Foreign Policy: The Coming Fight over Capital Flows

Foreign Policy
Winter 1998–99

The Coming Fight over Capital Flows

By Robert Wade _*

This abstract is adapted from an article appearing in the Winter 1998–99 issue of FOREIGN POLICY. In the face of the Asian economic crisis and gathering world slump, deep differences in opinion have opened up between the United States on the one hand and Asia and Europe on the other. These differences bear directly on the American design for a new world financial architecture and on American leadership of the world economy.

The United States believes that the current economic turmoil in Asia, Latin America, Russia, and much of the rest of the world has “home-grown” causes, particularly corrupt national banking systems that promoted misallocation of resources away from their most efficient uses, a position which the IMF supports. The United States proposes a “new global financial architecture” based on transparency, accountability, globally uniform standards, minimization of scope for “moral hazard,” and free capital movements to solve the problem.

Asia and the European Union do not share this view. On balance, they believe that the Asian crisis has its roots in the radical financial liberalization undertaken by governments of the region during the 1990s, reforms encouraged by the IMF. The EU is cautiously suggesting a new global architecture in which the world would be divided into monetary zones, each with some degree of protection through government controls on the movement of capital. This idea is also receiving support in Asia.

The current slump has brought these policy differences between Asia, Europe, and the United States to the fore. But what are the interests underlying the differences between U.S. plans for the world economy and those of Asian and European countries? The United States has a powerful interest in maintaining and expanding the free worldwide movement of capital. Because the U.S. savings rate is very low, the United States needs to tap the rest of the world’s savings to maintain its high level of consumption and investment. Moreover, Wall Street banks and brokerage firms want to expand their sales by doing business in emerging markets; capital controls have prevented such expansion. Finally, it is in the U.S. interest to have the rest of the world play by American rules for both international finance and multinational corporations.

The United States sees free capital movement as a wedge that will force other economies to move in its direction. As a result, the U.S. Treasury has been leading a campaign to get the main international economic and financial institutions to promote capital liberalization: Efforts include a revision of the IMF’s constitution (its articles of agreement) to require countries to commit themselves to capital account liberalization as a condition of fund membership and the World Trade Organization’s financial-services agreement commits countries to open their banking, insurance, and securities markets to foreign firms.

Asian governments see capital controls as a way of buffering their economies from the instability caused by fast inflows and outflows. Malaysia has recently imposed capital controls and Japan’s government has been considering doing the same. International Monetary Fund and U.S. officials expressed displeasure at these developments, also at Hong Kong’s and Taiwan’s introduction of restrictions on speculative currency trading.

This buffering is all the more important considering the relative lack of experience among most countries in the region in dealing with the international capital market and the thinness of banking regulation and supervision. In addition, the growing Asian sympathy for capital controls is based on the realization that Asian economies do not need to draw on the rest of the world’s savings. They are the world’s biggest savers saving about one-third of GDP. Finally, Asian perceptions of Asia’s interests are colored by resentment of American triumphalism.

The new German government has fortified the EU’s opposition to capital liberalization. European policymakers are worried about the fragility of European financial systems, which are dominated by banks. European banks depend heavily on interest rate spreads for their profits, more so than U.S. banks. Free capital movements squeeze banks’ interest rate spreads and hence their profits. European political leaders have also been more prepared than their American counterparts to recognize the damage that volatile money has done in the Asian crisis and thus to support capital controls as an integral part of the new world financial architecture.

A vast canvas of political battle has opened up. If the world deflation continues, and especially if the Europeans and the Japanese raise the stakes by talking seriously of a new Marshall Plan and debt write-offs as a new basis for world reflation, the United States may make tactical concessions on emergency capital controls as the lesser of two evils. But the differences in interests are real, and the United States—the U.S. Treasury, Wall Street, and multinational corporations—will resume pushing for free capital markets worldwide when the emergency passes. In the changed political landscape, however, it is by no means clear that the United States will win. Nor should it. The world is badly served by free capital flows. If we are wise, we will now strive to re-create an international regime that permits multiple forms of national political economy to flourish.