Current Developments in Monetary and Financial Law, Vol. 1

International Monetary Fund

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1999
• ISBN:
  9781557757968

NONE

Chapter 1 Developments at the International Monetary Fund

1A. Capital Account Liberalization

STANLEY FISCHER

This seminar provides an opportunity for discussions among senior legal advisors from central banks all over the world on a variety of important topics. I thought that I should talk about a few of the key topics on the international agenda including governance, the reform of financial systems, and capital account liberalization.

The notion of improving governance has two related connotations. One is the overall effort to improve the quality of administration in a country—an objective that is clearly within the reach of the IMF to encourage, at least in the economic sphere. Second, there is the related sense of improving governance by curtailing or eliminating corruption. This is a much more difficult issue to deal with but one that we in the IMF have increasingly been finding ways to address, when there are important economic effects.

Financial system soundness and reform are very high on the agenda of the international community after recent events in Asia and elsewhere. They gained increasing prominence after the Mexican crisis of 1994–95. The Basle Core Principles—a set of 25 principles for effective banking supervision—have been produced. While so far there is not an enforcement or monitoring mechanism, these principles, nevertheless, provide an important beginning in the establishment of an international standard for banking.

There are important challenges and opportunities for the international community as we seek to develop a variety of standards in different areas. The banking standard is one. The Special Data Dissemination Standard of the IMF is another. Accounting standards will be established by international accounting committees. The International Organization for Securities Commissions (IOSCO) has established standards for securities market regulation.

Once a standard or code of good practice has been agreed in a certain area, the question arises of how the international community should then proceed. How do you encourage countries to adopt a standard? If a standard is adopted, how do you monitor implementation? If we look at the international economy, the international regulatory framework is in its infancy. And if we ask why international financial crises have erupted on such a scale and frequency relative to domestic economies, and why domestic crises seem to originate so often from events in the international economy, the answer may have a lot to do with the absence of an adequate international regulatory and legal framework.

I believe that these standards will eventually play an important role, but we have to develop mechanisms to make that happen. I can envisage mechanisms that would relate to both sides of the typical international transaction—to the side of both the borrower and the lender. For example, the regulators in banking systems in the industrial countries could set their risk requirements against lending by their banks to particular countries on the basis of whether those countries are judged to meet the international standard in the banking sector, in the corporate sector, and so forth. There then would be an incentive from the lender’s side to lend to those countries that are better regulated and have sounder systems. And, of course, that in turn would also provide an incentive for all countries to implement the standards. Unfortunately, it will take years to get this system up and running. I believe we are in the international economy roughly where we were in the U.S. economy in the 1890s with regard to creation of a central bank, the lender of last resort, a regulatory system, and so on. The key issues are being discussed, but a very great deal of work is yet to be done. We are at the start of a process that will take many years but the movement is beginning to get under way rapidly.

The topic I will focus on the most is capital account liberalization. I want to discuss that in part because it has become controversial as a result of some resistance to the notion that the IMF should be given legal jurisdiction over capital account issues. You probably know that the IMF Articles of Agreement do not give the IMF, as a purpose, the liberalization of the capital account. They do give the IMF, as a purpose, liberalization of the current account, which has broadly been achieved. In the past 50 years, 146 of the IMF’s 182 members have accepted Article VIII of the IMF Articles of Agreement, which involves liberalization of current account transactions and a commitment to sustain that liberalization. We do not have the equivalent of Article VIII for the capital account and, for a long time, the issue of whether to move in that direction has been steeped in controversy.

Recently, some of the industrial countries have been urging that the IMF be given jurisdiction in the capital account area. Now why is this controversial and why, nonetheless, might it make sense? It is controversial because of the evident dangers of capital account liberalization achieved too forcefully and prematurely, without the necessary preconditions in place. We are all aware of countries that have liberalized their capital accounts prematurely or badly, and where foreign exchange crises of major dimensions have followed. Consequently, there is a reluctance to open up to capital movements. Moreover, the economic theory of free trade in goods is far better developed than the economic theory of free trade in assets, in capital flows. For example, in an article in the May 1998 issue of Foreign Affairs, Jagdish Bhagwati, the famous international trade theorist, maintains that there is no analogy between the argument for free trade and the argument for free capital movements. But I am not quite sure at the end how he reached that conclusion aside from reiterating it several times. The arguments are, in fact, related, being part of the general view that the allocation of resources on the basis of the market is likely to increase welfare. But the theories of free trade and the theories of free capital movements differ because capital movements have an intertemporal dimension and the economics of time and trading through time are more complicated than the economics of trade at a moment of time. So, in part, it is a theoretical matter. Professor Bhagwati is in part right.

Two other factors heavily influence why people are so concerned about capital account liberalization: first, the occurrence of crises, and, second, the long time that it took the industrial countries to liberalize their capital accounts. It was not until Mrs. Thatcher appeared on the scene that the United Kingdom finally liberalized its capital account. Restrictions persist in a variety of countries. And there is something else that I, having grown up in a developing country with capital controls, may perhaps understand better than my American colleagues. That is, once you have lived in a regime of capital controls, it is difficult to imagine another way of doing things. It simply is so natural to believe that the government should control the flow of capital that it becomes second nature. I grew up in Zimbabwe. I remember once encountering, when I was a graduate student at the London School of Economics, a man who had left what was then Rhodesia to live in the United States. He was explaining to me the miracles of living in the United States and he said, “You know, if I want to get foreign currency, what I do?” I said, “No, I don’t know.” He said, “I go to the bank and I ask for it.” And this was totally beyond my experience. It just could not be that you went to the bank and they gave you the foreign exchange if you asked for it and, of course, paid for it. I was used to a system in which you had to fill in a form and wait three months and provide justifications, and so on and so on—that was the way it was. And I think many of us have deeply ingrained in ourselves, if we grew up in a system like that, a belief that the other system cannot work.

It is natural to believe that foreign exchange is something that should be controlled. But that, in fact, is a comparatively modern idea. Nobody thought that way in the nineteenth century or even into the twentieth century—until after World War I, when capital controls were imposed. It is not a particularly natural way of doing business, but it is deeply ingrained into our thinking. Nevertheless, we were able to get over that way of thinking with regard to the current account. And when people tell us that the industrialized countries, which took a very long time to liberalize capital accounts, are urging others to do so more rapidly, we should remember the following: it also took these industrial countries a very long time to liberalize the current account. After World War II, European countries did not restore current account convertibility until 1958. Nevertheless, the transition economies went to current account liberalization very quickly, in a matter of a few years, some of them in a matter of months. This has not been a bad thing at all. It has been a very good element in that it establishes international prices and international trade in those economies. And I believe that the same will eventually develop in the capital account area.

Now let me explain briefly the case for the IMF to have an amendment of the Articles of Agreement, giving the IMF jurisdiction in this area, and giving it the goal of promoting capital account liberalization. Every single country in the world wants to enjoy the benefits of international capital. Every developing country wants to borrow from abroad on occasion. They are all trying to tap foreign markets. Why? Because these countries typically need capital. Other countries have it in excess—Japan for sure, possibly the United States, although at the moment the United States is in a current account deficit. There are large benefits to international trade in assets, and portfolio diversification is not the least of them. There is no very good reason why people in developing countries should hold their pensions all in their own countries. They should have the benefit of diversification. There is no reason why Americans should hold all of their assets in America. They should be able to hold a share of assets abroad. But it is primarily that countries want access to foreign capital, on terms that are not disruptive for their own economies. That is understandable and appropriate. This is a reasonable aspiration—one that the IMF agrees with completely.

The problems that arise from access to international capital and to the opening of capital markets almost all arise in relation to short-term flows—so-called “hot money” that flows rapidly and that can reverse direction all too quickly. But we see no disadvantages, none, to foreign direct investment.

Of course, many countries continue to resist foreign ownership of certain kinds of domestic assets. Sometimes, it is land, sometimes strategic industries, or other types of industries. Those reservations are understandable. We could easily imagine, within the framework of an amendment to the IMF Articles of Agreement, a derogation that says, with regard to foreign direct investment, that maintaining restrictions on foreign direct investment can be acceptable for certain reasons. As an economist, I must say that the more I see countries that do not maintain those kinds of restrictions, the less impressed I am by the need for them. When the former Czech Prime Minister, Mr. Klaus, was asked whether he feared that foreigners would own too much of the assets of the Czech Republic, he said something along the following lines, “Well, I understand that 50 percent of Belgian industry is owned by foreigners. When the Czech Republic gets up to that level, I will start to worry. In the meantime, I wish more of them would come in and invest in my country. I am not going to try and keep them out.” But every country can make its own decision in this area.

Problems can arise in the banking system, especially with respect to short-term capital flows. Experience suggests that countries should not open themselves to short-term capital flows until the financial system is ready, and even then maintaining some market-based disincentive to short-term capital flows may be justified until the macroeconomy is stable. If the financial system is weak and you encourage domestic banks to go out and borrow from abroad, and then the capital flow is reversed, the banking system can be hit hard—in the same way that the banking systems in the three East Asian crisis countries have been hurt. The banking system has to be strengthened overall before one should recommend opening up to short-term capital flows.

Strengthening the banking system includes hedging rules for individual banks and strong banking supervision and regulation to withstand the pressures that may come from the international capital flows. We regard an amendment of the capital account of the Articles of Agreement to promote capital account liberalization as helping to put in place a framework for encouraging the orderly liberalization of the capital account. That is what we believe is necessary. We have in the IMF for the current account both Article XIV status and Article VIII status. Article XIV status says that the country is availing itself of various restrictions on current account transactions that were in place at a particular time. When the country is ready to liberalize current account transactions, it accepts Article VIII status. We believe that a similar approach could be taken to the capital account.

Let me make two more comments before concluding. First, market-based prudential controls. Certain countries, in addition to prudential controls on banks, have market-based restrictions on short-term capital inflows. The famous Chilean market-based control requires a non-interest-bearing deposit with the central bank of Chile for short-term money.¹ This is a way of taxing short-term capital inflows. Whether it works is still disputed among countries and economists, but the former governor of the bank of Chile made what seemed to me a convincing argument. He noted that the central bank was holding a very large volume of reserves against these transactions. And if the tax was not being avoided, surely economic behavior was being influenced by it. I believe the evidence argues that, on balance, this approach can be helpful.

Second, how hard should the international community push on capital account liberalization? Well, I have in my office a map of the world highlighting Article VIII acceptance. It shows all the countries that have accepted Article VIII and those that have not. There remain a couple of big countries that have not done so—Brazil and Egypt among them. But the map now essentially covers most countries of the globe in green—green is the color we use in this map to show countries with liberalized current account transactions. I would hope that capital account liberalization will go gradually and slowly. That liberalization can take a very long time is illustrated by the experience of the current account. Brazil and Egypt—after 50 years—have not accepted Article VIII, but are members in good standing of the IMF. I cannot profess to being excited about the fact that Article VIII has not been ...