If the financial media is to be believed the International Monetary Fund is rethinking its views on liberalization of financial markets in developing countries. For more than two decades now the IMF has been the world's leading and most successful advocate of liberalization of financial markets in both developed and developing countries. There was however a difference in the role of the IMF in the so-called "mature" and "emerging" markets. Financial liberalization in the developed countries was an internal and autonomous process driven by the rise to dominance of finance capital. The IMF merely adopted that programme based on its discovery of the "value" of that regime.

The earnestness with which it subsequently pursued its new-found mission to open up financial markets in developing countries led to criticism that Wall Street, more than even the US Treasury, was influencing the stance of the IMF. This changed focus from an emphasis on trade liberalization accompanied with policies aimed at balance of payments adjustment to an emphasis on financial market policies served the IMF well, since it provided the Fund with a new role in a world of predominantly private capital flows. The subsequent success of the IMF in ensuring financial liberalization in developing countries was reflective of the new clout it had garnered as a formally-unnamed representative of international finance.

It is surprising, therefore, that in recent months there have seen a spate of analyses from the IMF attempting to revisit the experience with financial liberalization worldwide and assess the gains and losses from the wave of liberalization in developed and developing country financial markets over the last decade. This desire to revisit the debate on financial liberalization has been attributed to two factors. First, evidence that the viability of the Anglo-Saxon, particularly US, model of financial markets and financial policies, is itself in question. According to the Global Financial Stability Report released by the Fund in March this year, between the stock market peak recorded on March 24, 2000 and the end of February 2003, the S&P 500 stock market index had fallen by 45 per cent, the NASDAQ by 73 per cent and the FTSE Eurotop 300 by 55 per cent. This was the period which not merely witnessed the bursting of the new technology bubble, but also a further decline encouraged by evidence of accounting frauds and market manipulation. The resultant huge erosion of paper wealth has raised questions about the appropriateness of organizational forms in US financial markets.

More damaging has been the evidence that the last decade-and-a-half, when the wave of financial liberalization in developing countries was unleashed, has witnessed a series of financial and currency crises, the intensity of some of which has been severe. Moreover, analyses of individual instances of crises have tended to conclude that the nature and timing of these crises had much to do with the shift to a more liberal and open financial regime. The latest set of countries affected by the volatility described by the IMF as the "feast or famine" dynamic is in Latin America, where two relatively good performers till quite recently – Argentina and Brazil - have been hit by reduced or near negligible access to capital markets. These instances of volatility followed a spate of crises in developing-country markets in Asia, Africa, Europe and Latin America during the 1980s and 1990s. Yet, there were no signs of any rethink on the effects of financial liberalization, and the prevailing global financial architecture was defended by the Bretton Woods Institutions on the grounds that it has served the objective of economic growth well and requires, if anything, minor modifications accompanied by supportive institutional strengthening.

However, as mentioned, there are superficial signs of a change in attitude more recently. Am IMF Working Paper, authored by Graciela Kaminsky of George Washington University and Sergio Schmukler of the World Bank, authorized for distribution in February 2003 by the IMF's Chief Economist and Research Director Kenneth Rogoff, declares that findings in the "crisis literature" suggest that "booms and busts in financial markets are at the core of currency crises and that these large cycles are triggered by financial deregulation", even though some of "the finance literature tend to support the claim that deregulation is beneficial, with liberalization reducing the cost of capital."

More recently an IMF study dated March 17 2003 and titled "Effects of Financial Globalization on Developing Countries: Some Empirical Evidence", which includes Kenneth Rogoff among its co-authors, has gone even further. It recognizes: (i) that "an objective reading of the vast research effort to date suggests that there is no strong, robust and uniform support for the (neoliberal) theoretical argument that financial globalization per se delivers a higher rate of economic growth; and (ii) that even though neoliberal theory suggests that "the volatility of consumption relative to that of output should go down as the degree of financial integration increases, since the essence of global financial diversification is that a country is able to offload some of its income risk in world markets," in practice "the volatility of consumption growth relative to that of income growth has on average increased for the emerging market economies in the 1990s, which was precisely the period of a rapid increase in financial globalization."

This new candour on the part of the IMF has not gone unnoticed. The Financial Times declared that "the new study marks a continued shift within the IMF towards much greater caution in encouraging countries to open up their capital accounts," necessitated in particular by its experience in Argentina and Brazil. One other observer remarked that "The IMF has just abandoned its fatwa against the unmitigated evil of capital controls. Institutional confessions of error don't come much bigger than this one. But while the IMF's many critics are rubbing it in, they shouldn't forget that such a burst of intellectual honesty takes a lot of guts."

The reality regarding the IMF's attitude is, however, entirely different. A close reading of both the working paper and the study referred to earlier indicates that the IMF has decided to accommodate the growing evidence of the adverse consequences of financial liberalization in developing countries, not so much to learn from it and revise its positions but to provide what some are seeing as a more "nuanced" defence of financial liberalization. Kaminsky and Schmukler in fact argue that the problem with existing analyses of financial liberalization is that they separate countries into those that have and those that have not liberalized their financial markets. In actual fact, countries remove different kinds of restrictions at different times, which not merely lead to different degrees and patterns of financial liberalization, but also to "reversal" of the liberalization trend in many contexts.

Once these features of the extent of liberalization of individual markets are taken account of, they argue, the evidence suggests that stock market booms and busts have not intensified in the long run after financial liberalization. The real difference between developed and developing countries is that in the latter, the evidence indicates that in the short run financial liberalization tends to trigger larger cycles, even though it is beneficial in the short run. In mature markets, on the contrary, liberalization appears to be beneficial in the short run as well.

What explains this difference in the case of the developing countries. It is, according to the authors, the fact that institutional reforms aimed at increasing transparency and appropriate regulation of markets do not predate liberalization. It is only after liberalization is adopted as a strategy that governments turn their attention to institutional quality, resulting in the fact that the institutional requirements needed to ensure that liberalization delivers its beneficial effects are put in place only with a lag. This leads to the paradoxical contrast between the short run adverse and long-run beneficial effects of financial liberalization.

The IMF's own study builds on this argument, indicating that the timing and sequence of the release of the two studies may not be coincidental. Taking a more nuanced view of liberalization, as does the Kaminsky-Schmukler paper, the IMF study divides countries into those that are more and less financially liberalized not on the basis of their de jure liberalization suggested by their policies, but on the basis of their de facto liberalization as indicated by the volume of capital inflows and outflows relative to GDP. Thus, if a country has not adopted liberalization measures to any significant degree, but yet has received large capital inflows, it is treated as a more liberalized financial market. That is, the link between liberalization and capital flows is assumed and not established.

Having classified countries in this manner, the study finds that there is no clearly identifiable effect of financial liberalization on growth in developing countries, and that there is evidence that consumption volatility, in fact, increases with liberalization. However, the study goes on to argue: "Interestingly, a more nuanced look at the data suggests the possible presence of a threshold effect. At low levels of financial integration, an increment in financial integration is associated with an increase in the relative volatility of consumption. However, once the level of financial integration crosses a threshold, the association becomes negative. In other words, for countries that are sufficiently open financially, relative consumption volatility starts to decline. This finding is potentially consistent with the view that international financial integration can help to promote domestic financial sector development, which in turn can help to moderate domestic macroeconomic volatility."

This makes the proliferation of financial and currency crises among developing
economies a natural consequence of the "growing pains" associated with financial globalization, and therefore an inevitable stage they have to go through to realize the gains of liberalization. But what cause these short-term crises? The IMF study itself identifies four factors. First, international investors have a tendency to engage in momentum trading and herding, that can be destabilizing. Second, international investors "may" engage in speculative attacks on developing-country currencies, leading to instability that is not warranted by fundamentals. Third, the "contagion" effect that has been repeatedly observed, could result in international investors withdrawing capital from otherwise healthy countries. Finally, some governments, may not give sufficient weight to the interest of future generations and exploit financial globalization to over-borrow with purely short-term considerations in mind. All of these, needless to say, have a mutually reinforcing effect that exacerbates financial crises when they occur.

It should be obvious that of these the first three have little to do with the behaviour of developing-country governments or financial agents but with the behaviour of financial agents from developed countries. Since developing countries can do little about the latter, the case for preempting the effects of such behaviour with financial controls is strong. Yet, having recognized their importance the IMF study goes on to argue that: "The vulnerability of a developing country to the "risk factors" associated with financial globalization is also not independent from the quality of macroeconomic policies and domestic governance. For example, research has demonstrated that an overvalued exchange rate and an overextended domestic lending boom often precede a currency crisis. In addition, lack of transparency has been shown to be associated with more herding behaviour by international investors that can destabilize a developing country's financial markets. Finally, evidence shows that a high degree of corruption may affect the composition of a country's capital inflows in a manner that makes it more vulnerable to the risks of speculative attacks and contagion effects."

Developed industrial countries, the study implicitly suggests, do not have these institutional features that generate the vicious nexus between financial liberalization and short-term volatility, leading to periodic crises. To be like the developed, developing countries have to cross the "threshold", since the greater financial integration that this requires would automatically lead to improvements in institutional quality as well. So the implication is not that developing countries should give up on financial liberalization but that they should go far enough to ensure that it is accompanied with reform that delivers the institutional quality needed to realize the virtuous relationship between financial liberalization and economic performance.

This is indeed surprising, given the evidence of the factors that led up to the collapse of stock markets in the developed countries, especially the US. As mentioned earlier, that collapse was exacerbated by evidence of conflict of interest (as in the Merrill Lynch case), of market manipulation (Enron) and of accounting fraud (Enron, WorldCom, Xerox), which does not say much for either the transparency or quality of institutions in the US. If it was institutional quality that accounts for the threshold effect, if any such exists, then the instances of successful and failed financial liberalization should not coincide with their categorization as "mature" or "emerging markets".

The failure of the studies quoted to take account of these factors points in two directions. First, it suggests that the effort to make a more "nuanced" classification of countries into those that are more and less liberalized countries amounts to manipulating the evidence to yield results that defend liberalization in the long term, even though its consequences are obviously adverse. Second, the new candor is not a reflection of the need to change track, but of the need to ensure that liberalization is persisted with despite the ostensibly short-run "pains" of the process. The IMF's case is clear: it does not deny the volatility, the crises and the pain associated with financial liberalization; it merely sees them as the inevitable consequence of the pain that must be suffered to enjoy the long-run benefits of liberalization. The strategy is to assert that evidence that contradicts its case is actually supportive.

April 10, 2003.