Liberalisation and democracy

Print edition : August 27, 2004

A significant new study establishes that international currency and securities markets are driven by a handful of large investors who find democracy not only unnecessary but even contrary to their interests.

ONE of the myths most frequently propagated by market fundamentalists is that economic liberalisation and political democracy are intertwined and mutually reinforcing. This is not just argued by large capitalists and financiers; rather, it has been a theme taken up increasingly by the political leadership across the world.

Thus Bill Clinton famously declared, referring directly but not only to the post-socialist countries, that "democracy and open markets are on the march together." Within developing countries, there is much talk among political elites of how economic liberalisation can not only erode political authoritarianism, but also reduce some of the more irritating and unpleasant aspects of government control, such as "inspector raj" and the inordinate power of the minor bureaucracy.

However, as economic liberalisation has become more widespread and more and more countries have been affected by its effects, in particular the much greater mobility of capital, this early enthusiasm has been much tempered. There is much greater realisation that unfettered market functioning can have detrimental effects not only upon welfare and equity within societies, but even on political freedom.

The most significant factor in this regard is the impact of the domination of finance, and the ability of financial agents to influence major political and economic decisions of governments as well as to reduce the bargaining power of others in society, especially workers and peasants.

By now, this is probably well known in countries like India, and even if we did not recognise it earlier, we are daily given reminders of the power of finance through the decisions of the Central government. Thus, after an election in which the electorate unambiguously and overwhelmingly rejected economic strategies that privileged large capital and reduced economic security for most of the population, the new government emphasises its intention to stick broadly to the same policies that were proved to be so disastrous.

Most recently, in a Budget exercise that provides hardly any increase in expenditure allocation to the most crucial and necessary sectors such as agriculture, rural development and employment generation, there was a minor attempt to substitute capital gains tax with a (very small) turnover tax in the stock market. There was outcry among stockbrokers, unaccustomed to paying even this minuscule rate of 0.15 per cent, and almost immediately the government caved into the pressure of a few such financial players, to reduce the tax and exempt certain categories, thereby foregoing substantial revenue. Meanwhile, even the erstwhile capital gains tax has not been replaced. The associated revenue loss will, in turn, mean that there is less money available for needed public expenditure, given the self-imposed constraints upon the government, of "fiscal responsibility". This is surely anti-democratic, but hardly recognised as such.

More broadly, the very mobility of finance, and the consequent fear of capital flight cause governments to behave in undemocratic ways even without overt or explicit pressure. Tax increases are avoided and instead tax incentives to capital are provided; fiscal deficits are financed dominantly or exclusively through expensive market borrowing; such deficits themselves become objects of concern and are sought to be controlled; this in turn means that spending is reined in, even when the foregone expenditures are necessary for improving welfare and the living conditions of ordinary people.

Despite the growing evidence across the world that financial markets can operate in ways that actually reduce democratic accountability and the power of the people, there is relatively little academic work on the subject, particularly by political scientists. A book by Mary Ann Haley (Freedom and finance: Democratisation and institutional investors in developing countries, Palgrave 2001) seeks to address this gap.

Financial markets are known to be prone to imperfections of various kinds, typically stemming from incomplete or asymmetric information of the agents concerned. Haley points out that there are additional reasons to expect inefficiencies in the functioning of international portfolio capital markets in "emerging markets". Two of the main assumptions of the "efficient market" hypothesis are not fulfilled: the impossibility of market manipulation by a few investors or groups of investors; and equal access to information and similar reaction to that information by different investors.

Haley shows that there have been significant differences in the fund allocation of institutional investors in various emerging markets, depending upon the geographical origin of the fund itself. U.S. fund managers behave more like each other and very differently from European fund managers, for example. This reflects both intentional collaboration as well as more indirect forms, such as different political preferences or being affected by similar access to certain types of information.

OVERALL, there is a systemic tendency towards collaboration between large fund managers, which significantly biases the behaviour of financial markets in developing countries. First, of course, there is the shared belief in complying with the neoliberal economic doctrine, which leads to uniformity of attitudes towards economic policies. Second, the supremacy of the profit motive, and orientation towards short-term profits in particular, marks a significant departure from earlier forms of capital flows such as foreign aid. Third, information and communication pertaining to emerging markets, especially the role of the media which is itself highly controlled and often manipulated, affects the way both prospective investors and developing country governments view economic success. Fourth, organisations like industry associations of investors (as in the World Economic Forum or the Institute for International Finance) or multilateral institutions such as the International Monetary Fund (IMF) and World Bank become critical spaces in which investors can collaborate to achieve their objectives and influence developing country governments.

This helps to explain to some extent the overall political power of financial investors in particular, and why this power is typically so far in excess of the actual funds invested in any particular emerging market or even the qualitative significance of such flows in any developing economy. But in addition, there are specific mechanisms through which institutional investors operate to achieve policy changes and, therefore, their own profit objectives.

One such means of market manipulation is what is known as "front-running". This is preliminary trading (in order to influence price movements to one's own benefit) before executing a large order. This is illegal in most securities markets and increasingly difficult to do in developed country financial markets. But it is much easier in developing country markets because of the relative scarcity of information, lower numbers of large investors, illiquidity and thinness of market trading and lack of adequate regulation.

The use of the media is increasingly evident in front-running, such as when an investor makes comments in the financial press or television on the "ill-health" of an emerging market while purchasing shares in it, or conversely sell shares while commenting on the advantages of a particular stock. Detection is often difficult, but most investors agree that the practice is now widespread especially among foreign investors in emerging markets.

Investor activism has also become more pronounced, through direct involvement in the running of a corporation. The goals of domestic and international investor activism are essentially the same: to influence rates of return by pressing for diversification, growth and currency risk management by corporations. In developing countries, this can also translate into pushing for policy changes at the governmental level. In fact, lobbying - with both home and host country governments - has become an essential part of the activities of large fund managers.

This is why the preferences of institutional investors become significant. Top emerging market fund managers tend to show strong preferences for stability and neoliberal economic ideology in governments, often at the expense of political democracy and economic equity.

Haley points out that there are strong linkages between portfolio capital and neoliberal economic reforms. The element of competition between developing countries has altered domestic politics in emerging markets in several important ways. It has intensified and accelerated the neoliberal economic reform process, especially privatisation of state assets. It has obfuscated and even eliminated discussion of alternative strategies for economic development. The unity between the ideology of multilateral institutions and private institutional investor preferences has grown. It has privileged and empowered unelected and unaccountable technocrats within the domestic politics of developing countries. And finally, it has devalued and diluted the meaning of democracy for many countries, by focussing on success or failure in implementing neoliberal economic reforms as the main criterion for assessing political merit.

It is not surprising, therefore, that Haley's empirical review finds evidence of a significant loss of political and civil liberties and less attention to social and economic human rights in many emerging markets, particularly those with stock market capitalisation at or above 3 per cent of GDP (gross domestic product). Her study of Mexico, Brazil, Peru and Malaysia in the 1990s reinforces these conclusions.

This particular study establishes in some detail that international currency and securities markets are driven by a handful of large investors, whose primary interests are such that they may find political democracy not only unnecessary but even contrary to their interests. It is more than obvious, therefore, that the power of such agents needs to be controlled much more effectively, if developing countries that do value democracy are to preserve and strengthen it.