Managing Development

Junji Nakagawa

• Publisher: Routledge
• Year: 2006
• ISBN:
  9781134225576
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

Prestigious contributors including Barbara Stallings and Alicia Giron

Books on development always do well – we are a leading publisher in the field

Provides a range of approaches and viewpoints – both pro-liberal and anti

The phenomenon of globalization is studied in detail, with particular emphasis on East Asia

Part I

Globalization and global governance

1 Managing global risks and creating prosperity

The role of the IMF and regional financial architectures

Haider A. Khan

Introduction

The Asian Financial Crisis (hereafter AFC) and the contagion it created unleashed a process of questioning the wisdom of the standard recipe of the Washington Consensus. This is still continuing; but the real costs of the crises have forced on the policy agenda the question of what kinds of national and international policies and institutions are appropriate during the current period and in the foreseeable future. In this chapter, I will discuss the problems of national macroeconomic policies and governance within a framework of overall global and regional financial architectures. Whether state capacities exist for the formulation and implementation of national economic policies may depend in large measure on the kind of global and regional financial architecture in existence.

The methodological approach adopted here is that of evolutionary economics. The institutions I discuss and the alternatives I propose are all path dependent. They all also depend on a supporting structure of complementary institutional network (CIN).¹ Global financial architecture (GFA) and Regional financial architecture (RFA) both depend on their respective CIN within a global system of nation states. Given the real interdependence within the system, all actors have some stake in sustained growth and stability with equity. Thus the central argument of this paper is that sustainable policies at the national level require a supporting network of GFA and RFAs. Such national policies in their turn can contribute to the sustainability of the GFA and RFA. It can be shown that following an evolutionary theory of international financial institutions, two broad types of possible Global Financial Architectures can be identified.² In this paper, following Khan (2002c) the first is called an overarching type, exemplified by the classical gold standard and the defunct Bretton Woods system. The second is called a hybrid form that allows for the existence and coevolution of some Regional Financial Architectures as well. The changing roles of the IMF and national economic policies can be examined within these two possible financial architectures under globalization.

The role of structural unevenness in the global economy is particularly important to recognize within the proposed framework of analysis. The range of economies, the types of polities, the institutional capacities and resource endowments including technological progress and capacities for innovation all vary widely. A simple system of gold standard or adjustable peg or free and flexible exchange rate together with free multilateral trade under, say, the WTO arrangement may therefore be simplistic. It may better serve the needs of one group of actors, for example, the advanced economies with well-developed financial services sectors, than some others. How best to achieve a synchronized growth and development regime that is perceived to be fair by all is indeed a challenging problem. The GFA is defined here as a system of global financial arrangements for international payments with specific rules and procedures for the member nations to follow. If there exists a similar institutional arrangement at the supranational but regional level only then I call it an RFA. It will be seen that one attractive solution to the problem of global unevenness is to design a GFA which also includes a number of RFAs as an integral part of the global financial system.

An important initial distinction also needs to be made between the crisis management and crisis prevention tasks of GFA and RFAs. Of course, prevention, as the old bromide goes, is better than cure. Therefore, the GFA and RFAs are to be judged optimal in the sense of achieving the highest probability of prevention subject to the constraints of the system. However, it is not clear that the best GFA and RFAs from this perspective are also the best in promoting growth or managing crisis. For example at one extreme, an autarchic system may never have a crisis, but may not promote much growth. If there is a crisis because of domestic moral hazards and adverse selection problems, it may be difficult to manage because capabilities do not exist for crisis management under the assumption that these crises are rare events. But there could be GFAs and RFAs that can potentially develop the capacity for both better crisis management and crisis prevention. In a world of bounded rationality and institutional uncertainty, there may be considerable room for improvement along both the dimensions in an evolutionary sense. However, in such a world the application of the pragmatic principle of prudence would support the development of crisis management capacities at all times, since it will be difficult to prevent crises entirely under any type of open economy GFA and RFAs. The main goals, pragmatically speaking, are to minimize financial and economic instabilities while facilitating global payments, trade and investments.

Globalization, marketization and the role of global capital markets³

Globalization of financial markets has increased the flow of various types of capital across the borders. Observers have cautioned about the adverse effects on market stability. Indeed, even as marketization of finance across borders proceeds rapidly substantial instability is manifest in the global financial markets. As resistance to further marketization without regulation grows, the instabilities are likely to spread and result in political and social instabilities as well.⁴ For this reason alone, it may be wise to adopt a new and more pragmatic approach to GFA that can help policy making for greater well-being in the nations of the world. As mentioned before, this will help prevent a third type of crisis: a political and social crisis. The developments in Indonesia during the AFC illustrate how suddenly such crises can break out. The evolutionary theory developed here actually suggests a pragmatic path-dependent institution-building approach to a hybrid GFA. But the process is likely to be quite complex.

It is because of such complexities that the term “globalization” which is so much in vogue today has to be used with caution. When viewed historically, it appears that globalization is a contradictory process of international economic integration that was severely interrupted by the First World War, the Great Depression and the Second World War. The emergence of the Bretton Woods framework can be seen as a way to integrate the world with respect to trade while controlling the flow of private capital. The demise of Bretton Woods has set in motion forces of capital account liberalization that are often the most visible aspects of “globalization.” However, even this process is fraught with new instabilities as evidenced by the Mexican and – more recently and even more dramatically – by the Asian Financial Crisis. At the same time integration of trade even within the standard neoclassical Heckscher–Ohlin–Samuelson model would imply a fall in the wages of unskilled workers of the North thus increasing inequality there (Krugman 1996). The South is supposed to experience a more equalizing effect through trade; but empirically, there is very little evidence of this happening. Therefore, it is necessary to treat the rhetoric of globalization with caution. At best, we are experiencing a “fractured” globalization. Integration of financial markets, for example, can lead to great benefits for all in a truly liberal world of equal actors. However, in a world of unevenness the evolutionary paths may lead to crisis unless institutions are designed properly. Leaving everything to the markets may produce the supreme irony of ultimately leading to crises which prevent some very important capital and commodity markets from functioning.

For these reasons, it is best to ask what roles the global capital markets are supposed to perform in a world of free capital mobility. The functions are variously described, but mainly emphasize the transfer of resources from savers to investors globally. In addition, the agglomeration of capital, selection of projects, monitoring, contract enforcement, risk sharing and pooling of risks are also mentioned. All these are legitimate functions of capital markets. However, despite much talk the crucial problem of handling various kinds of risks and the inability of simple free markets with international capital mobility are nearly always elided. What are some of the most important of these risks?

Exchange rate risk refers to the possibility that a country’s currency may experience a precipitous decline in value. This risk is present in any type of exchange rate regime, with full or even partial currency convertibility. Both floating exchange rates and pegging a currency to another single currency, or even a basket of currencies present such exchange rate risk to various degrees.

Capital flight risk refers to the possibility that both domestic and foreign holders of financial assets will sell their holdings whenever there is an expectation of a capital loss. Exchange rate risk is one possible avenue through which such expectations may be formed. As with many types of expectations formation mechanisms, in a world of nonlinearity, bounded rationality and uncertainty, a Keynesian type of short-termism takes over. Investors head for the exit simply on the basis of short-term calculations of possible loss, and herd behavior is a likely outcome. Financial distress follows for the hapless country from which capital thus exits in a hurry. In the extreme situation of large short-term liabilities, the affected economy may land in a full-blown financial or even economic crisis.

There is thus a systemic risk of financial fragility associated with the above risks, and the stability of the financial and political institutions. This type of systemic risk raises the possibility of a financial meltdown. In case of the AFC, the risk of financial fragility increased over the 1990s through maturity mismatch of loans. The fact that many of the short-term loans were in foreign currencies without risk-sharing mechanisms such as currency swaps in place, created further exchange rate risk, which also increased the potential systemic risk. This is consistent with the view of Knight (1998), who affirms that although globalization has brought about spectacular increase in the flow of capital to emerging markets, the AFC demonstrates that it can also create financial instability and contagion. Under fairly realistic conditions, the banking system of emerging economies can respond in ways that worsen the impact of adverse shocks, causing severe macroeconomic repercussions and exacerbating systemic financial and economic fragility.

In the case of the AFC, we also witnessed a fourth kind of risk for vulnerable economies that others have also recognized.⁵ This is the risk of contagion.⁶ Some countries were unnecessarily victimized simply because expectations moved against their economic prospects as their neighbors experienced financial fragility and capital flight. This has important implications for both global and regional financial architecture. Both GFA and RFAs should try to minimize the contagion risk. Contagion can happen even without much financial and trade openness. However, the more integrated with the rest of the world, or even a region, an economy is, the more is the risk of contagion. There is some theoretical support for this last proposition in specific markets that are being globalized. For example, some argue that the globalization of securities markets can promote contagion among investors by weakening incentives of gathering costly country-specific information because the marginal benefit of gathering information may be decreasing as securities markets become more global in scope.⁷

The key problem which underlies the above risk scenarios, long recognized by the practitioners before theorists started to study it, is that given informational problems and the cost of building enforcing institutions, capital markets are almost always incomplete. Thus classical theorems of welfare economics no longer apply even within a closed economy. In a world of open economies these problems become more severe, and are directly related to the lack of global institutions of governance. The recognition of this point underlies the various proposals advanced so far. There are already many proposals for GFAs on the table.⁸ Even a partial cataloging will have to include the many national proposals (e.g. US, UK, French and Canadian), private proposals such as Soros’ credit insurance agency, Edward’s specialized agencies, Bergsten’s target zones and so on, and other international proposals. Among the international proposals could be included the IMF proposals, G7 and G22 proposals. Although they vary in scope and degrees of political realism, they share one feature in common. All of them fall into the overarching type of GFA category.

Although many of the proposals for GFA are possible theoretical solutions, the evolutionary approach looks at path dependence and sequential selection processes as crucial. We need to recognize that the actual evolution of such institutions of financial governance will depend crucially on coordination among the actors, in particular among some key actors in the global system. This leads us to the consideration of an evolutionary structural theory of GFA and RFAs.

An evolutionary theory of GFA: two evolutionary types of GFA

In order to motivate the discussion, we can return to some aspects of the AFC. In distinguishing among the countries that managed to survive the AFC and those that did not, John Williamson, one of the proponents of the “Washington Consensus,” pointed out that whether or not these countries had liberalized their capital accounts could be construed as crucial. Those that had not, survived.⁹

All Asian crisis countries had accepted the IMF’s Article VIII obligations, as evident from the historical documents. But as some have pointed out, liberalizing the trade and liberalizing the financial sector have different policy implications.¹⁰ In line with the discussion in the previous section, theoretically, one should carefully distinguish the welfare impacts of financial market liberalization in an uneven world from such impact in a smooth world of equals with information symmetry. Indeed, next to unevenness, the most critical element is the role and the presence of asymmetric information. In a financial market, gat...

Table of contents

• Cover
• Halftitle
• Title
• Copyright
• Contents
• List of Figures
• List of Tables
• Preface
• Acknowledgments
• Introduction: Managing development – globalization, economic restructuring and social policy
• PART I. Globalization and global governance
• PART II. Financial crises and restructuring
• PART III. Social policy in transition
• Index