Capital market liberalization, the international free flow of money and investments, was the most debated policy issue of the 1990s (Stiglitz, 2007) and became an important feature of contemporary globalization. However, this liberalization has also been a catalyst, an intensifier, and a geographic conduit of regional economic crises, and most recently, of the global economic crisis ignited in the United States in 2008.
The unbalanced importance of financial flows is evidenced by figures from the Bank of International Settlements (BIS) and the World Trade Organization (WTO). A previous analysis of those figures by Chilean economist Ffrench-Davis (2005) shows that for every US dollar transacted in the international trade market of goods and services, there are 40 US dollars transacted in the foreign exchange market.
Yet, according to Ffrench-Davis the problem is that these international financial flows have a high and growing participation of short-term speculative investments; the rewards and recognition systems of these funds managers are predominantly based on short-term returns; and there is a significant number of governments with a prevailing procyclical approach to managing macroeconomics. That means, these governments increase public spending during economic upswings and, conversely, cut it in times of recession, thus accentuating the downturn. In short, the importance of financial flows together with these three factors generates significant volatility in the performance of national economies, especially those of developing countries, which are smaller. If unregulated, financial flows can bring more instability than long term growth. They can exacerbate short economic performance peaks, but accentuate and prolong economic valleys such as the current one, with devastating effects on production, employment, profits, and tax collection. (Alarcon, Griffith, and Ocampo, 2009)
Latin America is a typical example. The region has been subject to profound recessions in the 1980s, in 1995, in 1998-2003, and currently, partly because of the volatility of international financial flows and the application of procyclical macroeconomics. According to Ffrench-Davis (2009), after the short so-called “Tequila Crisis” in 1995, abundant capital flows entered Latin American countries between 1996 and 1997 allowing improvement in economic activity. However:
“Productive investment remained low and, there had been a substantial appreciation of the exchange rate that punished the production of tradable goods and caused growing external deficits. The result was the emergence of new areas of vulnerability.” (Ffrench-Davis, 2009, p. 10)
Consequently, as soon as the effects of the 1997 Asian financial crisis hit Latin America a year later, several of its countries experienced massive capital outflows and strong currency depreciations that made them suffer an acute recession. That was the case of Brazil in 1998, Colombia in 1999, and Argentina in 2001, all of whose recessions subsequently lasted between three and six difficult years. This type of unstable boom-bust cycle of capital flows and its consequences have been common to a number of emerging markets around the world, not just Latin America. (Williamson, 2002)
On the other hand, advocates of capital market liberalization argue that this policy allows a more efficient capital allocation and better promotes growth and development for most countries. Yet, the actual experience of a significant number of countries since 1980 contradicts these claims. (Weller and Hersh, 2002)
In conclusion, the risks of capital market liberalization far outweigh its benefits for developing countries. Therefore, research and discussion must advance in the area of how regulation should be handled. World leaders already have a significant knowledge base. For example, it is well known that some types of capital flow, especially foreign direct investment, are much less problematic than others, such as short-term bank loans (Williamson, 2002).
Clearly then, national governments in developing countries must work on three fronts: first, the regulation of international financial flows, specially short term speculative ones, where we find good examples in countries such as Chile and China (World Economic Forum [WEF], 2010). Second, the improvement of national-level regulatory structures and systems for financial products and firms, where prominent regulators and scholars have already started to shed some light – see O’Halloran (2010). Finally, the dissemination of countercyclical macroeconomic policies and management practices in the developing world. This will stimulate the economy when it is in a downturn and cool it down when it is in an upswing (Feldstein, 2002). Surely, there is a way to regulate that promotes efficient capital allocation and productivity, while keeping significant risks under control. It is the responsibility of world leaders to work together in the creation and implementation of regulations that protect the welfare of people throughout the world.
- Alarcon, Griffith-Jones, and Ocampo (2009). How does the financial crisis affect developing countries? UNDP – International Policy Centre for Inclusive Growth.
- Feldstein, M. (2002). The Role for Discretionary Fiscal Policy in a Low Interest Rate Environment. NBER Working Paper No. 9203.
- Ffrench-Davis, R. (2005). Reformas para América Latina: después del fundamentalismo neoliberal. UN Economic Commission for Latin America and the Caribbean.
- Ffrench-Davis, R. (2009). El impacto de la crisis global en América Latina. Magazine “Revista Nueva Sociedad”, number 224.
- O’Halloran and Epstein (2010). Deregulation and regulation of finance in the United States since 1950. Columbia University – School of International and Public Affairs
- Stiglitz, J. (2007). Making globalization work. W.W. Norton & Company.
- Weller and Hersh (2002). Free Markets and Poverty. The American Prospect.
- Williamson, J. (2002). Proposals for curbing the boom-bust cycle in the supply of capital to emerging markets. United Nations University – World Institute for Development Economics Research.
- World Economic Forum (2010). World Competitiveness Report 2009-2010.