:: Jayati Ghosh

Return migration of capital

Jayati Ghosh

May.05 : The International Monetary Fund (IMF) — which must be the current world champion in recognising reality after the fact — has just come out with its latest Global Financial Stability Report. And guess what they have found? Global financial stability has deteriorated even further since their previous assessment in January, which was already pretty gloomy. And this time, things are worst not in the economies that were the cause of the current troubles, the US and the UK, but in the developing and transition countries.

It was always known that with global integration, there was bound to be a strong contagion effect of a crisis in the core capitalist countries. But it was not really expected that things would turn out to be even worse for some developing countries, especially when the governments of these developing countries had been faithfully following all the market-friendly and fiscally-disciplined prescriptions doled out by the current economic orthodoxy.

What is remarkable is that the global slowdown in exports is turning out to be only one — and typically not even the most significant — of the problems facing these countries. The feature that is hitting many developing countries is the sudden reversal of capital inflows. The IMF estimates that net private capital flows to emerging markets was only 1.34 in 2008 (compared to more than 5.5 per cent at its peak) and will be a negative 0.15 per cent in 2009. Much of this is on account of portfolio and "other" investment, which are estimated to be negative in both years, whereas the flow of FDI is expected to be positive, though smaller. This is not surprising since heavily leveraged firms faced with redemption pressures, such as hedge-funds, have played an important role, with nearly one-third of the $23bn in assets under the management of such funds in emerging markets having been repatriated in the fourth quarter of 2008.

This process of "deleveraging" is a reflection of the need of international banks and financial firms to withdraw capital from emerging markets to meet demands at home. But has had very damaging effects in emerging market countries. Stock markets have collapsed and currencies are depreciating sharply. Corporations that have accumulated foreign exchange liabilities find that declining revenues and higher cost of acquiring foreign exchange are squeezing profits, delivering losses and even threatening bankruptcies. Banks that have lent to these corporations are recording increases in non-performing assets and are cutting back on credit provision. And the flight of capital implies that consumers and investors who financed large consumption and investment expenditures with credit are being forced to cut back, worsening the shrinkage of demand. This is a vicious cycle that drives the downturn in emerging markets, some of which, according to the IMF, have become the focus of the crisis in recent months.

The other big decline has been in external commercial borrowing with multinational banks effectively going back home in terms of the credit they are willing to offer. According to recent estimates from the Bank for International Settlements, cross-border lending by banks shrank by $4,800bn in the nine months to December 2008, the sharpest fall ever recorded.

Nearly all the decline in foreign loans came from banks in western Europe which had substantially expanded their cross-border lending in recent years. US and Japanese banks, which had not expanded their international lending as aggressively in the pre-crisis period, actually increased slightly their holdings of foreign assets in the quarter. UK registered banks delivered the biggest overall decline in overseas lending, with foreign assets falling by £604bn in the quarter. While American banks have not yet shown the same tendency, other financial investment from the US has behaved in a similar fashion: thus Americans repatriated $750bn in the last three quarters.

At one level this is a classic response to crisis and uncertainty, as banks and other financial investors allow homing instincts to dominate over more rational perceptions of risk and the inherent strengths of different markets. But it is surprising in the context of the mainstream wisdom on the source of the global imbalances that led up to the current crisis.

The mainstream view on global imbalances was that it reflected changed savings behaviour of surplus countries, including those in the developing world. It was argued that developing countries, especially those in Asia, had turned cautious after the crises in 1997 and were therefore holding the foreign exchange they earned from exports as reserves. The resulting "global savings glut" was accompanied by a flow of capital to the developed countries, particularly the US, financing not just the current account deficit but also the boom in stock, housing and commodity markets. Because the resultant excess spending that generated the upswing in goods and asset markets in the US could not be sustained forever, the boom had to unwind through a process that inexorably led to a recession.

The first problem with this argument is that it misses the fact that in the case of most developing countries, including many of the exceptional performers in Asia (barring cases like China, where net exports were significant), the accumulation of foreign reserves was the result of the inflow of capital. Second, this inflow of capital took the form of a supply-side surge driven by financial developments in developed countries, with financial institutions in those countries being the "source" of capital.

Many developing countries had begun liberalising their rules with regard to capital inflows in the early 1990s and had gone the distance by the time of the 1997 crisis, after which capital flows to developing countries in Asia were curtailed. The resurgence of inflows after 2004 was not specifically driven by any new policy changes in the recipient countries, but by a push generated by excess liquidity in the source countries. The error on the part of the emerging market countries was that they had not imposed restrictions on capital inflows after the 1997 crisis, making them vulnerable to surges in capital inflows followed by reversals.

The crisis in some of these countries is a result of the reduction of these inflows. This is particularly true of transition economies of eastern and central Europe, several of which are in the throes of a severe external debt crisis.

But it is also true of several emerging markets in Asia, such as Indonesia and South Korea. In India we have so far seen only part of the negative effects. A full-blown payment crisis is yet to occur.