capital went not only to those who followed this line, but also into countries like Brazil that did not. And capital went in to finance private consumption. Previously when official flows went to finance consumption, rather than investment, the IMF and the World Bank would pressure the countries to adjust. But under the Lawson doctrine, the private sector debt for consumption was ignored. Also, the behaviour of the capital flows cannot be predicted by indicators. In 1992-1993, the fundamentals of the French economy were better than those of Germany, and yet the French franc came under attack.

In Latin America, Akyuz added, even a country like Chile which is less vulnerable to speculative attacks can be in trouble if expectations change, if copper prices go down or terms of trade move adversely.

In the 1980s, Akyuz said, Latin American countries were better off in a sense: they could renegotiate their debt. The lenders were only concerned about getting payment on their interest, and were not seeking the principal back. Now with non-debt creating flows, countries don’t have the luxury of renegotiations. It is a case of the foreigners taking their principal out. In such a situation, the only remedy for a country is to cut wages and reduce demand, and since it cannot (under the WTO agreement) restrict imports it has to devalue. . .

The kind of IMF facility being proposed to help countries facing difficulties over short-term capital flows, would present moral hazards for both borrowers and investors of short-term capital; such facilities never worked—as was the experience with the IMF commodity compensatory facility, and would end up as another conditionality window; and the amounts needed for such a facility are too large and any such IMF paper might end up in secondary markets like those of Mexico.

Roger Lawrence, who formerly headed the interdependence and macro-economic policy division and now heads the Centre for Transnationals (which advocates liberalisation of financial markets and services), suggested that the relationship between finance and real economy perhaps needed further study.

But Akyuz noted that there had been a large number of studies, within and outside UNCTAD, showing that when the finance sector of a country faced a crisis, it affected the real economy through recession and unemployment, lowering wages and affecting the social sector.

The bottom line, he said, is: Finance should serve industry and not the other way round.

Frenkel said though the Mexican crisis came as a surprise to many, it could not be called a surprise for the markets. In terms of the risk premiums and spreads, the financial markets had assessed the risks and had high spreads compared to the United States. When US interest rates went up, these investors went back to the US (with a lower risk).

Akyuz thought that with the $50 billion financial package, and the virtual US guarantee, funds could go back to Mexico, and those putting money in now might even benefit, there could be reversals again in the future for whatever reasons.

Frenkel said the package may help Mexico, but if the $50 billion is not seen as enough and there is no capital flow to finance the current account deficit, then there will be inflation, recession, etc.

Cornford said no one, not even those in the market and Wall Street firms, are able to say as to when the bubble in the market bursts and what factors influence the reversals—political, social or economic. All that could be said is that when the bubble is growing everyone joins, and when somebody pulls out everyone does too. It would hence be difficult to say what role the political developments in Mexico (beginning with the Zapatista rebellion, the elections and change of Presidency in November) played in setting off the crisis.

Frenkel was asked about the view of Argentine Finance Minister Cavallo that the country had $15 billion in reserves, that the currency board firmly linked money supply to the reserves, that Argentina had a 3.5% inflation rate, had a low public sector deficit compared to the Western countries and had only a $5.4 billion public debt maturing which could be financed if necessary from dometic savings.

The Argentine economist said that there was no quarrel over figures, but about the concepts. In line with the IMF (and Lawson) concept, Cavallo did not see any problem arising from private sector indebtedness, either in terms of servicing or paying back. He was only looking at it as a financing problem of the public sector debt: the $71 billion external debt (owed to residents and non-residents), the peso-dollar fixed exchange rate link and reserves to back it. (Argentina’s debt to non-residents, public and private, according to CEPAL estimates is $78 billion).

A country has to service its debt and pay for imports by exports to international markets. If Argentina had to service the $5 billion maturing debt in 1995, Cavallo’s argument was that it could be financed if needed from the reserves or by a higher rate of interest for the roll-over of that debt.

Argentina had a debt-to-export ratio of 412%, and a current account deficit in 1994 of $12 billion. To sustain the same level of activity in 1995, it would thus require inflows of $13 billion (in nominal terms) to finance the current account deficit and another $5 billion to pay back or roll over the maturing debt. But if this money does not come (not because of Argentine fundamentals, but the market reactions to Mexico and interest rate rise in the US, etc), then the reserves have to contract and because of the link between reserves and money supply—like the old gold standard—liquidity of the monetary system will be reduced and the economy will contract and go into recession, Frenkel said.

The dollarisation of the Argentine economy would not help since, unlike the US, Argentina cannot create dollars—it has to earn them by exports and current account surpluses.

So the way the IMF and Cavallo look at it is one concept, and the way the market (as seen from the risk spreads) and I look at it involves another.

The Third World Network referred to the views of the large coalition of Northern and Southern NGOs—the Development Caucus—in relation to the Social Summit and their call for a complete rethinking of the market philosophy, the Fund-Bank programmes and accountability, and suggested that in relation to UNCTAD-9, the secretariat should not merely look at whether the pendulum had swung too far, but should take a fresh look at the entire neo-liberal order and the development models.

A curious role was now emerging at the IFIs. The IMF and the World Bank, set up at Bretton Woods to mediate between capital markets and the needs of long-term development finance, first left it to the banks during the petro-dollar era. When the banks’ intermediation brought countries into a crisis—as a result of the Paul Volcker (at the US Federal Reserve) interest rate hikes, developing countries were pushed into the market-friendly theories, in effect making them do the intermediation and mix of deposits, short-term capital flows and foreigners buying equities in share-markets.

Now that the countries are coming to grief, as shown by Mexico, the IMF is proposing a facility so that it could intermediate and underwrite the short-term investors and speculators. While Keynes and (Harry Dexter) White had envisaged a stable monetary and financial system to offset any defects of the trading system, the WTO was now pushing a neo-mercantalist version of free trade, including financial sector liberalisation in the face of an unstable and non-existent monetary system. It was a contradiction that could only lead to social disasters.

Al-Shabibi wondered whether in the face of a globalised world economy and globalised financial markets, the arguments about short-term flows mean that no money is better than hot money.

Abrahamian responded by noting that the UNCTAD advice was not against short-term flows as such—they had their place for particular purposes —but overdependence on it to finance trade deficits and for development finance. The troublel with short-term money was that there was a herd mentality: someone goes in because the particular market was found attractive and others follow; but when someone reverses, everyone gets panicky and does the same, thereby causing a negative capital flow. In that sense, no money is better than negative money.

Michael Sakbani said there was need for careful analysis of which countries were in a position to liberalise, what and how. While an economy like the US could liberalise everything, developing countries were much more vulnerable and had to be more careful about trade liberalisation, particularly financial sector liberalisation—inflow, outflow and foreign currency deposits.