Capital markets and unsustainable growth

Print edition : April 14, 2001

The recent experience of Malaysia holds especially important lessons for the Indian economy at the current time.

FOR a relatively brief period in the aftermath of the South-East Asian financial crisis, Indian policy-makers did look to the region to extract some lessons for the Indian government's own plans regarding capital account liberalisation. Unfortunately, that period was all too brief. The apparent economic recovery in the region beginning in 1999, and the effective abandonment at the multilateral level of any serious discussion of reform of the international financial regime, both served to create a sense of complacency and to mute discussions of alternative trajectories. In India, the process of financial liberalisation, which had halted to some extent over 1998, was renewed with much enthusiasm by the Bharatiya Janata Party-led government especially from last year. And the obsession with stock market development and with the perceived need to attract significant amounts of foreign portfolio capital, which was a feature of the Congress(I) government of the early 1990s, appears to be even more marked in the current government. In the process, little attention is paid to the actual post-crisis experience of the South-East Asian economies. In fact, even serious analysis of the processes leading up to that crisis are no longer given much significance.

This blinkered amnesia is more than just a pity; it could actually be extremely dangerous. Many of the recent tendencies and events in the Indian economy, and most especially in the capital markets, appear almost like an action replay of the pre-crisis South-East Asian experience, albeit in somewhat slower motion. An excellent new book on the Malaysian economy (K.S. Jomo, edited, Malaysian Eclipse: Economic Crisis and Recovery, London, Zed Books, 2001) shows both that the nature of the crisis and recovery have been quite different from the standard interpretation, and that there are still very pertinent lessons from Malaysia relating to capital market strategies in particular.

While the book provides a sober and analytical assessment of the earlier development strategy and the nature of the response to crisis, including the temporary capital controls, its prime usefulness in terms of policy implications for other countries lies in its assessment of the type of financial system. Unlike the three worst-affected economies of the region (Thailand, South Korea and Indonesia), the Malaysian financial system was less bank-based and provided a greater role for the capital market. In fact, the banking reforms of the late 1980s contained the most dangerous consequences of sequential financial liberalisation that affected several other countries. Strict prudential regulation and very limited exposure to short-term credit from abroad protected the banking system, which was in consequence much less adversely hit, and Malaysia managed to avoid the forced closure of banks and non-bank financial institutions that became commonplace in other crisis-affected economies of the region.

This meant that for the Malaysian economy the stock market played a much larger role in worsening the crisis than elsewhere in the region. Capital inflows into Malaysia increased substantially in the mid-1990s, with foreign portfolio flows dominating and creating much volatility. The authors point to the need to distinguish even within these portfolio flows, suggesting that the investment behaviour (and even investment duration) of pension funds, mutual funds and hedge funds can be quite different.

It was capital flight by portfolio investors that drove the crisis in Malaysia. The authors point out that while the introduction of capital controls 14 months after the onset of a crisis was bold and certainly not the recipe for disaster that monetarist critics claimed it would be, it actually amounted to closing the stable doors long after the horses had bolted. They argue that a more differentiated set of capital control instruments should instead have been in place well before the crisis, which would also have prevented or at least reduced the speculative boom that preceded the crisis.

THE Malaysian experience thus points quite directly to the role played by a liberalised financial system which promotes reversible short-term capital inflows, in creating the conditions for crisis. In the mid-1990s, the unsustainable "virtuous" cycle of asset price inflation (which the authors argue may have boosted growth slightly through the wealth effect and its limited multipliers in Malaysia's very open economy) quite easily turned into its antithesis, a vicious cycle of asset price deflation which in turn added to deflationary tendencies.

Not only that, speculative capital inflows also operated to shift producers' incentives away from tradable to non-tradable sectors in the economy, thereby contributing to the creation of the current account deficits which they were then used to finance. So, instead of accelerating the pace of economic growth, such inflows were important to finance the import of financial services, investment income payments abroad, growing imports for consumption, speculative activity in regional stock markets, and output of non-tradables, especially real estate. Thus the inflows contributed directly and indirectly to the asset price bubbles whose inevitable deflation was dramatised by the onset of contagion from Thailand.

There is another very important point made in this book, which is rarely noted in analyses of the South-East Asian rapid growth process. The dominance of multinational companies, especially in more sophisticated, dynamic and export-oriented activities, meant the subordination of domestic industrial capital in the region. This allowed finance capital - both foreign and domestic - to become more influential in the entire South-East Asian region.

Indeed, Jomo argues that "finance capital developed a complex symbiotic relationship with politically influential rentiers, now dubbed 'cronies'... In these and other ways, transnational dominance of South-East Asian industrialisation facilitated the ascendance and consolidation of financial interests and politically influential rentiers. This increasingly powerful alliance was primarily responsible for promoting financial liberalisation in the region, both externally and internally."

Jomo and co-authors point out that the recent recovery, in Malaysia as elsewhere in the region, has been due primarily to Keynesian-style reflationary policies. This shows that the prior necessity of corporate governance reforms, as demanded by the International Monetary Fund and others, is not a precondition for economic recovery. But they also note that the basic conditions which allowed for the crisis, in terms of a financial system open to reversible short-term flows, persist. And there has been no reform of the international financial system, which is the basic precondition for preventing such future crises.

A lot of the description of the pre-crisis Malaysian economy, as well as the nature of unfolding of the crisis, will appear eerily familiar to readers of recent editions of Indian newspapers. In fact, even the political economy processes that are described, bear some relation to the political economy pressures at work in India at the moment. This suggests that those who wish to avoid a similar asset deflation process, even if it is less intense and more prolonged, would do well to heed the lessons of the Malaysian experience.

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