To What Extent Does External Financial Liberalization Affect Country Risk

Theoretical literature proposes that external financial liberalization would benefit by allowing them a smoother consumption through international risk sharing. Empirical evidence recently, however, does not support this paradigm.

Basically, external financial liberalization creates exposure to the following kinds of risk: both external and internal financial crisis propensity; reduced access to funds for small-scale producers and a deflationary effect on real economic activity. Consequently, this results in major social effects like volatile material conditions and unemployment for most citizens. Financial crisis propensity Financial liberalization results in in an increase in financial fragility, especially in developing countries. This makes them prone to currency and financial crisis. Evidence on capital inflows show that once an emerging market has been “chosen” as an attractive destination by financial markets, processes are consequently put in motion that often lead to crisis. This is as a result of the effects of a surge of capital inflows on exchange rates.

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However, this does not happen where the capital ends up adding to reserves instead of adding up to an increase in domestic investment. Investment in non-tradable sectors like real estate and domestic asset market generally, result from an appreciating real exchange rate. In addition, the upward movement of the currency discourages trade in tradables. In developing countries, this contributes to a relative decline in real economic sectors and deindustrialization. Difference in interest rates between international and domestic markets, in addition to, a lack of discretion by international lenders and investors, results in local agents borrowing heavily from abroad to invest in stock and property markets.

It is, therefore, no accident that all emerging market economies experiencing significant capital inflows also experienced stock market and real estate booms while the real economy may have been declining. These booms result in incomes that maintain domestic demand and growth in particular sectors of the economy growing at significantly high rates. With time, this leads to signs of macroeconomic imbalance in the current account deficit. This is a direct reflection of the impact of debt-financed private licentiousness. Since the Asian crisis of mid-1997, the significance of comprehensive macroeconomic policies after the liberalization of financial flows has been constantly emphasized.

Many emerging markets have faced problems resulting from allowing their current account deficits to grow too large, and reflect an excess of private, domestic investment over private savings. Fiscal deficits are not the ony macroeconomic imbalances for the government to worry about. This is the belated realization, but it still misses the fundamental point. And, the point is. With entirely uninhibited capital flows, a country cannot control the inflow or outflow amount of capital. Both movements can, consequently result in undesirable consequences if unbridled.

For instance, consider if a country is suddenly chosen as a foreign portfolio investment site. This would in turn result in huge capital inflows causing the country’s currency to appreciate. Rather than encouraging trade in tradables, this would inspire trade in non-tradables. This will then alter domestic relative prices and, moreover, incentives. At the same time, the inflows of capital are associated with current-account deficits, unless they are simply and wastefully stored as accumulated foreign-exchange reserves.

The basic macroeconomic problem, therefore, is that large current deficits are necessary by-products of a surge in capital inflow. Any country that does not exercise control or moderation over capital inflows will be subject to these pressures. At some point, the deficits can be too large and unsustainable that conditions are set in place for their own eventual reversal. In other words, there can be “prudent” macroeconomic policies once there are completely free capital flows, and a complete access to external borrowing by private, domestic agents. The behavior of capital flows determines the overall domestic balances or imbalances.

Deflation and developmental effects Financial liberalization is biased towards deflationary macroeconomic policies. It also forces the state to take up deflationary measures to appease financial interests. For starters, the need to attract international capital means that a country has to limit taxation, especially on capital. Prior trade liberalization will have also reduced the country’s indirect tax revenue. Therefore, after undertaking liberalization, tax-GDP ratios deteriorate.

This, in turn, imposes a limit to government spending, since capital is opposed to huge fiscal deficits. This reduces the growth-oriented activities of the government, in addition, to affecting the country’s possibility of countercyclical positions. Deficit financing is seen as an increase on the liquidity overhang in the system. It is, therefore, considered potentially inflationary. Inflation erodes the real value of assets.

In addition, government spending is usually “sovereign”. Using debts to finance such autonomous spending is usually viewed as bringing an arbitrary player, not profit motivated, into financial markets. Financial interests privilege the role of markets. If the state intervenes, it is seen as de-legitimizing the rrole of finance. Financial markets, therefore, prefer the control and reduction of government deficits. There is a limit to the amount that borrowers are willing to pay to finance agriculture and manufacturing, inasmuch as the maximum return on investment in respective fields is unlimited.

The social returns to manufacturing and agriculture investment are higher compared to real estate or stocks. However, despite this contribution to poverty alleviation and economic growth, financial credit for these investments may not be available. This is the reason why liberalization can be detrimental to the very financial structures that are important for growth of the economy. When the financial sector is left unregulated or under-regulated, the allocation of investible resources, and, consequently, the demand for and allocation of savings, is determined by market signals and financial enterprises. The allocation of investments and savings is determined by private rather than overall social returns.

These results in a propensity to direct credit finance to import-intensive less prioritized but more profitable sectors. Investible funds are left under the responsibility of a few large players who channel savings to already developed sectors of the economy. The social role of financial intermediation is thus lost, with effects largely on employment-intensive sectors like small-scale enterprises and agriculture.For example, the agrarian crisis facing most parts of the developing world can be substantially blamed on inaccessibility of institutional finance, which is a consequence of financial liberalization in these countries. Reduced credit to peasant farmers and small-scale producers has led to inaccessibility to working capital, rising costs and a reduction in the economic feasibility of cultivation.

By destroying these fundamental structures like agriculture, financial liberalization destroys the vital instrument of growth in society. Finally, across the globe, financial liberalization has only generated huge net flows of capital to developing countries. However, net outflows have been in the reverse direction in past several years. There has also been no noticeable increase in investment rates in emerging markets, who are substantial recipients of capital inflows. Instead, these countries have built up external reserves as a precautionary measure against financial crises.

For instance, in 2003, East and South Asia received approximately 186 billion U.S dollars of capital inflows. They, however, added to their foreign exchange reserves amounting to 245 billion U.S dollars the same year. However, in financial terms, developing countries are losing because the overall cost of holding these reserves exceeds the rate of interest that these debt capital inflows carry.