[PEN-L:7726] Capital Flows And Exchange Rates

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Foreign Policy In Focus

Vol. 4, No. 17,  June 1999

Capital Flows and Exchange Rate Policy

By Ellen Frank, Emmanuel College
Edited by Tom Barry (IPS), and Martha Honey (IPS)


Key Points
o	Countries are under increasing pressure to attract international
financial capital to meet trade and balance of payments needs.
o	To enhance their attractiveness to investors, countries are urged to
allow full and free convertibility of their currencies while attempting to
stabilize their exchange rates.
o	A stable exchange rate is fundamentally incompatible with unrestricted
speculative capital flows. Efforts to stabilize currencies in the wake of
speculative assaults are costly and damaging to emerging market economies.

As neoliberal policies foster greater privatization of the international
financial system, countries must rely almost entirely on private financial
flows to finance trade, to settle international accounts, even to meet
domestic credit needs. In efforts to attract private funds, countries from
Thailand and Mexico to Korea and Brazil have deregulated financial
transactions, lifting controls on interest rates, on capital flows, and on
the convertibility of domestic currencies. For most countries, this tilt
toward financial liberalization has proven more a curse than a blessing.
Liberalization schemes, particularly those promoted by the International
Monetary Fund (IMF) and the U.S., are fraught with dangers and dilemmas for
emerging market economies. One of the most damaging consequences of
liberalization is that it imposes upon emerging markets a set of
unacceptable and ultimately unworkable exchange rate policies.

An overriding goal of U.S.- and IMF-sponsored liberalization programs is to
enhance the attractiveness of the target country's financial assets to
financial investors. To be attractive, countries must attempt to insure
investors against private financial loss. Governments are advised to permit
full and free convertibility of their currencies into U.S. dollars so that
investors can enjoy full dollar liquidity. To further minimize investors'
risk of dollar losses, countries are encouraged to stabilize the value of
their local currencies against the U.S. dollar.

Full and free convertibility, however, has proven to be incompatible with
exchange rate stability. Once countries lift controls on short-term capital
movements and allow full convertibility of their currencies, the process of
exchange rate determination is privatized as well. For all practical
purposes, the external value of a country's currency in a liberalized
financial market is determined by speculative trading in the international
currency markets-something over which emerging market governments exercise
little control. Financial players understand this reality well. But
international policy officials routinely misrepresent the dynamics of the
financial market. They blame the inevitable currency crises on internal
failures of emerging market governments rather than on the speculative
nature of international financial markets.

Governments-like China-that prohibit trading in their currencies can
maintain a stable currency peg by preventing private transactions at other
than the stated exchange rate. In contrast, countries that allow full
convertibility have only weak levers by which to stabilize their exchange
rates. Like Argentina, they can institute a currency board, which issues
domestic currency only in proportion to foreign exchange reserves. This is
not a simple commitment to keep. In practice, a currency board commits the
state to intensely restrictive economic policies that serve to curb private
lending and slow wage growth-thereby demonstrating to financial markets the
state's serious commitment to the dollar peg. Even then, attacks on the
currency by speculators can overwhelm the government's ability to maintain
the currency peg, as Argentina recently discovered.

Brazil and other governments attempted to stabilize their currencies by
catering to the whims and demands of financial markets, adopting
restrictive fiscal policies and high interest rates. Implicit in the
concept of pegs such as Brazil's is the promise that foreign exchange
reserves will, if necessary, be deployed in defense of the peg (to buy
domestic currency when speculators are selling it) and that the government
will raise interest rates to whatever level is needed to protect investors
from currency losses. Countries that wish, like Mexico, to adjust their
dollar peg from time to time must generally compensate investors against
losses by settling interest rates higher than countries that submit to an
unchanging peg.

Emerging market efforts to placate investors with pegged exchange rates,
however, have proved pointless in the face of expanded currency
speculation. Eventually, the real economic stresses of dollar pegging
(repressed economic growth to prevent inflation, current account
imbalances) become obvious to speculators, and the gains to be won by
attacking the peg (the massive foreign exchange reserves committed to the
currency's defense) grow irresistible. Result: speculative assault on the
currency, futile and costly efforts by the government to hold the peg, and
finally, economic collapse. In the aftermath of the crisis, blame is
ascribed: to the government for "overvaluing" its currency; to the IMF for
delaying a bailout; to the markets themselves for excessive speculation.
The fundamental incompatibility between a privatized financial system and a
realistic exchange rate policy is rarely broached.

Problems With Current U.S. Policy

Key Problems
o	U.S. officials refuse to acknowledge past policy failures, instead
blaming emerging market governments for the attacks on their currencies.
o	U.S. policy is geared toward protecting financial firms against losses,
often at great cost to emerging market economies.
o	The U.S. has ignored or rejected calls for international financial reform
that might give emerging markets more realistic financing and exchange rate
options.

U.S. advice to emerging market governments has been inconsistent, even
contradictory, yet the U.S. resolutely refuses to acknowledge its policy
failures. Officials in the Clinton administration, as well as in the IMF,
are intransigent in their insistence that countries liberalize financial
regulations, yet they provide no realistic guidance on how countries are to
manage their exchange rates in a speculative and deregulated environment.
When liberalized capital flows result in excessive speculation against
emerging market currencies, U.S. officials blame exchange rate volatility
on emerging market governments who, it is claimed, have caused investors to
"lose confidence" in their currencies.

In country after country, the U.S. and the IMF first encouraged countries
to stabilize their currencies, and then (when the costs of doing so became
intolerable) advised those same countries to abandon their exchange rates
to the market, often with devastating effects. The U.S. advised Brazil, for
example, to defend its currency against speculators by raising interest
rates and cutting government outlays. Indeed, Brazil's defense of its
currency became a condition for releasing bailout moneys. That the
Brazilian economy was already staggering under short-term interest rates
nearing 50% did not seem to faze U.S. officials. Not until Brazil had spent
half its foreign exchange reserves defending its dollar peg did U.S.
officials-afraid that Brazil would be unable to make payments on its
external debt-reluctantly advise a devaluation.

In Thailand, Indonesia, and Korea, U.S. officials blamed speculative
attacks on the governments, claiming they had "overvalued" their currencies
even though there was no evidence of overvaluation and despite having
previously encouraged exchange rate stability to bolster investor
confidence. Moreover, U.S. Treasury officials have publicly excoriated
efforts by governments to stabilize their currencies by restricting
convertibility and short-term capital inflows. Deputy Treasury Secretary
Summers called efforts to reinstate capital controls "a catastrophe," yet
weeks later accused emerging markets of irresponsibly "lurching for
short-term capital." U.S. policy has been characterized by a blindness to
the inconsistency of its own advice and an unwillingness to countenance
even mild criticism.

Another major problem is that U.S. proposals to avert future currency
crises sacrifice the interests of emerging economies and, indeed, increase
the likelihood of speculative currency attacks. The policy of defending
exchange rates with a combination of high interest rates, foreign exchange
reserves, and IMF-led bailouts has been a virtual invitation to
speculators. In 1998 alone, speculators captured $130 billion in emerging
market reserves and nearly $150 billion in bailout funds. When speculators
shifted their focus from Asia to South America last year, the Clinton
administration proposed making additional "bailout" funds available with
which to defend Latin currencies. Critics immediately pointed out that such
a fund, far from dissuading speculation against currencies, would actually
embolden speculators by rewarding them for attacking pegged exchange rates.

The evidence that bailout funds that were intended to protect dollar pegs
are, in fact, a lure to speculators is now irrefutable. Critics of U.S.
policy have argued that emerging markets would be far better advised, in
the wake of a speculative attack, to abandon their pegs and lower interest
rates, thereby stimulating domestic growth. But such proposals have been
met with derision by Treasury officials, who seem to prefer policies that
protect international financial interests against currency losses, even if
these policies destroy the economies of emerging and indebted countries.

Finally, the U.S. has, in its public statements, refused to consider the
obvious linkages between speculative attacks on currencies and the more
general failure of the privatized international financial system to provide
realistic financing and policy options for emerging markets. U.S. policy
regarding exchange rates and capital flows is inseparable from policy
related to country indebtedness. Countries are expected to finance debt
service payments and trade imbalances with private capital flows and to
attract those flows by protecting investors against losses. This policy is
a failure. Yet until some alternative means of financing transactions with
the rest of the world is devised, indebted countries must expose themselves
to speculative capital. As long as the U.S. and the IMF prohibit controls
on short-term capital, speculative finance will predominate, and countries
will lurch helplessly between futile efforts to sustain damaging and
unsustainable pegs and uncontrollable devaluations of their currencies.

Toward a New Foreign Policy

Key Recommendations
o	Exchange rate policy must be dictated by the demands of development and
trade, not by the demands of creditors and private financial markets.
o	The power of private financial markets to set exchange rates-and thereby
dictate internal economic policy-must be curbed.
o	Exchange rate systems must respect the needs and inputs of all
participating countries.

The devastating attacks on East Asian and Latin currencies in recent years
have revived calls for international financial restructuring. European
governments recently proposed international discussion of a new system for
managing exchange rates, credit, and international liquidity-a proposal
dismissed by U.S. Treasury officials as "unworkable." Yet it is the status
quo of global financial markets that is unworkable, because it forces
governments into untenable and unacceptable policies in order to protect
the wealth of the international financial establishment.

As currently constituted, the international financial system is not only
unethical but is also dangerous to economic and ecological stability. When
speculators attack the currencies of emerging markets, their losses are
covered by the foreign exchange reserves of the target governments and by
bailout packages arranged by the IMF. The target countries are now obliged
to replenish these reserves and to repay these bailout funds by selling
what resources and labor they can mobilize. In the past year, East Asian
countries have vastly increased exports of pulp, lumber, and other
commodities at great cost to the environment and to the people of their
countries, while the attack on Latin American currencies has precipitated
rapid deforestation and land clearing. As world commodity prices collapse,
incomes in emerging markets plummet, and the pressure to accelerate
unsustainable production intensifies. The world cannot long endure this
state of affairs.

International financial policy must be reformed. Reforms should be
predicated on the goals of promoting sustainable growth, relieving poverty,
and reducing economic conflicts between nations. Countries need to exercise
control over their exchange rates in order to pursue internal development
goals, yet must, at the same time, agree to be bound by the economic needs
of other countries if world tensions are to be alleviated. Emerging markets
should be helped to devise exchange rate policies that serve the needs of
internal development and recognize the legitimate interests of their
trading partners. Exchange rate policy must be dictated by the demands of
development and trade-not by the demands of creditors and private financial
markets.

All other aspects of the international financial structure should be
evaluated on how they best support responsible and development-enhancing
exchange rate policies. The U.S. should use its leadership in international
organizations like the IMF and the G-7 to promote discussion and
development of a supportive international financial architecture. The range
of particulars is wide, but any reforms should be founded on three
overriding principles.

(1) The power of private financial markets to set exchange rates and
thereby dictate internal economic policy must be curbed. This can be
accomplished through the reinstitution of capital controls and/or through
the establishment of a transaction tax to curb currency trading, as many
have proposed. Controls and curbs are only partial solutions, however. By
themselves, they can serve to isolate countries from needed international
trade and financing opportunities. Internal
economic and political pressures may require that countries run imbalances
in external payments, and such imbalances need to be financed. If
governments are to retain policy independence, financing must be available
from sources other than the private market. A publicly organized
international lending facility is essential, not (as some have proposed) to
act as a lender of last resort to international banks but to serve as a
lender of first resort for payments imbalances between sovereign nations.

(2) Exchange rate systems must respect the needs and inputs of all
participating countries. The U.S. should not lend its support, tacit or
explicit, to any plan for the "dollarization" of Latin American economies
or to proposals for a pan-American monetary union. It is not that such an
outcome is, in itself, undesirable. There are numerous models for workable
and development-enhancing exchange rate systems, and regional monetary
unions may well be among the most viable. However, monetary union in the
Americas is premature. Monetary unions must be founded on institutions that
respect the needs of all participants. No such institutional structure
exists in the Americas today, nor do current proposals for monetary union
include in their visions a pan-American central bank that is democratic in
character. Proposals to dollarize the economies of Argentina or Mexico are
driven by the financial elite, who would sacrifice any remaining economic
autonomy in South America to protect the dollar value of their wealth. Such
plans are not based on any understanding or belief that the dollarized
economies would be given a voice in the management of dollar liquidity.

(3) The first priority in debt negotiation must be the stable, sustainable,
and democratic development of the world's economies. The details of
international debt restructuring and repayment must be consistent with
other development-enhancing changes in the international financial system.
Again, the range of particulars is wide, including debt forgiveness,
international bankruptcy clauses, and repayment in local currencies or in a
newly issued international settlement currency. What is essential is that
policy negotiations keep sight of fundamental principles and remember that
the financial system must serve the needs of the world economy, not the
other way around.

Ellen Frank is an associate professor of economics at Emmanuel College in
Boston and is on the editorial board of Dollars and Sense magazine.

Sources for More Information

Organizations
Association pour une Taxation des Transactions Financières pour l'Aide aux
Citoyens (ATTAC)
9bis, rue de Valence
75005 Paris
France
Voice: 33 (0) 1 43 36 30 54
Fax: 33 (0) 1 43 36 26 26
Email: attac@xxxxxxxxx
Website: http://www.attac.org/

Center for Popular Economics
Box 785
Amherst MA 01004
Voice: (413) 545-0743
Email: cpe@xxxxxxxxxxxxxx

Economic Affairs Bureau
One Summer St.
Somerville, MA 02143
Voice: (617) 628-8411
Email: dollars@xxxxxxxxxxx

Economic Policy Institute
Suite 1200
1660 L Street NW
Washington, DC 20036
Voice: (202) 775-8810
Fax: (202) 775-0819
Email: epi@xxxxxxxxxx
Website: http://www.epinet.org

Fifty Years is Enough: U.S. Network for Global Economic Justice
1247 E St. SE
Washington, DC 20003
Voice: (202) 463-2265
Fax: (202) 544-9359
Email: 50years@xxxxxxx
Website: http://www.50years.org

Institute for Agriculture and Trade Policy
2105 First Avenue South
Minneapolis, MN 55404
Voice: (612) 870-0453
Fax: (612) 870-4846
Email: iatp@xxxxxxxx
Website: http://www.iatp.org

Publications
Michel Chossudovsky, The Globalization of Poverty (London: Zed Books, 1997).
Ellen Frank, "Double Dealing," New Internationalist, May 1999.
Ellen Frank, "Unfettered Capital Wreaks Havoc," Dollars and Sense,
September/October 1998.
Robin Hahnel, "Capitalist Globalism in Crisis," Z Magazine, February 1999.
Robert Wade, "The Battle over Capital Controls," New Left Review,
September/October 1998.

World Wide Web
Asia Crisis Homepage http://www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html
Jubilee 2000 Web Page http://www.oneworld.org/jubilee2000

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