Liberalization of International Currency Mobility - Essay Example

? Liberalization of International Currency Mobility al Affiliation Liberalization of International Currency Mobility Capital flows is the movement of currency meant for investment or commerce. These transactions can take place at national and international levels, for the purpose of business production. Liberalization of capital markets has been on the rise since the early 1990’s, not only in developing countries, but also in first-world countries. Liberalization in this sense means the lessening of legal limitations to capital mobility. This liberalization has been facilitated by a number of factors. These factors include; the removal of credit limitations, privatization of majority of banks previously owned by governments and lower interest rates for borrowers (Quiggin, 2005). The banking sector has also experienced reduced or total withdrawal of entry barriers, liberalization of the security market and capital account. This free-flow of currency across borders has been facilitated by worldwide free-trade, occasioned by globalization. The privatization of capital flows has also seen a surge of capital movement within and across borders. Private organizations have been in a rush to provide financial assistance to people in need of money for business, investment, or otherwise. When the liberalization of capital movement was starting off, it seemed like a most lucrative idea that would see the soaring of economies in different countries. However, over the years, different financial crises have made a lot of people have a different opinion regarding free capital mobility. This essay is going to discuss the positives and negatives of capital flows in the international arena in regard to economic augmentation. In the field of free capital flow, it is hard to distinguish a certain factor as being advantageous and another as a limitation. All aspects have a positive and a negative side. Accordingly, the essay will focus at a factor at a time and weigh its benefits against its cons. Since the 1980’s neo-liberalists have been very strong proponents of liberalized currency mobility in the international field. Proponents of the neoliberal theory are of the opinion that only free markets can help achieve international economic growth. According to Grabel &Chang (2004) neoliberal theorists place prime importance on the function of markets in enhancing easy movement of currency and goods. Advocates of the neoliberal theory also hold that privatization of state-owned organizations is of prime importance to free capital mobility. Neoliberal ideas have proved to be viable to some extent, based on the results of the past twenty years. Globalization in the 1970s brought about transformations in the international financial system in terms of increased capital mobility and international trade. The advent of globalization made most countries to relax limitations to free flow of capital in the international field. Globalization means the opening up of borders to both goods and capital flows for the purpose of foreign investment. Private Banks Among the achievements of neoliberal ideas is the promotion of the private sector in both developing and developed countries. Private capital flows has over the years come to overtake public mobility of capital. Public movement of currency consists of governments exchanging capital, either through direct lending or through multilateral corporations such as the International Monetary Fund (IMF) and World Bank (Grabel & Chang, 2004). Rise in loaning institutions, foreign investment and portfolio capital mobility have all led to the promotion of private currency mobility. National banks cannot accommodate the high demands of local and overseas investors. Accordingly, many foreign classified banks have sprung up in order to facilitate borrowing and loaning of capital, especially to domestic investors (Frank, 1990). Considering that most governments do not have adequate lending power, these alien private banks source for finances in international lenders. Organizations such as the (IMF) and World Bank play a crucial role in giving loans to banks, who in turn loan investors. According to Herrera & Valdes (2001) investors, such as insurance companies tend to be attracted by privatized banks since their chances of expanding their assortments are better, than when dealing with government banks. The rationale behind this argument is that markets are the determinants of levels of lending; thereby ensuring that only the most promising projects are lent capital. The benefit of foreign private banks in global currency mobility is that these banks supplement the resources that governments and local banks have to offer. On the flip-side, overreliance on privately owned banks for loans is a worrying factor that puts the economy of a country at risk. Grabel & Chang (2004) are of the opinion that foreign banks often finance ideas, not projects. Most of these ideas are tentative business ventures that investors come up with and seek to have them financed by private banks. Due to relaxation of lending policies, most banks do not conduct a background study of the investor to determine whether the latter can repay the loan. Since it is a competition between banks, investors are haphazardly lent capital. Private-owned banks usually know the risk they are running by unsystematically issuing loans, but still pursue such actions. Such banks know that in case of any financial emergency, the government will step in to salvage the situation. Soon banks start experiencing losses on loans occasioned by bad borrowers. As a result, the economy suffers credit crunch, which is the substantial decrease in lending by banks. People then become suspicious of banks and the result is a decline in the economy, as no one is willing to borrow. Capital account liberalization Prior to the liberalization of capital movement, governments used to incur heavy expenditures in investment, but free flow of currency has helped reduce debits and inflation of budgets. When capital freely moves into a country, it allows for more investment than budgeted for, thereby increasing the country’s GDP. Countries which have embraced globalization and free flow of capital have helped their citizens to achieve much more than they could with their national budgets. This kind of capital comes from multinational lenders, for example, the IMF. However, this is not always a good feature since governments are at times forced to borrow from multilateral organizations to enable them cope up with increased borrowing and investment. This forces such countries to seek help from the IMF and other international bodies. They agree to repay the loan at a specific rate, over a given amount of time. In the event that the investments do not succeed, the banks are left owing a lot of money to the international bodies. This was the case in the financial crisis in Asia in 1997. In Thailand, the exchange rate was very high and the government could not support it, forcing the government to borrow largely from foreign organizations. This massive borrowing led to immense foreign debt on the part of the Thai government, further rendering the country bankrupt (Eichengreen, 2004). The contagion effect spilt over to other Asian countries that had trade-ties with Thailand. Apart from Thailand, South Korea was the other country that bore the toughest brunt of the financial crisis in Asia. The financial crisis in Asia was characterized by indirect proportions of GDP in relation to foreign liability. Essentially, most Asian countries specifically Thailand owed their creditors much more than their economies could produce. The result was currency depreciation, reduced asset price, and capital volatility. Eichengreen (2004) writes that the IMF intervened in an effort to save the situation by donating approximately 40 billion U.S dollars, but it was irreversible. Despite the numerous funds given to the Thai government, the baht continued to depreciate, particularly in relation to the U.S dollar. The situation in Asia was only salvaged in 1999 when a new government took over Thailand and instituted reforms in the banking sector. Transfer of technology There are advantages associated with liberalized capital movement that are not necessarily financial. When a country welcomes foreign investment, it is sure to benefit in various ways. For example, investors from overseas come with new ideas that could prove to be beneficial to the host country. For example, investors come with technological savvy that enables the locals to generate more capital through various technology-related investments. Use of the internet is among the chief ways in which countries can benefit. In developed countries, one can get information concerning the best countries in which to invest by simply searching on the internet. When overseas investors go to developing countries, they take this knowledge with them. This leads to improvements in the technological sectors of developing countries. Better technology automatically means more economic growth and in turn, better living standards. Market competition Studies reveal that liberalized currency mobility can raise a country’s output, thus enabling the country to compete economically in intercontinental markets. Reisen & Soto (2001) attest to this actuality with the example of Ireland and how it gained from capital flows, enabling Ireland to rank among the most economically influential countries in the European Union. Since Ireland adopted the euro in the early 1970s, major economies led by the USA flocked Ireland in search of investment opportunities. A host of international companies set up companies in Ireland in a bid to benefit from the numerous investment prospects. These investors poured money into the economy of Ireland and gave job opportunities to the locals. The result was the augmentation of the country’s economy, raising it to among the strongest in the European Union. Nonetheless, inequality in the mobility of international currency leaves many third-world countries outside the scope of international capital movement. Developing countries receive a very minimal share of international capital mobility. Most investors are not willing to take risks by investing in under-developed countries. Majority of investors, therefore, prefer investing in second-world countries that show potential for growth, thus profitable investment. Grabel & Chang (2004) affirm this by indicating that commercial banks are also unwilling to lend to developing countries, for fear of losses. One is then left wondering how developing countries are supposed to compete with others in the international arena. This kind of imperialism guarantees that the world remains stratified along financial borders, with industrialized countries becoming richer, while developing countries continue to grapple with poverty. Foreign investment Countries that have adopted the concept of liberalized capital mobility have benefited directly from local and foreign investments (Harrisona & McMillan, 2003). A liberalized financial sector encourages foreign investment. Essentially, more foreigners are willing to invest in a financially liberalized country, whose citizens are unwilling to invest abroad. This ensures that the country stands to gain financially as it enjoys both domestic and foreign investment. Foreign investments account for a large percentage of any country’s GDP. On the negative side, reliability on domestic investment only is dangerous, especially if locals have stopped investing in other countries. In the event of a crisis, such a country does not have anything to fall back on, since all its investments are locally-based. When a country experiences massive inflows of currency, it often leads to the appreciation of currency in the international market. This translates to the locals finding it easier to import goods and services. Conversely, exporters find it increasingly hard to export goods and services since their prices are so high that they lack international markets. Portfolio capital mobility Different policies have been adopted by countries that conform to the ideals of neoliberal theorists in terms of capital flow. In order to encourage foreign investment, various countries have removed credit controls, bank entries, and reduced interest rates for investors. This means that foreign investors do not have to pay high reserve fees to ensure their positions as investors. Removal of credit restrictions on foreign investment guarantees that the foreigners are more willing to invest. Consequently, increased foreign investments ensure that there are augmented funds in the domestic financial sector. With the increase in funds, many financial institutions spring up in host countries, in order to accommodate investors’ money. Banks and other financial institutions, therefore, start competing to have investors bank with them. Consequently, they are forced to offer better financial services to their customers, if they are to survive in the industry. Financial institutions are more willing to lend money to local institutions partnering with foreign investors for the sake of economic growth. At the end of it all, it is the host country that benefits from improved banking services. Relaxation of policies affecting interest rates, credits and requirements for investments can have adverse effects on the financial stability of a country. The major shortfall of liberalized capital mobility is temporary inflows. Apart from foreigners who invest directly, the other two aspects of private capital movement are usually short-term in most cases. This means that private capital lenders, as well as portfolio money flows are dependent on the stability of the economy. In the case of Asia for example, prior to the crisis, majority of investors had taken short-term loans to facilitate long-term projects. According to Eichengreen (2004), majority of these loans could mature in a very short time, as short as three months. This means that when the crisis hit, creditors could not get back all their money by simply increasing interest rates. Ironically, when the crisis had cooled down, Asian countries were once again forced to embrace free capital markets, in order to restore investors’ faith (Bhagwati, 1998). Economic policies Monetary liberalization has been known to be directly linked to occurrences of fiscal crises. Once a crisis occurs, the victim country does virtually everything to ensure that its economy does not suffer severely. Ishii et.al (2002) reveals that according to findings, most countries that have experienced monetary crises did so a few years after they embraced financial liberalization. Understandably, most of these countries lack proper mechanisms of dealing with the rate at which money pours into the country and end up mismanaging most of it. Financial mismanagement is suicidal to any organization. According to Bhagwati (1998), one of the first steps taken by such countries is, their financial institutions increase interest rates on lent money. Once interest rates are raised, most people become wary of the situation and start pulling away their money from that specific country. This causes sudden depreciation of national currency in comparison with other currencies. This capital flight is detrimental to a country’s economy, especially if it is the lenders and investors who pull away. Foreign banks usually withdraw their services at the slightest hint of an economic crisis. Short-term borrowers also run in search of better investment opportunities. When this happens, investors opt for liquidation of their assets, in order to secure their finances. Accordingly, economies of host countries become unstable and run the risk of collapse. Such countries end up losing their political liberty to determine the rightful economic policies for their country. Multilateral organizations such as the IMF, World Bank and Wall Street end up taking monopoly of the economies of crisis-prone countries. The government of the U.S is the strongest advocate of liberal capital movement and the use of multinational creditors as last resorts for financial loans to needy countries. Wall street is the world’s largest stock exchange market, thus, has a lot of influence on how global finances are run, in relation to underlying market principals. Some quotas have been advocating for the IMF to be given more powers to decide economic policies that nations wishing to borrow money should follow. If this is allowed, the IMF, Wall Street and other multilateral organizations will practically run both the economic and political sectors of their debtors. Information from the foregoing shows that liberalized capital movement has considerable profits for countries which choose to embrace it, only if handled carefully. However, critics of neoliberal theory, globalization, and the whole idea of free movement of capital have different opinions. These critics argue that in case of crises, liberated capital mobility could and does turn out to be disastrous. This phenomenon has also been illustrated in the above discussion. Evidently, the issue of capital flow is an intense one and it continues to elicit debates across the divide of economic specialists. One cannot solely say that a certain aspect of free capital mobility is either advantageous or disadvantageous. Ambiguity of the effects of free-flow of capital across borders has been illustrated throughout the essay. For example, private banks are beneficial in that they promote investment. On the other hand, they demean a country’s independence and increase its reliability on foreign capital. Foreign investment on its part, accounts for increased economic development and growth in the financial sector. Foreigners guarantee growth in GDP, but on the reverse side, if the same investors decide to pull away, the country is left suffering the implications of debts owed and lost opportunities for investment. As for economic policies concerning portfolio currency flows, they often operate in non-restrictive trade environment. Accordingly, relaxation of business policies such as lower interest rates and bank entries continue to encourage portfolio capital investment. However, if there are no clear guidelines on how far this relaxation should go, this could turn out terribly. According to Noy (2004) depreciation of currency, foreign debts among other financial crises could arise from uncontrolled relaxation of economic policies. In summary, liberalization of capital mobility if handled carefully could have several advantages to countries that choose to embrace it. Such countries stand to benefit from improved quality of life, economic growth and stability, technological advancement, and international recognition. In opposition, free capital mobility could also lead to inflation, currency depreciation, massive foreign debt, capital flight, and even complete financial crisis. Conclusively, liberalized capital mobility can only work in well controlled environments. Grabel & Chang (2004) advice that well restricted capital flow can make positive change in the economy of a country. The authors give the example of Japan, which has over the years continued to exercise strict measures especially concerning portfolio capital movement. Nevertheless, Japan continues to be an economic powerhouse in the international arena. Measures should also be put in place to ensure that investors do not have avenues for tax evasion. This is because, in the event of capital flight, most investors leave the country without paying their dues. As Bhagwati (1998) states, countries should not allow themselves to be swayed into adopting liberalized capital mobility, by people with vested interests. Financial institutions on their part should not impose conditions of compliance with capital flows on borrowers. International trade should be free and fair and individual countries should be allowed to make decisions that best suit them. Generally, the pros and cons of liberalization of capital mobility should be evaluated critically before making a decision to either embrace or reject this trend. References Bhagwati, J., 1998. The capital myth: The difference between trade in widgets and dollars. Journal of Foreign Affairs, Vol.77, no. 3. Chang, H., & Grabel, I., 2004, Reclaiming Development: An Alternative Economic Policy Manual. Zed Books: London. Eichengreen, B., 2004, Capital Flows and Crises. MIT Press: London. Frank, S., 1990, “Privatizing Public Enterprises and Foreign Investment in Developing Countries, 1988-93,” Occasional Paper no. 5. IFC and World Bank. Washington, DC. Harrisona, A., & McMillan, M., 2003, “Does Direct Foreign Investment Affect Domestic Credit Constraints?” Journal of international economic. Vol no. 61, pg 73-100. Herrera, L., & Valdes, R., 2001. “The Effect of Capital Controls on Interest Rate Differentials” Journal of International Economics, Vol no. 53, pgs 385–398. Ishii, S., Habermeier, K., &Canales-Kriljenko, J., 2002, ‘Capital Account Liberalization and Financial Sector Stability’Volume 211 of Occasional Paper - International Monetary Fund. International Monetary Fund: London. Noy, I., 2004. “Financial Liberalization, Prudential Supervision, and The Onset of Banking Crises.” Emerging Markets Review. Vol no.5, pgs 341–359. Quiggin, J., 2005, Interpreting Globalization Neoliberal and Internationalist Views of Changing Patterns of the Global Trade and Financial System. United Nations Research Institute for Social Development: Geneva. Reisen, H., & Soto, M., 2001, “Which Types of Capital Inflows Foster Developing Country Growth?” Journal of International Finance. Vol no.4, pg 1-14. Read More