Orders of the Day — The Economy

Part of the debate – in the House of Commons at 7:35 pm on 1st December 1998.

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Photo of Ruth Kelly Ruth Kelly Labour, Bolton West 7:35 pm, 1st December 1998

The hon. Gentleman completely misses the point. Does he not realise that 400,000 jobs have been created since the Government came to power, that interest rates are falling and that the inflation rate is on target for the third time? It is time to look at our domestic economic policies to see how that transparency can be injected into the global financial system.

It is clear that capital liberalisation can bring important benefits to developing countries, giving them access to savings that they might not otherwise have had. As east Asian countries erased capital controls during the 1990s, they enjoyed inflows of money amounting to between 5 and 10 per cent. of gross domestic product. That went hand in hand with faster growth, but fast liberalisation of capital markets can have its dangers. The 1990s witnessed a movement of capital to emerging market economies on a scale relative to GDP not seen since the gold standard era of the late 1880s to early 1900s.

Let us take the five countries that have been most damaged by the recent crisis—Indonesia, Malaysia, South Korea, Thailand and the Philippines. Between them, they had net inflows of $41 billion in 1994. By 1996, that had jumped to $93 billion. Over the years, inflows substantially exceeded the current account deficit, allowing Governments to accumulate $37 billion in additional reserves.

When panic hit last year, the net inflow turned into an estimated outflow of $12 billion. The swing in the net supply of private capital was a staggering 10 per cent. of the combined pre-crisis GDP of the five economies.

The response has been dramatic. Countries have had to slash domestic spending and rein back trade deficits, sometimes sharply. Malaysia has so far been alone in reimposing capital controls to shield itself from the frenzy of the markets and to buy itself some breathing space, but, by doing so, it deepened the crisis in other parts of the region, and undermined confidence among international investors in east Asia even further.

Many commentators, including the International Monetary Fund, have blamed the emerging market economies themselves for their problems. They have argued that any international help should be accompanied by even greater capital liberalisation and yet harsher economic policies, policies that the eminent United States economist, Paul Krugman, describes as "playing the confidence game"—trying to win back the confidence of the international markets.

Of course, the IMF is right in some respects. Some of the problems were home-grown and valuable lessons have been learnt. The evidence suggests that the extent to which capital movements are destabilising depends largely on the strength of a country's financial system and the soundness of its economic policies, but how on earth can anyone argue that the punishment that those countries face fits the crime? What the crisis has exposed far more than any policy "crimes" is the inadequacy of the international financial system in the face of an increasingly interdependent global economy, in which capital flows are virtually instantaneous.

For 50 years, our policies for regulation, supervision, transparency and—yes, I will say it—stability have been devised and developed for a world of relatively sheltered national economies, with limited capital markets. Now that markets transcend national boundaries, that system needs to be completely rethought. I congratulate the Chancellor on playing his part in international forums that are trying to do that.

What is now called for is a new Bretton Woods—not a system of fixed exchange rates, like the old system, but a new financial infrastructure. The Chancellor was right to underline the need for greater transparency and openness, including the implementation of codes of practice and conduct in monetary and fiscal policy and corporate governance. Those should strengthen incentives on Governments to pursue sound economic policies and enable market participants to price risk more effectively.

Financial supervision and regulation must also be improved and early warning mechanisms put in place to help to prevent further crises. Short-term mechanisms must exist in case crises do strike, with the international community able to mobilise capital quickly to underpin economies of countries whose policies are clearly sound.

Although we should recognise the benefits of free capital movements, international leaders and developing economies need to approach the concept of capital market liberalisation with a little more caution. As long as countries are open to massive movements of hot money, there will be problems. As long as capital flows freely, nations will be vulnerable to speculative attack and policy makers will be forced to play the confidence game.

Of course, it is not easy to limit the movement of international capital, at least not without threatening the strangulation of international trade, but we cannot sanction a system that allows developing countries to be exploited by foreign capital that they do not need and which then forces them to resort to panic controls on capital outflows when crisis hits.

I have been an advocate of a small tax, devised by the Nobel laureate, James Tobin, on foreign exchange transactions. That would make speculation more costly, while having little effect on long-term investment, but I accept some of the criticisms of the tax. Enforcement would be difficult and it would not necessarily solve problems such as have arisen in east Asia, where the biggest sellers of local currencies were not speculators; they were local firms desperately trying to hedge or to repay debts denominated in dollars. However, we could act to protect developing markets from the sort of onslaught that we have recently witnessed by encouraging them to liberalise their capital markets more slowly and cautiously. There are encouraging examples of the dividends that can be reaped from caution.

Take Chile, for example. In 1982, it had a crisis strikingly similar to that in east Asia. Since then, despite being a robust supporter of the free market, it has actively sought to discourage short-term inflows of foreign capital. All loans and bank deposits from abroad are, effectively, taxed. When a company borrows abroad, for example, 30 per cent. of the loan must be deposited for one year in a non-interest-bearing account at the central bank. The controls are likely to explain partly why Chile has enjoyed steadier growth than most other emerging economies over the past decade.

Would it not have been preferable if Thailand and Indonesia had restricted borrowing from abroad in a like manner, rather than encouraged it? Perhaps South Korea might have avoided such a run on its reserves if controls on short-term borrowing had limited its exposure to foreign banks.

Once financial and regulatory systems are well established, capital markets can be opened fully, perhaps with a new world financial authority standing ready to police global capital flows, ensuring that the necessary international standards are in place. In the event of a crisis and where a country adopts good policies, I would like a world financial authority to sanction temporary debt standstills by lending into arrears.

As Jean-Michel Camdessus, the IMF managing director, has put it, the IMF's goal should be to ensure that the world has adequate protection against the risks of globalisation, together with the chance to embrace the opportunities it provides. That should be our goal too.