Illustration by JAC

WHEN Hank Paulson, America's treasury secretary, urged China to liberalise its capital markets earlier this month, he sensed a hardened reluctance in his hosts. “There's no doubt that what is happening in the US markets is clearly giving the Chinese pause,” he said. America's subprime meltdown is not, it seems, the best advertisement for unfettered finance elsewhere.

Against this backdrop, Dani Rodrik of Harvard University and Arvind Subramanian of the Peterson Institute, in Washington, DC, have published a timely reappraisal of financial globalisation.* They conclude that it is far from obvious that developing countries benefit much from opening up to global capital. In principle, the free flow of capital across borders makes funds available more cheaply to poor countries and, by lifting investment, boosts GDP and raises living standards. The trouble is, economists have struggled to establish a strong link between freer capital flows and speedier economic development.

That has not stopped researchers from looking, and many believe a tangible connection will soon be found. Perhaps the effect is not picked up in studies because capital flows are hard to measure accurately, argue the optimists. Messrs Rodrik and Subramanian are not convinced: measurement error bedevils many studies, but that has not barred researchers from establishing that policies to improve education or trade are good for growth.

Perhaps foreign capital helps indirectly—by disciplining policymakers or by promoting reforms that improve the financial system. The authors say it is possible to make the opposite argument and find indirect costs. Plausibly, lifting restrictions on capital flows could undermine the domestic financial system because spendthrift governments can tap a larger pool of funds abroad. Also, the well-off have less incentive to lobby for reforms at home if they are free to store their wealth overseas.

Perhaps, then, the gains from globalised finance are latent and will be unleashed once catalysing reforms are in place? Maybe they will. But the wish list of complementary measures is difficult to tick off. Economies might reap the benefits of foreign capital more fully if property rights were stronger, contracts were more enforceable, and if there were less corruption and financial cronyism. But the authors point out that if poor countries could carry out such ambitious reforms “they would no longer be poor” and financial globalisation would be “a clearly dispensable sideshow”. With so much else to do first, liberalising capital flows would not be an obvious policy priority.

Foreign capital ought to be good for countries that have profitable ventures that lack funding because of low savings at home. But Messrs Rodrik and Subramanian argue that for many countries, it is not low savings but a shortage of good investments that is the binding constraint. Weak property rights, poorly enforced contracts and the fear that profits will be siphoned away make it hard to conceive of ventures that might generate a reliable return. When investment opportunities are scarce, capital inflows simply displace domestic savings and encourage consumption.

Cheap exports, not cheap money

Whatever their misgivings about cosmopolitan capital, the authors do not deny that deeper financial markets in general help to foster prosperity. Even in economies short of good investment projects, a sturdier channel connecting domestic savers and borrowers will help growth. The more domestic savings can be put to work, the less need is there for foreign capital, and using local funds helps keep the exchange rate down and promotes export growth. By contrast, encouraging foreign capital to flood in can put upward pressure on the exchange rate, making exports less competitive. In some circumstances, capital controls may be justified if they keep the currency cheap and promote growth.

Why do the authors make such a strong case for export-led growth as a means to development in poor countries, even if it is at the expense of more open capital markets? First, they believe, exports are a force for institutional reform. A firm making clothes to sell abroad demands consistent state regulation, reliable transport links and enforceable contracts with suppliers to a degree that a barbershop serving the domestic market does not. Second, exporters foster skills, technology and expertise that can fruitfully spill over to other enterprises.

Messrs Rodrik and Subramanian conclude that with the benefits of liberalised finance under the microscope in rich countries, it is time for more subtle thinking about the global picture. “Depending on context and country,” they write, “the appropriate role of policy will be as often to stem the tide of capital flows as to encourage them.”

That bold conclusion leaves some troubling issues unresolved. As China's experience suggests, keeping the exchange rate weak in support of export-led growth becomes harder to sustain over time. Nor is it easy to keep foreign capital out. Capital controls can be evaded by adjusting trade invoices: exporters can bring funds in secretly by over-invoicing for foreign sales. The authorities can use sterilised intervention to stop inflows pushing the exchange rate up, but this imposes its own costs on the economy—in terms of higher interest rates or a distorted allocation of credit.

It is possible too that over time capital inflows are becoming less risky and the collateral benefits more tangible. And more stable direct investments account for an increasing share of capital inflows. Countries will ultimately have to come to terms with global capital and the choice is not only whether to embrace or resist it. There is a third option: find ways to manage it. After all, few would now argue that financial progress should not be policed at all.





* “Why Did Financial Globalisation Disappoint?”, March 2008.