The real face of financial liberalisation

Print edition : February 13, 1999

An economy open to global financial flows tends to get caught in the mire of stagnation and lower social expenditures, both of which impinge adversely on the poor. This is what has happened in India.


THE term "financial sector reforms" is a euphemism for "financial liberalisation" which the Bretton Woods institutions have been advocating for Third World economies, and which a host of them as well as former socialist countries like Russia have actually adopted. The essence of financial liberalisation consists in three sets of measures: first, to open up a country to the free flow of international finance; secondly, to remove controls and restrictions on the functioning of domestic banks and other financial institutions so that they get properly integrated as participants in the world financial markets; and thirdly, to provide autonomy from the government to the central bank so that its supervisory and regulatory role vis-a-vis the banking sector is dissociated from the political process of the country, and hence from any accountability to the people. To be sure, not all these measures are immediately contemplated or demanded, but they represent the ultimate goal of financial liberalisation, which may be ushered in by stages.

The Bretton Woods institutions contrast financial liberalisation with what they call "financial repression", that is, the regime which was erected in India in the post-Independence period. What this regime visualised was a subordination of the financial system to the perceived needs of economic development. To this end, interest rates were kept low; banks and financial institutions were required to hold government securities up to a certain per cent of their total liabilities (the so-called statutory liquidity ratio), permitting the easy sale and cheap servicing of public debt; credit was directed to priority sectors, including especially agriculture; the Reserve Bank was retained as a part of the government and hence accountable to Parliament for its actions; banks were nationalised to ensure that they did not shirk their social obligations and established branches all over the country; strict controls were exercised on capital flows into or out of the country; and of course a fixed exchange rate with no current or capital account convertibility was maintained. There were no doubt problems with this regime, arising from the fact that the economy was experiencing capitalist development, and hence the credit needs of vast masses of small producers and even small capitalists could not be met cheaply from institutional sources. But within this overall constraint, the logic of the regime was to make the financial sector serve the needs of development, which, it was believed, necessitated its three main features, namely, its being anchored to the national economy and detached from world financial flows; its being obliged to give precedence to production over speculation for which it also had to observe controls on the price and direction of credit (not that speculation did not thrive but the objective of the regime was to control it); and its being accountable to the people via the government.

The purpose of financial liberalisation is to reverse all these features: to detach the financial sector from its anchorage in the domestic economy and to make it a part of the international financial sector; to make it operate according to the dictates of the market which means the end of cheap interest rates, of the regime of directed credit and of the distinction between productive and speculative credit needs; and to remove it from the ambit of accountability to the people. In short, the purpose of financial sector reforms is to make the financial sector an aliquot part of "globalised finance."

This, it is argued, would serve the development needs of the country better than the previous regime did, by attracting large amounts of foreign capital into the economy. This argument, however, fails to draw a crucial distinction, namely between capital inflow that adds to the productive capacity of the economy, and capital inflow that does not. Direct foreign investment (DFI), and that too not all of it but only a part of it, genuinely adds to the productive capacity of the economy. This is the DFI which locates production on our soil for meeting the global market or which produces goods essential for us but for which we lack the technology. But DFI which produces goods for the home market that only supplant what is being already produced does not add to our productive capacity: on the contrary it causes an implicit form of deindustralisation. And all capital flows in the form of deposits or portfolio investments constitute short-term flows that are essentially speculative in nature which do not add directly to productive capacity.

Financial liberalisation is undertaken in the name of attracting the first kind of capital inflow, but, for a variety of reasons, it scarcely succeeds in doing so. First of all, the total amount of all DFI inflows to the Third World (other than China which is in a separate category) is limited; secondly, even this limited amount is declining in the wake of the East Asian crisis; thirdly, productive, that is, non-deindustralising capital inflows, are even more meager; and finally, all "liberalised" economies are chasing these meagre inflows. Under these circumstances, financial liberalisation scarcely gives a boost to productive capital inflows. What it does, however, is to expose the economy to the vortex of speculative capital movements, that is, to the flows of short-term finance in search of quick profits.

SUCH exposure of the economy has at least three very important consequences. First, it causes deflationary policies in general and hence slows down both the growth rate of the economy and the magnitude of increase in social expenditure. Secondly, it exposes the economy to severe episodes of crisis, such as were witnessed in Mexico earlier and in East and South-East Asia recently, and these, among other things, cause "denationalisation" (that is, passing into foreign hands) of key domestic resources and means of production. Finally, it abrogates sovereignty and undermines democracy.

Let us look at these issues seriatim. In a world where finance capital is free to move wherever it likes, the tendency for it, other things remaining the same, would be to move to the advanced capitalist countries from the backward economies. In other words, not only the finance capital originating from the advanced countries themselves but even the finance capital originating from the backward economies would tend to get concentrated in the metropolitan centres where capital feels that it enjoys greater safety, greater social stability, and less of a threat to its hegemony. To counter this, therefore, the backward economies have to ensure that "other things do not remain the same", that is, have to offer blandishments to prevent capital from flowing out. These blandishments take the form, among other things, of higher real interest rates on average than those prevailing in the advanced countries. Financial liberalisation therefore is inevitably associated with an increase in interest rates compared to what prevailed earlier and with higher interest rates than in the metropolis. The increase in interest rates has an adverse effect on productive investment directly. It also has an adverse effect indirectly: it makes the servicing of public debt more expensive and hence squeezes the public exchequer, leading to lower public investment and, via the demand and supply constraints it causes, to lower private investment as well. The squeeze on the public exchequer also affects welfare expenditures adversely.

This squeeze could be averted if the government could raise larger tax revenue or could run a larger fiscal deficit. But in an economy exposed to free movements of finance capital, neither of these options is possible. Larger taxation of companies drives away capital, both productive and speculative; and larger indirect taxation is not possible when the government is committed to tariff reduction, which implicitly curtails the scope for excise duty increases as well (for otherwise there would be gratuitous deindustrialisation). Likewise, larger fiscal deficit has to be eschewed because, apart from violating the injunctions of the Bretton Woods institutions, it frightens away speculators. For all these reasons, an economy open to global financial flows tends to get caught in the mire of stagnation and lower social expenditures, both of which impinge adversely on the conditions of the poor.

THIS is exactly what has happened in India. Despite the fact that financial liberalisation in India is still incomplete, the real interest rates in the post-liberalisation era are much higher than what prevailed earlier, and this is one of the major factors accentuating the fiscal crisis and contributing to the cuts in public investment and social expenditure. The argument is often advanced that higher real interest rates encourage larger savings and hence make possible a larger investment ratio without causing higher rates of inflation. In post-liberalisation Indian economy, however, the investment ratio has not increased compared to what prevailed earlier, even as the inflation rate on average is, if anything, higher rather than lower. And yet the fiscal crisis has been aggravated, and public investment and social expenditures have been drastically cut, which only underscores the vacuity of the savings argument.

But this is not all. An economy that has undertaken financial liberalisation also becomes vulnerable to crises. When short-term funds flow in, they tend to cause an appreciation of the exchange rate, the consequence of which is to make imports cheaper relative to home production and hence lead to deindustrialisation. But if this is avoided through central bank intervention which supports the exchange rate by holding foreign exchange reserves, then that in turn enlarges liquidity in the economy, which is typically used either for an expansion of luxury consumption or for an expansion of investment in the domestic non-tradeables sector such as real estate, or for financing speculative booms in asset markets, especially the stock market. When short-term funds begin to flow out, there is both a downward pressure on the exchange rate and a collapse of asset prices, which reinforce one another, and cause an avalanche of outflow. Efforts by the central bank to manage the foreign exchange market by raising the interest rate to induce short-term funds to stay or to come back, have very little effect, or even have the opposite effect of further enhancing outflows by aggravating the asset-market collapse. On the other hand, interest rate increases lead to a contraction of the real economy. Thus, while the inflow of short-term funds, generally, has little impact by way of increasing the growth rate of the real economy, the withdrawal of short-term funds does affect the real economy adversely. And while the inflow of short-term funds occurs over a period of time, the outflow can be sudden, concentrated, and extremely destabilising, causing acute misery to the people, as we have seen in the case of the East and South-East Asian countries.

This extreme and acute nature of the crisis, to recapitulate, arises for the following reason: each of the two circumstances we have mentioned, that is, the downward pressure on the exchange rate and downward pressure on asset prices, can trigger a capital outflow and hence precipitate the other. They therefore reinforce one another in unleashing an avalanche of capital outflow and adding to the intensity of the financial crisis, which necessarily spills over to the real sector. The crisis can be triggered by either sources, but, once triggered, incorporates both foreign exchange and asset markets which conjointly aggravate it to extreme acuteness. Opening the economy to the vortex of international financial flows, therefore, apart from generally keeping the economy deflated, exposes it to acute crises triggered either in the foreign exchange or in the asset market, by the caprices of speculators.

THIS is exactly what happened in South-East Asia. These countries had used short-term capital inflows for investment in the non-tradeables sector. In particular a whole range of investment projects in real estate, in office buildings and in the expansion of financial services had been financed by domestic capitalists through short-term foreign exchange loans organised through domestic banks, after the onset of financial liberalisation. But when short-term funds began to be withdrawn, there was pressure on the foreign exchange market, and a rise in interest rates, under the advice of the International Monetary Fund, to counter that pressure. But this only resulted in a reduction of asset prices, an increase in the incidence of insolvency among the capitalists who had used borrowed foreign funds, and hence a threat to the banking system that had organised these loans: this caused an even larger outflow.

Financial liberalisation, therefore, was at the root of the South-East Asian crisis. To be sure, the earlier impressive growth performance of South-East Asia could not have been sustained in any case in the face of the slowdown in world trade. But these countries would not have got into such acute distress if they had not pursued a policy of financial liberalisation. This simple fact is sought to be obscured in various ways by writers emanating from the Bretton Woods institutions. Two favourite explanations of the crisis in these countries advanced by such writers run along the following lines: first, the crisis was caused because proper "norms" were not followed by the banks (this is often attributed to "crony capitalism", forgetting the fact that all capitalism is crony capitalism); the second explanation is that these countries failed to depreciate their exchange rates in time when their trade deficits were widening, and relied instead on short-term funds to finance widening current account deficits.

Both these arguments are vacuous: if free financial markets are supposed to be efficient allocators of resources, then they should have ensured that the exchange rate depreciated at the right time, and that banks that did not follow the correct "norms" did not succeed in obtaining funds from abroad. The fact that the markets did not ensure these suggests that the markets are not the efficient entities they are supposed to be, which undercuts the argument advanced in support of financial liberalisation.

As a matter of fact, precisely because of the operation of speculative forces the markets are not efficient allocators of funds. Precisely because of speculation, the actual movement of funds depends not on the so-called "fundamentals" but on short-run expectations of gains. And there is no way of knowing, except after the event, what should have been the correct price of foreign exchange or the correct amount of external funds inflow. The market is intrinsically incapable of distinguishing between speculation and enterprise. Hence the root of the crisis lies in financial liberalisation which engenders speculation. When the very agencies that advocate financial liberalisation tut-tut about speculation and pretend as if that is because of some local specificities of these countries, they are being dishonest.

The third important implication of exposing the economy to the vortex of international financial flows is that it undermines democracy and sovereignty. The essence of democracy is the pursuit of policies in the interests of the people. This of course does not happen in practice in societies characterised by class antagonisms, but even in such societies, the existence of democratic institutions acts as a check on the extent to which the people can be squeezed. An economy exposed to the free flow of international finance capital, however, is obsessed with the need to appease international financiers, to retain their "confidence": the thrust of policies in such an economy therefore, even in principle, is not towards serving the interests of the people but towards serving the interests of the speculators, which represents an inversion of democracy. The compulsion to serve the interests of international financiers at the expense of the people is reconciled with the fact of the existence of democratic institutions such as popular elections through several mechanisms: first, various efforts are made to attenuate democracy, such as the presidential form of government (under which, in Russia for example, unprecedented hardships have been inflicted on the people), or the removal of key decision-making from outside the purview of the political process (for example, the autonomy of the central bank). Secondly, and more pertinently, the objective constraints of such an economy make different political parties adopt the same economic programme. A Carlos Menem of Argentina gets elected as a Peronist candidate with working class support but proceeds immediately to squeeze the working class in order to appease international finance capital. A Fujimori of Peru does the same. In India three successive governments have pursued the same economic policies, and in the case of the Bharatiya Janata Party-led Government, policies which are in clear violation of those on the basis of which the BJP had sought the people's mandate.

THE reason for this effective restriction of choice before the people in the matter of economic policy lies in the objective situation of an economy with financial liberalisation, where losing the "confidence" of international speculators does indeed create massive immediate problems for the people. In other words, within the confines of a financially liberalised economy, if appeasing the international speculators imposes hardships on the people, then not appeasing them also imposes, in an immediate sense owing to capital outflows, hardships on the people. Since bourgeois, or even social democratic, parties lack the political will to come out of the confines of such an economy, they have to choose only between these alternatives. Or, looking at differently, unless the confines of such an economy are transcended, the choice before the people gets restricted to a point where democracy, and with it sovereignty, gets undermined.

Transcending the confines of such an economy is far more difficult than not creating such an economy in the first place. In countries like India where financial liberalisation still has not proceeded very far, it must be ensured that it goes no further. The basic argument advanced in support of it, namely that it would accelerate growth through capital inflows, is invalid. On the contrary, the type of capital flow that it does expose the economy to is such that democracy is undermined, growth and social expenditures are cut, and the threat of speculation-engendered crises becomes pervasive. As against such a regime, the real alternative to the dirigiste strategy of the Nehruvian kind lies elsewhere. If land reforms, larger public investment and social expenditure financed by direct taxes on the rich, and decentralised decision-making by elected bodies constitute the core of an alternative development strategy, then the appropriate financial regime must be one that dovetails with this alternative strategy. Subordination of finance to the needs of production is an essential condition of growth. This is what underlay the Asian miracles and this is also what the Indian dirigiste strategy brought about. The problem with the latter was not this fact of subordination but the fact that the strategy itself was at fault. It has to be replaced by a democratic redistributive strategy, and the direction of financial reforms must be such as to serve such a strategy. In other words, what is needed is financial reforms in keeping with an alternative democratic strategy, not financial liberalisation.

This is based on a paper presented at a National Seminar on financial liberalisation organised in Ernakulam on January 19, 1999 by the Bank Employees Federation of India (BEFI) in connection with its 5th All India Conference.

Dr. Prabhat Patnaik is Professor of Economics, Jawaharlal Nehru University, New Delhi.

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