What makes Hot Money Hot?

I pointed out last week that all countries (including the US) control their financial systems, since these are the most imperfect of markets, prone to panic and systemic collapse. I said the IMF viewed forex controls as old-style socialist controls rather than prudent supervisory ones, and so sought their early abolition. This was a grave error.

Left-wing critics in India blame IMF for blind adherence to the Washington Consensus. This is rubbish. The Washington Consensus was formulated by John Williamson, chief economist of the rid Bank for South Asia. Williamson has always said that full convertibility should be deferred to the very end of a liberalisation process. So IMF has been violating Williamson’s concept of the Washington Consensus.

All countries during World War II had forex controls, which were lifted very gradually. Europeans countries lifted trade controls first and capital controls much later. Britain became fully convertible only in 1979, Portugal and Ireland in the 1990s. Europe and Japan were always skeptical about IMF’s gung-ho attitude.

IMF recognised that full convertibility should take place in stages, yet wanted a transition in the Third World far more rapidly than Europe’s. It seemed to think that open markets for goods implied open markets for finance too.

This notion has been strongly contested by many economists normally regarded as Right-wing, including Jagdish Bhagwati. So the debate over convertibility is not a traditional Left-versus-Right one. Williamson is hardly a showcase specimen of Socialism.

In a recent article in Foreign Affairs, Bhagwati emphasises that banks and brokers handle other people’s money instead of their own, that leads 10 many risks, panics and system failures. These do not occur in markets for goods, so the two simply cannot be treated as analogous. Financial markets need supervision in ways that markets for goods do not.

The debt crisis of 1982 and Mexican crisis of 1994 were only the latest of a string of historical disasters caused by capital inflows that suddenly retreated. Highly- paid merchant bankers behaved like herds of cattle, stampeding in and out in euphoria and panic.

Bhagwati points out that many countries have achieved miraculous growth despite having capital controls. Totally free capital flows can indeed help, but also carry a huge risk of disaster. The potential gain is too small to make the risk worthwhile, he argues.

I have a separate point to make. The Asian crisis showed how weak and inept banks and supporting systems in the region were. But even in manufacturing, Asia is far less efficient than the US or Japan. Labour productivity in manufacturing in South-East Asia is perhaps a quarter of Japan’s. But wages there are one-tenth the Japanese wage, and that more than compensates.

No such compensating effect occurs in banks or financial markets.

There, local inefficiencies are not offset by low wages, for there is no low-paid army of proletarians and wages are a negligible part of total costs. Hence, investing finance in developing countries is far more risky than investing in factories, and so more volatile.

Much has been written about the volatility and dangers of hot money. Marxist professors and journalists warn that the daily turnover in world forex markets is now a trillion dollars, more than the combined reserves of all countries. This leviathan, they argue, must be controlled.

This, alas, is a typical Leftist misunderstanding of the problem, a reversion to the old Socialist notion that you must nationalise or control anything big. Please note that of the trillion-dollar daily turnover in global currency markets, 95 per cent is in rich-country currencies, which do not suffer at all from volatile capital flight. Only 5 per cent of currency trades are in Third World currencies, yet these can cause huge problems.

So clearly the problem is not size. Financial flows between London and New York are far greater than between New York and Jakarta, yet only the latter wreak havoc.

Hence, the popular notion that global capital represents hot money is false. Enormous flows between London and New York are cool, whereas tiny flows to developing countries can be hot. The heat arises not from the money, but from the countries.

In a developed country, expectations are astonishingly stable. Wall Street gets into a tizzy if US interest rates are raised or lowered 0.25 per cent, whereas some South-East Asian markets have seen interest rate changes of 25 percentage points. Stability in developed markets mitigates the risk of disaster. So every fall in prices is treated by other market players as an opportunity to buy cheaply, not as a disaster to run away from: Every movement one way produces a horde of contrarians moving the other way. A developed-country market is like a milling crowd.

By contrast, developing-country markets look like stampeding herds. Euphoria and panic are more common and much greater in such markets. If enough players move one way, everyone runs in the same direction. Players see a big change as a risk rather than an opportunity. Contrarians, so plentiful in rich countries, are scarce in developing ones.

Why do the very same investors who are contrarians in New York turn into herds in Jakarta or Bangkok? The answer is that in risky places, running with the herd is a rational way of reducing the chance of being stranded. Lone wolves are easy prey, but a wolf pack is strong.

Now herd behaviour may cause the financial system to collapse. But each member of the herd is trying to save his skin, not the system. So to protect the national interest, you need prudential supervision that minimises the risk of the system collapsing, reduces instability, and thus encourages contrarians.

Supervision is not enough. Rich countries have a huge ‘soft’ infrastructure for finance in the shape of strong, supporting institutions that help mitigate risks. They have good lending skills, high accounting standards, voluminous information systems, high-quality supervision, good governance (that penalises crooks and manipulators, and compensate innocent victims). This supporting infrastructure is weak or absent in developing countries. Until it develops—and that could take decades- -risks in developing markets will always be much larger. Herds will dominate contrarians.

So there is a strong case for following Williamson’s advice, and putting off full capital convertibility till the end of the liberalisation process.

However, the reason for doing so is not the Left-wing one of socialist controls on anything big.

I am distressed that many Indian politicians are patting themselves on the back, saying controls in India have prevented the sort of financial carnage seen in South- East Asia.

Now it is certainly true that if you bind your banks hand and foot, they will not have enough rope to hang themselves (as happened in South-East Asia). But a trussed and gagged banking system is no cause for satisfaction or self-congratulation.

We do not need a quick rush to a fully convertible rupee. But we urgently need reforms to make our banks strong and capable; to make corporate accounts reveal the truth and not the fiction they do today; to improve governance so that crooks and manipulators are jailed instead of dominating the financial community. We need the right reforms in the right sequence.

Finally, remember that even if all developing countries clean up their financial systems and governance soon, that does not necessarily mean lifting all controls on capital flows.

The financial systems of the US and Europe are all regulated, and on similar prudential grounds there is a case for regulating international capital flows too.

We certainly do not need Socialist controls, we certainly do not need a licence-permit raj, yet we need to fashion appropriate prudential controls in financial markets.

How should we reshape IMF and the whole international financial system to achieve that goal? Read about it in this column next week.

What do you think?