With capital, let’s not go with the flow
It is now official; scepticism of globalisation has entered into the political mainstream. In the United Kingdom, immigration influxes led many to argue in favour of Brexit and the increased border control it offered. Industrial decline and wage stagnation in the United States sparked wide scale debate about the merits of global free trade, prompting the election of a man espousing heavily protectionist policies. What was missing perhaps from these lively policy discussions, if we can call them that, was consideration of the free flow of capital – an equally important tenant of our liberal economic order.
The current scale of cross-border capital flows is rooted in the liberalisations of the past 40 years. The Thatcher government removed the Exchange Control Act of 1947, which had tightly controlled foreign direct and portfolio investment by British citizens. India, China and many other developing countries relaxed controls on Foreign Direct Investment (FDI) during the 1990s. As displayed by Chart 1, this has led to an explosion in the global movement of capital over the past several decades. In monetary terms, global capital flows now dwarf trade or immigration: in April 2016 daily turnover in foreign exchange markets was $5.1 trillion, 6.1% of world GDP.
Free capital flows, in theory, facilitate a more efficient allocation of resources and benefit all involved. By liberalising their capital accounts in the 1990s, Uganda and other Sub-Saharan African nations could tap foreign finance to bolster domestic investment. Even Britain has been a massive beneficiary of free global capital flows – inward FDI alone amounted to 1.77% GDP in 2015. This has helped to elevate productive investment in the UK and finance its current account deficit.
Underdevelopment theory dictates that capital drains from developing to developed nations, impoverishing the former. The empirical evidence for this is in fact very nuanced. Whilst capital has flowed away from developing economies since 1997, between 1950 and 1981 they received an average net inflow of between 1.1% and 2.6% of GDP.
It is perhaps misleading however, to focus on averages encompassing a broad span of time – for the most economic damage has been inflicted by rapid short term reversals of hot money flows. With the volumes as high as they are, outflows can dramatically destabilise monetary and financial systems. This occurred during the Asian Financial Crisis of 1997, where investors withdrew en masse from several emerging Asian markets. Due to their substantial Dollar debt, the accompanying currency devaluation raised servicing costs immensely and contributed to a crippling financial crisis.
In the wake of the 2008 Financial Crisis, Federal Reserve interest rate cuts sent enormous amounts of capital to poorer countries in search of higher returns. Partly as a result of this, debt in emerging markets surged from 150% of GDP in 2009 to 195% in 2015. Low commodity prices, weak Chinese growth and higher US interest rates have caused hot money flows to reverse, sparking depreciations in Brazil’s real, China’s yuan and other emerging market currencies. This has increased the burden of these countries’ Dollar debt and exacerbated inflation.
It is vital in this debate that we distinguish between FDI and hot money flows. The former is investment in productive assets by foreign entities, whereas the latter are temporary financial flows, often directed by hedge funds, that circulate the globe trying to maximise profit. As such, FDI is a significantly more sustainable and beneficial form of capital flow.
Faced with economic turbulence, many nations may feel tempted to erect draconian capital controls, ignoring the economic benefit of FDI. Governments should instead impose selective capital controls on harmful speculative flows as well as use macro-prudential measures such as higher bank capital requirements to limit asset price bubbles. Furthermore, we should strive for a more pluralistic global monetary system, as the Dollar’s current dominance renders countries vulnerable during sudden exchange rate changes.
Let us hope that when capital’s day does come, politicians propose well-planned, pragmatic changes rather than reckless populist measures. Yet in this day and age that is quite a fantastical thing to hope for.