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Can we trust capital markets?

Time (GMT +00) 13:00 14:15

Avinash Persaud, State Street Bank
Benu Schneider, Overseas Development Institute
Rupert Pennant-Rea

Avinash Persaudquoted Mahatma Ghandi: 'the measure of a civilisation is the way its people treat their poor'. He recommended that capital-starved countries pursue a mix of the five different sources of finance capital available to them, including bank borrowing, capital markets and foreign direct investment (FDI). He said it is reprehensible that developing countries face higher tariffs than developed countries who fiercely defend their domestic monopolies, and gave the U.S. State pension funds investing in South Africa in the 1980s as an example.

With the growing scarcity of pure aid and dwindling official assistance, there is a clear role for humanitarian assistance and problematic aid is best graduated away from. Bank loans can lead to situations such as that in the Latin American sovereigns in the 1980s. FDI is better, but negotiating skills are lacking in developing countries. Avinash Persaud recommended equity markets which makes countries stakeholders and voters in the world market.

If OECD countries invested in foreign markets, returns would be higher, risks lower and diversification more possible. If emerging market economies received some of these flows, they would receive $150bn today, instead of the actual $25bn where they miss out on cross-border portfolio flows, and bust/boom is a possibility. Although bond portfolios share the same characteristics of a short-term loan and were instrumental in the Asian crisis, G7 countries continued to promote them. Attempts to lock them in are laudable, he said, but only encourage flows to leave even faster. The value of a stable equity portfolio, where traders move prices, is much more informed by a capital gain. Equity, like FDI, can provide more than just capital and, additionally, demands effective regulation, strong governance, international disclosure and accountability. For it to work, restrictions and regulations that impede should be removed, while ones that promote should be adopted. Suspicion of capital markets in the developed world, Avinash Persaud concluded, does a disservice to the poor.

Benu Schneider wondered if, given the advantages and disadvantages of different types of capital flows, it is possible for developing countries to effectively access the right mix according to the level of financial development and other parameters in the domestic economy. She argued that official borrowing still had a very important role to play in emerging markets in the transition period which would allow these economies to implement reforms targetted at strengthening domestic financial markets, supervision and regulatory standards and giving their domestic economies the resilience to deal with the vagaries of international capital markets. Working out the transition process, in her view, was the key to successful capital account liberalisation. She felt that very poor countries benefit best from official assistance and FDI for natural resources and trade credit. However, FDI too was volatile although less than other components of capital flows, and one had to worry about the sources of volatility and analyse whether it can lead to a crisis situation. Benu Schneider particularly emphasised the management of liabilites created by FDI and pointed to the transactions through which investors can exit a country. Portfolio flows are volatile but bond flows are more volatile than equity flows. Bonds have shown reversibility trends more than equity flows. Our understanding of capital markets is not complete. It is only after each crisis that we understand more, and often it is better, in the cost-benefit analysis, to pay a higher price and opt for more stable flows.

Benu Schneider's account of the characteristics of bond and equity markets can be seen in in his presentation. Exchange rate policy has important implications regarding bond and equity flows. Bond flows tend to flow to countries with more stable or fixed exchange rates. Rethinking is needed by the IMF and G7 which expressed that deeper bond markets and liquity are needed. Recent experiences in Argentina and South Africa put some doubts on their policy advice. More research is needed to analyse different components of capital flows. The correct mix of capital flows and diversification is needed, rather than just liquidity of flows. Accepting the distinction between bond and equity flows opens up the debate as to whether exchange rate policy decisions come first in view of which type of flow a country deems it right to attract. There is a sequencing issue with respect to bonds and equities too. It is debateable as to whether bond markets should be developed first or not. Many entries for capital account liberalisation were accepted without meeting the pre-conditions. Apart from the pre-conditions and sequencing issue, Benu Schneider emphasised the need to distinguish between capital controls and prudential restrictions. It is necessary to see which of these controls impeded financial intermediation and which were necessary to protect a country from undue risk exposures. Many prudential restrictions were thrown out in may countries as controls were perceived to be negative. Some countries in transition, such as Uganda, which pursued a large current and capital account liberalisation programme did not even keep the necessary instruments to track the distinction between current and capital account transactions. We need a wider discussion on this so that if a particular country needs to re-introduce restrictions on some instruments/sectors as a matter of prudence, that this is not seen as a credibility issue in domestic and international markets. Benu Schneider believes that the lack of information on other capital flows generated by FDI may lead to the next economic crisis. In conclusion she believes capital markets have proved to be more efficient for industrialised countries which have access to re-finance, than for developing countries which do not, and that we have not made enough progress in international financial architecture to deal with the issues which emanated from the last crises.A number of points were raised in the discussion.

An international law on bankruptcy for states and governments might lead to better international capital markets in developing countries, but pursuing an international treaty would be difficult and sensitive investors might be further put off by legal interference.

As an alternative to the diversity advocated by Avinash Persaud, and to the (limited) credit guarantees offered by the IMF, perhaps increased finance directed into emerging country bonds could be underwritten by the G7 countries to increase short-term finance flows in developing countries, to insulate them from global recession.

Multinationals with good projects attract capital and domestic saving. Perhaps the answer lies in capital flows being in the real, not private sector. However, as with the 'dot.com bubble', capital is still needed to start up. Absorption and 'round-tripping' of flows are problems, and there needs to be an efficient allocation of domestic resources before a country integrates with international capital markets.

Capital account liberalisation is not a static event. It is a dynamic process and countries can, over time, have different degrees of capital account liberalisation consistent with their underlying conditions and external international environment.

The weaknesses of information flows, transparency and lack of a level playing fields are problems. A renewed understanding in developing countries of the psychology of investors, governments and business, is essential.


During the event they discussed how capital-starved countries pursue a mix of the five different sources of finance capital available to them, including bank borrowing, capital markets and foreign direct investment (FDI).