Go With The Flows? Capital Account Liberalisation and Poverty

Go with
the fl ow s ?
Capital account
liberalisation
and poverty
April 2001
Published by
With the support of

The Heinrich Bll Foundation,
Washington Office
About Bretton Woods Project Acknowledgements
The Bretton Woods Project monitors the World The Capital Account Liberalisation and Poverty
Bank and International Monetary Fund in collabo- meeting, January 11-12th 2001, on which this
ration with NGOs and researchers.Established by a report is based, was made possible by the gener-
network of 30 UK NGOs in 1995,it circulates infor- ous support of the Department for International
mation undertakes research, and advocates for Development,UK.
change in these institutions.Issues it has addressed
include structural adjustment programmes, condi- A full transcript of the meeting is available at
tionality, the World Bank/IMF growth model, and a www.brettonwoodsproject.org.
number of controversial projects.
Thank you to the participants of that meeting for
The Project produces a regular bulletin, the their energy, critiques,creativity and good humour.
Bretton Woods Update, which is available in print,
email and web versions. Thank you to Valpy Fitzgerald and Frances Stewart
and the staff at Queen Elizabeth House, Oxford
Bretton Woods Project University for hosting the meeting.Thanks also to
Hamlyn House Alex Cobham for the report, Capital Account
Macdonald Road Liberalisation and Poverty, prepared for it.
London N19 5PG
Email:info@brettonwoodsproject.org Thank you to Laura Butler for her invaluable help
www.brettonwoodsproject.org in preparing for the meeting. And to Laura and
Sophia Mahmud for their patience and help with
Bretton Woods Project is supported by the C. S. preparing the transcript.
Mott Foundation and the John D. and Catherine T.
MacArthur Foundation. Many thanks to the Heinrich Bll Foundation,
Washington office, for supporting the publication
of this report.
About Oxfam
Editing: Angela Wood,Bretton Woods Project
Founded in 1942,Oxfam works with poor people and Jenny Kimmis,Oxfam
regardless of race or religion in their struggle Layout: Anni Long,Oxfam and
against hunger, disease, exploitation and poverty. Barry McCann, www.waggledesign.com
Cover: King Graphics,
Oxfam GB king@king-graphics.co.uk
274 Banbury Road
Oxford OX20 1RQ
Email: chumphreys@oxfam.org.uk
www.oxfam.org.uk
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Go with the flows? Capital account liberalisation and poverty

Contents
Preface i
From Capital Account Liberalisation to the Real Economy:

Putting People First, Angela Wood
1 Push Factors for Capital Account Liberalisation ...................................................................1

1.1 Private Capital as a Substitute for Aid Flows..................................................................................1
1.2 Linkages Between Trade,Capital Account Liberalisation and the Balance of Payments................1
1.3 Linkages Between Privatisation and CAL.......................................................................................2
2 From Capital Account Liberalisaton to Poverty: Identifying the Linkages.......................3

2.1 Liberalisation,Resources and Growth............................................................................................3
2.2 Access to Capital Flows and Impacts on Assets.............................................................................4
Liberalisation Episodes: When Capital is Flowing in.....................................................................4
Crisis Episodes: Capital Outflows..................................................................................................5
Government Intervention..............................................................................................................5
2.3 Changes in Government Spending.................................................................................................6
Redirecting Government Spending................................................................................................7
Volatility of Government Spending................................................................................................8
The Cost of Foregone Taxation/Tax Competition..........................................................................8
2.4 Market Discipline and Government Policy....................................................................................9
Market Sentiment and Government Budgets.................................................................................9
Market Confidence: Crisis Periods and Recovery .......................................................................10
Conclusions..................................................................................................................................11
Capital Account Liberalisation and Poverty, Alex Cobham
Executive Summary......................................................................................................................................13
Introduction .................................................................................................................................................14
1 Financial and Capital Account Liberalisation ......................................................................15

1.1 Definitions and Interactions.........................................................................................................15
1.2 The Extent of Capital Account and Domestic Financial Liberalisation........................................16
1.3 Growth Effects of Financial Liberalisation...................................................................................17
1.4 Growth and Capital Account Liberalisation.................................................................................18
2 Crisis Periods .............................................................................................................................20

2.1 The Socialisation of Private Debt.................................................................................................20
2.2 Macroeconomic Policy Response ................................................................................................21
2.3 Real Economy Impacts.................................................................................................................22
2.4 Some Conclusions........................................................................................................................23
contents continue overleaf

3 Impact on Government Finances and Policy ......................................................................23
3.1 Government Finances ..................................................................................................................23
3.2 Managing Capital Inflows.............................................................................................................24
3.3 Market Discipline.........................................................................................................................25
3.4 Taxation and Capital Mobility......................................................................................................26
3.5 Some Conclusions for Government Finance and the Poor..........................................................27
4 Liberalisation and Industry .....................................................................................................27

4.1 Liberalisation,Macroeconomic Uncertainty and Financing Investment in Firms........................28
4.2 Liberalisation and Credit Availability............................................................................................28
4.3 Stock Market Development..........................................................................................................31
Conclusions..................................................................................................................................32
References....................................................................................................................................35
Comments:
Dr Louis A.Kasekende..................................................................................................................38
Filomeno S.Sta.Ana III .................................................................................................................41
Aart Kraay.....................................................................................................................................43
William Larralde ...........................................................................................................................47
Mark Allen.....................................................................................................................................49
Kamal Malhotra ............................................................................................................................51
List of Participants........................................................................................................................................53
Web Resources.............................................................................................................................................54

Preface
G7 Finance ministers and central bankers meeting account) and poverty reduction, it may require
in Palermo, Italy, on February 17,2001 have com- governments to prioritise the former at the
mitted themselves to meeting the United Nations expense of the latter.Whilst the Poverty Reduction
international development goals by 2015. The Strategy process emphasises government leader-
goals include halving the proportion of people liv- ship and civil society participation,the codes and
ing in extreme poverty, achieving universal pri- standards being imposed by the G7 through the
mary education and reducing by two-thirds infant IMF have neither of these qualities. Neither are
and child mortality rates.According to the minis- they truly optional for governments.
tersstatement,a three-pronged strategy to reduce
poverty involves: Several inconsistencies between CAL and poverty
creating a more favourable environment for reduction suggest themselves:
attracting private investment flows into the it is questionable whether CAL is a determi-
poorest countries; nant of investment flows and therefore growth

channelling more resources,in a more efficient and poverty reduction;
and coordinated way, to the social sectors there is the potential that government policy
through country-owned poverty reduction in a liberalised financial climate will be limited

strategies;and in its ability to be pro-poor focused;
a new multilateral trade round and opening putting in place the appropriate institutions
markets in developed countries to exports and regulatory measures to govern a liberalised

from the poorest countries. financial system could divert scarce resources
away from poverty reduction measures;
The ministers commitment to fight poverty it appears likely that CAL will contribute to
reduction is welcome. Facilitating private sector greater inequality by benefiting the rich more
investment and more social spending are undoubt- in good times and hurting the poor more in
edly important aspects of a strategy to do so. bad times.
However, if capital account liberalisation (CAL) is
to be a central element in attracting foreign private Countries considering further integration with the
sector flows then there is potentially considerable global financial system need to be able to distin-
conflict between these prongs of the strategy. guish between the liberalisation measures neces-
The financial crises in Asia, Russia and Brazil sary to facilitate international trade and invest-
contributed to a more nuanced approach to CAL, ment (and therefore beneficial for a country
that is, capital account liberalisation should pro- choosing such a growth path) and those which
ceed more cautiously and with the appropriate are not.They also need to be aware of, and have
sequencing to avoid financial crisis. However, the ability to assess, the trade-offs in relation to
there is no evidence that CAL does or does not pro-poor growth strategies. Capital account liber-
contribute to poverty reduction and only limited alisation is not an all or nothing process,and there
understanding on the transmission mechanisms are lessons to be learnt from previous experiences
involved. Yet G7 ministers assume that CAL is an of liberalisation.
ultimate goal and they are driving the reform agen- Prompted by these concerns, in January 2001
da forward.What seems to be overlooked is that the Bretton Woods Project and Oxfam organised a
liberalisation should not be a goal but a means to meeting1 with Non-Governmental Organisations,
an end. That end, as the ministers have now academics, civil servants and staff from the World
endorsed, should be poverty reduction. Yet there Bank,International Monetary Fund (IMF) and other
has been little analysis of how to sequence CAL to international institutions to discuss the linkages
achieve the best outcome for the poor. between capital account liberalisation and poverty
What is wor rying is that although the IMF has reduction. The meeting, held at Queen Elizabeth
a mandate (whether explicit or implicit) to pursue House, Oxford University, was concerned with
both financial liberalisation (domestic and capital identifying the potential linkages through govern-
Go with the flows? Capital account liberalisation and poverty i

ment policies and through impacts on sustainable Part 1 is a summary of the discussions at the
livelihoods.The meeting was a useful starting point Capital Account Liberalisation and Poverty meet-
and highlighted that there are many more ques- ing (for a list of participants see the end of this
tions than we have answers to.This report does not publication). Parts 2 and 3 are the paper and cri-
attempt to provide those answers but to suggest tiques prepared for the meeting.
some transition mechanisms through which CAL
might impact on the poor. Angela Wood, Bretton Woods Project
1 Thank you to the Department for International Development for their generous support,which made this meeting possible.
ii Go with the flows? Capital account liberalisation and poverty

F rom capital account liberalisation to the real economy: putting people first
From Capital Account Liberalisation to the Real Economy:

Putting People First 1
Angela Wood, Bretton Woods Project
1 Push Factors for Capital Account Liberalisation
Recent decades have seen a range of pressures on 1.1 Private Capital as a Substitute
developing countries to open up to foreign capital for Aid Flows
flows: through World Bank and International
Monetary Fund (IMF) conditionality, World Trade A justification for pursuing liberalisation is that it is
Organisastion (WTO) rules, membership of the necessary to attract private flows to substitute for
Organisation for Economic Cooperation and declining aid flows. Capital account liberalisation
Development (OECD),or membership of regional helps create an attractive environment for capital.
trade arrangements. Financial integration, it is The market, it is argued, will ensure that resources
argued, is both good for growth and necessary to flow from countries with high savings (i.e.investable
co-ordinate participation in international trade resources) to those countries with low savings but
and investment. profitable investment opportunities. In so doing
Since the South East Asia crisis and the subse- there will be benefits to the rich country investors
quent crises in Russia and Brazil there has been who can diversify their portfolios to reduce risks and
some rethinking about domestic financial and cap- find more profitable investment opportunities and
ital account liberalisation. Whilst there is now a the poor countries will gain access to funds for
commitment to proper sequencing and pacing of investment and therefore growth.
reforms there remains the implicit (and often In reality, whether private capital can substi-
explicit) assumption amongst the G7 govern- tute for development aid will depend on how indi-
ments and the leaders of the International vidual developing countries manage the integra-
Financial Institutions (IFIs) that countries will tion process and what policies they have in place
move increasingly towards full liberalisation. to attract, manage and direct flows.The distribu-
However, outside these circles there is a growing tion effects of financial opening will likewise
acceptance that the arguments for CAL are not depend on the nature of liberalisation and who
well founded and that the liberalisation process can benefit from it. While empirical evidence on
needs to be seriously reconsidered. the gains from financial integration in developing
Whilst there has been a back tracking from for- countries is hard to find,the recent financial crises
malising CAL through the IMFs articles of agree- in East Asia,Russia,and Brazil have made the risks
ment2, instead,as William Larralde pointed out,it is all too apparent.
being pursued by stealth,[it] is being replaced by
a more subtle mechanism,such as embedding the
same objective into the adoption of international 1.2 Linkages Between Trade,
standards and codes, best practices and the like, Capital Account Liberalisation
which are being formulated without adequate par- and the Balance of Payments
ticipation of developing countries in inter-govern-
mental and non-governmental bodies and also For some, liberalising the capital account is the
through WTO commitments regarding financial natural extension of liberalising trade,although,it
services,trade related agreements,etc. has been widely acknowledged,even by free trade
advocates,that there are not the same strength of
arguments for doing so 3.
As Matthew Martin argued, in the poorest coun-
tries,where regulations and monitoring are minimal,
there may be little choice but to liberalise the capital
Go with the flows? Capital account liberalisation and poverty 1

account if the trade account is liberalised, since trans- main agenda of vested interests engaged primarily
fer pricing and other practices allow companies, par- in nontradables such as utilities, telecommunica-
ticularly multinationals, to move capital in and out tions,transportation, and real property.
remarkably easily. Exporters may generate internal pressures for
A more positive argument provided by Mark CAL. Allen suggested that What tends to happen
Allen is that, The greater degree of current is that local firms engaged in the export business
account integration now prevailing throughout the are looking, for example, for hedging functions of
world and changes in technology have helped banking services which the banks can only pro-
change the arguments for capital account liberali- vide if there is some liberalisation in the capital
sation. Competitiveness pressures may be greater account. If these demands are not met, then the
with trade liberalisation, and a firm in a developing costs are higher for local businesses than for for-
country may require access to more extensive eign companies, which have access to certain
banking services and cheaper capital. Such consid- resources and financial facilities abroad.
erations have led countries to remove some restric- In crisis periods the links are particularly prob-
tions on cross-border banking activities and to lematic. Reflecting on events in Indonesia, Kamal
deepen the pool of capital that their firms can tap. Malhotra suggested the translation of the capital
At the same time, it has become much easier to cir- account liberalisation crisis into an exacerbation of
cumvent capital controls, firstly because of new the effects of trade liberalisation policy, was fairly
technology,but also because it is easier to hide cap- stark. The effects on prices - various food prices and
ital movements in the huge volume of trade. their availability, what happened in terms of medi-
Capital inflows facilitated by CAL have allowed cine availability etc - and the differential impact of
countries, for example Thailand, to mask or cope that in terms of the poor versus the rich are fairly
with increasing trade and current account deficits clear. This may be seen by some as two separate
brought about by trade liberalisation since the things,trade liberalisation and then financial liberal-
inflow of capital has allowed countries to achieve isation, but when you have a crisis in one are a ,h ow
an overall balance of payments.The problem is that does that actually impact on policies in the other
once capital has been attracted in, if there is no area and exacerbate or highlight some of their
improvement in the trade account, then the coun- downside effects?. And, the other side of this -
try must continue to attract new inflows and it will again in the case of Indonesia and Thailand - is the
remain sensitive to any outflows.Thailands mount- desperate attempt to use natural resource based
ing trade deficit was not problematic until investors exports to claw their way out of the crisis in terms
judged it to be too high and withdrew their money. of generating foreign exchange.
CAL can also contribute to trade account pres-
sures if inflows cause exchange rates to rise as Men
Sta Ana argued:In turn, the strong or overvalued 1.3 Linkages Between Privatisation
currency undermines the real sector of the econo- and CAL
my. Both exports and import substitutes are
penalised.The overvalued currency makes exports A further pressure for capital account liberalisa-
expensive and imports cheap to the detriment of tion has been privatisation. Many countries have
competing domestic goods.Again, this means dis- reformed investment rules to allow foreign own-
placement of workers both in agriculture and in ership of domestic enterprises and utilities.This
industry. Further, the overvalued currency leads to has often been the thin end of the wedge driving
investors shifting from tradables to nontradables. further liberalisation of the financial sector to
For a country with a soft state (the Philippines allow international trade in stocks and shares and
being a prime example), this would all the more the development of stock markets.
reinforce the booty capitalist character of the This process was invigorated in Thailand,South
state. Paul Hutchcroft (1998) defines booty capital- Korea an Indonesia in response to the crisis.
ism as a patrimonial state typified by business inter- Deeper liberalisation to allow the sale and foreign
ests capturing the state apparatus. To be sure, the ownership of national enterprises was a key con-
capture of the states regulatory power becomes a dition for IMF bail-out assistance.
2 Go with the flows? Capital account liberalisation and poverty

2 From Capital Account Liberalisation to Poverty:

Identifying the Linkages
The linkages between CAL and poverty are not need to be understood in terms of their effects on
direct. Whether CAL has an indirect effect on the rural and urban poor, those engaged in produc-
poverty depends on whether liberalisation gener- tion for export markets and those engaged in
ates incoming flows, how these flows are domestic or subsistence production and on the dif-
absorbed in the economy and whether they are ferent elements which contribute to poverty.
available to the poor and small and medium enter-
prises, i.e. do they support pro-poor growth. In
addition liberalisation can have indirect impacts 2.1 Liberalisation, Resources and
on government policy through governments Growth
efforts to encourage and maintain flows. Indeed,
there are more direct roots for affecting poverty Participants broadly agreed that growth is an
reduction.However, it is important to understand important element of a poverty reduction strategy,
that macroeconomic policies do have income and particularly for the poorest countries.Therefore it
distribution effects and how they may or may not is pertinent to consider whether CAL contributes
support a pro-poor strategy. The concern is that to growth.
CAL should not foreclose these more direct means The IMF supports CAL on the basis that it
or worsen the poverty/inequality situation. helps to attract in more resources for investment
Fernando Carvalho reflected that it is impor- which can be positive for growth4. However, as
tant to distinguish between two types of poverty: Aart Kraay remarked the difficulty with that argu-
that which stems from low income and that which ment is that the one thing thats been laboured at
stems from inequality. For the former, growth may length before, correctly, is that capital controls in
be the priority, but in the latter, how CAL impacts most cases are not the binding constraint on
(directly or indirectly) on the distribution of investment in a country. Bad domestic policies can
opportunities and wealth is important. take much of the blame. And the second point
Not only does CAL bring potential opportuni- that hasnt been discussed,but its worth putting
ties it also creates the potential for crisis.Thus,it is on the table,is that theres actually surprisingly lit-
important to consider what the net effect on tle evidence that investment raises growth despite
poverty may be and whether the effect is asym- what we all like to say.
metrical,i.e.do the poor benefit less in good times These views are supported by Alex Cobhams
and suffer more in bad? review of the literature which concludes that
Charles Abugre remarked that whilst the poor there is no a priori linkage between CAL,inflows
are likely to benefit in good times, through higher and growth. However, whilst new foreign inflows
wages and asset prices, these benefits are only tem- may not be forthcoming, liberalisation may be
porary and are reversed in bad times. It is not clear expected to encourage flight capital5 to return,
then what the overall impact is on the poor in the which may be the most stable and pro-poor in-
long run.As Frances Stewart pointed out, in a crisis flow associated with CAL.Louis Kasekende point-
the scale of losses felt by the poor are not likely to ed out that this is Ugandas experience:
be as great as those experienced by those who are Conversely, most of these [African] countries
more wealthy. However, the concern is that the [with capital controls] experienced return of cap-
poor are less able to recover. The overall impacts ital flight after financial liberalisation. Uganda, for
on inequality could be expected to be negative for example,earns on average,US$500million annual-
the poor (both in good and bad times) but further ly from the return of capital flight and workers
investigation is necessary to prove this. remittances alone since it liberalised its capital
As with other adjustment policies,it is clear that account.
some sections of the poor are likely to benefit or One aspect of CAL which may limit the poten-
lose more than others. It is not helpful to aggregate tial for increased growth or even reduce it,partic-
the poor as one group. For example, the impacts ularly in the sectors important to the poor such as

agriculture,is volatility6. Cobham points out in his 2.2 Access to Capital Flows and
paper that as it becomes easier for capital to flow Impacts on Assets
in and out of a country, volatility in the macro-
economy increases,leading to greater uncertainty. The benefits from liberalisation appear to be most-
This may constrain the investment decisions of ly related to the efficiency with which domestic
smaller firms in particular. Whilst larger firms and markets can allocate capital.However, efficiency is
investors are able to make use of international understood in terms of the profitability of invest-
capital markets to hedge against risks and uncer- ments,not their potential to reduce poverty. If we
tainty, this option is often not open to smaller busi- take the latter as the primary objective then do we
nesses and investors. This is confirmed by see benefits to liberalisation? Or perhaps more
Kasekende who noted that liberalisation has led to specifically, when are there benefits to liberalisa-
greater volatility of prices;it is extremely dif ficult tion and should it be a priority for governments
to think of any insurance scheme at the level of with few resources,little capacity and high levels
the peasant farmer to hedge against that risk,and of poverty?
the volatility in the exchange rate has affected
viability of a number of small-scale farms.
Contagion creates an additional source of Liberalisation Episodes:
volatility. Brazil is a good example. To maintain its When Capital is Flowing in
inflation control policies, which relied on a fixed
exchange rate, in a liberalised environment, the When new capital flows in, who gets it? Stewart
government was repeatedly forced to raise inter- remarked that it seems very unlikely that the poor
est rates to 40 percent and o ver to address volatil- are going to get it dis-proportionally to their initial
ity caused by crises in Mexico and Asia.In addition share of income,it seems almost certain that they
to the uncertainty about the level of interest rates, wont.Also, there is rather clear evidence of a lot
high rates can be expected to discourage all but of it going into land speculation in the urban
the most profitable investments. areas,so it seems likely, unless you have very tough
Carvalho suggested that, interest rates [in intervening policies, that that side of the channel
Brazil] tend to be on average higher than is con- would not be positive for the poor.
sidered sustainable, because the repeated experi- Martin insisted that it is important to distin-
ence with increasing rates feeds a kind of bearish guish between the types of flow and to track them
sentiment in terms of interest rates. Everybody to determine their various impacts. For example,
knows that at any time interest rates can be raised the distributional impacts of flows and their trans-
again if you have a serious crisis in Argentina or in mission mechanisms through employment,labour
any other place. So you tend to have a situation policies, wages and access to land and so on,par-
where either interest rates are kept too high or ticularly need to be understood7. This will be nec-
maturities are kept too short because nobody will essary to determine whether there is an optimum
commit resources at low interest rates to longer mix of flows that can reduce volatility and
periods if you know that you are subject to this increase benefits to the poor, as Abugre suggested
kind of volatility. there might be. For example, Martin considered
Since CAL is unlikely to have a significant pos- that the impact of private transfersi.e. domestic
itive impact (and may potentially have a negative capital flight which tend to flow back to the home
impact) on poverty reduction through growth, it economy after liberalisation,are much more likely
is important to consider whether it has an impact to have a positive impact on poverty reduction
through the distribution of income and wealth because they tend to go to people creating small
and access to basic services, i.e. on government to medium enterprises or building houses, using
spending. largely local materials etc. It is likely that those
flows are much more pro-poor. Alternatively, if a
government,in order to sell a parastatal utility to a
foreign investor, abandons all pro-poor regulations
which ensure their access to the service,that is a

direct impact of foreign capital flows on the Alternatively,Aart Kraay argued that crises could
prospects of future poverty reduction. have an equalising effect. He points out that the
It was generally agreed that it is important not gini-coefficients, which measure wealth inequality,
to simply assume that Foreign Direct Investment declined between 1996 and the end of 1998 for
(FDI) is basically good,and thus different types of Indonesia, Korea and Thailand; the two numbers
FDI into different sectors must be distinguished. respectively, are 38 and 37,30 and 29 and 43 and 41.
In addition,it is important to understand whether He offered anecdotal evidence that the poor were
the beneficial flows actually are facilitated by able to benefit from falling asset prices in Thailand
financial liberalisation. If not, there may be few during the crisis;There were cases of farmers com-
benefits of liberalisation but many potential costs, ing into the capital city to take advantage of the fact
particularly transmitted through higher exchange that there were sales on Mercedes.All these people
rates,interest rates and volatility. who had made a lot of money speculating on real
Even if liberalisation (both CAL and domestic estate and were really hurting, were selling off
financial liberalisation) does not actually draw in Mercedes at bargain basement prices.
more capital it could lead to a change in the inter- However, it is not surprising that some sections
nal allocation of capital.Cobhams paper address- of the poor may well benefit whilst others suffer.
es this in part 4.In particular, there is the potential For example, in Thailand, it may well be that farm-
for increased competition between banks and ers producing for export benefited, whilst those
other financial institutions to skew resources away who were not, i.e. smaller farmers did not.This sug-
from rural areas to urban centres and from small gests that its not simply a question of looking at
and medium enterprises to large corporations. who wins and loses in terms of income quintiles,
Another factor which needs to be examined,as impacts on sub-groups of the poor need to be
Stewart suggested, is whether those with more examined. Also, as Stewart pointed out, how quick-
assets are likely to benefit more. For example, ly and to what extent are the poor able to recover
there is evidence from Kenya that after domestic compared to the more wealthy? In relation to this it
financial liberalisation many poor people were will be important to investigate whether the poor
denied access to basic bank services because their are forced to sell more of their assets (relatively)
savings/assets were too small. 8 during and after a crisis and whether the value of
the poorsassets decline faster or slower than those
of the rich, and whether there are longer term
Crisis Episodes: Capital Outflows income and employment impacts (in both the for-
mal and informal economies) for the poor.
In a crisis situation, Malhotra considered that the
rich might be better able to protect their assets.
He considers the problem from the perspective of Government Intervention
the ability to relocate savings, i.e. in terms of
whose assets are more mobile: In the case of Many agreed with Stewart that,intervening poli-
Thailand, even before the crisis,a certain group of cies to direct capital more to the poor are hugely
people close to the government, close to the poli- important.Kasekende remarked that the task for
cy makers, in fact big business, relocated their governments was to find policies that were mar-
money before the devaluation. They were able to ket friendly but which could accommodate the
relocate their assets because there was a liberal needs of the people.
capital account. One means for improving the usefulness of
In the case of Mexico, Valpy Fitzgerald pointed capital inflows is to direct them to priority sectors
out that when per capita national income i.e.to adopt proactive investment promotion poli-
regained its pre-crisis level it was with greater cies. If the objective is poverty reduction these
inequality, it shows theres a permanent poverty might focus on the agricultural sector and rural
effect, in the sense that the same income levels enterprises and small and medium sized firms.
will generate a larger level of poverty and that has However, liberalisation has meant the dismantling
a lot to do with the asset effect. of most investment boards which have been

replaced with hands-off, one-stop investment potentially positive upswing effects is market dis-
shops the only function of which is to facilitate cipline on government budgets. This limitation
investment with no consideration for the quality. may not be so severe if government revenues
Jonathan Leape argued that it is a misconcep- increase in the upswing (or if they are more pro-
tion to view financial liberalisation as a retreat by poor focused). A question that needs to be looked
government:Liberalisation is primarily a retreat at then,is whether this potentially positive impact
from certain types of means for achieving certain is curtailed by competition amongst countries for
types of ends, but the ends havent changed ver y investment which limits governments ability to
much.If we think of capital controls,the objective generate more revenue from foreign investors.
was not the control in itself of course, but the It would be nave to assume that governments
desire to try to insulate the economy to some are necessarily operating pro-poor policies with
extent from these external shocks. That objective capital controls. Indeed, Kraays paper, given the
is still there. If we think about provision of credit limitations with the data that he identifies, sug-
to rural areas, yes some pretty ham-fisted and gests that although countries with capital controls
heavy-handed mechanisms were used in the past tend to have higher fiscal deficits there is no rela-
to do that,but thats still an important objective. tionship between total government spending and
There needs to be more emphasis and more cre- social spending between countries that have open
ative thinking on new, market-compatible ways of capital accounts and those who do not.However,
achieving these same objectives. So recognising will CAL reduce the opportunities for govern-
for example,that you can no longer rely on banks ments to increase spending on the poor (in par-
to cross-subsidise loss-making loans to small busi- ticular) in the future? As Malhotra remarked,if, as
ness into rural areas, we need to think in terms of a result of CAL and the market discipline kind of
explicit subsidies from government. argument, and equally importantly as a response
Angela Wood suggested that directing and/or to crisis, pro-poor deficits are not allowed, or sig-
maintaining credit to vulnerable groups and firms nificant deficits to either protect expenditure or
in times of crisis was equally important, which increase expenditure are not allowed,thats much
suggested that Governments should establish more important.
mechanisms in good times which could be scaled Several participants remarked that taxation is
up in times of crisis. often not the most effective means of redistribut-
However, its not simply a matter of ensuring ing income, government spending is much more
access to capital but also maintaining access to important. Unfortunately, as Cobhams paper
basic assets. Regulations, such as land reform and notes, pro-poor government spending could be
tenure policies, need to be implemented which seriously impaired by CAL,because:
protect access of the poor to basic assets.
government resources are redirected to other
purposes;
2.3 Changes in Government government spending will become more
Spending volatile as the economy becomes more
volatile;
Poverty is not simply about income, it has many opportunities for raising revenues are reduced
aspects, including issues such as access to basic through competition between countries for
services.In this regard,impacts on social spending investment flows;
can have direct impacts on the poor. Fitzgerald the size of budget deficits and ability to raise
posed the question that if you assume that in the extra tax revenue may be constrained by mar-
downswing the poor are negatively impacted ket sentiment (discussed in section 2.4).
because of the impact on government budgets,
amongst other things, then does the upswing
period have a positive impact on budgets which
would make the impacts more symmetrical rather
than asymmetric? One aspect that could limit the

Redirecting Government Spending dilemma, if it emerges again, will probably be dealt

with by allowing exchange rate depreciation, rather
As the Cobhams paper identifies, several mecha- than trying to maintain a fixed exchange rate and
nisms suggest themselves by which government then coping with the capital inflows through steril-
spending on social services, for example, may be isation. So I think there is some reason to believe
reduced or diverted these include: that both those cases represent problems of the
implementing codes and standards; past, rather than the future.
the costs of sterilisation and reserve However, the need to maintain large reserves is
accumulation; a significant cost for governments, diverting
higher debt servicing costs (in good and bad resources away from other uses and this problem
times). will remain.
External and domestic debt servicing costs
If countries are to benefit from capital account lib- could increase via two routes after CAL:if it leads to
eralisation and capital inflows, then they will need a rise in the domestic interest rate; and if a govern-
to develop appropriate regulatory and monitoring ment must borrow to overcome a crisis. If budget
mechanisms and institutions, and capacity to man- deficits are constrained because of market disci-
age inflows. This will require a substantial amount pline or IMF conditionality, the impact of higher
of financial resources as well as government staff debt servicing costs will be cuts in other areas. 10
time and capacity. Whilst poor countries might be In crisis periods, its very clearly the case that
able to divert resources to these areas, it raises the government spending on social sectors declines11,
question of where they are being diverted from, although, as Allen argued, the Bank and Fund (and
and could they be utilised for more directly pro- other regional development banks and donors)
poor activities. Certainly, there may only be a few have made loans and in some cases grants available
cases of governments which are already focussed to maintain spending and implement social safety-
on poverty reduction, but diverting resources to nets. In Thailand, the government also supplement-
implement certain codes and standards is not going ed its budget, as Malhotra pointed out, by selling
to encourage others to address poverty reduction. public utilities:The reason they were sold was that
Martin suggested that donors must be prepared to they were profitable, and so you could have one off
provide the financial and technical resources to income effects or revenue effects for the budget.
allow poor countries to invest in these areas.To pre- Obviously this has major long term implications,
vent that much needed aid resources are not divert- structural as well as social.
ed from other pro-poor uses, technical assistance Maintaining social spending during crises in
budgets should be refocused. these ways is likely to have negative effects on
Cobhams paper points out the costs of sterili- future spending. Social spending during the Asian
sation and reserve accumulation9. Allen argued that crisis was maintained at the cost of building up
sterilisation will be less important in the future:A considerable debts. Governments also incurred
similar argument on the question of sterilising massive debts to bailout investors and the banking
inflows, is that all those cases of import surges sectors. Whilst the IMF eventually allowed the
which were the big issue in the first part of the 90s Asian crisis countries to increase their budget
were largely cases where the countries were dis- deficits during the latter part of the crisis12, in the
inflating from very high inflation rates, using the recovery period, the IMF has insisted that budget
fixed exchange rate regime, whilst trying to main- deficits are reduced.With enormous debt burdens
tain domestic policy autonomy - in this case raising governments have no alternative but to cut spend-
interest rates to try to disinflate. It was in that envi- ing in other areas, this has been the situation in
ronment that we found this problem of the capital Indonesia13.
inflows coming in under sterilisation which was In addition to the debt burden,donor financing
described in Cobhams paper. Now, most of those of the social sectors has structural implications.As
high disinflation problems have been removed and Malhotra pointed out,The nature and composi-
these countries are now generally on flexible tion of this funding has also helped erode the gov-
exchange rate systems, I think the sterilisation ernments capacity for national policy making,

coherence and long-term planning in crucial were concerned about the transmission mecha-
social sector and human development pro- nism through the budget, perhaps we should be
grammes and expenditures. thinking not in those terms, but we should be tar-
geting foreign exchange reserves in terms of budg-
etary volatility. Budgetary volatility that is coming
Volatility of Government Spending through movements in foreign exchange, private
flows, or exchange rate induced foreign exchange.
As the volatility in the economy increases so too And,maybe we should be thinking in terms of an
does the volatility of government spending environment, or a policy environment, in which
because: governments make use of foreign exchange
revenues are more volatile; reserves precisely as a tool to minimise volatility
the amount of reserves that must be held is the transmission of external volatility as a conse-
volatile;and quence of CAL through the budget because per-
prices are more volatile. haps it could be argued that thats one area where
that volatility is particular costly.
Chris Adam reflected that the issue of volatility is
indeed extremely important, because volatility in
capital flows alters both the volume of the tax The Cost of Foregone Taxation/Tax
base in a way that may be destabilising, but also Competition
the purchasing power of the tax base. The latter is
affected by changes in the exchange rate that feed Cobham argues in his paper, that the competition
through the budget affecting the relative purchas- to attract investors leads to a reduction in potential
ing power of the government and its ability to tax revenues. As a result inequalities are likely to
deliver public services. Changes in the exchange increase because the burden of taxation can be
rate could potentially lead to damaging stop/start expected to fall most heavily on workers because
volatility in public expenditure.In the Asian crisis they are immobile,particularly through value added
countries governments ability to provide ade- taxes and user fees,which dont just impact on the
quate social services were impaired by their employed but also the under-employed and unem-
inability to import, for example,there was a drop ployed. Sta. Anna took this analysis a step further
off in attendance at Indonesian health clinics and pointed out that, inequality is likely to be fur-
because the government could not import drugs. 14 ther increased because taxation will fall on immo-
Adam pointed out that this volatility is wors- bile labour, those workers who are unskilled i.e. the
ened by volatility in aid flows: The one area poor. Alternatively, Adam suggested that if inflows
where there is an important tool for policy inter- increase the marginal productivity of labour and
vention is the volume, timing and form of official the labour tax base, tax rates might decline.
flows and I think one of the key issues in this Fitzgerald argued that there is clearly a need
debate on CAL and poverty alleviation is: whats for a coordinated response,at least at the regional
the role for government aid? How do you think level, on taxation. Whilst Leape cautioned that
about the redesign of aid policy in an environment transfer pricing would always make it difficult to
where economies are operating with relatively tax multinationals.In addition to setting tax rates,
open capital accounts? Fitzgerald suggested that attention should also
He suggests that this may be a reason to review focus on sharing information that would allow, for
the IMFs model: In a text book model of IMF example, countries to tax the assets of their own
macro-economic management, the thing that deter- citizens held abroad. In addition to raising rev-
mines the level of foreign exchange reserves that a enue, this would also be a disincentive to capital
country would want to maintain in its central bank flight,because one of the major reasons for capital
is to do with the aggregate level of imports. So you flight is tax avoidance.
want to use foreign exchange reserves to act as a
buffer against movements against aggregate
imports. But in this [liberalised] environment, if

2.4 Market Discipline and the same time as a fixed exchange rate, an open
Government Policy capital account and domestic policy autonomy:
One of the lessons that we draw from the
Kraay argued that good policies are likely to be the Mexican and Asian crisis and in Brazil, is that its
key factor contributing to increased investment very difficult to maintain a fixed exchange rate,
flows.In the pro-CAL literature it is argued that lib- and so we have seen a generalised move to float-
eralisation forces countries to adopt good poli- ing rates in these economies.This means that for
cies because of market discipline, i.e. foreign most of these countries, weve given up a fixed
investors will only invest in countries where infla- exchange rate leaving us with capital market lib-
tion, budget deficits and balance of payments eralisation and domestic policy autonomy. If that
deficits are low, thus CAL encourages govern- model is correct, it should be possible to accom-
ments to maintain macroeconomic stability. modate more or less expansionary fiscal policy
However, the disciplineimposed serves the inter- through the exchange rate movements, without
ests of foreign and domestic investors not neces- touching the capital account liberalisation.
sarily those of the poor. It remains to be seen whether this means that
In crisis situations market discipline, imposed by market discipline will be less important in the
the markets or the IMF, has resulted in widespread future.Intuitively, it seems likely that investors will
social protests, for example, in Argentina,Turkey and always find negative aspects of economic policy
Indonesia.Ironically, by worsening social conditions to help ration their choices,in which case,market
market confidence may actually worsen making it discipline is likely to continue to play an impor-
harder for the economy to recover. tant role in investor decision-making.
Putting the objections to externally imposed
policies and their social costs aside,does CAL lead
to good policy? Arguing that governments should Market Sentiment and Government
first finance expenditure from tax revenues, Sta. Budgets
Ana,commented that CAL is a lazy policy. It allows
governments to avoid other reforms which would Market discipline or sentiment as Carvalho pref-
be unpopular to elites but which could increase ered, because this expresses the more flimsy
revenue collection from taxation.The point is nature and obscure actions of the market, has
remarked Sta. Ana,a comprehensive tax reform implications for government spending,in particular
agenda that makes the tax system buoyant, effi- through restrictions on the budget deficit and neg-
cient and progressive reduces the temptation of ative reactions to progressive taxation proposals.
governments to open up their capital accounts. In general, foreign investors look for low budg-
In addition Sta. Ana considered that some of et deficits because this suggests low inflation
the so-called gains in economic fundamentals which will protect their investment earnings.But
[attributed to market discipline] are illusory. He as Sta. Ana questioned, who is it that has deter-
pointed out that seemingly good [macroeconomic mined that a budget deficit of more than 4% is
indicators] can mask uncertainty,i.e.low inflation unsustainable? Granted in some cases this may be
is often achieved because of high interest rates,an the case but in others it is not. It clearly depends
overvalued currency and a stable exchange rate.In on how the money is being spent and/or whether
the short run investors take apparently rational deficits signal a failure to take other actions for
decisions but when a crisis strikes these decisions political reasons.A significant problem with mar-
look decidedly less rational. ket discipline is that all countries are treated the
Alternatively, Allen pointed out that to regain same; allowances are not made for individual
policy autonomy a government can either re- countrys circumstances.
impose capital controls (as Malaysia did) or liber- Referring to Cobhams suggestion that market
alise the exchange rate. With a growing shift to discipline may not be harmful if government
flexible exchange rates,market discipline will not spending is excessive and inefficient, although it
be a significant issue.He points to Paul Krugmans might not encourage pro-poor spending, Sta.Ana
model of the Impossible Trinityof maintaining,at remarked that even if cuts in spending may

increase efficiency they are still likely to have a poors only safetynet any action that reduces
negative impact on the poor as health and educa- unemployment or underemployment will be sig-
tion budgets are also cut. nificant for poverty reduction. However, most
A related issue,pointed out by Carvalho,is that analysis has focussed on unemployment effects,
governments are unlikely to be able to adopt pro- overlooking the impacts of increased under-
gressive tax systems with liberalised capital employment.
accounts because market sentiment is likely to be The average person on the street in Bangkok
adverse. Indeed,the signalling effects are likely to at the time of the crisis was concerned about
be much wider than the fiscal deficit.The market whether they would have a job, rather than how
is also likely to be adverse to the introduction of much higher inflation was anticipated through the
laws such as the Community Investment Act in use policy response. So the monetary policy trade-off
in the USA to direct a proportion of new invest- in this area was not appropriate,especially not in
ment to poor communities. Indeed for poverty the early parts of the crisis,commented Malhotra.
rooted in inequality a solution will require a The employment effects of interest rate policy
restructuring of the economy in ways which are responses and the way this impacted on small and
likely to be opposed by investors. medium enterprises, who are the largest employ-
ers of people in the real economy, was a very very
serious effect.
Market Confidence: Crisis Periods Kraay noted that a World Bank paper15 shows
and Recovery that hiking interest rates to very high levels to
restore market confidence as a crisis emerges is
To restore investor confidence in a crisis period, not effective. Malhotra pointed out that in
the IMF has insisted on raising interest rates. Thailand, confidence was not restored by high
Malhotra pointed out that the trade-off between interest rates because investors were concerned
monetary policy (high interest rates) and employ- with other factors in the economy.
ment is substantial.Since employment is often the

Conclusions
This paper takes an initial look at some of the analysing to what extent market discipline will
potential negative transition mechanisms between constrain pro-poor policy making;
capital account liberalisation and poverty. It is identifying regulations and policies which can
necessary to understand these in order to identify help the poor to gain greater access to cheap-
appropriate systems, regulations and controls to er credit, to save and to benefit from domestic
address them in ways that empower and give and international financial liberalisation;
opportunity to the poor. understanding the differences between poor
The transition mechanisms identified in this countries compared with middle income
paper can be distinguished between private i.e. countries.
impacts on family wealth, that is, employment,
income, value of assets, ability to save and so on, As Kraay pointed out,the clearest conclusion that
and public, through impacts on government emerges from the empirics is that there are no
spending,in particular the provision of basic serv- clear conclusions. And so the burden of proof for
ices,and taxation.These mechanisms are likely to unravelling the benefits and costs of capital
have different impacts, or intensity of impact, account liberalisation lies with all those interested
depending on whether the economy is relatively in providing sound development policy advice.
stable or going through crisis. Also,they will have It was generally agreed that empirical, cross
different impacts on different groups in society country models are not likely to yield useful infor-
and amongst the poor. It is vital that these are stud- mation because whether CAL has indirect positive
ied further. or negative impacts depends on the circum-
There will obviously be other mechanisms and stances in each country. This makes the case for
these need also to be identified. Key areas for analysing the potential impacts on a case by case
future research include: basis. The UK governments proposal for road
differentiating and monitoring flows by type to maps16 for financial reforms may be a helpful step
understand their impact through the economy, forward to taking such an approach. However,
distinguishing between quantity and quality they will not be helpful if the assumption is that
effects; the ultimate goal is capital account liberalisation.
understanding how flows impact on prices, The goal should not be the tool,the goal is pover-
such as exchange rates and interest rates and ty reduction and CAL may or may not be part of
how important these are for the poor; the tool box that will help to achieve it.
understanding what are the effects on the for- But as Leape noted, evidence-based policy
mal versus the informal economy and the link - requires evidence. Currently the available data is
ages between the two; very poor, not only for those of us who are ana-
understanding the impacts on the poor lysts or academics,but those who are policy mak-
between those integrated into the market econ- ers in the countries themselves. This creates a
omy who can respond to market based mecha- very strong argument for building up this evi-
nisms and those in the subsistence economy; dence, data collection and analytical capacity
identifying whether there are different impacts within countries should be a priority for donor
on the poor in countries which are more com- support. There is also scope for NGOs to suppor t
modity market dependent; creative initiatives in this area, ways we can get
teasing out how the impacts of crises are trans- new kinds of information, household sur veys etc
mitted from country to country and the which can bring to bear new linkages which were
impacts on different groups of the poor; undoubtedly not yet aware of in this area.
understanding whether there are asymmetric In terms of measuring and monitoring invest-
impacts on different income/social groups; ment flows, Allen added that if we are concerned
analysing the impacts of greater volatility and about trying to understand the impact of liberali-
how aid policy can help to stabilise the macro- sation and the resulting capital flows on poverty,
economy; growth and other things, we really do need to

know what is happening with capital flows and I Endnotes

think it is hard to underestimate how little we
1 This is a summary of the discussions at the Capital Account
know about this,in particular with the developing Liberalisation and Poverty meeting held in Oxford, 12th Januar y
countries,lower and middle income. 2001.The views expressed in this paper are those of the individu-
als and do not necessarily reflect those of the institutions they are
As Cobham concludes in his paper, whilst
associated with.See the end of this report for a list of participants.
there is no clear evidence how CAL impacts on
the poor, through the real economy, it suggests 2 In 1997 agreement was reached that the IMF should extend its
Articles of Agreement to formalise its role in pursuing Capital
that the major powers, the G8 and the interna- Account Liberalisation in member countries.Like Article 8,which
tional institutions through which they assert commits countries to current account liberalisation,member coun-
tries would be expected to proceed towards liberalising their finan-
themselves, should not codify such reforms or
cial sectors and capital accounts.Since the crises of the late 1990s,
make them fundamental aims of international there has been much less talk of extending its mandate in such a
agreements, such as the General Agreement on formal way, however, it has been mooted by the Italian government
which is hosting this years G7 summit.
Trade and Services or the IMFs articles of agree-
ment. Neither should the IMF proceed with 3 See for example, Jagdish Bhagwati, The Capital Myth in Foreign
Affairs, May 1998
domestic and international liberalisation until it is
clear what the objectives are in each case and 4 For example, see Barry Eichengreen et al, 1999, Liberalizing
how liberalisation will contribute to these, and it Capital Movements, Some Analytical Issues, Economic Issues 17,
IMF,Washington DC,p13.
is able to assess the potential impacts.
5 Flight capital is often regarded as a foreign fl ow.
6 For an analysis of how liberalisation has reduced growth generally

see Eatwell and Taylor, 1999, The Performance of Liberalised
Capital Markets, IPPR Working Paper; Danny Rodrik,1998, Who
Needs Capital-Account Convertibility? Princeton Essay in
International Finance.
7 Godfrey Kanyenze referred to the pressure to liberalise labour mar-

kets in the African context which he links to capital account liber-
alisation.In South Africa, there is increasing pressure for invest-
ment friendly labour markets.
8 Charles Soludo and Musunuru Sam Rao, 2000, Potential Social

Impacts of the new Global Financial Architecture.
csoludo@infoweb.abs.net
9 Also see David Woodward,1998, Drowning by Numbers:the World

Bank, IMF and North South Financial Flows, Bretton Woods
Project,UK
10 See Peter Stalker, 2000, Beyond Krismon, the Social Legacy of

Indonesias Financial Crisis, UNICEF Innocenti Insight,Italy.
11 This may be the governments choice and not imposed by the IMF.
12 Malhotra pointed out that by the time the tight fiscal policy was
loosened the damage to the economy and social sectors had
already been done.
13 Peter Stalker, 2000.
14 Ibid
15 Aart Kraay, Do High Interest Rates Defend Currencies Under

Speculative Attack?, draft 1999,World Bank.
16 DFID, Eliminating World Poverty:Making Globalisation Work for

the Poor, White Paper on International Development,December
2000

Capital account liberalisation and poverty
Capital Account Liberalisation and Poverty1

Alex Cobham, Queen Elizabeth House, Oxford University
Executive Summary
This paper discusses the implications of capital ly anti-crisis measures will be insufficient to
account liberalisation (CAL) for poverty reduction ensure that Capital Account and domestic financial
in developing countries. The findings raise con- liberalisation are beneficial to the poor. The mas-
cerns about the predicted benefits. While theory sive costs to the poor of crisis periods the com-
implies there will be efficiency benefits for inter- bination of reduced levels of social expenditure,
national finance, the existence of growth benefits reduced levels of transfers, increased unemploy-
for developing countries of both short term ment and reduced real wages are most apparent.
flows and foreign direct investment (FDI) has The findings of this paper the costs of both
simply not been established by empirical research. inflow and outflow periods, and the absence of
Moreover, a variety of costs and a number of fur- proven growth benefits have a number of sub-
ther potential dangers for countries liberalising stantial policy implications. First and foremost,the
their capital accounts in particular, and their proponents of capital account liberalisation
domestic financial markets, have been identified. most notably at the IMF must recognise that the
Many of these costs are associated not only with burden of proof is on them to establish benefits in
crisis periods, but also periods of capital inflow. terms of both poverty reduction and economic
CAL may contribute to reduced levels and sta- growth.The underlying assumption of a great deal
bility of government finances, and hence reduced of the BWIs approaches, that there are benefits
provision for the poorest and reduced investment. given the right initial conditions, must be serious-
In addition both CAL and domestic financial liber- ly rethought until that proof has been provided.
alisation may increase unemployment as finance is The international institutions, and international
diverted away from rural areas and from smaller policymakers more generally, must seek to assist in
firms in search of higher investment gains. The stabilising flows to developing countries and
implication is that the approach of the Bretton allowing macroeconomic policy flexibility if pover-
Woods Institutions (BWIs), requiring stronger ty reduction is to be achieved. Capital account lib-
supervisory and regulatory institutions essential- eralisation is simply not a priority in this context.

Introduction
The key question in the current debate on capital sequencing. Countries need to carefully manage
account liberalisation and international financial and sequence liberalisation in order to minimise
integration is that of their impact on poverty. The the risk of crises.The aim of this paper is to estab-
problem for policymakers, both at the national lish whether putting poverty considerations at the
level in developing countries and internationally top of the agenda changes the established view of
for the multilateral institutions, is that the link the benefits of liberalisation.
between capital account liberalisation and pover- The paper is set out as follows. Section 1 sur-
ty is far from clear. Despite the adoption of pover- veys the considerable evidence on the growth
ty reduction as a central objective by the Bretton effects of financial and capital account liberalisa-
Woods institutions, analysis of macroeconomic tion, and notes the clear absence of proven
policy in terms of poverty impacts has yet to growth benefits.Section 2 then describes some of
become a central approach. the impacts of recent crises in the aftermath of lib-
This paper sets out to assess the linkages eralisation episodes.Sections 3 and 4 then consid-
between capital account liberalisation and poverty, er the basic channels by which capital account
with a view both to indicating areas in which fur- liberalisation affects the poor during periods of
ther research is necessary and outlining some pol- capital inflow. Figure I shows the framework
icy options for developing country governments. which will be used to follow the linkages through
The dominant view in policy circles, even with government finances and policy choices on the
the recent more measured approach, is that any one hand, and through industrial and personal
doubts about the benefits of capital account liber- access to credit on the other. A number of serious
alisation can be addressed through careful policy potential costs of liberalisation are outlined.
Figure 1: Stylised Linkages of Capital Account Liberalisation
Capital Account and

Financial Liberalisation
Impact on Impact on
G o v e rnment Budget Private Economy
Private Revenues & O ff i c i a l Domestic F o re i g n

flows E x p e n d i t u re flows Financial Multinational
Market s
Access to Industrial
c re d i t P e rf o rm a n c e

1 Financial and Capital Account Liberalisation
This section examines the growth impacts of because governments allocate credit less efficient-
financial liberalisation,2 providing a background to ly than the market.3 It is also argued that under
the discussion on poverty impacts in the rest of financial repression saving is constrained by the
the paper. The empirical literature is briefly sur- interest rate ceiling, which reduces investment
veyed,and the extent of capital account liberalisa- and,in turn, growth.
tion in a range of developing countries is assessed.
The section begins with some basic definitions. Capital account liberalisation (CAL) is the
process of removing restrictions from internation-
al transactions related to the movement of capital.
1.1 Definitions and Interactions It can involve the removal of controls on both
domestic residentsinternational financial transac-
Financial liberalisation involves the elimination tions and on investments in the home country by
of various forms of government intervention in foreigners.Liberalisation can apply to both inflows
financial markets: essentially allowing the market and outflows of capital. Capital account restric-
to determine who gets credit and at what price, tions can take various forms including: limiting
i.e. financial liberalisation is the process of remo v- domestic banks foreign borrowing; controlling
ing elements of financial repression. Key ele- foreign capital coming into the economy;limiting
ments of domestic financial liberalisation (DFL) the sectors of industry in which foreigners can
include: the elimination of credit controls; the invest, and restricting the ability of foreign
deregulation of interest rates; free entry into the investors to repatriate money earned from invest-
banking sector; bank autonomy; and privatisation ments in the domestic economy. Table 1 presents
of the banking sector. Proponents of domestic a large,though not comprehensive, range of exam-
financial liberalisation have long argued that free- ples of controls, grouped according to this dis-
ing the financial sector from government inter- tinction.
vention is beneficial for economic development
Table 1: Types of Capital Controls Used
Types of Flow to
Domestic Economy Controls on Inflows Controls on Outflows
Portfolio - equity Forms:Blanket control,inflow tax (% of transaction Form:Blanket control up to 100% tax.
value),minimum stay restrictions (e.g.Chile had a Intention:Last resort measure prevent
12-month sliding scale of taxes until 2000) deepening of crisis,allow government main-
Intention:Reduce volatility, change maturity compo- tain lower interest rates hence reduce dam-
sition of inflows (towards longer-term). age to industry (in vestment).
bonds Form:Restrictions on foreign holding (up to 100%). As above.

Intention:Reduce volatility.
Direct investment Form:Investment boards Forms:Profit repatriation restrictions,or

Intention:Ensure integrity of national industry. reinvestment requirements.
Intention:Ensure local economy benefits.
Bank lending Forms:Reserve requirements on foreign borrow- As portfolio flows.

ings enshrined in Basle Accord (preferably
reserves held in foreign cur rency).
Intention:To remove risk of bank collapse precipi-
tated by withdrawal of foreign credit (and remove
exchange risk on forex borrowing).
Note: Controls listed are as they apply to foreign capital flows.Domestic capital is also subject to the same controls,to reduce volatility and as a last resort
measure in the same way, and also to prevent the flight of capital intended to avoid taxation or the detection of related crime.

The connection between domestic financial liber- potentially destabilising effects: the competitive
alisatin and capital account liberalisation is a effect of entry by foreign financial institutions into
strong one. The two processes can be considered the banking and Non Bank Financial Institution
in terms of their interlocking and (potentially) (NBFI) sectors, and the liquidity and volume effects
mutually reinforcing effects on the economy. of large foreign capital inflows to domestic equity
These effects can be separated into those affecting markets.The sequencing literature is unanimous in
individual agents,and those affecting the financial scheduling capital account liberalisation after
system as a whole. First,the incentives for foreign domestic financial liberalisation.
investors to enter should increase after domestic
financial liberalisation as returns tend to improve.
This should also reduce the motivation for domes- 1.2 The Extent of Capital Account
tic capital flight. and Domestic Financial
Second, more efficient financial markets Liberalisation
should lead to higher volumes,and better quality,
of investment. This improves the performance of Williamson & Mahar (1998) survey 34 countries (9
industries and the economy overall. Better eco- industrial and 25 developing),which have under-
nomic performance (assuming trade liberalisa- gone some financial liberalisation in the period
tion) should lead to greater trade integration, and since 1973. The survey illustrates the extent to
hence a greater demand for foreign exchange and which financial liberalisation has been a dominant
financial instruments denominated in foreign cur- orthodoxy in recent decades.
rency. This increases the need for full convertibil- Financial and other liberalisation was the per-
ity of the domestic currency. vasive theme of policy in Latin America during the
Third, a prerequisite for CAL to be successful is period 1970-95. Figure 2 shows the capital
a greater degree of domestic financial libearlisa- account picture for some sample Latin American
tion. Allowing foreign investment in domestic countries, indicating the considerable variation
financial markets calls for minimum levels of both and periods of alternating liberalisation and
market efficiency and institutional and regulatory repression. The Latin American average captures
capacity to safeguard stability.These stem from two the fitful nature of liberalisation in the continent.4
Figure 2: Some Capital Account Liberalisation Trends, Latin America 1970-95

Countries in other regions have also seen consid- 1.3 Growth Effects of Domestic
erable financial liberalisation over the past twenty Financial Liberalisation
years. Adam (1999:264) notes that many African
economies have undergone comprehensive The clearest impact of domestic financial liberali-
reforms, in terms of the liberalisation of markets sation is seen in changes in saving and investment
(both for goods and [financial] assets), and notes rates due to the freeing of interest rates. Higher
that the process has been more far-reaching in saving, and hence investment, sould drive higher
Zambia, Ghana and Uganda while more gradual in growth rates. The evidence for each is considered
Tanzania. Zambias capital account liberalisation in turn.
was carried out at a stroke in 1994, after a period In studies over a number of years (e.g. 1978,
of domestic financial liberalisation. Kenya carried 1980,1984,1989, 1995) Fry finds that national sav-
out significant financial liberalisation in the early ing is increased by higher real interest rates.
1980s, and suffered a serious banking crisis in However, the evidence of others is less conclusive.
1986. Malawis financial liberalisation was largely This seems to be primarily because DFL can equal-
complete by the early 1980s, while Uganda, ly drive increases in consumption (based on
Lesotho and South Africa followed in the mid increased access to credit). In a number of coun-
1990s. The Franc Zone had generally liberal mar- tries, such as the UK, New Zealand, Turkey, USA,
kets from the 1980s. In the Middle East and North Argentina, Chile, Colombia, and the Philippines,
Africa, Egypt, Israel, Jordan, Lebanon and Turkey there is evidence of a fall in the saving rate after
have substantial capital account convertibility, recent liberalisation or deregulation episodes.6
while Algeria,Morocco,Syria and Tunisia retain sig- Mexico and Thailand also saw consumption booms.
nificant restrictions.5 However, Hussain (1996) finds that saving in
India began a gradual financial liberalisation in Egypt increased by 6% of GDP per annum after
the 1980s after nearly forty years of national DFL,while Schmidt-Hebbel et al (1994) speculate
industrialisation planning, and began a structural that the fall in Chilean saving may have been a
adjustment program in 1991. Reforms included short-term effect which was later reversed.Mosley
the freer import of capital goods, removal of the (1999) finds that savings rates fell in Kenya and
restrictions against foreign equity holdings Malawi, rose slightly (became less negative) in
exceeding 51% and measures to attract FDI. China Lesotho, and rose significantly in Uganda. Even if
is following a gradual financial liberalisation path, increased saving rates are accepted,the effects on
although one that has been accelerated to meet investment rates are not at all clear.This is because
the conditions imposed for WTO entry. two separate effects are unleashed by the removal
The East Asian countries have followed various of interest rate ceilings. While more saving should
patterns of financial liberalisation. Taiwan and Korea occur at higher interest rates so that the supply of
focussed heavily on FDI-attracting strategies in the funds for investment is increased,the concomitant
1960s and 1970s, although both countries retained increase in the cost of capital reduces the demand
significant controls on short-term flows and banking for investment funds.
entry. Malaysia, Thailand and later the Philippines Demetriades & Devereux (1992) find that the
had largely liberalised finance and capital markets latter effect outweighs the former for a panel of 63
before the crises which hit the East Asian economies developing countries from 1961 to 1990.In other
in 1997 and 1998. Singapore and Hong Kong had lib- words, DFL and higher real interest rates can
eralised these some twenty to thirty years earlier. reduce investment (and hence growth).The most
There is now a vast empirical literature that widely accepted view is that positive but reason-
attempts to measure the actual effects of financial able real interest rates are the most conducive to
liberalisation on growth. The key findings of this investment and growth; and that DFL does not
literature are discussed below while the poverty necessarily produce these.
effects of liberalisation, which the literature has Williamson & Mahar (1998) list Australia,
almost universally ignored, are detailed in later Bangladesh, Chile, Malaysia, New Zealand, Sri
sections. Lanka,Taiwan,Thailand,Turkey and the US as coun-
tries having experienced sharp increases in rates

after DFL;while rates fell in others,including Israel, and foreign bank lending. Briefly, FDI is by its
Italy and the UK.There is no clear positive impact nature the least easily reversible, short-term bank
of DFL on the volume of investment. The implica- lending the most vulnerable to reversal, while
tion is that the benefits are driven by the resulting portfolio investment (especially equity flows) can
increase in financial development, that is, the effi- also exhibit high volatility. Table 2 illustrates the
ciency with which the financial sector mobilises relative volume of these flows.
savings on the one hand and allocates capital for FDI has tended to concentrate on relatively
investment on the other. Recent studies by World few regions (China,East Asia and Latin America) -
Bank staff provide robust evidence of a link ten countries host three-quarters of the flows to
between GDP (or GDP growth) and levels of finan- developing countries. However, if we take into
cial development.7 What is missing from this work, account the relative size of the host countries, we
however, is any convincing evidence of causality find that as a share of gross domestic product or
(and higher growth/higher GDP countries would fixed capital formation, the ratios for FDI in Sub-
be expected to undergo a process of stronger Saharan Africa are similar to those for Latin
financial development). Jung (1986), finds evi- America and actually higher than the ratios for
dence of causality in both directions. Asia. Portfolio investment and bank lending do
While the exact mechanism through which seem to be biased towards middle-income rather
financial development impacts growth has not than low-income countries, even when market
been empirically investigated in detail,8 the pre- size is taken into account. This reflects in part the
ferred view is that the positive impact stems main- under-development of capital markets and bank
ly from gains in market efficiency rather than vol- sectors in poorer countries.10
ume of funds increases in the quality rather than Literature on the growth effects of capital
the quantity of investments.9 The impacts of DFL account liberalisation is ambiguous.On the linkages
on credit allocation by sector of industry, and on between freeing up of capital account regulations
investment by firm size,are detailed in section 3. and long-run economic growth, Quinn (1997)
However, the evidence suggests that improved remains the only work to find a benefit to removing
efficiency of markets and hence investment is the controls. Levine & Zervos (1998) find no evidence
key benefit of financial development through lib- of long-run effects on the growth of the capital
eralisation. stock (which would be expected to yield a higher
long-run economic growth path). Klein & Olivei
(1999) do find that open capital accounts have an
1.4 Growth and Capital Account effect on financial deepness and, through this chan-
Liberalisation nel, on economic growth. They make the standard
argument that through a more efficient market,
It is useful to distinguish more clearly between dif- which reduces problems of asymmetric informa-
ferent types of capital flow:between foreign direct tion and transaction costs, a greater volume of sav-
investment (FDI); foreign portfolio investment ings is mobilised to more productive purpose. They
(FPI), consisting of equity flows and bond flows; do not, however, draw the conclusion from these
Table 2: Value of Capital Flows to Developing Countries, US$bn

1991 1992 1993 1994 1995 1996 1997 1998
Net private capital flows 123.8 119.3 181.9 152.6 193.3 212.1 149.1 64.3
Net direct investment 31.3 35.5 56.8 82.7 97.0 115.9 142.7 131.0
Net portfolio investment 36.9 51.1 113.6 105.6 41.2 80.8 66.8 36.7
Net bank lending* 55.6 32.7 11.5 -35.8 55.0 15.4 -69.4 -103.4
Net official flows 36.5 22.3 20.1 1.8 26.1 -0.8 24.4 41.7
Changes in reserves -61.5 -51.9 -75.9 -66.7 -120.2 -109.1 -61.2 -34.7
Current account balance -85.1 -75.6 -116.0 -72.0 -91.0 -91.8 -87.1 -59.2
Source: FitzGerald,1999. * denotes other net investmentin the original source table (IMF, 1999).

findings that capital account liberalisation in devel- FDI has an ambiguous effect on growth
oping countries yields growth benefits.
This is because they do not find evidence of FPI has a generally negative impact on long-run
the same effect in countries which are not mem- growth.Distinguishing between MICs and LICs
bers of the OECD. In other words,the finding does on the basis of initial financial development,
not hold for developing countries. Klein & Olivei and between equity flows and bond flows, he
attribute this to the absence in developing coun- concludes that:
tries of the necessary economic, legal and social (i) for higher levels of previous stock mar-
institutions.This approach is consistent with the ket development (i.e. for some MICs but
sequencing arguments,as well as with the findings no LICs), volume of equity flows are
of King and Levine (eg. 1993), and would appear more likely to be positive for growth;
to lend support to the G7s codes and standards- (ii) volatility of equity flows is negatively
based approach to the reform of the global finan- correlated with growth in all cases;
cial architecture. (iii) net bond flows and net equity flows
Further interesting findings on the impact of have no impact on domestic savings
capital account liberalisation can be found in a rates.
paper by Kraay (1998). Kraay first confirms the
absence of evidence of the growth benefits of cap- These results certainly imply support for the
ital account liberalisation, and then investigates proposition that some countries (i.e.the LICs) do
two common interpretations. First, and in line indeed have financial sectors too underdeveloped
with the arguments detailed above, he considers to liberalise their capital accounts.However, there
the view that the benefits will only be obtained by is also a lack of significant support for liberalisa-
countries with sufficiently goodpolicies and insti- tion in middle-income countries.Durham (2000c)
tutions.This he dismisses on the basis of a number concentrates solely on the ef fects of stock market
of econometric analyses. development on investment and growth.As in the
Second, Kraay examines the view that the work of Klein & Olivei, he finds that it is higher
growth benefits of capital account liberalisation income countries which drive the overall positive
are obscured by the costs of associated volatility. relationship between stock market development
This, too, he dismisses, finding that there is little and growth.11 Initial GDP and country credit rat-
evidence that volatility of capital flows is signifi- ings are significant, which implies that the gains
cantly higher in financially open economies. accrue to already wealthier countries. Moreover,
However, the result does not allow for initial levels the increased investment and growth benefits of
of financial development. It therefore ignores the equity flow liberalisation are present to an extent
relatively greater impact of volatility on countries in some middle-income countries, but cannot be
where the corporate, and particularly the financial, observed in lower income countries.
sectors are relatively weak or underdeveloped. It must be concluded on the basis of this liter-
Durham (2000a,b,c) attempts to assess the dif- ature survey that the growth-related benefits of
ference between middle-income (MICs) and low- capital account liberalisation for developing coun-
income countries (LICs) in terms of the impact of tries have not been established. Indeed, since
capital account liberalisation.In the first (sur vey) there is a significant body of work which has
paper, he notes that an important and obvious but searched for effects,it is more accurate to say that
nevertheless largely omitted variable in econo- these results have not been observed and may not
metric work has been the initial level of financial exist at all. This goes against the conventional wis-
development. In particular, he suggests the exis- dom behind the approach of the Bretton Woods
tence of threshold levels of financial develop- Institutions: namely that the benefits of liberalisa-
ment which may have to be reached in order for tion will accrue to those countries who follow the
the gains from liberalisation to be felt. right policies,and who have the right institutional
and supervisory standards in place.This view is in
Durham draws the following conclusions in the fact specifically refuted by the work of Kraay.
second paper: The major concern is that not only do the

growth-related benefits of liberalisation appear to areas of government finances and private invest-
be non-existent, but also that liberalisation may ment may be caused not only by the day to day
have significant costs and those costs may be most volatility of capital flows, but also by the potential
strongly felt by the poorest groups. This paper for sudden and massive outflows.The latter condi-
now focuses on the impact of capital account lib- tions and restricts the behaviour of both govern-
eralisation on poverty. In particular, the impact on ments and the private sector. Their behaviour is
the volatility of the domestic economy is examined detailed in sections 3 and 4 respectively,but the fol-
as it is in this area that the costs of liberalisation lowing section focuses on the impact of crises
can be most easily observed.Instability in both the which have often followed liberalisation episodes.
2 Crisis Periods
The clearest costs of financial liberalisation occur The impact in terms of social indicators has been
in the form of macroeconomic crises,which have at least as great.This section describes the chan-
grave consequences,especially for the poor. There nels through which crises affect the poor. The
is a considerable literature showing that domestic main channels explored, following the general
financial liberalisation episodes have been consis- approach of the paper, are through government
tently followed by financial crises.12 Capital finances on the one hand, and industry and per-
account liberalisation brings further risks as the sonal access to credit on the other.13 Through the
economy is opened to considerably more volatile first channel, the socialisation of private debt is
flows,and the potential for the banking sector to considered separately from the general macroeco-
become dangerously overexposed is extended. nomic policy response. Both are seen to have
Casual obser vation suggests periods of capital potentially large costs.
inflow are frequently followed by banking,curren-
cy or twin crises. Glick & Hutchinson (1999)
analyse these events in 90 countries between 2.1 The Socialisation of Private
1975 and 1997. They find that twin crises are con- Debt
centrated in the group of financially liberalised
emerging market countries (ie MICs),and that the Where developing countries face crises in their
power of banking crises to trigger currency crises financial sectors, they generally fall into one of
is most marked in this group.The costs in eco- two categories. In the case of low-income coun-
nomic terms can be extremely high; Singh & tries, banking crises after financial liberalisation
Zammit (2000) put the cumulative cost of twin characteristically involve the problem of bad
crises as high as 18% of GDP lost in each case. A loans, where the balance sheets of banks and
number of crisis episodes were identified and other financial institutions are overwhelmed to
studied in the consultation draft of the World the point of insolvency. In the case of higher-
Banks World Development Report 2000: income countries, the financial sector often
encounters difficulty when it has become depend-
Jordan,1989 (real GDP fell 13.5%); ent on continued access to foreign capital to main-
Argentina,1995 (per capita GDP fell 4.2%); tain its activities. Problems come to the fore fol-
Mexico,1995 (per capita GDP fell 8.1%); lowing a re-evaluation of the sectors prospects by
Thailand, 1997 (average real GDP fell 10% in the suppliers of this capital, or alternatively fol-
1998 alone); lowing a large change in the exchange rate.
Indonesia, 1998 (GDP growth rate fell from In both these scenarios, governments have
4.5% in 1997 to -14.3% in 1998); very strong incentives to step in and ensure the
the Philippines,1998 (real GDP turned around continuing operation of the financial institutions.
from 5.2% growth in 1997 to -0.5% in 1998). Whether in the case of Kenyas banking crisis in
1986, the East Asian crisis or indeed the United

States bail-out of the Long Term Capital Venezuela (1994) and Korea, Indonesia, Malaysia
Management (LTCM) hedge fund, governments and Thailand (1997).Indonesia,Chile,Thailand and
have been forced to act in order to minimise the Uruguay exceeded 30%.The average cost across
damage to the sector, as well as to the real econo- the 40 cases was 12.8% of GDP.
my by transmission. The implicit (or in some cases Despite the high costs, governments cannot
explicit) guarantees provided by governments to escape the need for intervention in some cases
the banking sector and large corporations can because of the potential negative impacts on
result in vast costs for governments. These costs domestic industry. The intervention by the US
are ultimately borne by the countrys citizens and, authorities in the LTCM hedge fund case shows
in some cases, by donors. how this is still true for countries with highly
The scale of banking sector rescues has developed financial sectors. This gives some indi-
become daunting in recent years. In Korea, for cation of how impossible it would be for poorer
example, the authorities spent some US$50bn on countries with much more concentrated banking
recapitalising banks following the recent crisis. sectors to withstand banking collapses without
The figures for Indonesia and Thailand were intervening. The need to maintain some level of
around US$70 billion and US$20 billion respec- access to credit for domestic industry is great, to
tively (World Bank,2000). Banking rescues of this combat as far as possible the real economy effects
kind, provoked by the need to prevent systemic of financial crisis. The real economy costs are
banking crises, can increase the moral hazard dealt with below, but first we turn to other aspects
problem. Since investors (rightly) judge that cer- of the policy response.
tain groups and companies will not be allowed to
go bankrupt,and hence the costs of failure will be
largely borne elsewhere,they have an incentive to 2.2 Macroeconomic Policy
continue lending even when they judge the recip- Response
ients to be highly risky.
As it is the recipient countries, rather than the UNCTAD (2000) notes that although the [East
investors,that bear the costs of rescues,moral haz- Asian] crisis in each country had its own charac-
ard ultimately leads to a drain on taxpayers and teristics,there is little doubt that extremes of col-
multilateral donors. 14 The impact on government lapse and recovery have,in large part,been due to
spending at a time when the economy is at its misguided policies (p.vi). UNCTAD argues that
weakest,and the need for a public safety net great- contractionary monetary policy, essentially the
est is to reduce greatly the proportion available imposition of high interest rates, that was
for social expenditure. Buch & Heinrich (1999) designed to stabilise currencies not only failed to
examine the Russian crisis that began in August do so but also seriously exacerbated the negative
1998,and recommend that recapitalisation should output and employment shocks. UNCTAD stress-
be carried out by foreign investors rather than es that the raising of interest rates actually proved
governments, to limit moral hazard problems. to be much more damaging than currency depre-
Banks which cannot attract funds should be ciations themselves, and caused severe disloca-
closed (despite the possible short-term costs of tions in the corporate and financial sectors.
reduced access to credit for domestic industry), Domestic industries were unable to borrow at a
and governments should take control from previ- critical time,leading to their further dilapidation.
ous shareholders to facilitate the hand-over and The use of tight monetary policy, designed to
minimise asset-stripping. protect the currency, was one key element of the
As noted above, the economic costs of crises International Monetary Fund (IMF) policy
can be very high. World Bank researchers response in the crisis-hit countries of East Asia.
Honohan & Klingebiel (2000) identify 40 banking Perhaps more damaging,though, was another main
crises in developed and developing countries,and plank of IMF policy advice, that of reducing gov-
show that the cost for nine of these exceeded 15% ernment spending. Fiscal tightening was seen as
of GDP: Chile and Uruguay (1981), Cote dIvoire essential to regain the confidence of investors and
(1988), Japan (1992),Slovakia (1992),Mexico and ensure a speedy recovery of foreign capital flows.

These objectives,however, need to be weighed 2.3 Real Economy Impacts

against the both the immediate effects on social
spending and the longer-term impacts on eco- In Korea, where the socialisation of private debt
nomic structure and social indicators. Social involved massive costs and policies were insuffi-
investment funds were used as a vehicle to ensure ciently focused on the needs of domestic industry,
some most basic provision of social support, and Ferri & Soo Kang (1999) show how small and
social safety nets were expanded in all the East medium-sized businesses suffered unduly from a
Asian crisis-hit countries.However, in light of soar- credit contraction. This combined with the policy
ing unemployment these measures were clearly of high interest rates to price the remaining avail-
inadequate. able credit out of reach of the smaller firms and
Fiscal contraction required spending cuts in ensured that the financial crisis passed onto busi-
general programmes.In Brazil, the federal govern- nesses and society.
ment agreed with the IMF to reduce the fiscal Between October 1997 and April 1998, Koreas
deficit from 8% to 4.7%.This included a reduction unemployment rate more than tripled from 2% to
of expenditures of $7bn,of which more than 10% 6.7%.15 For those still employed, nominal wage
fell on priority social spending programmes. growth fell from 11.6% in the first quarter of 1997
Indonesia reduced health expenditure by 8% in to zero in the corresponding quarter of 1998,
1998 and 12% in 1999,and education expenditure while real wage growth then fell from 6.9% to
by 41% in 1998 (rebounding by a third of this drop 8.9%. Over the same period,inflation almost dou-
in 1999). Korea and Thailand seem to have been bled from 4.7% to 8.9%. As a result,urban poverty
relatively well able to protect their primary health- tripled to 23% by the third quarter of 1998, and
care spending, and at least maintained social remained at double pre-crisis levels one year later
spending as a percentage of GDP, although nation- (World Bank, 2000). The number of people in
al income had fallen (World Bank,2000). absolute poverty in Korea also tripled as a result of
Notwithstanding the immediate impacts of the crisis.
cuts in the areas of education and healthcare, In Thailand,Chomthongdi (2000) reports how
there are perhaps more damaging social and struc- high interest rates increased the damage to indus-
tural impacts.The rupturing of the long-standing try, leading to the closure of up to one thousand
entente between government and the workforce businesses a month, with the negative knock-on
in Korea will have consequences long after even effects for employment. At the same time,the clo-
poverty indicators have returned to their pre-crisis sures also reduced consumption and further flat-
levels.The fire-sale of profitable, well-performing tened demand, prolonging the recession. Private
public utilities in Thailand to reduce the budget investment fell by almost half in 1998,as the econ-
deficit and meet loan conditionality will have long- omy worsened. Indeed, the pattern throughout
standing structural implications for the economy, the region was one of falling investment while
for government finances and hence for the poor. consumption was relatively protected (World
In the crisis episodes detailed above,the policy Bank, 2000).The longer-term implications for the
responses appear to have been primarily focused rate of recovery and future growth rates are par-
on external factors,such as maintaining the pres- ticularly worrying.16
ence of foreign capital, rather than being driven by Households were affected by lost employment
the needs of the domestic economy. In particular, as well as by a number of other factors. On the one
the policy of fiscal tightening while social needs hand, higher-income households lost out through
expanded seems counter-intuitive. The socialisa- the erosion of value of their larger assets:real estate
tion of private debt has the impact of relatively and shares. Relative price changes had broader
protecting large (foreign) investors. At the same impacts. Currency depreciation on the whole
time, the macroeconomic policy mix has tended increased the price of tradable goods, most notably
to penalise, at least in the short term, domestic, agricultural produce, and so net producers i.e.
and especially smaller, businesses.The impacts on those of the rural sector who produce more than
industry are detailed below. they consume benefited. However, the urban
poor and rural workers as net consumers lost out.

Whether access to credit, for businesses as 2.4 Some Conclusions

well as for households,can be ensured efficiently
through government intervention is not clear. For This section has outlined briefly some of the
businesses, Ferri & Soo Kang at the World Bank clearest costs associated with post-liberalisation
recommend that policymakers may want to pro- financial crises. Crisis response policies appear to
vide relief possibly through market-based have been focused on encouraging an externally-
actions to make bank loans available to healthy led recovery, rather than on domestic stabilisation
firms in sectors (such as exports) on which recov- in terms of employment and investment in indus-
ery depends(1999).If the priority is redefined as try. Such prioritisation may have been ill-judged.
maintaining employment during a crisis, as much The economic and social costs associated with
as pushing the recovery afterwards, then a differ- crises, and the key elements of policy detailed in
ent set of (nonetheless healthy) firms may be tar- this section, are clearly very high. There is also a
geted. For households, the question of access to pressing need for research into the types of meas-
financial services for the poor is examined further ures that could help ensure the flow of credit to
in section IV. More research would be needed to smaller businesses and poorer households during
identify types of program which could operate crisis episodes.
with most impact on the poorest, thus making Proponents of financial and capital account lib-
best use of restricted government funds. eralisation would argue that the benefits associat-
ed with capital inflow periods would outweigh
the costs associated with crises.This paper will
now turn to the poverty impacts of capital inflow
periods.
3 Impact on Government Finances and Policy
This section examines the effects of capital 3.1 Government Finances

inflows on poverty through induced changes in
government budgets and macroeconomic policy. Reductions in government income will involve
Full capital account liberalisation in low-income spending cuts that can have significant costs for
countries involves allowing not only foreign direct the poor. Biggs (1998) shows that fiscal cutbacks
investment, but also capital inflows to bond and in developing countries have historically targeted
equity markets and to the banking sector. These investment most heavily, while providing relative
inflows can create serious restrictions on govern- (but far from complete) protection to wages and
ment policymaking. Two different effects can be transfers. Reduced infrastructure investment con-
discerned. First, government finances can become tributes to poor economic performance, while lack
constrained by the cost of managing inflows as of institutional strength reduces governments abil-
well as by the need to satisfy the market view of ity to raise taxes effectively. There are both short
fiscal prudence. Second, increased levels of and long-term impacts on health and education
macroeconomic instability can impact on govern- provision when government spending (investment
ment revenue sources, with implications for gov- and recurrent) on these sectors is reduced.
ernment expenditures. This section will begin by Most direct for the poor will be the effect of
considering the general position of developing even the disproportionately small cut in transfers.
country government finances before beginning to Despite the relative protection afforded to this cat-
assess the effects of liberalisation. egory of spending, the impact may be great
nonetheless, since transfers to the poorest will
form a very great part of their total incomes.

These are incomes they can already ill afford to 3.2 Managing Capital Inflows
see cut. Clearly, the impact of reduced levels of
government finance will hit the poorest groups The most direct route through which capital
hardest. It is not only reductions in spending that account liberalisation reduces the overall level of
have costs,however, but also reductions in the sta- government budgets available for fiscal expendi-
bility of government finances. ture is by diverting expenditures to other avenues;
Since government revenues are volatile, their in particular, managing the associated capital
ability to commit to programmes of expenditure is inflows. As Henry (2000) showed,liberalisation is
undermined.As well as undermining the stability a significant factor in triggering equity flow
of those who rely on transfers to attain some min- booms. Liberalisation may also result in increased
imal standard of living,it also reduces the ability of bond, bank and (possibly) direct investment
governments to attract complementary private inflows. These inflows, and most especially the
investment,hence reducing their overall potential short-term flows which are less stable,put upward
to assist development.Toye (2000) details the rela- pressure on the domestic exchange rate because
tive instability of various sources of finance.Most investors purchase local cur rency to invest in the
unstable is aid,and recent evidence shows that aid stock market. To prevent exchange rate apprecia-
flows have been not only volatile but also strongly tion which raises the cost of exports and lowers
pro-cyclical.17 The most stable source of govern- those of imports, and can thus reduce domestic
ment finance has been through debt and money production damagingly the government must
creation.Arguably,given the observed failure of aid sell domestic currency and buy the incoming for-
to assist in smoothing government expenditures, eign exchange,thereby building up their reserves
these are the only stability-enhancing tools avail- of foreign currency.
able to governments. However, money creation This would increase the domestic money sup-
has significant inflationary consequences, and ply by the amount in question,however, leading to
inflation has costs for the poor in particular inflationary pressures and associated problems,so
because of their inability to acquire inflation- a common next step is to sterilise the inflow. This
proof assets. is achieved by selling the equivalent value of gov-
This leaves debt as the sole most effective tool ernment bonds to return the money supply to its
for governments to smooth their expenditures original level and prevent the emergence of infla-
and protect the poorest. Capital account liberali- tionary pressure.This counteracts the money sup-
sation opens domestic bond markets to interna- ply expansion because selling bonds involves tak-
tional investors,and hence allows greater liquidity ing domestic currency in exchange, and hence
for governments and also domestic corporate reduces the available money supply which in
bond-issuers.The ability of governments to raise turn reduces the impetus for prices to rise.
additional finance through bond issues, however, The government has in effect increased its lia-
is subject to the market discipline and fiscal poli- bilities in the form of bonds issued but also
cy issues which are discussed below. increased its assets by the same amount, in the
The remainder of this section concentrates on form of foreign exchange reserves. Assuming
explaining how both the level and stability of gov- these reser ves are held as interest-bearing assets,
ernment finances are negatively affected by capi- commonly US Treasury bills, the government has
tal account liberalisation.It is worth pointing out not necessarily worsened its position. However,
here that the discussion that follows does not the price to the government of these manoeuvres
assume that governments,if unrestrained by liber- omitting transactions costs will in fact depend
alisation,will necessarily follow efficient pro-poor on the interest rate differential between the devel-
growth strategies.However, it seems uncontrover- oping country and (in this case) the US rate.
sial to assume that having stronger and more sta- Stiglitz (2000) gives the following example.If a
ble finances will allow governments greater free- company in the developing country borrows
dom to adopt such a strategy if they choose.18 $100m from a US bank,then since it is perceived
as relatively highly risky, it must pay 20% interest.
If the government holds foreign exchange

reserves (in US T-bills) to offset this borrowing, it ing deficits or building up surpluses in the budg-
receives 5% interest.The annual cost to the poor et) to combat inflationary pressures. Autonomous
country of this arrangement is then $15m. The inflows (of foreign capital) reduce the downward
cost to the government, if it is carrying out full pressure on the exchange rate and allow a relax-
sterilisation, may be different. If the government ation of monetary policy (and hence increased
has sold bonds to the value of $100m,to maintain growth),while outflows increase downward pres-
a stable money supply, and being relatively risky, sure and require a monetary contraction.
but less than the company in question pays 15% While this appears to represent a beneficial
on this debt,the direct cost to the government is response to inflows,there are obvious costs. Policy
$10m a year.19 will necessarily follow the cycle of foreign capital
While this is the value in foregone fiscal expen- flows,which have been seen to be highly pro-cycli-
diture,the actual cost in foregone investment may cal with countries economic conditions, rather
be greater given that efficient government invest- than acting to stabilise the economy. In this sce-
ment would also have levered in private invest- nario then, this model encourages pro-cyclical gov-
ment.The effect of the capital inflows is to seri- ernment policy increased spending in booms, and
ously reduce the level of government expendi- cutbacks during recessionary outflow periods
ture. Moreover, since reserve accumulation and and hence increased macroeconomic volatility.
hence the current and future level of government Whether the aim of government policy is to pre-
expenditure must react to volatile short-term vent an appreciation or a depreciation of the
flows, there is a further price to pay in terms of exchange rate, the management of capital inflows
increased uncertainty of government finances. has costs in terms of increased instability of gov-
To compound these costs of sterilisation, the ernment finances and the macroeconomy more
widely-held view (with regard to industrialised generally, and also of reduced expenditure under
countries at least) is that it cannot be successfully the sterilisation case at least.
operated as a long term policy. This is because the
inflows are generally the result of an interest rate
differential between the domestic and interna- 3.3 Market Discipline
tional markets.Sterilisation, involving the issue of
more bonds (presumably at the same or a higher The second key channel through which capital
interest rate to ensure demand) will not address account liberalisation affects the level and stabili-
this problem and may exacerbate it,and therefore ty of government finances is the mechanism of
cannot be a long-term solution. One other nega- market discipline. The concept of market disci-
tive impact of sterilisation is that as has been pline reflects the sensitivity of investors to certain
observed in many, especially African, developing government policy variables. In theory, govern-
countries government bond issues dominate the ments are forced to have good economic poli-
market to the exclusion of other issuers except cies, lest capital flow out of the country(Stiglitz,
the largest corporates.In other words, following a 2000,p.1080). Although Stiglitz does not make the
policy of sterilisation may exacerbate the prob- distinction,goodpolicies are those investors per-
lems of domestic industry in raising debt financing ceive as consistent with strong investment
for investment. returns.In practice,since investors base their deci-
Alternatively, governments applying the IMFs sions on only a very narrow range of information,
Monetary Programing model may be focussing changes in the level of governmentsdeficits,infla-
policy on preventing a depreciation of the tion (or expected inflation) and short-term indebt-
exchange rate (Khan and Huq,1990). This desire edness ratios in particular, can lead to very rapid
stems from the associated inflationary pressure: adjustments of investorsportfolios.This apparent
firstly imports become more expensive, and sec- myopia is in part determined by the evaluation
ondly cheaper exports increase the foreign methods of the influential international credit rat-
demand for domestic production which in turn ings agencies.20
drives up domestic prices also. Governments will For a developing country with a liberalised
therefore be holding monetary policy tight (reduc- capital account,the resultant changes can involve

inflows or more particularly outflows of great lying output, employment and investment.Three
magnitude relative to the total size of the econo- further areas of concern are the potential for cap-
my. The importance of avoiding such recession- ital flight after the removal of controls,the impact
inducing flows therefore ties the hands of govern- of increased capital mobility on the incidence of
ment in important areas of macroeconomic poli- taxation, and the effects of tax competition
cy. Market discipline acts as a deterrent against between countries.These are treated in turn.
allowing high levels of inflation or running fiscal Capital flight may be defined as the transfer of
deficits.Countries which maintain significant con- funds out of countries motivated by domestic eco-
trols on short-term flows, by contrast, can use nomic and political uncertainty (Schineller, 1997),
countercyclical macroeconomic policy to smooth but is often used to refer to all flows from capital-
recessions and reduce macroeconomic volatility. scarce to capital-abundant economies. Strictly
China is just one example. defined, flight ought to involve illegal and unde-
It is interesting to draw out two implications of clared capital movements, and there is an exten-
the above discussion. First, rather than preventing sive literature detailing attempts to measure these
fiscal excesses, market discipline in developing flows.21 This paper is concerned with the ef fect of
countries may prevent the efficient use of removing controls.
resources and pro-poor fiscal policy. If fiscal deficits Doolley & Kletzer (1994) find that when
are used by (some) developing countries to effi- domestic financial markets are liberalised,and it is
ciently promote investment and protect the poor, known that outward flows will not be unduly
the market discipline of capital account liberalisa- restricted,large amounts of domestic flight capital
tion will reduce the ability of these governments tend to return to seek investment opportunities at
both to crowd in private investment and to target home.The actual effect of capital account liberali-
the poorest of their citizens through a social safety sation on capital flight may be generally positive
net. In other words, capital account liberalisation then in increasing domestic investment by domes-
will have negative poverty effects both directly, tic capital-holders. However, other factors are
through government expenditures, and indirectly, also clearly important. Even the case of Uganda,
through reduced investment and growth. where the 1997 liberalisation has been seen as
On the other hand, where governments are beneficial - particularly due to the return of flight
using fiscal deficits inefficiently, the market disci- capital - it is clear that the improvement of condi-
pline ef fect of liberalisation will be to curtail the tions for investors was the driving factor.22
wasteful use of limited resources.While there may Another concern is the impact of increased
be no direct poverty ef fects of this,crowding out capital mobility on taxation. To encourage inflows
of private investment by inefficient government and avoid inducing capital outflows, governments
expenditure may cease,with concomitant positive have an incentive to tax capital less. If tax rev-
effects for investment quality and hence growth. enues are to be maintained,this may mean that the
This interpretation is supported by Kraays (1998) tax burden falls more heavily on workers and con-
finding that capital account liberalisation has ben- sumers,as the less mobile factor. This would have
efits only for countries with bad policies or insti- regressive distributional consequences. The (rela-
tutions - ie that market discipline may prevent the tive) reduction of taxes on capital is in effect a
adoption of good policies. reduction of taxes on those with greater wealth.
Moreover, higher tax on labour affects the poorest
most heavily. The income of the poor derived
3.4 Taxation and Capital Mobility from work forms a proportionately larger part of
their total income,compared with owners of cap-
Two further avenues through which capital ital. The very poorest may be protected to the
account liberalisation can affect government extent that they are not in fact part of the formal
finances and poverty are capital mobility and tax- economy, and hence unaffected by changes to the
ation. Most obviously, the associated macroeco- taxation system.However, changes which increase
nomic volatility may make tax revenues increas- the burden of taxation on labour will inevitably
ingly variable because of the instability of under- increase the disincentive for the poor to move

into the formal sector.23 banking flows. For example, the Bangkok
Finally in this section, we turn to tax competi- International Banking Facility (BIBF) in Thailand
tion between developing countries for capital has been used to funnel low-tax capital into the
flows, and in particular for FDI. Many developing country. The BIBF was particularly heavily used in
countries particularly the smaller ones attempt Thailands post-crisis fire-sale of domestic assets
to attract foreign investment through tax incen- to international investors. Another example is in
tive policies in an attempt to compensate for local India, where Mauritius is used as a tax-avoiding
distortions and inefficiencies,or to simply prevent point of entry to the countrys capital markets.
foreign investment from going to neighbouring or
similar countries.However, such incentives play a
limited role as determinants of foreign investment, 3.5 Some Conclusions for
and even where successful - e.g. in some export Government Finance and the
promotion zones - involve significant fiscal costs.24 Poor
Studies have shown that tax competition
between industrialised countries for foreign direct Capital inflows (especially short-term) lead to par-
investment can result in the benefits of the invest- ticular problems for government finance.Through
ment being obtained by the multinationals.25 This the management of capital inflows, the associated
problem is even more acute in poorer countries,as market discipline, and changes in the ability of gov-
the level of direct investment will be more sensi- ernments to raise tax, both the level and stability of
tive to the tax rate in a small developing country government finances are undermined. The impli-
than in a large industrialised country (or bloc of cations for the poor are potentially disturbing.
countries). This is because the cost of ignoring one The burden of reducing fiscal budgets has
developing country is small for the multinational. tended to fall on infrastructure investments,
While foreign direct investment is acknowl- arguably the most important area for investment
edged as the most positive form of capital flow to in order to facilitate private investment and
liberalise, agreement on tax and subsidy competi- encourage economic development. The reduc-
tion is necessary to ensure some of the benefits tions in social spending (although generally pro-
accrue to the host countries and that tax revenues portionally smaller) have potentially damaging
are not unduly undermined. Only a universal consequences for the poor. In particular, reduc-
agreement, involving both developing and indus- tions in health and education budgets can have
trialised country governments, can ultimately extensive long-term impacts for the poorest.
solve the problems of harmful tax competition. The high and sometimes dangerous volatility
While tax competition to attract foreign port- of private capital flows is also exacerbated by offi-
folio investment does not occur in the same way cial flows. Since they exhibit both volatility and
as for FDI, it does exist in different forms. This pro-cyclicality, they are currently contributing to,
involves deliberate government measures to facili- rather than minimising, precisely the instability
tate the use of tax havens or tax loopholes to which capital account liberalisation produces.
encourage the entrance of foreign portfolio and
4 Liberalisation and Industry
To examine the impact of capital account liberali- poverty impact of foreign direct investment is not
sation on poverty through structural and perform- clear, however.
ance changes in industry, it is necessary to treat On the one hand,the potential positive impact
separately the different types of capital flow. of FDI in terms of both real investment, export lev-
Foreign direct investment,as a longer-term flow, is els, technological capability-building and human
not associated with instability in the same way as capital accumulation can be significant. On the
short-term bank lending and portfolio flows.The other hand, however, a number of caveats about

the positive impacts should be highlighted. The be more volatile and hence less likely to be suc-
competitive effects on a market of entry by a well- cessful.28 This leads to their high failure rates (typ-
backed multinational company can be destructive; ically 50% after 5 years) and lower growth rates,
if domestic firms are unable to compete, the ulti- observed in both developed and developing coun-
mate market size may shrink, reducing employ- tries,with concomitant reductions in the employ-
ment. Furthermore, multinationals are more likely ment capacity of the economy and negative
to source their inputs from abroad, which both impacts on poverty.
reduces the level of domestic employment gener-
ated and weakens the recipient countrys trade
balance. Finally, affiliates of multinationals tend to 4.2 Liberalisation and Credit
be less labour-intensive than domestic firms (espe- Availability
cially SMEs) and this will have employment (and
household income) effects. The general air of greater uncertainty that capital
In this section we therefore focus on two more account liberalisation causes, and therefore the
directly poverty-related channels. First, the differ- uncertainty about investment decisions is rein-
ential impact of short-term capital flow instability forced by the greater uncertainty about credit
on different sizes of firm is considered, together availability that SMEs are subject to as a result of
with an analysis of what this means for employ- both domestic financial liberalisation and capital
ment. Second, this section examines the differen- account liberalisation.The expectations of SMEs
tial impact of changes in credit allocation and the concerning their ability to access funds will be a
availability of financial services more generally for crucial determinant of both their in vestments and
the poor. performance, and hence of their employment
capacity.
Financial sector deregulation, which involves
4.1 Liberalisation, Macroeconomic changes in the freedom both of domestic banks to
Uncertainty and Financing undertake international transactions and of for-
Investment in Firms eign banks to enter the domestic market,as well as
increasing competition, has important ramifica-
Short-term capital inflows, and the resultant tions for the availability and allocation of credit.
macroeconomic instability, have a number of The classic Stiglitz & Weiss (1981) model of
important consequences for domestic industry. credit rationing shows how banks will refuse cred-
What is particularly significant here is the asym- it to firms for viable projects on the basis that
metric impact of increased levels of macroeco- obtaining the necessary information on the firms
nomic uncertainty on firms and particularly their and their investment projects would be too
investment decisions.26 Smaller firms are dispro- expensive.29
portionately negatively affected by the potential This problem is exacerbated in many develop-
for volatility associated with capital account liber- ing countries by the especially weak position of
alisation in developing countries.As was seen in SMEs.Affiliates of foreign multinationals by their
section 2, the channel of credit to and from the very nature are largely exempt from local financ-
domestic financial sector can very quickly dry up, ing constraints. Large domestic companies or
and this danger is especially strong for smaller groups generally have preferential access to bank
firms, even when there is not a threat of crisis.This credit,and are thus relatively protected from capi-
is problematic because small and medium-sized tal market fluctuations. SMEs are the most vulner-
enterprises (SMEs) and very small enterprises able then to capital outflow-induced shifts in cred-
(VSEs) account for the bulk of employment in it availability, and the concomitant impact on the
developing economies, because there are fewer poor can be strongly negative.
larger firms and smaller firms tend to be more In terms of domestic financial liberalisation,
labour-intensive.27 granting domestic banks the freedom to allocate
Uncertainty impacts most strongly on the credit on a pure profit basis can have a number of
investments of smaller firms by causing them to effects.That predicted by theory is the most posi-

tive: simply that banks now compete freely, and have similar effects in terms of increased competi-
hence become more efficient in their credit allo- tion and efficiency. Foreign entrants will bring new
cation,make fewer bad loans, support more prof- technologies,new techniques and expertise in risk
itable projects, generate more profits to reallocate assessment, which will (at least eventually) filter
and thus facilitate both more and better invest- through to domestic rivals. This should then
ments.Gregorio & Guidotti (1992) find for a set of improve the quality of loans made, and reduce the
98 developed and developing countries that about extent of credit rationing since banks will be better
three-quarters of the positive effects of financial able to assess their limited information on firms.
sector development result from this type of effect A number of dangers are also present however.
and hence superior quality of investments, and In addition to heightening the risk of crises as
only the remaining quarter from greater quantity discussed in section 2, it is possible that the
of investment. entrance of foreign banks will have a range of neg-
However, it is important to question the extent ative impacts on the financial sector. Competition
to which any increase in lending accrues to the pri- can lead to a number of responses, all of which
vate sector rather than government. Brownbridge either reduce costs or increase revenues. In the
& Gayi (1999) survey the changes resulting from first category are measures to reduce the cost of
financial reforms in eight LDCs: Bangladesh, Laos, obtaining deposits to loan, of running a branch
Nepal, Madagascar, Malawi, Tanzania, Uganda and network, of non-performing loans, and of risk
Zambia. They find that only Nepal showed a sig- assessment.
nificant rise in private sector bank borrowing. In Reducing the costs of a branch network may
other words, the observed increase in financial have negative consequences for rural dwellers
activity may only relate to government operations, especially. Since rural branches serve a less densely
and not involve any greater (employment-enhanc- populated area, they may be the obvious choices
ing) investment by firms. for closure. Since rural areas are already relatively
For SMEs,it is possible that the effect of domes- underbanked (in terms of geographic concentra-
tic financial liberalisation is simply to shift the ori- tion, though not necessarily by population), this
gin of SME financing from the informal to the for- will further limit the access of a significant section
mal sector, and hence there will be no net benefit of the population to financial services. This has
in terms of investment volume. Kariuki (1995) potential costs through reduced saving and invest-
confirms this for Kenyas domestic financial liber- ment in rural communities, and hence of reduced
alisation. For a sample of firms,the average volume output and employment (or subsistence) levels.
of credit fell in every year from 1985 to 1990, Matin,Hulme & Rutherford (1999) point to the
except for a 1.5% rise in 1986. success of the Bank Rakyat Indonesia in setting up
The allocative effects in terms of sector and sub-branch units to reach a mass rural clientele
firm size are also unclear. Jaramillo et al. (1992) and hence broadening significantly the provision
conclude that,in the case of Ecuador, financial lib- of financial services to the poorest,but this is not
eralisation led to more technologically efficient a common phenomenon in the wake of financial
firms receiving a greater share of credit.However, deregulation. Brownbridge & Gayi (1999) found
these happen to have been also the largest firms, that entrance into the banking sectors of their
and it was the previously subsidised smaller firms eight countries did tend to lead to increased
which suffered a credit withdrawal. As with China access to financial services but only in urban
today, the impact of liberalisation was to increase areas. Only the purchase of a rivals rural branch
credit-rationing among SMEs (see box). For gov- network by Finance Bank (Zambia) went against
ernments,the question will be whether the posi- this trend.
tive growth effects of greater credit allocation to Reducing the costs of both non-performing
more efficient larger firms outweighs any employ- loans and risk assessment are potentially contra-
ment costs of reduced credit to SMEs. dictory. If banks choose to reduce the number of
A second area of financial sector deregulation is poor quality loans,this will involve taking greater
the granting of domestic entry to foreign banks and care with future lending decisions. Investing in
financial institutions. This would be expected to improved risk assessment methods and informa-

tion about potential borrowers should reduce quality of industry investment and resulting
rationing and improve the access to credit of employment and poverty levels,although the risk
sound businesses (especially the disproportion- of financial crisis may be lessened.
ately rationed SMEs).The easier option however The alternative response to increased competi-
may be to introduce more rationing for smaller tion involves increasing revenues. This will essen-
firms,and focusing on less informationally opaque tially take the form of raising interest rates on lend-
larger firms as seen in China (see box) and prob- ing, but this may be through redirecting lending to
ably Kariukis (1995) Kenyan firms. higher risk groups or alternatively to (possibly
Reducing the costs of risk assessment can also international) capital markets where returns may
involve disintermediation transferring deposits be higher. The first of these will have the obvious
to (possibly international) capital markets where dangers of raising the risk in the banks portfolio,
information is readily available and risks fairly and without proper supervision can precipitate
clearly seen, rather than lending them out to busi- crisis.The second will reduce the volume of lend-
nesses.This has obvious negative effects for the ing available directly to businesses, and hence
Financial Markets in China Pro-Poor Policy vervus Liberalisation
Chinas slow but steady progress towards financial and at least partial capital account liberalisation has
been characterised by a problem particular to transition economies.On the one hand,the large state-
owned enterprises (SOEs) are being privatised, and large numbers of jobs are being cut.The govern-
ment,despite some ideological misgivings,is desperate to encourage small,private enterprises as the
only alternative source of employment (and indeed growth). It is therefore keen to ensure flows of
funds for investment to this particular sector, and hence is interested in secondary board (stock) mar-
kets to allow smaller firms to raise investment funds, although these remain underdeveloped with
problems of transparency and regulatory strength.
On the other hand,the financial liberalisation which is continuing apace is having rather contrary con-
sequences. Part of the World Trade Organisation agreement in place requires that foreign banksaccess
to domestic markets be greatly increased within a fairly short timeframe.Domestic banks are therefore
being hurriedly prepared for the harshest market conditions they have ever faced. While seeking the
necessary profitability, and clearing their books of bad loans,they are also trying to find profitable lend-
ing opportunities without repeating the same bad loan problems.Moreover, they are being urged to
make funds available to the newly approved private enterprises that have little in the way of credit his-
tories or track records of business success by which to signal their creditworthiness.
The result of these competing pressures is that banks are building up large quantities of unlent
deposits,since the privatised SOEs are no longer demanding loans in the same quantities,and are not
policy-designated lending targets. At the same time, the banks are attempting to introduce market-
based risk assessment techniques to prevent bad lending, and hence SMEs are being very strictly
rationed.The effects of the ongoing financial and capital account liberalisation then are being seen as
a squeeze on lending to already underfunded SMEs,with the inevitable knock-on impacts of reduced
investment, growth and employment.
Smaller developing countries,although their banks may not have bad loans to the same extent,are like-
ly to suffer the same effects in terms of greater rationing. Policymakers then are faced with the
quandary of liberalising their financial markets and abdicating influence on the targeting of funds,
while at the same time seeing the main employment providers of their economies suffering a credit
withdrawal.The resultant poverty impacts may be large, even if the ultimate growth effects (of even-
tually more efficient financial markets) are beneficial.

increase the extent of rationing for smaller firms poverty, both conventional liberalisation of the
which cannot access capital markets themselves. interest rate (allowing lending at an interest rate of
A third aspect of financial sector deregulation, around 40%, as is common among the microfi-
that of freeing-up domestic banks to transact inter- nance institutions to cover the high costs of net-
nationally, has been touched on already. The works in rural areas) and policies to promote insti-
potential for domestic savings to be channeled tutional development can have positive effects.
abroad to international capital markets will lower Matin et al. (1999) survey financial services
the availability of credit to domestic firms, provision for the poorest in low-income countries
although the entrance of foreign banks may com- and find two trends in particular. One is a general
pensate for this. The risk is that domestic financial trend towards more low-level, informal financial
institutions, that do not have sufficient expertise intermediation (e.g. the return of deposit collec-
or supervision,will seek funds from foreign finan- tors in Nigeria after a fall in confidence in the
ciers without taking into account the exchange banking system); and the other, more situation-
risk or the possibility of short-term loans not specific responses from formal institutions (e.g.
being rolled over. This was the case in some of the the doorstep financial services offered in Dhaka
crisis-hit East Asian economies. slums by SafeSave).
Finally, we need to consider in more detail the The overall effects of capital account liberalisa-
effects of financial liberalisation and increased tion on domestic industry and credit access are far
competition on rural access to credit.A key fea- from clear. The apparent absence of research on
ture of especially African developing countries has the preconditions for capital account liberalisa-
been the overwhelming absence of deposit-taking tion to improve (or at least leave unchanged) the
institutions willing to handle small sums operating access of domestic firms to credit is indeed paral-
in rural areas. Mosley (2000) notes that this con- leled by the absence of research to indicate the
tinued unabated after a series of financial liberali- preconditions for capital account liberalisation to
sation reforms in Kenya (1982-4), Malawi (1985-7 be at least poverty-neutral.A deeper understand-
ad 1994-6),Uganda (1992-4) and Lesotho (1994-6). ing of the channels involved is required then, even
Mosley found that liberalisation brought few for purely domestic financial liberalisation.
direct benefits, but the innovation of (especially
Non Governmental Organisation) credit institu-
tions increased access (to some financial services 4.3 Stock Market Development
at least) dramatically in both Kenya and Uganda
where the NGOs were most active. More worry- An alternative source of financing for enterprises
ingly, even in these cases, the access of the very is through equity, that is, raising money on stock-
poorest groups did not significantly increase markets by selling stock or shares.There is a con-
despite the improvement for more marginal indi- siderable literature on possible connections
viduals below but closer to the poverty line. between stock market development, and in par-
Increased competition has not had any notice- ticular capital account liberalisation in this area,
able impact on the microfinance institutions.That and investment and growth of developing coun-
is, despite the success of, for example, the PCEA tries.30 However, the only confirmed benefit is a
Chogoria in Kenya and the CCEI/Gatsby Trust one-off increase in investment (Henr y, 2000), but
scheme in Cameroon, private sector competitors no long-run increase in the capital stock (Levine &
have not moved in. Furthermore, liberalisation Zervos, 1998).Moreover, since equity markets are
specifically of the microfinance sector has had dominated by large firms and privatised state
serious negative effects. In Malawi, the privatisa - firms, the benefits of equity markets will not be
tion of the (failing) SACA and Malawi Mudzi Fund directly felt by smaller firms and so the employ-
led the new company to seek collateral for its ment impacts will be less. Only in the largest
credit provision, and hence de facto disqualify a developing countries such as China (see box)
large sector of the poor from access. Mosley have secondary boards stock markets aimed at
makes the more general points that while this allowing smaller firms to raise funds for invest-
type of liberalisation may have negative effects for ment been at all successful.

As with access to credit,small firms struggle to capital market investment rather than business
attract finance through the market because of lending. This has negative implications for pover-
their informational opacity. This could lend sup- ty where the latter would be more directly pro-
port to the case against focusing efforts too nar- ductive in terms of employment benefits. While
rowly on stock market development in smaller some studies have implied a correlation between
low-income countries. Additionally, the develop- stock market development and overall ease of
ment of stock markets as opposed to other finan- financing,as Demirguc-Kunt & Maksimovic (1999)
cial development may act as an incentive for dis- report, they find no correlation between stock
intermediation. This is the trend for banks to market activity and the ability of smaller firms to
devote greater proportions of their resources to access finance.
Conclusions
This paper has reached a number of conclusions policy analysis, whether within the Poverty
concerning the linkages between capital account Reduction Strategy process or more generally.
liberalisation and poverty. While theory implies That discussions on the reform of the global
there will be efficiency benefits for international financial architecture must include developing
finance, the existence of growth benefits for devel- country representatives and viewpoints is also
oping countries of both short term flows and FDI clear. Moreover, the prioritisation of individual
has simply not been established.Moreover, a vari- codes and standards for individual countries
ety of costs for liberalising countries, and a number should be based on research of their specific lev-
of further potential risks,have been identified. els of financial and economic development, and
The key conclusion for policy-makers then not imposed externally on the basis of an unsuit-
must be that retention of the option to make use of able industrialised country model. Finally, future
capital controls within an appropriate macroeco- research work should focus on clarifying the
nomic policy structure is essential. The underlying impact of liberalisation on investment on the one
assumption that liberalisation has definite benefits hand,and policy restrictions on the other.
is not a sensible starting place from which to begin

Endnotes
1 This is an edited version of a longer paper commissioned by for more details.Carvalho (2001) goes further by drawing a paral-
Bretton Woods Project and Oxfam for the Capital Account lel between Fund and Bank conditionality and the discipline
Liberalisation and Poverty meeting held at Queen Elizabeth imposed by capital account liberalisation.He sees both within a
House,Oxford University on 12th January 2001. A full version of process undermining the policy freedom of developing country
the paper is available at governments.
http://www2.qeh.ox.ac.uk/research/wp.html.
19 Note that a similar calculation for sterilising net inflows to all
2 Financial Liberalisation refers to both domestic financial liberalisa- developing countries would imply a cost of $9.6bn in 1998 (or a
tion and capital account liberalisation. staggering $32bn in 1996).However, the question of how capital
account liberalisation affects interest rates has not been fully
3 See the work of McKinnon and Shaw. Following the Mexican cri- answered.Williamson & Mahar (1998) find that financial liberali-
sis of 1982,a view emerged among policymakers that it was sation was followed by higher real interest rates in Australia,
closed financial markets that not only caused crises but also fail- Bangladesh,Chile,Malaysia,New Zealand,Sri Lanka,Taiwan,
ures of economic de velopment. See Rodrik (1996) for more on Thailand,Turkey and the US,but lower rates in a number of oth-
this issue. ers including Israel,Italy and the UK.A corresponding survey for
capital account liberalisation does not exist (to the authors
4 While some smaller economies (e.g. Honduras) follo wed a fairly knowledge).On the whole,however, capital account liberalisation
smooth movement towards liberalisation, many of the larger should provide momentum to a process of equalisation of risk-
economies (e.g. Chile, Brazil) underwent changes of direction, adjusted rates.Since developing country governmentsdebts are
before returning to liberalisation policies. Morley (2000) and relatively risky, this implies that they are likely to have to pay a
Morley, Machado & Pettinato (1999) detail the position of individ- higher real (non-risk-adjusted) interest rate on their liabilities
ual countries. (bonds issued) than they receive on their reserve assets (T-bills
purchased),although not necessarily by as much as the 15%
5 Nsouli & Rached,1998,p1 Stiglitz uses.
6 See relevant studies by Bayoumi (1993),Chapple (1991),Uygur 20 Collier & Gunning (1999) refer to two particular pieces of work
(1993),and Williamson and Mahar (1998). reflecting the underlying flaws:Haque et al.(1998) show that
while the three major in vestor risk ratings are lar gely explicable
7 See Beck and Levine (2000),Demirguc-Kunt and Levine (1999), in terms of policy fundamentals,they have a high degree of per-
Beck,Demirguc-Kunt,Levine,and Maksimovic (2000). sistence and the dummy for Africa is large and significant.Hence,
newly reformed countries in Africa find that their ratings are slow
8 Although Beck & Levine (2000) does include, for the first time, to change,and that they are contaminated by a bad neighbour-
some theory of industrial growth to underlie the proposed rela - hoodeffect. Jaspersen et al.(1998) show that the risk ratings are
tionship, following Rajan and Zingales (1999). significant in regressions of private investment(pp.11-12).
9 Greenwood & Jovanovic (1989) present the classic model of effi- 21 See FitzGerald & Cobham (2000) for a comprehensive sur vey.
ciency gains.
22 I am grateful to discussants at the QEH meeting for clarifying this.
10 See FitzGerald & Cobham,(2000) for further details. See the comments of Adam and Kasekende in particular.
11 Evidence has been found for a temporary increase in investment 23 Note that this ef fect of potential capital flight is compounded by
caused by stock market liberalisation,that is,a one-off boom a different effect of actual outflows.Outflows will erode the tax
(Henry, 2000),although problems of causality remain. base (by reducing the total stock of capital and labour in the
economy).Even if the tax structure is unchanged by capital flight,
12 See for example Demirguc-Kunt & Detragiache (1998) and proportionally more tax will fall on the remaining capital and
Williamson & Mahar (1998). labour. Since the percentage of transferable (capital) assets of a
person will be lower, the poorer he or she is,the poor are least
13 The analysis in this section will focus primarily on the events in able to avail themselves of the potential for capital flight and suf-
East Asia from 1997, for which data is relatively plentiful.This is fer most from the changed balance of taxation.
not to assume that crises in other (e.g.low income) countries
shared exactly the same characteristics,nor to deny their impor- 24 See,e.g.,UNCTAD, 1999:There was consensus [among the
tance. experts assembled by UNCTAD] that while [tax] incentives ha ve
their pros and cons,their role essentially remains subsidiary. More
14 As Kamal Malhotra points out in his comments,the costs were fundamental factors are political and economic stability, project
even more clear in the MIC cases where the countries were not feasibility, market considerations,investment climate and infra-
eligible for IDA concessional financing. structure(p.9).
15 Lee & Rhee (1999) 25 Haufler & Wooton (1999)
16 The following paragraphs draw on World Bank (2000). 26 UNCTADs Trade & Development Report (1996) shows that e ven
advanced countries have seen basic macroeconomic varia bles
17 This problem has been especially marked in African recipient i.e.consumption,investment,trade become more volatile since
countries,and with regard to the multilateral donors.See Pallage financial liberalisation.
& Robe (2000) for details.
27 Mead & Leidholm (1998) sur vey the available data and show that
18 I am grateful to discussants at the QEH meeting for highlighting the share of microenterprises or Very Small Enterprises (VSEs) in
this point.See the comments by Allen and Malhotra in particular employment (of those a ged 15-64) runs from 17% to 27%:

Botswana 17%, Kenya 18%,Lesotho 17%,Malawi 23%,Swaziland ment can be either increased or reduced by the level of uncer-
26%,Zimbabwe 27% and the Dominican Republic 19%.With the tainty faced by firms in a market.
exception of the latter, the employment in question is predomi-
nantly in rural,non-town areas,and in commerce rather than man- 29 Combining this with investment under uncertainty shows how
ufacturing.The majority of VSEs are owned by females and smaller firms are constrained to make relatively bad decisions
employ a majority of female workers. decisions which are more time-constrained,and inevitably result
in more volatile outcomes.This causes in particular the high
28 The general effects of uncertainty about macroeconomic and mar- death rates of SMEs.
ket-specific prospects on investment have been analysed exten-
sively through the literature on the real optionsapproach (see 30 See Durham (2000)
Dixit & Pindyck,1994).Essentially, the models show how invest-

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Dr Louis A Kasekende Deputy Govern o r, Bank of Uganda
Dr Louis A. Kasekende
Deputy Governor, Bank of Uganda
Uganda liberalised its capital account in July 1997, productivity and potential output (i.e., the supply
following a long financial liberalisation process potential and demand conditions) are likely to be
that started in 1992 with liberalisation of the cred- permanent and beneficial to the economy.
it and exchange markets and included the opening In general, capital inflows that are associated
of the current account. My critique is, therefore, with an increasing share of investment in GDP are,
based on my experience as practitioner in a cen- over the longer term,likely to be more beneficial
tral bank operating under a fully open economy. to the economy. If the share is dominated by
The paper makes a striking conclusion,arguing domestic consumption,little benefit will accrue to
that capital inflows that occur in the wake of lib- the domestic economy unless it spurs a supply
eralisation of capital accounts do not bring specif- and productivity response, for example, when an
ic benefits to an economy.The findings show that economy is in recession.
these flows cause massive and clear costs to the Another aspect, is whether or not the inflows
poor in terms of reduced social expenditure, are debt creating, and if so, is the current deficit
reduced level of transfers, increased unemploy- they generate sustainable? My judgement is that
ment and reduced wages.In other words,the case non-debt-creating inflows are beneficial to any
for capital account liberalisation is weak. economy. Uganda attracts such flows in the form
of workers remittances and FDI. If however, the
flows are debt creating,the economy will still ben-
A faulty Conclusion? efit so long as the current deficit they generate is
sustainable.That is to say, any increase in foreign
I find this conclusion rather startling for the fol- liabilities caused by capital inflows would eventu-
lowing reasons. First and foremost, capital account ally have to be repaid through higher exports.
liberalisation does not necessarily lead to capital
flows. Capital will always flow into areas or
economies were they will fetch high returns or are Ugandas Experience
safe. For, example, in most African countries before
financial liberalisation,there were distortionary or In Uganda,the liberalisation of the capital account
bad policies, which generated uncertainty that has been followed by relatively large trade flows,
caused capital flight even in the presence of capi- transfers and investment flows. Returning capital
tal flow controls. Conversely, most of these coun- flight constitutes the bulk of these inflows,but for-
tries experienced return of capital flight after eign direct investment (FDI) has also increased.
financial liberalisation. Uganda, for example, earns Uganda has,therefore,not suffered from volatility
on average, US$500million annually from the of inflows associated with portfolio investment-
return of capital flight and workers remittances type flows. A recent pilot survey by Bank of
alone since it liberalised its capital account. Uganda confirms that portfolio investment does
The effects of capital flows on an economy not exist in Uganda, but that cross-border debt
depend upon the reason for their entry, and how may exist.
they are used once they arrive. It is my submission Chart 1 shows de velopments in FDI and other
that flows,which allow foreign investors to hedge inflows from 1990/91 to 1998/99.FDI inflows rose
risks or increase short-term rates of return,are like- from US$2 million recorded in 1991/92 to US$230
ly to be speculative, temporary and destabilising. million in 1998/99. Similarly, private transfers
Nevertheless, if the correct policy responses are increased from US $ 80.5 million in 1990/91 to US
chosen, that can be dealt with.These flows are like- $ 415.2 million in 1995/96 but suffered a drop in
ly to be portfolio investments or financial deriva- 1996/97 to US $ 308.3 million.In the subsequent
tives. Likewise, flows that respond to changes in year, private transfers recovered to a record level

Chart 1: Capital growth in Uganda 1990/91 to 1998/99
of US $ 539.0 million.Unfortunately, the recovery The sum total of all this is that Uganda has
was short-lived and private transfers fell back to been growing at an annual average rate of 6.5%.
US$375.0 million in 1998/99. The fastest growth areas have been manufactur-
Given Ugandas low domestic savings ratios, ing,construction,and the transport and communi-
liberalisation of the capital account and the asso- cation sectors.The Household Survey conducted,
ciated flows has boosted Ugandas investment per- recently, indicates that poverty has been reduced
formance.Table 1 shows that private sector invest- from 56% to 46% in absolute terms. This is evi-
ment rose from 12.6 per cent of GDP in FY dence that there are growth benefits of capital
1996/97 to 12.8 per cent in FY 1998/99 and is account liberalisation.
projected to rise to 17.0 per cent in FY 2002/3.
Table 1: GDP Growth, Private Savings and Private Investment (% of GDP)

Period 95/96 96/97 97/98 98/99 99/00 2000/1 2001/2 2002/3
proj. proj. proj.
Monetary GDP 75.7 78.3 77.0 77.0 77.0

Non-monetary GDP 24.3 21.7 23.0 23.0 23.0
Gross Domestic Investment 18.4 18.5 16.9 18.8 24.6 17.8 25.1 25.6
Public 6.4 5.7 6.0 10.9 8.7 8.6 8.6
Private 12.6 11.2 12.8 13.7 9.1 16.4 17.0
Gross National Savings 15.7 17.6 14.7 14.4 19.3 13.3 18.0 19.6
Public 4.4 5.2 4.6 2.6 7.1 4.8 5.3
Private 13.2 9.4 9.8 16.7 6.2 13.3 14.3
M2/GDP 10.9 11.7 12.3 12.1 11.4 11.8 12.1 12.2

Nominal GDP 5,565.3 6,022.9 7,104.0 7,963.4 8,655.8 9443.0 10568.0 11,858.0
(billions of shillings) 9 5 30 1 8 0 0 0
Source:Backg round to the budget 2000/1 and Ugandan authorities and Fund Estimates and Projection

Other benefits pose monetary policy challenges to the central

bank and constrain financial intermediation.
Financial repression resulted in negative returns However, the solution is not to re-impose capital
on financial assets, which led to inefficient finan- controls since,in my view, the benefits of an open
cial intermediation and low savings.Controls also economy far outweighs the costs, but to improve
caused duality in the economy with the emer- the quality and dissemination of data, maintain
gence of parallel markets in the goods and service macroeconomic stability, strengthen supervision
market, and in the market for foreign exchange. of the financial system and improve instruments
This tended to constrain development of markets for hedging against risks.
and,consequently proper allocation of resources.
Liberalisation appears to have released the claws
of control and reintroduced price signals for allocat- Response to specific findings
ing resources by restoring confidence in the role of of the CAL & Poverty Paper
the free market. This is evidenced by the return of
capital flight. Financial liberalisation has also I now respond quickly to the specific conclusions
brought about increase in farm gate prices, financial about the impact of capital account liberalisation
deepening,increase in domestic savings,etc. on economies as revealed by the survey of
research findings.
There is no evidence that financial liberalisa-
Risks of capital account liberal- tion increases the cost of funding. In our case,
isation interest rates have come down significantly from
50% before financial liberalisation to the current
As financial liberalisation shifts the risk burden average of 21%. There is also growing evidence
from government to the private sector the risks that some firms are soliciting cheap funds off-
can complicate macroeconomic management. For shore.The problem in Africa is really not of high
example,open capital accounts can offer financial interest rates, but of availability of bankable proj-
institutions the opportunity to provide open, ects.This makes banks shy away from lending.
unfunded letters of credit,guarantees and banking There is no guarantee that high fiscal deficits
services to both residents and non-residents in accommodate pro-poor projects. It may lead to
both domestic and foreign currencies,and off-bal- inefficient financing thus, hurting the poor. It
ance sheet transactions. These services can be could also lead to inflation if government borrow-
sources of exchange and credit risks especially to ing is from the central bank.
the domestic banks,which may have little experi- Nevertheless, under a liberalised environment
ence in managing the risks. The risks can make and tight budget management, the poor can still
financial institutions become insolvent. be protected:
In Uganda, we have noticed that speculators develop markets so that monetary policy can
can switch deposits between accounts denomi- be relied upon to manage short term shocks;
nated in local and foreign currencies whenever ring fence social expenditure. Uganda uses
there are depreciationary or appreciationary pres - Medium Term Expenditure Framework (MTEF)
sures in the foreign exchange market. We have to increase predictability of budgetary policy
also noticed dollarisation of transactions whenev- and budgetary allocations by providing a three-
er there are severe depreciationary pressures on year rolling projections and budget ceilings for
the shilling.This distorts the distinction between each sector. The intention is to provide each
tradeables and non-tradeables in the domestic sector with the predictable flow of resources;
economy and makes the calculation of real maintain macroeconomic stability.
exchange rate difficult. All these complications

Filomeno S Sta. Ana III Action for Economic Refor ms, Philippines
Filomeno S. Sta. Ana III

Action for Economic Reforms, Philippines
The Cobham study on capital account liberalisa- alisation became an attractive substitute to painful
tion and its impact on poverty is indeed refresh- domestic reforms as a means to obtain more capi-
ing, for it substantially discusses and analyses the tal to reach a higher level of economic maturity.
costs of capital account liberalisation during the Bluntly said, capital account liberalisation has
so-called normal times. Until this time, the litera- become a lazy way of getting financing.
ture on the social effects of capital account liber- Capital account liberalisation by itself does not
alisation during the non-crisis or pre-crisis period automatically translate into significant capital
is scarce. inflow. Capital-scarce countries must compete for
It is dif ficult to establish a direct link between capital coming from abroad. This brings to the
capital account liberalisation and poverty, but the fore the issue of locational competition, for which
link can be established indirectly through macro- tax policy is an important tool. The implication of
economic mechanisms such as fiscal policy, mon- this is that it is not labour in general that suffers
etary policy, and exchange-rate policy. Yet the from the heavier tax burden,as compared to capi-
determination of macroeconomic policies rests on tal,but the part of labour that is the least mobile,
other considerations and objectives.This is not to i.e. the low skilled, low educated (the poor, in
dismiss the relevance of the link; rather it demon- short). Highly mobile labour, which is highly
strates how extraordinary the challenge is to skilled, highly educated, would tend to benefit
advance the proposition that capital account lib- from the reduction of income tax rates.Because of
eralisation contributes to poverty. tax competition, governments in capital-scarce
countries are tempted,if not compelled,to reduce
income tax rates, which tends to make the tax
Government Financing structure less progressive or more regressive.With
the share of revenues sourced from direct taxes
One cost elaborated in the Cobham paper per- (corporate and individual) shrinking (and may we
tains to the constraint on government finances. add the reduction of tariffs as well), governments
The proneness of many developing countries to can be expected to rely more and more on indi-
borrow to finance growth makes it tempting for rect taxes and user fees. Undoubtedly, this would
them to liberalise their capital accounts. To be impact not only on labour in the formal sector but
sure, governments should first and foremost rely also on labour in the informal sector, the under-
on national savings,including taxes,before resort- employed,and the unemployed.
ing to borrowing. However, the problem of some
countries, including the Philippines, is that even
when there is economic recovery or growth, tax Market Discipline
collection as a proportion of GNP remains dismal.
Growth is not only the determinant of tax A final point on fiscal policy as it relates to capital
receipts, other important variables include the account liberalisation is the debatable proposition
efficiency of tax administration, the extent and that,where governments are using fiscal deficits
degree of tax evasion, the confidence in gover- inefficiently, the market discipline effect of liberal-
nance,and the quality of growth itself. ization will be to curtail the wasteful use of limited
Putting in place a comprehensive tax reform resources.As the paper points out, this may have
agenda that makes the tax system efficient, pro- no direct poverty effects. Undeniably market dis-
gressive and buoyant reduces the temptations of cipline is an effective way to curtail inefficient fis-
governments to liberalise their capital accounts.In cal deficits.The assumption is that a target of a low
the case of high-growth economies wherein budget deficit or a balanced budget will force gov-
national savings together with tax collection are ernment to spend wisely and efficiently. However,
relatively high (e.g., Korea), capital account liber- it can be argued that the reduction of government

Filomeno S Sta. Ana III Action for Economic Reforms, Philippines
spending, even if such spending was inefficient, state. Paul Hutchcroft (1998) defines booty capital-
will have an impact on poverty reduction.The cut ism as a patrimonial state typified by business inter-
in deficit spending will still reduce the expendi- ests capturing the state apparatus.To be sure, the
tures for social and economic services. capture of the states regulatory power becomes a
We have to be emphatic in criticising the cur- main agenda of vested interests engaged primarily
rent tendency to dogmatise the correctness of low in non-tradables such as utilities, telecommunica-
budget deficits using a rigid benchmark. The tions,transportation, and real property.
dogma absolutely treats low budget deficits or bal-
anced budgets as part of market discipline and
good fundamentals but where on earth is the evi- Rethinking Growth Strategy
dence that a budget deficit breaching three per-
cent of GNP or approximating four percent of Finally, the debate on capital account liberalisation
GNP is alarming (the word used by pundits to is linked to the debate on growth strategy.
describe the current Philippine government Undeniably, growth is a necessary condition to
deficit of four percent of GNP)? eradicate poverty. But the debate revolves around
In the Philippine case,I will be the first to con- the quality of growth. Capital account liberalisa-
cede that the deficit of the Estrada administration tion,it is argued,is necessary for growth.Empirical
is indeed alarming. It is using the deficit to cover evidence (and common sense) would show that
up its failure and lack of political will to reform tax financial flows merely follow growth.This is the
administration and address tax evasion. Massive direction of the causality. Among the variables
government resources, which enlarge the deficit, that attract capital from abroad are a) the rate of
are being used to prop up a morally bankrupt and return on domestic assets being greater than the
venal administration. But whilst its important to rate of return on assets of the rest of the world (in
address this, it has nothing to do with what is an this regard,interest rates are a proxy to assets) and
acceptable deficit level. b) the risk premium.It is hence unsurprising that
the major recipients of capital or financial flows
are the high-growth economies,especially in East
Exchange Rate and Interest and Southeast Asia.
Rates Clearly then,it is in normal times or in times of
growth when all kinds of capital are pouring into
The pernicious effects of high interest rates and the economy. And it is precisely during these
an overvalued currency need further elaboration. times that an extraordinary measure like capital
Higher interest rates as a result of sterilisation lead control is necessary. The liberal flow of capital
to a dampening of investments and a rise in unem- may inflate growth, but such growth as the 1997
ployment. Further, higher domestic interest rates crisis has proven, is risky and unsustainable and
attract more capital from abroad, leading to fur- has enormous social costs.Given the bitter lessons
ther currency overvaluation.In turn,the strong or of the 1997 global financial crisis,will policymak-
overvalued currency undermines the real sector ers allow capital exuberance to dominate the
of the economy. Both exports and import substi- economy in the name of growth? Or will they tem-
tutes are penalized. The overvalued currency per the growth by, inter alia, screening capital
makes exports expensive and imports cheap to flows as a means to make growth more sensitive
the detriment of competing domestic goods. to development goals? It is a relief to know that
Again,this means displacement of workers both in even the most conservative institutions like the
agriculture and in industry. IMF have conceded the relevance and appropri-
Further, the overvalued currency leads to ateness of capital controls in certain conditions.
investors shifting from tradables to non-tradables. Such acknowledgment is enough to move forward
For a country with a soft state (the Philippines the debate towards for mulating the policies and
being a prime example), this would all the more measures that will check the dangers attendant to
reinforce the booty capitalist character of the excessive and fickle financial flows.

Art Kraay World Bank
Aart Kraay
World Bank
Should we expect capital much empirical evidence is messy (but some evi-
account liberalisation to have dence of benefits does exist).
large measured growth effects?
On growth effects Quinn (1997) finds pretty
Measuring capital controls is difficult: robust evidence that capital account liberalisation
raises growth.
almost all measures of policy based on IMF
Exchange Arrangements and Exchange Some evidence that capital controls are associated
Restrictions which measures the presence with crises.
(not strength) of selected (not comprehensive)
controls on residents (not foreigners);
Does capital account liberalisa-
the few available measures of outcomes such tion raise inequality?
as volume of capital flows or onshore-offshore
interest differentials are also problematic. The paper presents several arguments that capital
account liberalisation limits the possibility of pro-
Should capital account liberalisation have direct poor fiscal policy by:
growth effects?
worsening the terms on which governments
Theory points to better risk sharing and better borrow
allocation of investment with at most one-time
level effects on income. diverting public resources to cover the interest
costs of sterilizing capital inflows
Possible links to growth less clear, one mechanism
might be that better risk sharing lets investors excessive discipline placed on fiscal policy
choose higher-return but riskier projects? by fickle and uninformed international
investors
Should capital account liberalisation have indirect
growth effects? narrowing the tax base through capital flight
and exemptions for foreign investors.
CAL leading to investment leading to growth
argument is weak because it assumes that (i) Two conditions are necessary for these to lead to
capital controls are the binding constraint,and greater income inequality:
(ii) investment raises growth, both of which
are dubious propositions empirically; in the absence of capital account liberalisation
public policy is pro-poor;
CAL leading to policy discipline (i.e. macro-
economic stability) to growth argument is policy adjustment to this discipline is anti-
more plausible and there is independent evi- poor.
dence for both steps in the argument. But
effects of CAL may not show up in growth Since this is an empirical question it is helpful to
regressions that control for other dimensions look at the (very imperfect) data on capital
of policy. account liberalisation, fiscal outcomes, and
inequality (which the paper unfortunately does
Given these ambiguities it is not surprising that not do).
Collect data on capital controls (IMF indicator

of restrictions on capital account transactions), capital account liberalisation matters for fiscal pol-
fiscal policy outcomes (government consump- icy or is associated with higher inequality and
tion/GDP, fiscal deficits/GDP, public spending poverty. But of course there are lots of caveats:
on health and education/total public spend-
ing), and inequality and poverty outcomes Measurement is difficult, for capital controls
(Gini index, average incomes in bottom quin- (as discussed above) and especially poverty
tile,and dollar-a-day headcounts). and inequality (where we are constrained by
the limited availability of high-quality compara-
Set of observations limited by availability of ble household survey data). So cant rule out
income distribution and poverty data (forms possibility that in all of this the data simply
an unbalanced and irregularly-spaced panel of arent informative for either the view that cap-
observations). Restrict attention to inequality ital account liberalisation does matter for
observations spaced at least five years apart, policy, poverty and inequality, or that it does
collect data on average of policy variables in not.
five years prior to date of survey.
There may be plenty of non-linearities or omit-
Look at relationship with CAL in levels and in ted variables which are obscured by parsimo-
changes. nious linear regressions like these.
Simple (-minded?) correlations are not very prom-

ising in terms of delivering clear evidence that What does all this mean for cap-
capital account liberalisation matters for fiscal pol- ital account liberalisation and
icy or is associated with higher inequality and poverty reduction?
poverty. But of course there are lots of caveats
such as: Clearest conclusion that emerges from the empir-
ics is that there are no clear conclusions. And so
presence of capital controls may be proxying the burden of proof for unravelling the benefits
for low income (or other things); and costs of capital account liberalisation lies with
all those interested in providing sound develop-
relationship between capital controls and out- ment policy advice.
comes plausibly different in rich and poor
countries. Can capital account liberalisation either be
advocated or ruled out because of its first-order
To begin to address these problems estimate consequences for poverty? Probably not.
regressions for rich and poor countries like:
Can capital account liberalisation be a useful
Outcome = 0 + 1 Income + 2 Capital Controls + e component of a broader package of reforms
designed to make markets,especially financial
Outcome = 1 DIncome + 2 Capital Controls + e markets, work better? Probably, with all of the
usual appropriate caveats about sequencing,
Simple (-minded?) regressions are also not very supporting institutions, etc.
promising in terms of delivering clear evidence



William Larralde G roup of 24
William Larralde
Group of 24
The Cobham paper maintains that the capital ital flows to developing countries is such that
account liberalisation (CAL) process makes the management of economic and financial policies to
task of developing country governments much harness it becomes the main task of public policy
more difficult, by demanding market-friendly poli- in developing countries to the detriment of pro-
cies that ensure macroeconomic stability, promote poor policies and programmes and to the anti-
growth and fight poverty, in an environment of cyclical macro-management of the economy. If
greater financial volatility brought about by an such a conclusion is accepted,one can also posit
enhanced integration into, and dependence on, that any status quo, regarding the financial sector
the international private financial markets. and the capital account in any developing country,
is preferable to full financial liberalisation or pos-
It is worth noting that this is usually further com- sibly even to a partial liberalisation.
plicated by the fact that such liberalisation occurs There is a basic flaw in such a reasoning,which
in the context of: is the assumption that the pre-existing set of con-
a liberalisation of policies and regulations ditions before CAL were conducive to sus-
related to the domestic financial sector and to tained economic growth and poverty eradication.
the trade of goods and services, including In this regard I would like to expand on several
financial services; considerations relevant to the appraisal of the
in most cases as part of an economic adjust- impact of CAL on poverty in developing countries.
ment programme in an adverse national and The analysis assumes optimistically that the
international economic environment in terms governments of developing countries were reach-
of slow or negative growth; ing the poor and that poverty eradication was a
difficulties for servicing domestic and external primary goal of their policies.The reality is radi-
debt; cally different: governments in developing coun-
deteriorating terms of trade; tries respond to similar powerand real-politik
balance of payments difficulties; motivations as in the rest of the world.
no or limited access to financial markets and Focusing on the poverty impacts of macroeco-
the likes. nomic policy may ignore more important causes
of poverty. I believe that too much is being expect-
It was in recognition of the varied set of condi- ed from macroeconomic policy, particularly from
tions in different developing countries and the macro-policy prescriptions of the IMF, for
regions of the world, that the G-24 itself made poverty eradication,with very little chance of suc-
public early-on in the discussion on CAL its stand cess.This is not to say that I am suggesting that the
for an orderly, cautious and gradual approach consequences of alternative macroeconomic poli-
(Caracas Declaration, February 1997). This decla- cies on income and wealth distribution should not
ration was made at a time when the so-called be studied,measured and included as a fundamen-
international community was still pushing res- tal criterion for decision making; nor that macro-
olutely for an amendment of the IMFs Articles of economic policy is neutral to the particular inter-
Agreement, in order to extend its mandate over ests of particular groups. Rather, that in most
memberscapital account regimes with a view to cases, the root causes of poverty are not being
furthering CAL in all member countries (meaning attacked,not even analyzed in depth. For example,
developing countries and countries in transition). those deriving from population pressures, the
Going to the papers central argument that highly skewed ownership of assets such as arable
CAL negatively affects prospects for growth and land, and in general the mechanisms of distribu-
poverty alleviation even in the event of capital tion of income and wealth that have persisted in
inflows, the implied conclusion seems to be that todays poor countries over many decades, if not
the current instability of international private cap- centuries.

William Larralde G roup of 24
The push for the formal inclusion of CAL and tem is at the lowest end of priorities for reforming
financial sector opening as a mandate to be insert- the international financial architecture, yet, the
ed in the IMF Articles of Agreement is being working of financial market forces are among the
replaced by a more subtle mechanism, such as strongest, the fastest, the most unstable and the
embedding the same objective into the adoption most harmful expressions of globalization.
of international standards and codes, best prac- Whatever the merits or demerits of CAL for
tices and the like, which are being formulated economic development in developing countries,
without adequate participation of developing LDCs or MDCs, the fundamental problem is that
countries in inter-governmental and non-govern- the international monetary and financial system is
mental bodies and also through WTO commit- dominated by three currencies (two national and
ments regarding financial services, trade related one regional) which operate with little or no
agreements, etc.This takes me to the most funda- regard for the ef fects of their monetary policy on
mental matter of the necessity to establish a set of the rest of the world. Particularly problematic is
global rules and institutions for governing the the excessive weight of the United States as both
functioning of the global economy. I will not the main international currency issuer and by far
expand on this at this time,but simply assert that the dominant importer of capital from industrial,
the governance of the international financial sys- transition and developing countries.

Mark Allen I n t e r national Monetary Fund
Mark Allen
International Monetary Fund
This paper leaves me thinking that tracing the rela- by which capital account liberalisation would
tionship between capital account liberalisation and facilitate growth.Which dominate in practice,and
poverty is too ambitious a task. It is remarkable are there ways of both having your cake (i.e., the
how little we know about the relationship positive effects of liberalisation) and eating it too
between macroeconomic policy and poverty, or (i.e., avoiding the negative consequences)?
for that matter what government expenditure poli- Capital account liberalisation is a further step
cies help the poor in the longer run;indeed,there beyond domestic financial liberalisation, and the
are those who argue that the link between growth latter can help or harm growth and the poor in the
itself and poverty reduction is tenuous. If these same ways that the former can.Indeed,the record
basic building blocks are not in place, it is going to of severe domestic financial crises following
be difficult to establish the long chain of causal domestic financial liberalisation in both industrial
relations between the restrictiveness of the capital and developing countries is remarkable.
account and the incidence of poverty. Nevertheless,as Cobham points out,the evidence
Broad cross-sectional regressions of growth on shows clearly financial liberalisation is conducive
indexes of capital account openness do not sup- to growth and the reduction of poverty.Why then,
port the hypothesis that capital account liberalisa- would we not expect capital account liberalisa-
tion is good for growth.But this finding provides tion in the appropriate circumstances to have a
no support for the hypothesis that the poor would similar positive effect on balance?
benefit from maintaining a restrictive capital Cobham applies a precautionary principleto
account regime.All that these regressions tell us is the issue of capital account liberalisation: since
that the relationship between capital account lib- there is no evidence that liberalisation leads to
eralisation and growth, if any, is obscured by the growth, and there is evidence of it being accom-
absence of other variables in the regression that panied by crises that have certainly hurt the poor,
also have a bearing on the interaction of capital liberalisation should be avoided.The paper does
account liberalisation and growth. not tackle the other side of the question,which is
We have learned that there are at least four cir- that there is evidence that the use of capital con-
cumstances in which opening up a countrys cap- trols has not helped countries avoid crises, that
ital account can be inappropriate, if not disas- they have been costly, and that they breed corrup-
trous.When: tion. Edwards points out that Korean policy mak-
prices are distorted and the current account ers in 1997 and Brazilian policy makers over the
restricted; same period believed that the controls on infl ows
the country faces major macro e c o n o m i c they had in place would protect them from the
imbalances; crises which nevertheless hit them.1 He also notes
domestic banks are insolvent; that the Latin American countries which tried to
prudential regulation of banks and markets is strengthen capital controls in the 1980s,
inadequate. Argentina,Brazil,Mexico,and Peru, were the ones
to suf fer the most prolonged recession and most
In addition, there have been lessons about the rampant inflation during the decade. By contrast,
sequencing of capital account liberalisation itself. those which avoided controls and also did the
The relevant question now is how capital account most to restructure their economies, Chile and
liberalisation that takes these lessons into account Colombia, were the only ones to show any growth
affects growth or poverty. in the decade. Russia might also be cited as an
There are many channels by which capital example of a country where extensive capital con-
account liberalisation may affect growth and the trols not only do not prevent capital flight,but pro-
poor negatively.There are likewise many channels vide a major vehicle for cor ruption.

Mark Allen I n t e r national Monetary Fund
Anecdotal evidence does not support the idea generally associated with the use of disinflation
that those countries which maintain restrictions strategies involving an exchange rate peg and tight
are more successful at combating poverty. Their monetary policy. This combination created the
relatively closed capital accounts may have helped incentives to pull in large amounts of short-term
shield India and China from the Asian crises, and capital, in turn vitiating the macroeconomic poli-
the countries have managed to grow relatively fast cy stance. The improved economic management
in the presence of controls.However, if the World exhibited by many emerging market countries has
Banks statistics are to be believed, neither has reduced the amount of disinflation that remains to
been particularly successful in reducing the num- be done,and fixed exchange rates are now much
bers of the poor. rarer. It should be possible to handle future cases
These examples do not of course prove that of excessive capital inflows by allowing the
capital controls are universally harmful, but they exchange rate to appreciate.
do indicate that one should pause before recom- The seriousness of the capital account crises of
mending their use. To make a useful contribution 1997-8 is without question. The current accounts
to policy formation, we need to come up with of the Asian countries affected moved in the crisis
more specific advice about the sort of restrictions year by 10 percent of GDP, thanks to the size of
that are appropriate in different circumstances. the outflows. In such circumstances,real incomes
One of the main channels that Cobham identi- must fall until GDP can recover, and the challenge
fies by which capital account liberalisation may is to protect the poor in this process. Social
affect the poor is the constraints it puts on expan- expenditures were among those least affected by
sionary domestic policies and in particular on gov- the programmes,although they could not hope to
ernment spending.Capital restrictions can restore shield people from all effects of the crisis.
some autonomy to domestic macroeconomic pol- The programmes were not focused on the
icy and allow it to be directed towards poverty achievement of fiscal balance. Initially, when the
reduction. There is some evidence that public depth of the crisis was not yet evident, the only
spending is lower in countries where the capital fiscal tightening prescribed was that needed to
Endnotes
account is more open.2 The case is also based on offset the carrying costs of the new debt incurred
Krugmans impossible trinity, that a country from recapitalizing the banking system. Fiscal pol- 1 Sebastian
Edwards, T
cannot have an open capital account, a fixed icy was intended to be neutral. But when the Mirage of
Capital
exchange rate, and autonomous macroeconomic depth of the likely fall in GDP and in government Controls,
policy simultaneously. revenues became apparent,the programmes were mimeo, Ma
1999
The Krugman argument provides a useful rapidly redesigned to allow the automatic stabiliz-
2 Barry
model for recent crises. In each, the capital ers to operate. Eichengree
account was more or less open,and each was try- It is an interesting question whether a larger fis- Capital
Account
ing to defend a fixed exchange rate.In the end,the cal deficit is the appropriate response to a depres- Liberalisat
What do C
political strains that the resulting domestic poli- sion. This is clearly the Keynesian solution and country
cies created led to an abandonment of the peg. works in most industrial countries. It works Studies Tell
(mimeo.
Post-crisis, most countries have opted for capital because the stimulation of the more expansionary October 20
for World B
account liberalisation and a floating exchange fiscal policy is not offset by a loss of confidence in Economic
rate, but this should have restored their macro- policy sustainability. Investors and consumers have Review) cit
Garrett and
economic autonomy. Whether any relationship confidence that the increased government debt Mitchell.He
also mentio
between capital account liberalisation and the will not be inflated away, but will be honored.This that Quinn
level of public spending persists in a world of flex- is not necessarily the case during a capital market came up w
opposite
ible exchange rates remains to be seen.But if the crisis in an emerging market. It is quite possible results.
Krugman model holds, we would expect the rela- that the expansionary effect of a larger deficit will 3 See Barr
tionship to be weaker in the future,as well as the be more than offset by further capital flight if Eichengree
Capital
incidence and costs of crises lower. investors fear that it signals a significant rise in Controls:
Capital Ide
A similar line of thinking leads to the conclu- inflation.3 This is a case where capital controls Capital Fol
sion that the problem of capital inflow surges is might help, providing that the short-term gains off- mimeo,
November
largely a matter of the past.These episodes were set the medium-term costs of their imposition. 1998

Kamal Malhotra United Nations Development Pro g r a m m e
Kamal Malhotra1
United Nations Development Programme
I have been asked to focus my comments on crisis marginalized population groups in Thailand, has
periods. Let me begin by indicating that I agree been the privatisation of some of the more effi-
with the overall thrust of the paper and recognize cient, profit-making public utilities to finance the
and appreciate the important potential contribu- budget deficit.
tions it is making given the paucity of research Poverty and unemployment are inextricably
and analysis on this topic and the urgent need for linked, hence the monetary (e.g. interest rate)
more of both,especially from a developing coun- trade off between inflation and employment is
try perspective. crucial. While inflation does obviously hurt the
poor, most people if they were polled would
rather have employment with higher inflation
Major Overall Comments than the other way around, for obvious reasons.In
this context,the deflation,with significant increas-
Notwithstanding the acknowledged global impor- es in unemployment and underemployment,
tance of the Asian crisis experience, and the les- which occurred as a response to the crisis in
sons learnt from it, it is important to examine countries such as Thailand, directly and severely
empirical evidence on the impacts from other exacerbated the poverty crisis. This is particularly
recent and different financial crises (e.g.Mexico in so in countries where there are no effective for -
1994-95,Russia in 1998) in the South and East.To mal social security and insurance systems except
understand whether the effects of other crises are employment.
consistent with and reinforcing of those from the The incidence of underemployment in all the
East Asian crisis. Asian countries, especially in SE Asia, with its
There is a need to differentiate the poverty, direct poverty, inequality and social implications
employment and other structural and social was much more severe than formal unemploy-
impacts of the crisis much more between North ment figures would have us believe.Closely relat-
East and South East Asia and between short term ed was the increased informalisation of the work
and long term impacts. For example, these impacts force with its much more severe and largely
in the Republic of Korea have been significantly dif- undocumented poverty, social dislocation impacts
ferent from those in Thailand and Indonesia in and coping and survival strategies.
terms of their structural nature ,s everity and length. It is also important to consider social invest-
ment funds (SIFs) because they were the major
poverty response mechanism of the Bretton
Social and Structural Impacts Woods institutions (BWIs), ADB and governments.
The very nature of their basic assumptions and
It is important to understand the short and long- design ensured that their impact on structural
term structural inequality implications of the cri- unemployment or underemployment and there-
sis, not just its poverty implications. Some of the fore poverty in the short-term,let alone the long-
more significant broader social implications of the term was negligible.
crisis, for example, the enormous reverse migra-
tion that took place in Thailand and the social dis-
location and reduction in remittances from urban From Financial Crisis to the
to rural areas that accompanied it, and the break- Real Economy
down of the historical government compact with
labour in the Republic of Korea, also need to be It is crucial to emphasise that what began, espe-
understood.One of the most far-reaching structur- cially in the Republic of Korea (but also in
al and social implications,especially for poor and Indonesia and the Philippines and to a lesser

Kamal Malhotra United Nations Development Pro g r a m m e
extent in Thailand), as a private sector crisis of US$ meant that basic food and medicine became
illiquidity in the financial sector, was quickly and unaffordable and even unavailable to the majority
unfortunately converted into the twin crises of of the Indonesian population, particularly the
both the private and public sectors as well as a poor and most needy.
structural crisis of both the financial and real The Thai crisis was clearly created and fuelled
economies because of the nature of the donor and by a national economic growth strategy which
government policy response to the illiquidity cri- was heavily dependent on the twin external,
sis.This policy response has to be blamed for the unsustainable and often contradictory engines of
much more serious,widespread and longer pover- trade and capital account liberalisation.The caus-
ty and employment impacts than a much more es, severity and poverty, inequality and social
containable private sector crisis of illiquidity in impacts of the 1997 crisis were a result of the
the financial sector would have entailed. simultaneous twin crises of the countrys export
competitiveness strategy, in the context of trade
liberalisation by countries such as the Peoples
The Linkages Between Trade Republic of China, and its premature and unregu-
and Financial Liberalisation lated capital account liberalisation strategy.
To elaborate,as I first argued in 1997,when the
The relationship between trade and financial lib- Asian crisis began in Thailand, (East and
eralisation needs to be explored for a number of Southeast Asia Revisited: Miracles, Myths and
reasons, not least to understand why there has Mirages, FOCUS Papers,November 1997),the ini-
been such a vocal and impassioned critique of tial success of Thailands low-end value added,
capital account liberalisation by ardent and influ- labour-intensive export growth was overtaken by
ential free trade advocates such as Dr. Jagdish its relatively high labour cost in relation to labour
Bhagwati of Columbia University. However, equal- productivity because of the countrys failure in its
ly, if not more importantly, this relationship needs post-primary education policy and pitiful invest-
to be explored because of the empirical evidence ment in research and training.This has led to the
from the SE Asian crisis,which clearly showed that loss of Thailands export competitiveness,particu-
trade liberalisation policies in the context of finan- larly in the much more aggressive global context
cial liberalisation can also severely exacerbate of trade liberalisation embraced by most develop-
poverty, inequality and other social impacts even if ing countries and, especially competition for the
the proximate primary cause of the crisis was cap- same exports at much more favourable labour
ital account liberalisation. cost to productivity ratio in the Peoples Republic
In the case of Indonesia,its capital account lib- of China.
eralisation crisis exposed the vulnerabilities and In addition,the relationship between trade and
shortcomings of its trade liberalisation policies, capital account liberalisation is important to
highlighting and bringing into sharp focus the explore because in all the Asian crisis countries,
poverty, inequality and social impacts of the latter but especially in SE Asia,a key and desperate strat-
much more clearly. I am referring here specifically egy that national governments have attempted to
to the food security and medicine crisis, which prioritise in their efforts to claw their way out of
became evident in Indonesia soon after its finan- the crisis is to promote natural resource based
cial crisis. Trade liberalisation policies,which had exports, which will clearly have both short and
increased Indonesias dependence on basic food long-term negative environment,poverty and food
and pharmaceutical imports, started to look par- security implications for particularly the poorest
ticularly misguided from the perspective of pover- population groups in these countries, who are
ty, inequality and increases in social chaos when heavily dependent on the agricultural and other
the severe devaluation of the Rupiah against the natural resource base.
Endnotes
1 The views expressed here are those of the authors and should not be attributed to UNDP.

List of Participants
Charles Abugre William Larralde

Integrated Social Development Centre, G24 Liaison Office,
PO Box 8604,Accra North Ghana 1875 I Street N.W. Suite IS 2-285, Washington D.C.20431 USA
abugre@ghana.com Wlarralde@g24.org
Chris Adam Jonathan Leape

Centre for the Study of African Economies, Centre for Research into Economics and Finance in Southern Africa,
University of Oxford,Manor Road,Oxford, OX1 3UL UK London School of Economic and Political Science
christopher.adam@economics.ox.ac.uk Houghton Street,London WC2A 2AE UK
j.leape@lse.ac.uk
Mark Allen
International Monetary Fund, Kamal Malhotra
700 19th ST NW, Washington DC 20431,USA United Nations Development Programme,
mallen2@imf.org UN Plaza,Room 2060,New York 100170 USA
Kamal.malhotra@undp.org
Fernando Carvahlo
Institute of Economics, Federal University of Rio de Janeiro, Mathew Martin
Avenida Pasteur, 250 - sala 3,22290-240 - Rio de Janeiro - RJ Brasil Development Finance International,
Fjccarvalho@uol.com.br 4th Floor, Lector Court 151-53 Faringdon Road
London EC1R 3AF UK
Alex Cobham mail@dri.org
Queen Elizabeth House,
Oxford University, St Giles,Oxford OX1 3LA UK Rob Mills
Alex.cobham@qeh.ox.ac.uk European Network on Debt and De velopment,
Rue Dejoncker 46,B-1060 Brussels Belgium
Charlotte Denny Rmills@eurodad.ngonet.be
The Guardian,119 Faringdon Road,London EC1R 3ER UK
Charlotte.denny@guardian.co.uk Lucy Nichols
Oxfam America,
Valpy Fitzgerald 26 West Street Boston,MA 02111 USA
Queen Elizabeth House,Oxford University, Lpnichols@oxfamamerica.org
St Giles,Oxford OX1 3LA UK
Edmund.fitzgerald@qeh.ox.ac.uk Robin Robison
Quaker Peace and Social Witness,
Ricardo Gottschalk Drayton House,Euston Road,London WC1H UK
Institute of Development Studies, ROBINR@quaker.org.uk
University of Sussex, Falmer, Brighton BN1 7RE UK
r.gottschalk@ids.ac.uk Filomeno Sta Ana
Action for Economic Reforms,
Richard Hughes PO Box 242 University of the Philippines
HM Treasury, Global Policy & Institutions Dileman.Quezon City 1101,the Philippines
Parliament Street,London SW1P 3AG UK aer@pacific.net.ph
filomenoiii@yahoo.com
Godfrey Kanyenze
Zimbabwe Congress of Trade Unions Frances Stewart
PO Box 3549,Harare,Zimbabwe Queen Elizabeth House,
zctu@mango.zw St Giles,Oxford OX1 3LA UK
Frances.stewart@qeh.ox.ac.uk
Louis Kasakende
Bank of Uganda Rachel Turner
PO Box 7120.Kampala,Uganda Department for International Development,
louisk@starcom.co.ug 94 Victoria Street,London SW1E 5JL UK
R-TURNER@dfid.gov.uk
Jenny Kimmis M-DOBLER@dfid.gov.uk
Oxfam,274 Banbury Road,Oxford OX2 7DZ UK
Jkimmis@oxfam.org.uk Kevin Watkins
Oxfam, 274 Banbury Road,Oxford OX2 7DZ UK
Tim Kessler Kwatkins@oxfam.org.uk
Initiative for Policy Dialogue,
1101 15th Street NW, Suite 802,Washington DC 20037 USA Angela Wood
kessler@ned.org Bretton Woods Project,
Hamlyn House,Macdonald Road,London N19 5PG UK
Aart Kraay Awood@brettonwoodsproject.org
World Bank,
1818 H St NW,Washington DC 20433 USA
Akraay@worldbank.org

Web Resources
www.stern.nyu.edu/globalmacro www.devinit.org/findev
Global Macroeconomic and Financial Policy Site DFID funded Finance and De velopment Research
run by Nouriel Roubini at the Stern School of Programme identifying effective financial sector
Business,New York University, with academic and policies for promoting poverty reducing econom-
policy papers,newspaper and journal articles as ic growth in poor countries.
well as good links to other relevant sites.
www.qeh.ox.ac.uk
www.ids.ac.uk/ids/global/Finance/intfin2.html Contains research reports on financial sector
Institute of Development Studies (IDS) website issues,capital flows and developing countries
on Globalisation and monitoring the from researchers at Queen Elizabeth House,
International Financial Architecture with IDS Oxford University.
papers and links to other websites.
www.brettonwoodsproject.org
www.odi.org.uk Reports and briefings on IMF and World Bank
Overseas Development Institute (ODI) website policies and reform options.
with information about research programmes
and lists of publications and briefing papers. www.cafod.org.uk/policy.htm#international
Contains reports and briefings on the social costs
www.focusweb.org of financial crises,in particular see Capital
Focus on the Global South website with informa- Punishment:Making International Finance
tion on social and economic impacts of Asian cri- Work for the Worlds Poor.
sis and IMF reforms.See in particular Prague
2000:Why we Need to Decommission the IMF www.obsfin.ch/index.htm
and World Bank. Observatoire de la Finance (Financial Monitoring
Centre) provides articles, research and comment
Http://attac.org on aspects of finance and the common good.
Association for the Taxation of Financial
Transactions for the Aid of Citizens (ATTAC) web- www.fondad.org/published.htm
site with papers and networking opportunities Forum on Debt and Development site listing use-
on currency speculation taxes and other financial ful publications,see in particular Private Capital
architecture issues. Flows to Africa: Perception and Reality, Nils
Bhinda and others,1999.
www.twnside.org.sg
Third World Network (TWN) website with infor-
mation and publications on the Global Financial
and Economic Crisis.
www.ased.org
Heinrich Bll Foundation hosts the Asia-Europe
Dialogue on alternative political strategies.
Contains comments and reports on the social
impacts of the financial crisis in Asia and the
global financial architecture.

Go With The Flows? Capital Account Liberalisation and Poverty

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Go with the flows? Capital account liberalisation and poverty

From Capital Account Liberalisation to the Real Economy:

1 Push Factors for Capital Account Liberalisation ...................................................................1

2 From Capital Account Liberalisaton to Poverty: Identifying the Linkages.......................3

Capital Account Liberalisation and Poverty, Alex Cobham

1 Financial and Capital Account Liberalisation ......................................................................15

2 Crisis Periods .............................................................................................................................20

contents continue overleaf

Go with the flows? Capital account liberalisation and poverty

4 Liberalisation and Industry .....................................................................................................27

Go with the flows? Capital account liberalisation and poverty

poorest countries; nant of investment flows and therefore growth

through country-owned poverty reduction in a liberalised financial climate will be limited

markets in developed countries to exports and regulatory measures to govern a liberalised

Go with the flows? Capital account liberalisation and poverty i

ii Go with the flows? Capital account liberalisation and poverty

From Capital Account Liberalisation to the Real Economy:

1 Push Factors for Capital Account Liberalisation

Go with the flows? Capital account liberalisation and poverty 1

2 Go with the flows? Capital account liberalisation and poverty

2 From Capital Account Liberalisation to Poverty:

Go with the flows? Capital account liberalisation and poverty 3

4 Go with the flows? Capital account liberalisation and poverty

Go with the flows? Capital account liberalisation and poverty 5

6 Go with the flows? Capital account liberalisation and poverty

Redirecting Government Spending dilemma, if it emerges again, will probably be dealt

Go with the flows? Capital account liberalisation and poverty 7

8 Go with the flows? Capital account liberalisation and poverty

Go with the flows? Capital account liberalisation and poverty 9

10 Go with the flows? Capital account liberalisation and poverty

Go with the flows? Capital account liberalisation and poverty 11

know what is happening with capital flows and I Endnotes

6 For an analysis of how liberalisation has reduced growth generally

7 Godfrey Kanyenze referred to the pressure to liberalise labour mar-

8 Charles Soludo and Musunuru Sam Rao, 2000, Potential Social

9 Also see David Woodward,1998, Drowning by Numbers:the World

10 See Peter Stalker, 2000, Beyond Krismon, the Social Legacy of

13 Peter Stalker, 2000.

15 Aart Kraay, Do High Interest Rates Defend Currencies Under

16 DFID, Eliminating World Poverty:Making Globalisation Work for

12 Go with the flows? Capital account liberalisation and poverty

Capital Account Liberalisation and Poverty1

Go with the flows? Capital account liberalisation and poverty 13

Figure 1: Stylised Linkages of Capital Account Liberalisation

Capital Account and

Private Revenues & O ff i c i a l Domestic F o re i g n

14 Go with the flows? Capital account liberalisation and poverty

1 Financial and Capital Account Liberalisation

Table 1: Types of Capital Controls Used

bonds Form:Restrictions on foreign holding (up to 100%). As above.

Direct investment Form:Investment boards Forms:Profit repatriation restrictions,or

Bank lending Forms:Reserve requirements on foreign borrow- As portfolio flows.

Go with the flows? Capital account liberalisation and poverty 15

Figure 2: Some Capital Account Liberalisation Trends, Latin America 1970-95

16 Go with the flows? Capital account liberalisation and poverty

Go with the flows? Capital account liberalisation and poverty 17

Table 2: Value of Capital Flows to Developing Countries, US$bn

18 Go with the flows? Capital account liberalisation and poverty

Go with the flows? Capital account liberalisation and poverty 19