This was the title of the workshop presented as part of the 'Seminario Internacional de Macroeconomia Para o Desenvolvimento' (International Seminar on the Macroeconomics of Disinvestment) at the Federal University, Rio de Janeiro, Brazil, on 29 January, 2003.
 
The workshop was presented by 'O Instituto de Economia da UFRJ' (Institute of Economics, Federal University, Rio de Janeiro) and IDEAs (International Development Economics Associates).
 
The workshop, which was presided over by Franklin Serrano (UFRJ, IDEAs), had three sessions-two in the morning and one in the afternoon. The first session concentrated on theoretical problems regarding free capital flows, and the second on international experiences. The afternoon session focussed on the economic policies of Brazil. The audience mainly comprised people with an academic background, the majority being students and teachers of economics.
 
Franklin Serrano, as the first speaker at the first session, offered an analysis and critique of the bi-polar exchange rate regime. Though the bi-polar vision has suffered a disaster in recent times, modern economic theory has been unable to bridge the gap. Given the recent developments in developing economies and the tendency for central banks to fix an internal rate higher than the equilibrium so as to attract foreign capital, the existing fixed and flexible exchange rate models do not work any more, and fiscal and monetary policies have lost their uses as described in traditional theory.
 
At a theoretical level, Serrano explored the Mundell–Fleming model with a different interest rate treatment. The use of exchange rate devaluation, under a floating exchange rate regime, as a mechanism for adjustment tends to lead to worse devaluation as it adds to the internal–external gap. Earlier, the speed with which the capital account adjusted was always slower than the speed with which the commodity account adjusted. Now, with capital mobility being very high and with the increase in importance of short-term capital, there is no time-gap or lag between commodity and capital account adjustments. Movement from a fixed to a flexible exchange rate regime does not essentially address this problem. So, moving from one to the other does not solve the problem that free and fast capital mobility imposes on the economic system. The solution, Serrano suggested, is to take things slowly and not go in for drastic and hasty financial liberalization.
 
The next speaker, Prabhat Patnaik (Jawaharlal Nehru University, New Delhi, India), highlighted the fact that a major fallacy of neoliberal policies is the failure to distinguish between stock and flow decisions. The fact that individuals make a concrete decision regarding the form in which to hold their savings has been ignored by neoliberal economists since they work with an implicit assumption of full employment where all savings are invested. Under this assumption, a higher interest rate is said to automatically lead to higher savings and therefore higher investments. Simultaneously, given a savings schedule, increase in public investment actually crowds out private investment by adjusting the interest rate, keeping employment (already full) unchanged.
 
Patnaik suggested that this idea is fallacious because savings and income (Y) change simultaneously and therefore assuming a fixed savings pool and fixed (full) employment is erroneous. With fiscal policy, it is possible to increase savings, and therefore employment. Neoliberal economics needs to recognize that stock and flow decisions simultaneously determine equilibrium savings and investment.
 
Governments in developing countries, urged Patnaik, should go in for expansionary policies like distribution of foodgrains stock, expansion and utilization of industrial capacity, rather than let the private sector replace its activities.
 
In the context of free capital flows, the Mundell–Fleming model, for example, had suggested that interest rates would be equal everywhere. But, Patnaik pointed out, in reality this is not so, since capital always prefers to go to the north rather than to the south. Therefore, the south always has to pay a premium on its interest rate. A higher interest rate will tend to reduce private investment. It will also make government borrowing unsustainable if the growth rate is lower than the interest rate. Therefore government expenditure has to be reduced, and government investment and subsequently the growth rate will fall, as will private investment. An additional problem is that the rate of interest never, by itself, determines capital inflow.
 
In any case, increased capital flow has its own problems. Higher capital flows may go towards replacing domestic private sector investment, that is, it may actually cause domestic deindustrialization. If this capital inflow can be used to finance private domestic or government investments, there would not be a problem. But usually this does not happen. In addition, borrowing short-term funds for financing long-term investments is quite unlikely. Further, the fact that foreign exchange reserves will also be used up might mean heading towards a crisis in the long run.
 
On the other hand, under a flexible exchange rate, if capital inflow increases, the real exchange rate appreciates and foreign capital gets a higher return compared to government investments. This creates contractionary movements in the economy. But the reverse is not completely true. When capital flows out the exchange rate does not depreciate so much, since expectations regarding the real exchange rate going down are much higher as real wages (and therefore workers' demand) cannot fall so much. So the expansionary process does not really take place to a large extent and, in addition, government intervention in such cases may actually set in motion a deflationary process.
 
The second session in the morning started off with an introduction to IDEAs by Jomo K.S. (University of Malaysia, IDEAs). After describing the organization, its objectives and aspirations, he invited the audience to visit the official website. He then went on to speak about three issues surrounding financial liberalization (FL)—first, the consequence of FL; second, the process by which FL creates a net capital outflow; and finally, the question of capital management.
 
The consequences of FL have been many. First, except for brief time-periods in Asia and Latin America, there has been an overall outflow of capital from the developing countries. Second, the lower costs of funds that were promised as a benefit of FL have not been realized. Third, financial deepening was supposed to reduce risks. This has happened, but because of new financial instruments, the likelihood of systemic risk has in fact increased. Financial capital inflow has also generated a strong deflationary impact since capital inflows are very sensitive to consumer price inflation and therefore governments have generated a strong tendency to control inflation. However, as country experiences show, the higher the extent of inflation targeting, the lower has been the growth rate. Finally, international financial liberalization has undermined the possibility of development finance that is long-term in nature.
 
The phenomenon of net capital outflow that has taken place as a result of FL has in turn its own sources and consequent complications. Firstly, asset price bubbles have occurred more, and more but this does not contribute to development. Secondly, with the availability of cheap credit, consumer binges by the rich have become a common phenomenon, but again, this kind of spending is not related to development. Thirdly, there has been a suggestion that overinvestment occurs as a result of increased availability of capital, but the speaker did not quite agree with this view. Fourthly, so far the prudence that has been exercised has meant that central banks have increased their reserves to offset these flows. So, contrary to common perceptions, there are no increases in actual stocks.
 
Jomo went on to stress the need for capital management and detailed the considerations that should be borne in mind while doing so. First, capital controls have historically been followed in many countries, and more recently in Malaysia. Emphasizing the rationale of 'national interest', he pointed out that in Brazil this was a viable option in the interests of the national business community. Second, the discussion must now go beyond the realm of whether to have 'capital control or not', but to 'what kind' of capital control. Types of capital control, given their historical associations and therefore the vocabulary used, are very important. The role of political coalitions or social forces is also crucial in this regard.
 
Third, the degree of market-friendliness is important. Controls in India, China and Taiwan Province of China, for example, seem much more market-friendly and effective compared to those in Chile and Columbia. Fourth, policy-makers need to differentiate between portfolio flows and FDI, and to encourage the latter but not the former. The type of FDI also represents an important policy choice. Fifth, capital controls need to decide whether to control inflows and outflows, and distinguish between the interests of citizens and the corporate sector. Sixth, policies regarding mergers and acquisitions need to be clarified. Finally, structuring exemptions so as to effectively signal incentives and disincentives is another factor to be taken into account.
 
Jomo ended by stressing the need for careful discussions between policy formulators and people with a detailed and nuanced knowledge of the subject.
 
Carlos Medeiros (UFRJ, Brazil), the next speaker, discussed the impact of liberalization on income distribution in Latin America, especially Brazil.
 
Latin America was characterized by an acute dollar shortage in the eighties, which was reversed in the nineties. However, over-availability of foreign funds actually did not increase economic growth nor did it increase the stability of the system; rather, it gave rise to higher volatility and other problems like the import of bubbles and a succession of other investments. The domestic interest rate was cut to attract foreign capital over this period.
 
The effect of all this on income, argued Medeiros, was adverse. Income growth per capita in Latin America was a low 1.4 per cent, though Chile recorded higher growth. Productivity and employment growth as well as the investment ratio were low, with a high disparity between and within sectors (for example, between agriculture and industry). Over 1990–98, there was high mass migration from Latin America, especially Mexico, the Dominican Republic and El Salvador. Both government and private employment also fell sharply in most countries, including Brazil and excepting Chile.
 
Empirical analyses, though limited by data constraints, shows that over this period, inequality increased significantly in Argentina, Chile, Mexico, Bolivia, Colombia, Peru and Venezuela, while it stayed high but stable in Brazil. Poverty too increased in Argentina, Mexico and Venezuela. A hollowing out of the middle earners has been a major trend in all of Latin America, and is especially intense in Brazil. This reflects the deindustrialization of labour force. Severe concentration of income at the top is another major characteristic of Latin America. Real minimum wages at the end of the nineties was less than that paid at the beginning of the eighties in all countries in this region, with the exception of Chile, Colombia and Brazil.
 
The devaluation of human capital in Latin America was associated with unstable growth and consumer booms, both of which were a fall-out of the liberalization process. As a result of the regime of high interest rates, income has been concentrated in the new rentier class of bond-holders. There has been a strong polarization process that has created positive income effects only for the rich and the corporate sector, more importantly. This has changed the power relations in favour of the private sector as opposed to the public sector. In the labour market, inequality of distribution in salaries has come about as a result of increased disaggregation of the labour market. Public sector jobs and trade unions, on which the middle and the poorer classes are dependent, are becoming less important. At the same time, except in telecommunications, other investments have failed to confer any benefits to the ordinary people.
 
The next speaker was Reinaldo Gonsalves from UFRJ, Brazil. He discussed the reasons or needs for using capital control as an instrument of macroeconomic management, as well as the critical issues that must be kept in mind while implementing capital control.
 
First, capital control is necessary for decreasing interest rates in Brazil and in the rest of Latin America. Second, it is also necessary for controlling public debt in the hands of non-residents and residents of foreign descent, because a high public debt ends up in sterilizing public resources. Third, capital control is the key to long-term development for making available long-term funds and to keep away external resources from strategic sectors. Fourth, it is required for preventing domestic savings from going out, which would have a negative impact on the rate of development. At present smaller companies are unable to get international funds and also pay a much higher interest rate, which poses a strategic inconsistency problem in the development model. Fifth, drugs and arms trafficking have increased as a result of capital account liberalization, even in Brazil. This issue, related to political and social parameters, is of great significance, the speaker emphasized. Cases of corruption and decay in the political and social system are a fall-out of the present system of financial liberalism.
 
But while setting up a system of capital control, certain factors need to be kept in mind. Capital control in Brazil needs to go hand-in-hand with credit control as a permanent policy. It also needs to be coordinated with some FDI control. An appropriate mix of macroeconomic policies (fiscal, credit and exchange rate policies) that are compatible and consistent with capital control must also be put in place. Simultaneously, a strategic level of foreign reserves must be maintained for facing crisis situations. In the Brazilian situation, capital control is a key factor that could bring forth development and macroeconomic balance. In addition, de-dollarization of public debt is a very important issue.
 
Gonsalves placed great emphasis on capital control, since the goods and services sector is more difficult to control as restrictions there are perceived as real and strong interference. Finally, the speaker reminded the audience that international policies and coordination between countries are very important. Capital control, since it affects the financial elite, is a difficult political option. It is also necessary to be cautious towards and discerning of the type of advice that is forthcoming from bodies that have vested interests, like the World Bank, as well as other forms of the large economic elite.
 
In the afternoon session, Fernando Cardim de Carvalho of UFRJ focussed attention on the economy of Brazil. He started off by discussing how the question of 'imposition' of capital control, as opposed to the removal of existing controls, is a very tricky one, since the very mention tends to trigger off adverse economic behaviour. There is also a great difference between the formal impact of capital control and its real effects.
 
Moving to Brazil, he discussed how the Brazilian economy is supposed to have significant controls but in effect, does not. This is so because although the legislation required is already in place it is not really implemented. The government's task is therefore simpler and requires only an implementation of those legal provisions.
 
The speaker next drew attention to 'two major issues'. The first concerned the question of moving from a fixed to a floating exchange rate system. He suggested that this would not by itself solve the problem. The concept of equilibrium does not work because in the event of a devaluation, expectations regarding that devaluation will make the rate higher. A floating exchange rate offers no solution to the volatility generated by capital flows.
 
The second question was whether controls have to be permanent or not. The major reasons cited for control are two. First, they will help the domestic market by reducing the domestic interest rate, as has happened in Malaysia. In the case of Brazil, one needs to wait and see whether that will work. But it is the second reason that provides the need to have permanent controls in Brazil, Carvalho argued. In Brazil, as in Mexico and Thailand, the major problem with capital flows since 1998 is that it is the residents who take funds out with them. These include not only the rich but also the middle class, who are free to invest abroad through foreign banks. The change in the nature and the greater potential for damage of the capital flow problem has now made it imperative that the controls be permanent. Political autonomy is also a must for these objectives.
 
Finally, capital controls must cover the plugging of investments abroad, for which the law was already in place. Restrictions need to be imposed on both inflow and outflow (on luxury spending abroad on the basis of foreign exchange scarcity). Financial companies also need tight legislation for stricter control of their investments abroad. Learning along the way and coping with adverse public opinion are of utmost importance. Coping with the increasing pressures from the IMF is another task the government must train itself to do.
 
The last speaker, Ricardo Carneiro (UNICAMP), concentrated on the political aspects of the issue under discussion. Carneiro, who has been a long-time economic advisor to President Lula, pointed out the difficulties faced by even a leftist government, of following a policy such as capital control. The government could fix the interest rate but since it had no controls over the exchange rate, this was discarded. There is, in reality, no autonomy for macroeconomic management.
 
But this does not mean that Brazil has to live without a development path in the absence of capital control. Brazil can try to exert some control over the interest rate, though it is difficult. It can also use semi-economic institutions for this purpose. In addition, the state, which has a tax-base of 34 per cent of the population, can try to effectively allocate the tax resources. The government can, as a matter of policy, hinder certain types of systems, say outflows, by creating bureaucratic hurdles rather than by obvious or direct policies.
 
Carneiro stressed the need for a gradualist approach towards achieving the ends that a country like Brazil obviously needs to pursue. Given the complications of the current predicament in which Brazil finds itself, the speaker was keen to highlight the use of cautious methods that can achieve the apparently impossible task of keeping the people and organizations like the IMF happy at the same time.
 
The audience came up with detailed questions on many of the issues discussed—on country experiences (especially in Asia and a comparison of that with Brazil), on the validity of the Tobin Tax, on technical methods and measures used for calculating income inequalities. Questions on President Lula's apparently soft stand on economic appointments and policies in Brazil dominated the afternoon session. The workshop generated a lot of interest and discussion, some of which continued even afterwards, on the issue of financial capital flows, which is a major concern for developing countries today.

February 21, 2003.