Trading Away Capital Controls under Bilateral Trade Agreements
The sinister move by the US to curb the use of capital controls under the guise of just concluded bilateral trade agreements with Chile and Singapore has not received adequate attention. America’s economic predominance – and the resulting shape of the global economy – has long rested on a combination of bullying, threats and inducements, but recent US bilateral trade deals signed with Chile and Singapore hint at something entirely more sinister. This is because both agreements include strict financial conditions alongside aggressive safeguards for intellectual property which go beyond multilateral benchmarks agreed by the World Trade Organization.
The fact that Chile and Singapore have agreed to surrender the use of capital controls in return for more favorable market access should set the alarm bells ringing. If bilateral trade deals banning capital controls become de rigueur it means a country using them to defend its economy will end up compensating American investors for the inconvenience.
The US’s insistence on curbing capital controls is baffling particularly when there has been a rethink in the international policy circles on capital account liberalization in the aftermath of the Southeast Asian financial crisis. Even the supporters of free trade (for instance, Jagdish Bhagwati) are now vociferously advocating the need to enforce capital controls.
The Southeast Asian crisis has emphatically demonstrated to the world that capital account liberalization is a vexatious issue with numerous reverberating effects. An open capital account is perceived as a source of risk rather than benefit. Particularly in the case of the developing countries, the costs of an open capital account are enormous because volatile capital flows can cause sharp swings in real exchange rates and financial markets thereby engendering instability in the financial system and the real economy.
The neoclassical theories assert that capital controls are useless, ineffective and distortionary. Grounded on flawed assumptions that markets are perfect and financial and real assets are no different, the neoclassical theories conclude that capital controls cannot work. The ground reality is however quite different. Both the developed and the developing countries have imposed controls on both inward and outward movements of capital to meet the wider objectives of economic policy, particularly those related to national development and macroeconomic stability. Rapid economic development has occurred amidst tight controls on financial markets in the two most successful cases of the post World War II period, namely, Japan and South Korea. China and India are experiencing rapid economic growth under a stringent regime of capital controls. Can anyone buy the argument that growth rates in China would have been much higher than the present (over 8 per cent) had the country removed capital controls? Even Malaysia, which re-imposed capital controls in the aftermath of Asian financial crisis, has grown faster than other economies in the region. The significant decline in the use of capital controls corresponded with the breakdown of Bretton Woods system and ascent of neo-liberal ideology in the 1970s. Yet a number of developing countries maintain some kind of capital control despite liberalization and deregulation of their economies in the last two decades.
Capital controls are indispensable tools in the hands of the developing countries to protect and insulate the domestic economy from volatile capital flows and other negative external developments. Even before the eruption of the Southeast Asian financial crisis, many countries had experienced financial crisis because their capital account was open. Italy and France had liberalized their capital account just before the ERM crisis.
Similarly, Mexico and the Southeast Asian countries had undertaken extensive capital account liberalization in the 1990s. Turkey and Bolivia also faced similar consequences with the removal of capital controls. Removal of capital controls was one of the major factors that perpetuated financial crisis in Chile in the early 1980s. With the macro economy firmly controlled by the “Chicago Boys,” the rapid liberalization of capital account and financial markets by Pinochet regime was accompanied by increased capital flight and volatility thereby creating a severe financial crisis. In the aftermath of the financial crisis, the Chilean authorities realized the importance of prudential controls and reversed its financial liberalization agenda.
Unlike Singapore, Chile still maintains several controls on capital inflows in the form of unremunerated reserve requirement and a minimum stay of one year in order to discourage speculative capital inflows. Not only these controls significantly altered the composition of capital inflows in favor of long-term inflows, but more importantly, it helped the country to remain protected from the contagion effects of the Mexican crisis of 1994-95 and the Southeast Asian crisis of 1997. No a mean achievement in the present volatile financial world! These measures, often cited as successful examples of restricting ‘hot money’ inflows, have even been endorsed by the IMF and the World Bank.
It stands to reason that the probability of occurrence of a financial crisis in Chile and Singapore would increase manifold with the removal of capital controls as envisaged in the bilateral trade agreements with the US. So next time, if a financial crisis on account of sharp reversals of capital flows occurs in Chile or Singapore, don’t blame the macroeconomic fundamentals or “crony capitalism,” blame these bilateral trade agreements!
The bilateral trade agreements with Chile and Singapore have to be visualized in a wider historical context. In the past, the US’s efforts to push ahead its wider agenda of capital account liberalization and investment liberalization through multilateral fora had not yielded positive results. During the GATT Uruguay Round negotiations from 1986 to 1994, a number of developing countries opposed the US proposal to include a comprehensive investment agreement on the negotiating agenda.
Faced with severe opposition, the US advocated the Multilateral Agreement of Investment (MAI) under the aegis of the OECD in the early 1990s. Largely due to differences among the member-countries of OECD on certain issues coupled with massive protests by NGOs and labor unions, the MAI was finally shelved in 1998. During the same period, attempts at IMF to include convertibility of the capital account in its Articles of Agreement also lost momentum in the aftermath of the Southeast Asian financial crisis.
Undoubtedly, the US has been successful at the WTO in removing restrictions on capital transactions in certain sectors (for instance, Financial Services Agreement) whereby the countries have agreed to a legal framework for cross-border trade and market access and establishing a mechanism for settling disputes. Yet the US has not been able to persuade many developing countries to accept a multilateral investment agreement at the WTO that would incorporate comprehensive capital account liberalization and investor protection measures, as envisaged under the NAFTA and MAI. If recent negotiations are any indicator, the proposal to launch a multilateral agreement on investment at the WTO (as part of Doha round) is unlikely to be a smooth ride for the US.
In the light of these experiences, the US has perhaps realized that it is difficult to pursue rapid liberalization agenda in a multilateral forum. In the post-Southeast Asian financial crisis world, a blanket approach advocating rapid liberalization is unlikely to succeed. Whereas a gradual approach aimed at expanding liberalization agenda through bilateral agreements has better chances of success. A bilateral agreement is much easier to negotiate, without entailing close scrutiny and opposition by critics.
Can anybody deny that these bilateral agreements would not ultimately pave the way for launching a more comprehensive multilateral agreement in the future?