Global Policy Forum

A recent paper from the IMF on financial integration may turn out to be a pleasant surprise for IMF critics. Financial integration, including the debate on capital controls, is an esoteric topic that obviously cannot compete with developments such as the US invasion and occupation of Iraq and the spread of the SARS virus in capturing public attention. Yet, the implications of financial integration - for developing countries and for globalisation itself - are far-reaching. The cumulative effect of the series of financial crises that have beset East Asia, Latin America, Russia, Turkey and other emerging markets is an important factor behind the slowdown of the global economy and the deterioration of the quality of life of millions of people.

The IMF paper expresses caution over the unswerving belief that financial integration helps promote growth and reduce macroeconomic volatility in developing countries. In the heyday of the Washington Consensus (defined simplistically as the agenda of liberalisation, privatization and deregulation), the IMF was the most avid advocate of financial globalisation, including the liberalisation of capital accounts in developing countries. The Philippines liberalised the capital account in the early 1990s as part of an IMF programme. In the later half of the 1990s, a move to have capital account liberalisation incorporated as a main IMF objective gained ground.

The authors of the recent IMF paper on financial integration state that "a systematic examination of the evidence suggests that it is difficult to establish a strong causal relationship between the degree of financial integration and output growth performance." They also state that "the process of capital account liberalisation appears to have been accompanied in some cases by increased vulnerability to crises. Globalisation has heightened these risks since cross-country financial linkages amplify the effects of various shocks and transmit them more quickly across national borders."

On the supposed benefits of increasing growth and reducing macroeconomic volatility, the authors find that "there is no proof in the data that financial globalisation has benefited growth, [and] there is evidence that some countries may have experienced greater consumption volatility as a result."

It appears that the IMF is no longer doctrinaire about financial integration and capital account liberalisation. It also seems that the IMF is ready to give up "one-size-fits all" prescriptions for developing countries. The IMF paper carries a lot of weight - one of its co-authors is Kenneth Rogoff, the IMF's outgoing Chief Economist and Director of Research. This is the same Rogoff who, in June 2002, had a fierce debate with Joseph Stiglitz about globalisation and the IMF role. Stiglitz, who was awarded the Nobel Prize in Economic Sciences in 2001, is a staunch and consistent critic of the IMF's push for accelerated financial integration. In this paper, without saying so directly, Rogoff admits Stiglitz was at least partly right. The paper says "the principal conclusions that emerge from this analysis are sobering, but in many ways informative from a policy perspective."

Nevertheless, skepticism remains over what may be perceived as an IMF turnabout. C.P. Chandrasekhar of the International Development Economics Associates (IDEAS) contends that "the IMF has decided to accommodate the growing evidence of the adverse consequences of financial liberalisation in developing countries not so much to learn from it and revise its positions but to provide what some are seeing as a more 'nuanced' defense of financial liberalisation." To illustrate his point, Mr. Chandrasekhar examines the IMF view that there is a "threshold effect," that at a mature level of financial integration there will be a reduction of macroeconomic volatility. He says "the implication is not that developing countries should give up on financial liberalisation but that they should go far enough to ensure that it is accompanied with reform that delivers the institutional quality needed to realize the virtuous relationship between financial liberalisation and economic performance."

Despite such "nuanced" IMF analysis, developing countries may well view it as allowing them more leeway to slow down on financial integration and the attendant capital account liberalisation. Argentina has recently introduced controls on short-term speculative flows. And the statement from Tom Dawson, IMF Director of External Relations, is encouraging: "it's not an issue on which we have strong theological views. Indeed there have been a number of countries where controls on short-term incoming flows, where the rules of the game are fairly well established, have worked out quite well."

Yet, we are not certain how long this new stance of the IMF on capital controls will last. Mr. Rogoff will be leaving the IMF soon, and the critical position on financial integration may be reversed. The incoming IMF Chief Economist, Raghuram Rajan, a professor at the Chicago Graduate School of Business, is a firm believer in free markets. In one interview he declared: "[I] believe in open borders. The evidence is out there for everyone to see, there has been an immense rise in wealth and opportunity over the last thirty years in both developed and developing countries as borders have opened up."

Of course, many people, including mainstream economists, will dispute Mr. Rajan's statement. It seems then that the debate on financial integration will once again intensify as Mr. Rajan formally takes over his new position. One big fight!

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