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Keynote Address on
Globalization and International Capital Flows


Prof. J.D.Agarwal

Professor of Finance & Founder Chairman & Director, Indian Institute of Finance
Chief Editor, Finance India
Email: jda@iif.edu

Aman Agarwal
Director, IIF Business School , GGS Indraprastha University, Delhi, INDIA
Honorary Professor of Uzbekistan, Tashkent State University of Economics, UZBEKISTAN
Adjunct Professor of Finance, Indian Institute of Finance, Delhi,INDIA
Associate Editor, Finance India, Delhi, INDIA
Secretary & Treasurer, Jyoti Foundation, Delhi, INDIA

The authors gratefully acknowledge the technical support of Indian Institute of Finance and IIF Business School. I (Aman) would like to thank Franco Modigliani, Robert C. Merton, Fredric Mishkin and J.D. Agarwal who have inspired me in many ways to work on this complex issue. We would like to thank my colleagues at Indian Institute of Finance, Mr. Deepak Bansal, Senior Lecturer, Mr. Pushpender Singh Raghav and Ms. Yamini Agarwal, Lecturer, for their assistance in preparation of this paper.. The views and reviews presented in the paper are views and opinions of the authors, based on our research and experience and do not depict institutional or countries views or of the institutions the authors are associated with. All errors and omissions are our own.

© J.D.Agarwal, Indian Institute of Finance

Soft copy of the paper (In PDF Format)

  1. Invited to deliver the Keynote Address at the National Conference on Globalization Decadal Indian Experience, organized by ATMA MAYYIL and the Institute of Technology, Kannur University, Kerela, INDIA on 17th January 2004.
  2. Contact: Indian Institute of Finance, Ashok Vihar II, Delhi 110052. INDIA Phone: 0091-11-27136257; Fax: 0091-11-27454128; Email: jda@iif.edu
  3. Indian Institute of Finance http://www.iif.edu
  4. Finance India (Quarterly refereed journal of Finance) http://www.financeindia.org
  5. Contact: IIF Business School, [GGS Indraprastha University], 4, Community Center II, Ashok Vihar, Phase II, Delhi 110052. INDIA, Phone: 0091-11-27437917, 27451212; Fax: 0091-11-27454128; Email: aa@iifbs.edu OR jf@vsnl.com OR aagarwal@lsealumni.com
  6. IIF Business School http://www.iifbs.edu


Globalization has altered the economic frameworks of both developed and developing nations in ways that are difficult to comprehend. The persistent rise in the dispersion of current account balances of the world as a whole, wherein the sum of surpluses match the sum of deficits has grown substantially since the World War II. Also the emergence of unregulated global markets appears to have moved towards a more stable and growth oriented economic globe. Last three decades,1980 onwards, have been witness to Globalisation, Liberalization and economic crisis’s. This trend has been observed both in developed as well as developing countries. The sequencing started with globalisation and liberalisation of trade and investment, banking industry and capital flows. Economies have been hit one after the other with the fashion and need for market driven capitalist and liberalized economic system. The 90’s has also seen the emergence of E-finance which apart from the efficiency, product enhancement and lower cost of transaction has facilitated the crisis frequencies, globalization and movement of capital flows internationally without much control. The significant reduction in global trade barriers over the past half century has contributed to a marked rise in the ratio of world trade to GDP. External finance has set forth the movements for growth in trade and development across regional barriers. We have attempted to address the issue - Should globalization and capital flows be allowed to proceed and thereby create an ever more flexible international financial system.

JEL Code:

Keywords: Globalization, Capital Flows, Economic Growth, International Financial Architecture, Financial Crisis, Contagion, Economic Development, India, Spillover Effect

Prof. T Govindankutty Nair, Principal, Institute of Technology, Kannur University & AMTA MAYYIL; Dr. M P A Rahim, Chairman, Institute of Technology (KU); Dr. Subramanium Swamy, Former Union Minister for Commerce, Law & Justice & Professor Harvard University; Dr. K. G. Nayar, Former Chief Executive, Cashew Exports Promotional Council f India; Dr. B. Mohan, Sree Venkiteswara University; Ms. Subdhashini Muthukrishnan, St. Joseph’s College, Bangalore; Honorable members of the Organizing Committee at the Institute, the scientific committee members of the Association and other distinguished dignitaries on the dais, members of the this august audience and ladies and gentlemen, it is a matter of great privilege for me to have been invited to deliver the keynote speech on Globalization and International Capital Flows in this prestigious National Conference on “Globalization – Decadal Indian Experience”, organized by ATMA MAYYIL and the Institute of Technology, Kannur University, Kerela. At the outset I must congratulate the organizers for organizing this conference, selecting an extremely timely theme and having representation from almost all over the globe. It reflects the vision of the Association, the Institute and the organizers. Organizing a national conference is very difficult task and tremendous efforts are required by a team of committed and devoted professionals to give it a final shape.

The organizers have rightly chosen the theme of this National Conference as Globalization. Globalization is generally characterized by global productivity, profits, raise in standards of living (maintaining social equality), bringing in far more effective and efficient government and market driven economic system by optimum utilization of resources. Globalization has altered the economic frameworks of both developed and developing nations in ways that are difficult to comprehend. The persistent rise in the dispersion of current account balances of the world as a whole, wherein the sum of surpluses match the sum of deficits has grown substantially since the World War II. Capital Flows on the other hand are generally characterized to set in Volatility, intense fluctuations of the price in financial markets, sharp economic growth, contagionation and financial crisis. This is due to the risk and uncertainty of the nature of Capital Flows. The emergence of unregulated global markets appears to have moved towards a more stable and growth oriented economic globe.

I wonder as to what extent I would be able to justify this great responsibility of delivering this keynote address. It is a very difficult task and a great responsibility. However, it would be my endeavor to be up to the mark as far as possible or to the expectations of the organizers and galaxy of intelligentsia.

7. See Click & Rose(1998, 2001), Eichengreen, Rose & Wyplosz (1996), Kaminsky and Reinhard (1998), and , Van Rijckeghem & Weder (1999).

I. Introduction

A great attention has been paid to global economic issues in the last decade. This has been a natural byproduct of the increasing inter-dependencies of all national economies. This has accentuated in recent years due to the emergence of several developing countries as global economic forces, the reorganization of production process, change in nature and location of development and finance. One can clearly observe this with the economic growth and self sufficiency attained by India, China and quick re-emergence from crisis of the ASEAN countries.

To define ‘Globalization’ is a difficult task, as it has been defined and redefined every now and then. Different sections of a society look at this term from the benefiting side. Latest talk of globalization have moved from the financial benefits/crises, which has arisen since late 80s to the political and democratic positioning. In the recent editorial comments of Sachin Chaudhary , he has projected that globalization has two key terms - modernity and capitalism. These being two different poles, however, evolved as a result of the same process. The classical thinkers do believe that modernity is good, however, capitalism is a bad word even today. When we say so, we refer to the 5/6 population of the world, which has lived and benefited from the non capitalistic base society. Rajan Raghuram , recently in his book on “Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Special Opportunity”, argued that incumbent capitalists are shifting free markets because they stand to lose the most from greater competition .

Conservative economists, since Adam Smith, have promoted the idea that a free-market economy that has minimized government regulation and more dependence on the forces of supply and demand, which is considered to be the most reliable and efficient economic system. Yet, the 1990s financial crises (Agarwal & Agarwal, 2001), stock market crashes, scams (corporate/political) have lead to economic contractions. These events have not only devastated countries around the world but also increased social tension and disparities. The frequency and extent of these financial debacles have led policymakers, regulators, economist, journalists, market operators and the masses to call for reforms in the form of a new "international financial architecture & a self sufficiency model".

8. Editor, Economic and Political Weekly
9. Director, Research Department, IMF
10. Take US tariffs on imported steel, for example, which the authors dismiss as a handout to politically powerful owners and top managers of distressed U.S. steel firms.

Given the downside, the increase in global productivity on the other hand has primarily been there because of spreading recognition in recent decades that the mixed economic system tapered towards market orientation works best. Today, India is most appreciated and talked economic system, dispite the level of corruption and wastage of economics resources. The market driven mixed economic system has well acknowledged decade showing responses to the market signals by private initiatives to make profits, raise standards of living and reduce social disparities. This is far more effective and efficient than only government-directed or private allocation of resources. Not only countries like China and India, where political stability has been maintained, but also those in Eastern Europe (where governments were overturned) have been shifting toward economic systems that place greater reliance on market transactions. These trends help unleash the huge productive potential within an economy.

Shift in the economic systems has been heightened with the pace of technological change, the declining cost (of generation and transmition of information & goods), international capital flows and globalization. We can see the effects of these change here at home, where it has considerably boosted the growth rate of productivity since the mid-1990s after the economic reform processes were set in. Globally, globalization and cheaper capital has enabled faster and more efficient access to information, which has intern eased the integration and coordination of geographically diverse production processes. This development has opened opportunities to transfer production to locations where it can be accomplished less expensively and with increased stakeholder’s wealth.

Globalization and stable growth in qualitative capital flows in India has lead to faster growth in demand and productivity. Also, managed inflation, since 2000, is likely to support the monetary policy to remain accommodative, supporting economic growth and increased employment, without endangering price stability. A number of studies such as Speidell and Sappenfield (1992) and Ferson and Harvey (1994) suggest that global allocation strategies, consisting of choosing cross-border market combinations that are mean-variance efficient, result in increased linkages between world equity markets. India is slowly progressing towards achieving similar state. International linkages and benefits from diversification are expected to be inversely related, in that higher correlations between markets are less effective in decreasing portfolio variance. Markets are said to be in long-term equilibrium when long-term expectations in one can be used to predict long-term movements in another market. The markets are then said to be co-integrated. Hence the spillover effects can be observed in co-integrated markets. International portfolio managers are hence concerned with linkages in the short and the long run.

Market linkages affect investors differently, based upon whether resources have been allocated strategically or tactically. In today’s global village, global strategic asset allocation consists of determining the long-run policy asset weights in a portfolio by estimating the long-term average asset returns and covariance between capital markets. However, the short-term changes in market conditions are irrelevant and less co-integrated markets are used to determine a more efficient mean-variance set. In recent times, spillover effects have been of special interest for investors who allocate tactically, because global tactical asset allocations principally aim at capitalizing on “predictions” or local inefficiencies. Accordingly, the more interdependence between markets, the more efficiently resources are allocated between those markets and the less relevant is global tactical allocation strategy. In practice, it is common for to implement a global tactical or strategic asset allocation by choosing markets across developed countries and treating the remaining illiquid and smaller countries as a block that are chosen based on the weighted capitalization proportions of an emerging country index.

Several pre-crisis studies have show that cross-market linkages are weak, which negates any justification to treat the Asian countries as a block in a mean-variance maximization objective. For instance the study of Eun and Shim (1989) finds week linkages between Hong Kong and Japan by using variance decomposition and impulse response functions using a Vector Auto Regression model (VAR) to assess the strength and innovations from one market to the others from December 1979 to December 1985. The findings of Lee, Petit, and Swankoski (1990) study investigating the daily return relationships among Korea, Singapore, Hong Kong, Japan and Taiwan from January 1980 to December 1988 suggests that the returns on the Asian exchanges are segmented. Also a continuation work of Eun and Shim, Chowdhury (1994) uses a VAR to study the stock market interdependencies in four Asian countries (Hong Kong, Singapore, Korea and Taiwan) from January 1986 to December 1990. The authors do not find significant links between these four stock markets; though the first two were responsive to financial and technological innovations in the US and Japan. These findings were corroborated by other similar studies from Chan, Gup and Pan (1992), Defusco, Geppert and Tsetsekos (1996), Liu and Pan (1997) and Agarwal and Agarwal (2001).

The regional meltdown of 1997 is, therefore, surprising and suggests that a shift-contagion took place in regional cross-market linkages as a result of crisis-driven changes in investor perceptions, endogenous liquidity shocks, role of e-finance in capital flows and adjustments of the political economy. Over 10 middle-income developing countries experienced major financial crises between 1994 and 1999 the damaged living standards and, in some cases, toppled governments and left millions worse off. Suddenly, the issue of financial contagion and the pace and sequencing of deregulation and liberalization is in question. Forbes and Rigobon (2001) have defined shift-contagion as a change in the nature of interdependence between economies. While it is difficult to assess the channels of contagion, shift-contagion is interesting in itself for at least two reasons. First, if contagion occurs, it will undermine the effectiveness of international diversification in reducing portfolio risk. Second, while it is always difficult to predict if or when economic and political disturbances will occur and how they will affect capital markets, contagious shocks can have disastrous effects on global portfolios with substantial allocation weights in unstable equity markets.

The sequence and breadth of events in the 1997-98 Asian crisis have given birth to policy measures that are likely to have altered the relationship between capital markets globally. Consequently, the validity of pre-crisis studies on cross-border market relationships is under question. Thus, a critical question needs to be answered: Have Asian capital markets gone back to being segmented after the crisis or, to the contrary, did the Asian financial crisis accelerate the integration process between global markets? As a corollary, if a post-crisis, cross-border, long-term equilibrium persists, it would negate the argument for strategic allocation in the region and further justify that Asian markets should be looked upon as a block in a globally diversified portfolio. Additionally, if information spillover increases as a result of the crisis, short-term inefficiency disappears and one might question the usefulness of a tactical allocation across markets.

II. World Economy at the Turn of the Century

We would also like to touch upon how the events in the world economy at the turn of the century have influenced the process of globalization and capital flows in the International Financial Markets.

The world economy recovered smartly in 2000 from the East Asian crisis of 1997-99. The estimated world output growth of 4.7 per cent registered in 2000 is the highest since 1988 while the estimate of world trade at 12.4 per cent has been the highest in the past 25 years. World real GDP growth is estimated to have declined to 2.3% in 2001 (before increasing to 3% in 2002). However, the recovery has proved to be fragile. The world economy has grown at the highest average rate in the late 1990s, despite the marked slow down on account of the crisis in different regions of the world (Agarwal & Agarwal, 2001). Similarly, the average rate of growth of world trade at 7.18 per cent achieved during 1996-2000 is higher than that registered during any sub-period over the past two decades. In large part, the robust performance of the world economy during the last five years of the last century reflects the strong performance of the US economy in the past several years. The continued expansion in the US and the other economies has been considerably fuelled by the productivity improvement in the US industries resulting from IT applications. The impressive recovery of the world economy and world trade in the early part of 2000 generated all around optimism as countries expected to benefit from the favorable spillovers in the form of rise in demand for their exports. However, the optimism has proved to be short lived for various reasons.

The slow down of the US economy, since 1998, is having a compounded effect on the growth of the world economy by adversely affecting the demand for the products of partner countries as well. The world is a self reliant ecosystem, which has learnt over centuries to self-sustain itself, given the rise and fall or empires and civilizations. However in the short run, the effect of the impending slow down will be more severe on the growth rate of world trade. The world trade is likely to reduce to nearly a fifth of the rate achieved in 2000 to around 2.7 and 5.2 per cent in 2001 and 2002, respectively.

The September 11th, 2001 terrorist attack, the recent financial scandals reports in U.S., the Afghan Air Strikes and the U.S. Intervention in Iraq in 2003 have serious economic effects on World Economy. These would lead to tremendous flows of capital and increase in volatility of international financial markets. Some of the worst affected sectors have been the textiles and garments exports; information technology; air travel and tourism; hospitality and insurance; financial services and the insurance industry. The implications for developing countries are apparent in the form of reduced inflows of foreign investments especially of those from foreign institutional investors. The uncertainty coupled with the slow down tends have affected the foreign direct investment inflows to the different regions, as investors hold back the investment decisions and affect growth and economic development.

The volatility in the oil prices is also a highly destabilizing factor for the world economy. It is more devastating for oil importing developing region of the world than for the others. Given the strong cartel in the form of OPEC operating in this market, it is not possible to rule out oil price shocks of the type faced in the early 1970s, the early 1980s, the early 1990s and 2000 or even in the future. It is imperative for international community to create a mechanism to regulate and stabilize oil prices at a certain reasonable and sustainable level. The intervention should bring the OPEC and other oil producers to observe some international discipline. Further, there should be some special fund to moderate the impact of volatility in oil prices for the poorer developing countries. The OPEC decision to cut output whenever oil prices tend to fall as witnessed in early 2001 indicates that oil prices will fluctuate around US$30-35 per. barrel. Therefore, oil importing countries will have to adjust their economies to the new level of oil prices in the coming years.

Transition from GATT to WTO in 1995 constitutes one of the most important developments in the world economy of the twentieth century. It has wide-ranging implications for the global economy. The emerging WTO regime is important for the national development, trade, investment and technology policies of member countries. But by far the main beneficiaries of trade liberalization have been the industrial countries. The developing countries would face another set of challenges with further liberalization of insurance, banking and the services sectors. The recent developments in the Cancun WTO meeting are an eye opener and a major set back to multilateral trade regime. The member developing countries need to prepare themselves to take part in the ensuing negotiations effectively to safeguard their interests. Issues of preparedness on their part require them to jointly take advantage of the emerging multilateral regime rather than passively implementing their commitments. This requires for an appropriate strategic thinking and concerted action on their part.

One of the important events for the future of wold trade is the entry of China into the WTO regime. The accession of China to the WTO and the consequent MFN status that it will receive from other WTO member countries may have some implications for the competitiveness of some of the emerging economies.

It is clear, however, that the challenges of globalization today; the resultant volatility in the international financial markets; emergence of e-finance and capital flows; the rise in productivity and the role of government and regulatory bodies cannot be adequately handled by a system that was largely designed for the world 50 years ago. Changes in international economic governance have to keep pace with the growth of international interdependence.

III. Financing Asia
III. 1. Towards sound Corporate and Regulatory Environment

Adverse shocks in the last one decade followed by sustained economic growth in most Asian economies has regained the confidence in a stronger and stable Asia. The revival has been sponsored by growth of exports, self sufficiency, conservative approach along with the welcome of modern means of financing growth and consumption. A large proportion is also contributed by increase in the government spending for infrastructure development and growth. Given the attention paid to Financing issues and the volatility in capital flows observed in the last five years investment, bank lending and per capita growth has not seen the expected rise. This weakness has been addressed due to some of the negativity due to crisis-affected economies. Some may consider this as negative; however, we believe it is a needed correction for a stable and strong foundation for sustained growth in future.

In economies like India and China, where the financial crisis was not much felt, overall investment has been brisk accompanied by strong credit expansion providing a cushion for the rest of Asia and the World for growth. It can be well observed through the way FII and FDI investments having moved from all over the world to Asia in last five years, despite 1997-98 scenario.

The reduction in bank lending has had far reaching consequences for financing. Firms tend to suffer from credit crunch if bank lending falls short of demand, leading to curtailment of investment and affects output growth and employment. It has also been argued that contractions in bank lending have played a vital role in the US 1990-91 recession and that of Japan in the 1991-96 (Agarwal and Agarwal, 2001; Stanton, 1998). Changes to bank lending behavior observed pre/post 1997-98 and 2000 onwards in Asia have enabled re-foster economic confidence and growth in Asia. Though, it is still considered that there is subdued bank lending. However this is primarily due to banks being flooded with foreign funds (FDI/FII). A major shift in NPA has been a signaling effect towards the improving health of corporate and financial sector. Having said this, one must not forget that the restructuring after the savings and loan (S&L) debacle in the US lasted for two decade and for Japan (since late 1980). Both these economies have not been able to recover fully even today. (Agarwal and Agarwal, 2001)

The last decade has observed varied economic performance worldwide. Looking at Asia, we find that growth rates in the India and China have held up well since the mid 1990s, a number of East and Southeast Asia economies were hit hard by the financial crisis, with severe GDP contractions in 1997-98. These were Thailand, Indonesia, Korea, Malaysia and Philippines. A general rebound in growth, since 1999-00 has been observed (see Figure 2; Table I). Though, growth has been volatile in comparison with the pre-crisis period followed by weakening in 2001 and strengthening in 2002 in Asia. The recovery as said before has been by a resurgence of exports, extensive Inflows into Asia from rest of the world, emergence of services sector, exchange rate adjustments and increased government spendings .

Figure 1 : Real GDP growth in selected Asian economies
(Annual % change)

Source: Datastream and International Financial Statistics

III. 2. Financial Systems: Globalization and Liberalization

About two decades ago, when Japan started to liberalize its financial systems and markets to global markets and trends, with the US starting the liberalization process (specially deregulation of the banking sector, interest rates and capital flows) also around the same time, the financial troubles and volatilities in the international markets seemingly began. It was not that both these economies had bad financial markets. The fact was they had no idea as to how the financial markets would react and what turn would the domestic financial markets take as a fallout of the liberalization of the markets and capital flows. Both the US and Japan observed in early 1980s a strong recession in the capital markets and turbulence in the financial market as a whole. Lots of financial institutions were on the verge of bankruptcy. Most of them were bailed out from financial disaster, which would have otherwise brought both the economies into trouble. The effects of the crisis in these two big economies, as a result of the liberalisation of banking, capital flows and trade at the same time has spread to other economies around the globe (Agarwal and Agarwal, 2001). In the late 1980s, both these economies again faced recession, which was more observed in 1989 in the US and in Japan in 1991. The others who addressed crises in the ‘90s were the UK, Russia, Mexico, East European, Latin America, East Asia, Russia again and finally coming back to Japan and the US again. Though, different

12. With the emergence of threat of terrorism, attach on US on 11th September, a clouds of distrust and confusion due to corporate frauds, wars in arabic region and political reformulations (elections due for major part of the world).
13. For security and infrastructure.

14. The nation endured a deep recession throughout 1982. Business bankruptcies rose 50 percent over the previous year. Farmers were especially hard hit, as agricultural exports declined, crop prices fell and interest rates rose.

But the recession, combined with falling oil prices and the Federal Reserve's tight control of money and credit, helped to curb runaway inflation. By 1983, the economy had rebounded and the United States entered into one of the longest periods of sustained economic growth since World War II. The annual inflation rate remained under 5 percent from 1983 through 1987.

Still, serious problems remained. Farmers' problems continued, and their suffering was compounded by serious droughts in 1986 and 1988. Federal deficits soared throughout the 1980s. From $74 thousand-million in 1980, the federal budget deficit rose to $221 thousand-million in 1986 before falling back to $150 thousand-million in 1987. The U.S. trade deficit hit a record $152 thousand-million that same year. A stock market crash in the autumn of 1987 led many to question the stability of the economy.

In fact, the U.S. economy did slow and dipped into recession in 1991, and then began a slow recovery in 1992. As a result of the slowing economy and other factors, the federal budget deficit began heading upward again. Although the stock market recovered, the financial industry was particularly plagued with problems, with numerous savings institutions, as well as some banks and insurance companies, either collapsing or falling into such a shaky state that the federal government had to take them over. Well into the 1990s, credit market and other problems lingered on. By contrast, other sectors of the economy, such as computers, aerospace and export industries generally showed signs of continuing growth. An Outline of the American

causes have been given as reasons for each of these crises, we have reasons to believe that all these countries faced the crisis more due to liberalization of financial markets, capital flows and liberalisation of trade acting simultaneously in similar patterns as was observed in the US and Japan in the early ‘80s. Also other economies in the ‘90s observed a spillover effect of these two major economic recessions in the ‘80s . It may seem that we are trying to pose a bad picture of the globalization process. It is not so. But when all these three liberalization processes take place or are brought into an economy at the same time, they would not only take the financial environment in the economy by surprise but also bring it to a vulnerable state. Some of the international institutions (like the IMF, the WTO & World Bank), which propagate the ideology of liberalization and globalization need to understand that a phased and well laid out liberalization is needed and not just an straight line induction policy of all these three at one go. Also they need to provide these economies with relevant information and tools, when they propose these ideas, as to how to go about to strengthening the banking and financial markets so as to avoid financial disasters. When a country like the United States could not insulate itself from the crisis situations from time to time during the banking reform and capital liberalization process since the ‘70s till date, how can most of the smaller economies where the financial markets are not as strong as in the US, have weak regulatory bodies, are prone to more financial volatility, international institutional grading, economic & military risks and have had a protected environment for decades, expect to save themselves from the crisis debacles?

Economy Department of State, United States of America, International Information programme. (http://usinfo.state.gov/usa/infousa/trade/ameconom/pt3.htm)

15“…some analysts see the current crisis as the outcome of a growing distortion of the global economic system rooted in the efforts by Japan and other high-savings East Asian economies to protect domestic local industries from imports while sustaining high levels of exports, particularly to the more open, low-savings U. S. economy. In a sense, it is argued, an economic "bubble" that built up in Japan in the late 1980s and burst in the early 1990s, reemerged in the rest of Asia as a result of the failure of the Japanese Ministry of Finance (MOF) to take the necessary steps to liquidate hundreds of billions of dollars worth of non-performing loans. Rather than forcing Japanese banks to sell assets to cover their losses or take the politically unpalatable step of using public funds for a financial system bailout, as the United States did to deal with its savings and loan crisis of the 1980s, the MOF made it possible for banks to disguise the decline of their assets and to continue to make profitable but risky loans to the fast growing Asian economies.” Richard P. Cronin, Specialist in Asian Affairs, Foreign Affairs and National Defense Division in the CRP Report to the Congress - Asian Financial Crisis: An Analysis of U.S. Foreign Policy Interests and Options on January 28, 1998 & also see R. Taggart Murphy, Making Sense of Japan: A Reassessment of Revisionism. National Interest, Spring 1996: 50-63.

Though the liberalization of the financial markets has been one of the greatest inventions in the history of financial markets, it seems to have acted as a curse also . Whenever the liberalization process of the financial markets is accompanied by a liberalization of capital flows and trade in a country, the country by virtue of its domestic financial marketers not knowing or having any prior experience of the new environment (which comes forth as a result of liberalization) are unable to handle the situation. Most of these countries have had a very restrictive, controlled and regulated environment (not by rules and regulations but more so at the whims and wishes of the governmental bodies and the leaders) prior to liberalizing the markets accompanied by liberalization of capital flows and trade.

The situation is like when a person is made to live in a house for years, governed by strict rules and regulations (in a closed environment), and then suddenly asked to go out into the open world and face it. Not only this, but given the financial strength to venture into this new environment by external and internal sources. Even though the person may be most intelligent and capable, this situation is bound to bring troubles for him and for others in interaction. This is so because he was best for the previous environment and not the new one forced on him. Similar has the case been with the US, Japan, Russia, Mexico, East Europe, Latin American and East Asian countries apart from other turbulences, which these countries were observing prior and during the liberalization periods. The US and Japan were financially strong, and they have had fairly strong and good systems. Hence they could bear the impact and were in a position to use international organizations to develop ways to have the effect transferred, instead of bearing all the shock themselves. There have been varied views on the Japanese financial systems, which show that Japan did not have a well developed and regulated finance
16. “In general, financial liberalization measures in Asia-largely a product of the 1990s-were not accompanied by the creation or strengthening of institutions to monitor and regulate Asian banking systems. Vast outflows of investor funds from the strong U.S. economy in search of higher returns, and the recycling of huge Japanese trade surpluses in the form of bank loans and investments in Asia, contributed to a dangerous buildup of debt and excessive property development and manufacturing capacity. In testimony before the House Banking and Financial Services Committee on November 13, 1997 Federal Reserve Chairman Alan Greenspan noted with understatement that "In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk."” CRS Report on Asian Financial Crisis: An Analysis of U.S. Foreign Policy Interests and Options by Richard P. Cronin, Specialist in Asian Affairs, Foreign Affairs and National Defense Division January 28, 1998
17. “...the economies became increasingly integrated with the world economy. This opening up, however, also meant that exchange rate regimes potentially move vulnerable to currency crisis.” R. Gaston Gelos & Ratn

markets and institutions in comparison to the US. In a speech Beyond the Asian Crisis by Mr. Kiichi Miyazawa on the occasion of the APEC Finance Ministers Meeting in Langkawi, Malaysia on May 15, 1999, it was said Indeed, the substantial liberalization in 1993 and thereafter of the capital accounts of five Asian economies South Korea, Indonesia, Malaysia, Thailand, and the Philippines led to the inflow of approximately US$ 220 billion in private capital into the region during the three years from 1994 to 1996. The reversal of flows that occurred in 1997 as a result of a sudden shift in confidence amounted to roughly US$ 100 billion. No economy or region can withstand this kind of sudden shift in market sentiment, from euphoria to panic, and the resulting huge reversal of private flows. Also some of the cases given in R. Gaston Gelos and Ratna Sahay, IMF, Financial Market spillovers in transition economies are in support..

I would like to bring forth the view of Michael Mussa, Economic Counsellor and the Chief Economist at the IMF on this issue. Michael in his dinner Keynote speech on 20th April 2001 at the conference in New York, beautifully portrayed the development of the banking sector in the US and globally. He brought forth the cases where the banks in the US failed in the ‘50s and the ‘60s with the opening up and approval to the banks to expand outside the state jurisdiction within the United States. Also the S & L problem which arose at the beginning of the ‘80s due to the deregulation of interest rate caps and liberalization of other banking norms was made reference of. He also discussed some issues on the vulnerability of the emerging market banking sectors due to non-existence of strong banking supervisions and financial markets. His speech made it quite clear that the banking industry has not only addressed the financial turbulence of the crisis situation in the emerging markets, but these were also observed in the US, Japan and other developed nations during their process of banking liberalization.
Sahay from IMF “Financial market spillovers in transition economies” journal The economics of Transmission Vol IX No1.

III. 3. Liberalizations (of Capital Flows, Financial Markets & Trade) carving the path for Crisis or Enhanced Growth

The crisis or enhanced growth are seen as a resultant of the three liberalization processes i.e. liberalization of capital flows, financial markets and trade being set in together. Based on our previous studies, we have observed that the time difference between the three liberalizations has been either negligible or too short in the emerging economies of 90s. When any economy is subject to economic and financial influence from these three fronts (financial markets {including banking system}, trade and capital flows), then it is bound to experience turbulence. Not only did the economies in the ‘90s address these turbulences, but they also had weak financial systems and weak currencies as compared to financial investment institutions. Also because of the flexibility of movement of money with due credit to technology and E-finance, the effect of the crisis was more rapid and transferring.

Firstt arrow flow chart

This can be better understood via the corporate spill over strategy (see Appendix I). A similar strategy seems to have been used by Japan and the US, to transfuse the financial distress situations, to what is called the spill-over effect. The issuance of US$ or Yen denominated debt, financing of corporations in other countries and for expansion purposes, expansion of banking activities have been some of the mediums which are seemed to have been used for the spill over effect. For all these activities, “New Money”, also referred as seniorage money (when used for financing deficits), is brought into action. This new money to finance these activities does not give rise to inflation immediately, which is the case with seniorage money. As this money does not affect domestic money supply in the short run.

The spill-over effect as pointed out earlier, was also given reference to by Richard P. Cronin, Specialist in Asian Affairs, Foreign Affairs and National Defense Division in the CRP Report to the Congress - Asian Financial Crisis: An Analysis of U.S. Foreign Policy Interests and Options on January 28, 1998. There were a lot of bond issues and FDI investment made in East Asia by Japanese companies, which were in bad financial shapes in Japan. Japan also tried to sell the idea of creation of an Asian Monetary Fund (AMF), which, in fact, was an excellent idea. The formation of AMF, so conceived by Japan, was to constitute a via media to use it for Yen stabilization, to use it for postponing financial problems faced by Japanese companies and to guide the financial movements in Asia. This was based along the lines of the US model of domination of IMF, World Bank and the UN to get its way through and not only bring in sustained growth in the US but also monetary stability. This can be seen from the incidents after the World War II situation. When the then developed economies were structurally shattered due to the War, the idea of creation of the World Bank and the IMF in 1913 to finance reconstruction of Europe on the back of US Labor was utilised for the same. Unfortunately, the yen depreciation and the unsuccessful attempt at formation of the AMF did not allow Japan to get the growth for reduction in NPL problem with Japanese companies and financial institutions, thus leading to the spill over of the debts accompanied by all the three forms of liberalisation processes in East Asia.
18. See Graph 15 Note 1. Also see Manju Agarwal, Aman Agarwal & Biswajit Barua Inflation:Study with respect to India, Finance India, June 1998. Also see NATURAL LAW THESIS by Bernard Palicki - Appendix 5.2 Effect of Inflation on Poverty Level Income and Stock Market Averages as a Measure of Total National Capital Investment (http://www.ovaloffice.org/2000/images/gfa521b.gif)

Also IMF’s report World Economic and Financial Survey September 2000 points out in the ‘Role of Foreign Banks in Emerging Markets’ section that Indeed, the growing presence of foreign banks opens up a new channel for the transmission of disturbances from the mature to emerging markets is in support.

19.See Graph 24 for Yen/$ position in 1990s
IV. International Financial Markets & the Capital Flows

International Financial Markets have observed volatility of capital flows, which to a great extent is a contributing factor of the financial developments in the world economy. Financial developments have played a critical role in promoting industrialization in countries such as England by facilitating the mobilization of capital for large investments. Financial development contributes significantly to growth. Such developments are central to poverty reduction. Some of the researches have shown that financial development directly benefits the poorer segments of society and also income redistribution. Strong financial systems are the key factor for proper financial developments. One of the important functions of Financial Systems is to shift risk from those who are unwilling to those who are willing to bear it. Financial derivatives help diversify risk and enhance qualitative nature of asset allocation. For a strong financial system, one requires supporting financial institutions and well developed financial markets to reduce the information costs of borrowing and lending and making financial transactions. Financial Institutions include institutions like banks, insurance companies, provident and pension funds, mutual funds, compulsory savings schemes, cooperative banks, credit unions, informal financial intermediaries and securities markets. Financial systems vary across boundaries, socio-politic spheres and economic outcomes. Generally, banks and financial institutions dominate most formal financial systems, but lately stock markets are gaining importance particularly with international capital flows. The entry of FIIs in the stock markets and relaxation of portfolio investments by the emerging markets is playing an important role in the growth and co-integration of financial markets globally.

However, in the current era of liberalization and globalization of financial markets, the economies of developing countries have become highly vulnerable to speculative capital movements in and out of the country. The economic crisis in Mexico in 1994, more recently the currency crisis in the East and South East Asian countries in 1997, the Russian crisis in 1998, the Brazilian crisis of 1999 and the Argentinean crisis of 2001 have highlighted the role played by speculative capital movements and contagion effect in triggering-off the crisis situations. The financial crisis of July 1997 that has affected some of the best performing Asian economies has been a subject of intense concern. It has provoked rethinking, world over, on the risks and benefits that liberalization of financial and capital markets and the global integration has carved, especially for the developing countries. It has also highlighted the importance of the prudent regulation of the domestic financial and banking sectors. Finally, it has exposed some of the weaknesses of the existing approaches in handling the crises such as those enforced by the IMF. Given the increasingly interdependent nature of the world economy, the fortunes of all the countries are highly inter-linked.

IV. 1. Capital Flows to Developing Countries:

International capital flows and trends affect the volatility in the international financial markets. The volatility of financial flows may undermine the economic policy objectives of an economy, such as the achievement of inflation rate, exchange rate targets and balance of payments. Volatility and short-term financial assets also affect long-run policy objectives of an economy. They make it difficult to finance long-term investment projects. The developing economies require gigantic funds for building up infrastructure and undertake other investment projects.

The decade of the 1990s has seen major transformations in the magnitude and composition of external resource flows to developing countries. The magnitude of the external resource inflows to developing countries nearly trebled between 1991- 97. The inflows, however, declined during 1997-99, as the world was reeling under the shock of the economic crisis in Mexico in 1994, East and South East Asian countries in 1997, the Russian crisis in 1998, the Brazilian crisis of 1999 and the Argentinean crisis of 2001. The most striking trend of the 1990s with respect to the external resource flows has been their changing composition. The official flows have gradually dried up from US$ 61 billion in 1991 to US$ 39 billion by the end of the decade. As a result, their share in the total resource flows has come down from 50 per cent in 1991 to just 13 per cent in 2000. The bulk of the resources received by developing countries now comprise of private capital flows.

The composition of the private capital flows has also undergone change over the 1990s. Flows from International Financial Markets, viz. portfolio equity investments and bank lending and bonds, have grown rapidly between 1991 and 96. Since then they have declined, especially in the wake of crisis in some countries. The private debt flows (bank lending and bonds) turned negative in 1999 before recovering somewhat in 2000. Portfolio equity investments have also shrunk between 1996 and 98 but have staged a smart recovery during 1999-2000. The private capital flows, therefore, are highly volatile. They tend to aggravate a crisis situation by suddenly leaving the host country, making the financial markets highly volatile.

The rising magnitude of external resources over the 1990s has to be evaluated in terms of resource requirements. It is a matter of interest to ascertain whether the resource availability has been growing more rapidly than the growth of the economies. It is evident that resource flows to developing countries had been growing faster than their GNP up to 1998, when it reached the level of 5.56 per cent. The proportion of resource flows to GNP came down sharply in 1999, but it started to recover in 2000, with the proportion in 2000 at 4.36 per cent being slightly higher than 4.31 per cent in 1994.

One striking feature of resource transfers to low income countries is that the net transfers, after providing for total debt service, have been declining and constitute a small proportion of the total disbursements. This leads to the building up of the debt trap and an eventual collapse. It is obvious that some way has to be found by the international community to prevent such situations of negative net transfers from occurring by monitoring the debt levels and net transfers and to take corrective steps (e.g. restructuring of debt) at appropriate time.

Economic growth, based on capital flows, initially seems to bring in tremendous results. However, it had turned out to be a curse in the 90s for the emerging economies. A series of international financial crises in the 90s have increased doubts about the benefits of such flows. The weak relationship between capital flow liberalisation and long-run growth has surfaced as a fall-out of the liberalisation of capital flows. What do we exactly mean when we talk of liberalisation of capital flows? It actually refers to full capital account convertibility and relaxation of restrictions, rules and regulations that an economy might have towards free movement of capital. The chapter on “International Capital Flows and Economic Growth” in the World Banks report on Global Development Finance 2001 gives a good review of the relationship between capital flows, domestic investments and productivity growth and the costs that arise from capital flow volatility. The experience of the 90s has also raised concerns that the incidence of financial crisis is increasing, driven by the boom in capital flows.

As we said before, the benefits of capital flows are clear and bold. Developing countries have wanted larger flow of resources from the developed economies. This dream came true with the IMF, the World Bank and the WTO suggesting and enforcing the same. But it is the importance of safety mechanisms to guard against the impact of volatility that was not accounted for, which poses a serious concern. Capital flow volatility works through financial sector instability; that is, it contributes to amplifying the volatility of domestic consumption and production when the domestic financial sector is weak. Which has been the case in almost all the economies where capital flow liberalisation was implemented or enforced upon. Also Bertola and Drazen (1994) suggest that volatility of capital flows shows the variability in domestic economic conditions and this gets enhanced by policy measures to restrict capital flows.

"Capital inflows are generally welcome in developing countries to ease external constraints and help to achieve higher investment and growth. However, a sudden and large surges in such flows cause several concerns. If the capital inflows are volatile or temporary, the country will have to go through an adjustment process in both the real and financial markets. The large capital inflow and outflows have important implications for the economy", said Rangarajan, former Governor, Reserve Bank of India in the Sir Purushottamdas Takhurdas Memorial lecture .

IV. 2. FDI Inflows in Developing Countries

The International financial markets are also affected by the FDI flows. FDI has emerged as the most important channel of external resource transfers to developing countries in the 1990s. FDI
20.See Kaminsky and Reinhart 1999 “The Twin Crisis: The Causes of Banking and Balance of Payments Problems” ; Bordo & Eichengreen 2000 “Is the Crisis Problem Becoming more Severe?”
21. Caballero, Ricardo (May 2000) “Macroecomic Volatility in Latin America: A View and Three Case Studies.”
22. Berola, Giuseppe, and Allan Draze. 1994, “Will Government Policy Magnify Capital Flow Volatility?”

have also acted as an agent of integration of economic activities across the countries in the 90s. Compared to the average annual growth of trade in goods and services of about 6-7 per cent over the 1990s, FDI inflows have grown at an average annual rate of 20 per cent over 1991-95 and at 32 per cent during 1996-99 despite the economic crisis in some important regions of the world. As a result, the magnitude of global FDI inflows has increased from US$ 159 billion in 1991 to US$ 1.27 trillion in 2000. FDI inflows are expected to be less volatile and non-debt creating. They are also expected to be accompanied by a number of other assets that are valuable for development, such as technology, organizational skills, and sometimes even market access, among others. Hence, most countries – developed as well as developing – compete among themselves in attracting FDI inflows with increasingly liberal policy regimes and incentive packages. This has been the specific reason for India to stick to stringent FII norms, thereby enabling more FDI capital flows to move into the country. However, the expansion of the magnitude of FDI over the 1990s has benefited only a handful of developing countries.

The recent growth of FDI flows has been fuelled by cross-border mergers and acquisitions (M&As) in North America and Europe as a part of ongoing wave of industrial restructuring and consolidation. The value of cross-border M&As sales has grown from US$ 81 billion to US$ 720 billion over 1991-99. The bulk of these M&As (US$ 645 billion of the US$ 720 billion) are concentrated in the industrialized countries. The industrial restructuring and consolidation in the industrialized world, in turn, has been provoked by regional economic integration.

FDI inflows received by developing countries have expanded from under US$ 42 billion in 1991 to US$ 240 billion in 2000. The growth of FDI inflows in developing countries seem to have been slower than that of global inflows, especially in the late 1990s. The share of developing countries in FDI inflows rose sharply during the early 1990s from 26 per cent in 1991 to over 40 per cent in 1994. Since then it has steadily declined to below 24 per cent in 2000. The sharp rise in the share of developing countries in the early 1990s was largely owing to the emergence of China as the most important host of FDI and FII flows in the developing world.

There has also been a shift in the relative importance of different regions as hosts of FDI inflows received by the developing countries since 1993. Developing Asia has been the most important host region of FDI inflows accounting for over half of FDI inflows to developing countries. Initially, developing Asia’s share showed a rising trend peaking at 70 per cent in 1993. However, its importance has declined steadily since then. Latin American countries have steadily improved their share since 1993 with their share converging to the Asian level towards the end of the decade. The strong trend towards regional economic integration has helped Latin American countries to improve their share in FDI inflows while the East Asian crisis has taken a toll on the share of Asian developing countries.

Within Asia also the relative importance of sub-regions is changing. China dramatically improved her share in the inflows to developing countries from 10 per cent in 1991 to 38 per cent in 1993. Since then, however, China has not been able to keep its share in the inflows into Asia. Share of some of the Asian countries, viz. Hong Kong, Taiwan, and South Korea has fluctuated around 14 per cent up to 1997. It has risen sharply over 1998-99 largely owing to cross-border M&A activity in post-crisis South Korea. ASEAN countries, particularly, Singapore, Malaysia, Thailand, Indonesia, Philippines, have been popular hosts of FDI in the region. Vietnam has also become an increasingly important host following its integration with ASEAN.

The region initially lost its share largely owing to the emergence of China. During the 1994-96 periods, ASEAN countries actually improved their share in Asian inflows. Since 1997, they have lost their share owing to the crisis of 1997. In particular, there has been disinvestment in Indonesia for the past two years in a row. South Asia, comprising some of the poorest countries in the region, has been a marginal host of FDI inflows. The region is facing a further marginalization as a host of FDI inflows since 1998, even though it was spared from the direct effect of the currency crisis.

There are sharp inter-country variations in FDI flows to different countries. FDI inflows are highly concentrated in a handful of high and middle income countries. Low income and least developed countries remain marginalized in the distribution of FDI inflows. The share of 45 least developed countries as a group in global FDI inflows is negligible at half a per cent and it shows a declining trend over the 1991-99 periods. Just ten most important hosts of FDI among developing countries account for over 80 per cent of all inflows received by developing countries in 1999. The concentration in the top ten recipients has increased from 66 per cent in the mid-1980s to over 80 per cent in late 1990s. The expanding magnitudes of FDI inflows tend to create optimism among poorer countries regarding the potential of these inflows for expediting the process of their development.

Global FDI inflows declined in 2002 for the second consecutive year, falling by a fifth to US$ 651 billion – the lowest level since 1998. Flows declined in 108 of 195 economies. The main factor behind the decline was slow economic growth in more parts of the world and dim prospects for recovery at least in the short term. Besides there has been falling stock market valuations, lower corporate profitability, a slow down in pace of corporate restructuring in some industries and winding down of privatization in some countries. A big drop in the value of cross-border mergers and acquisitions figured heavily in the overall decline. The number of mergers and acquisitions fell from a high of 7894 cases in 2000 to 4493 cases in 2002. Their average value fell from US$ 145 million in 2000 to US$ 82 million in 2002. The number of deals of mergers and acquisitions worth more than $ one billion i.e. from 175 in 2000 to only 81 in 2002 – the lowest since 1998.
23.Financial Express “Capital flows curbs tricky – Rangarajan” November 17th, 2000

The decline in FDI in 2002 was uneven across regions and countries. It was also uneven across sectorally: flows into manufacturing and services declined, while those into the primary sector rose by 70 per cent. Services are the single largest sector for FDI inflows. The equity and intra-company loan components of FDI declined more than reinvested earnings. Geographically, flows to developed and developing countries each fell by 22 per cent (to US$ 460 billion and US$ 162 billion respectively). Two countries – the United States and UK accounted for half of the decline in the countries with reduced inflows. Among developing regions, Latin America and Caribbean were the hardest hit, suffering its third consecutive annual decline in FDI with a fall in inflows of 33 per cent in 2002. Africa registered a decline of 41 per cent. FDI in Asia and the Pacific declined the least in the developing world because of China which with a record inflow of US$ 53 billion making China the world’s largest host country for FDIs. CEE did the best of all regions, increasing its FDI inflows to a record US$ 29 billion.

There was a sizable decline of FDI inflows in 16 out of the 26 developed countries. Australia, Germany, Finland and Japan were among the countries with higher FDI inflows in 2002. FDI outflows from developed countries have also declined in 2002 to US$ 600 billion. The fall was concentrated in France, Netherlands and U.K. While FDI outflows from Austria, Finland, Greece, Norway, Sweden and US increased.

V. Restructuring of IMF

Agarwal (2004b) proposed that there is an urgent need for restructuring the IMF to handle the financial crisis faced by various nations in a more meaningful way. First, there is a need for considering in a systematic fashion, not only the role of world institutions, but also of regional arrangements. Accordingly, regional monetary funds to monitor, regulate and suggest measures to countries of the region may be set up. Regional Monetary funds should be set up to assist developing countries in different regions for meeting their temporary liquidity problems and to help them avert default which may perpetuate the crisis by shaking the confidence in these economies. An attempt was made in this regard in 1997. The Japanese government had proposed to set up an Asian Monetary Fund (AMF) first in 1997 to monitor the region’s economies and provide early warning to the respective governments on the impending crisis. It could also provide speedy assistance to deal with the crises in their early stages so as to prevent them from spreading. AMF could also be a significant step towards decentralization of international monetary and financial decision making that is presently concentrated in the Washington, DC. Regional Monetary Fund could understand region specific issues better that IMF. However, despite strong support within the region, the proposal for an AMF did not get far. It was opposed by the United States and IMF, as it posed a threat to the monopoly of IMF. However, in 1998, Japan proposed the Miyazawa Plan at the Annual IMF-World Bank meeting, which is a more modest proposal. It seeks to provide a $ 30 billion package for the region for short-term trade financing as well as recovery through long-term projects. It was suggested that the Japan Export-Import Bank, the World Bank and the Asian Development Bank could jointly take part in the initiative. As a part of this initiative, Japan established short-term swap arrangements with South Korea ($5.0 billion) and Malaysia ($2.5 billion). Other regions of the world need to set up regional monetary funds. Agarwal in his keynote address in Chile on “Volatility of International Financial Markets: Regulation and Financial Supervision” proposed that “India can take initiative to form a regional IMF- SAARC Monetary Fund to assess and help the member countries of this region”. Secondly, there is an urgent need to review the working of IMF as IMF package of reviving economies is often counter productive for most of the countries approaching IMF. Often IMF prescribes the same set of conditionalties to every economy irrespective of its requirements. For instance, the IMF package uniformly insists on belt tightening, devaluation and demand compression measures that affect growth adversely and hence make recovery even more difficult and aggravates volatility in financial markets. Furthermore, despite a widespread recognition of the role played by the capital account liberalization in accentuating the crisis, the IMF has been pushing the affected countries towards accelerated capital market liberalization in the wake of the crisis. IMF often adopts a short sighted and rather inflexible approach to crisis management. Malaysia decided to withdraw from the IMF Program soon after it was initiated to the program after the crisis. Instead, Malaysia adopted an unorthodox approach to dealing with the crisis that included imposition of capital controls although temporarily and the adoption of a fixed exchange rate regime. More importantly, Malaysia’s approach also included lower interest rates and fiscal expansion or pump priming by the government as against belt tightening measures and balancing of budget included in the IMF package. As a result, Malaysia did not suffer the kind of social consequences that other affected countries did and the recovery was rather quick with a 5.8 per cent growth of GDP in 1999 and 8.5 per cent in 2000, compared to much lower rates of growth achieved by Thailand, Indonesia and the Philippines under the IMF program. Thirdly, there is also need for revival of SDRs Allocation. Special Drawing Rights (SDRs) were established by the IMF at the end of the 1960s to supplement international liquidity. SDRs were supposed to become the principle reserve asset. However, the allocation of SDRs has been abruptly halted since 1981, thus adversely affecting the ability of developing countries to supplement their reserves and making them vulnerable to the liquidity crisis. They have been forced to borrow on onerous terms to augment their international reserves. The institution of SDRs continues to be relevant, especially for developing countries and it should be restored as soon as possible by the IMF. There is, therefore, need for a thorough reform of the IMF’s working and bringing flexibility into the package that keeps in mind the specific needs of the affected countries.

IMF is currently viewed as a single global institution with no alternatives. It should rather become an apex institution with a network of regional or sub-regional monetary funds.

VI. Conclusion

The question of whether globalization should be allowed to proceed is vital. This primarily rests on the judgment as to whether the society is ready for greater economic freedom, volatile competition and reduced controls. On the face, these decisions do depend on those who govern the society. However, it is the society at large which deems the decision on the natural law “Survival of the fittest”.

To say that some economies prosper and others sink at the hands of globalization would be wrong. Looking at long-term growth trends, one can certainly see the benefits to all reaping in. There is no gain without pain. The agreement among regions and societies on the stand for those economies that have been open to cross-border trade and flows have has seen a positive trend. Clearly, ideas shape societies and economies. Most economists would agree that vigorous economic competition, opening up of society, capital and labour movements over the years has produced a significant rise in the quality of life for vast majority of population in mixed market-oriented economic system, including the downtrodden. The highly competitive free market paradigm, however, is viewed by many at the other end of the philosophical spectrum. This is nothing else but a simple tradeoff from a longer-term perspective in any meaningful sense. During the past century, economic growth has created resources far in excess of those required to maintain subsistence. That surplus, even in the most aggressively competitive economies, has been in large measure employed to improve the quality of life along many dimensions. To cite a few, we see, greater longevity due to better health services , better education environment with increased social mobility, improved work conditions and the ability to enhance our surroundings and adapt.

Talking of globalization and international capital flows, it is highly relevant for any economy to bring in fiscal discipline, restructuring of public expenditure priorities, tax reforms (widening of tax base and reduction), liberalization of interest rates, managed exchange rates, trade liberalization, policy to enhance FDI / FII investments, motivating privatization, setting forth the regulation and secured citizen’s life. The global economy is facing major adjustments on several dimensions simultaneously. The successful adaptation to change requires great flexibility. It is difficult to anticipate how the international environment will unfold. The evolving geographic, political, technological consolidations for higher production of goods and services is brining in the new revolution for the global economy. This is shifting the balances between spending and production with financial mobility at a light's speed. The fear that lies ahead is the poorly formed diagnoses and incorrect policy prescriptions, which may lead to unintended adverse consequences for the world economy. The world is moving towards a new regime of re-formulation of the elements of rigidity in exchange rates, in labor markets, in finance, international trade and economic framework. Given the limitations of growth and adaptability as seen over centuries of existence of human civilization, the channels through which the adjustment process brings forth rigidity concentrates stresses increasing the risk of market disruptions, economic resiliency leading the world to not unleash the full potential of the rise in global productivity and intern raise of standards of living and reduction of disparities of incomes. Market economies require a rule of law. A society without state protection of individual rights, especially the right to own property, would not build private long term assets, a key ingredient of a growing our desired modern economy. Yet an excess of rules in the extreme case, has shown to stifle initiative and produce economic stagnation.

Economic performance in the Asia-Pacific region (excluding Japan) has been impressive, with real GDP increasing by over 6 percent in 2002, and the smaller relatively open economies turnaround relative to 2001. This strong growth - at a time when the recovery in industrial countries has been relatively week - has raised the issue of whether Asian economies have become less reliant on demand from outside the region following the WTO-linked opening of China and increased inter-regional trade. With the rapid export growth seen in the first half of 2002 now slowing, the question of whether growth in Asia has become more self-sustaining is important for the outlook, particularly if the weakness in the global electronics sector evident since mid-2002 persists.

India, the largest democracy of the world, is all set to become major economic power. India faced its worst ever financial crisis in 1991 when its foreign exchange reserves fell below one billion dollars, inflation rate was as high as 16.7 percent, suffering from high fiscal deficit, high unemployment rate and several other economic weaknesses and other odds. India has successfully launched and handled its economic reforms process of privatization and liberalization to bring about macro economic stabilization despite the US sanctions. Its foreign exchange reserves have crossed 100 billion dollars ; fiscal deficit is within tolerable limits, growth rate of 7 percent expected for the current year; the rupee is gaining strength despite RBIs intervention, banking and financial institutions have improved, BSE Sensex has crossed over 6000 points from a low level of 3000 six months ago. The overall outlook of the economy is encouraging.

India’s entry and sustained growth in the last decade opens up immense possibilities for becoming a truly favoured global nation and economy. India has benefited from the old heritage (dating back to 7000 years), traditional value system and economic and societal norms. These have empowered India and Indians to accommodate and adjust with changing times and scenarios over the history. We have seen times when there was free movement of labor and capital in the golden arena of our nation Bharat. Today’s globalization does encompass part of it, wherein capital and trade is certainly an issue. However, labour has been restrained from this. It has been observed that all large multi-ethnic societies, after attaining the status of development, lose interest in removing poverty, especially when poverty is associated with ethnic and cultural groups that lack or lose political clout. The issue of poverty is a paradox of plural democracy when it is wedded to global capitalism. And the paradox is both political-economic and moral. The gradual privatization and the consequent need to regulate investments; the growing importance of private investment and the emergence of the mixed-market economy are some of the characteristics of the political economy of India resulting from its engagement with the global economy in the 1990s. If we are really talking of a globalized world, then we need to free ourselves of these barriers and allow the market mechanism to freely flow and be part of this large society.

24.The Finance Minister on December 22, 2003 had stated that the steady rise in the forex reserves was boosted by foreign investment inflows, trade flows and revaluation gains on the dollar’s weakness against global currencies. The significant aspect is that the forex reserves, which is next only to Japan, China and Korera in Asia, is most non-debt creating in nature. The Finance Minster further added that, the forex reserves had increased by about US$ 94 billion since 1991, while the external debt had gone up only US$ 20 billion. According to Reserve Bank of India, foreign currency assets surged to $96,549 million as against $92,148 million, in the corresponding period last month. Meanwhile, the gold reserves increased to US$ 4,038 million as against US$ 3,920 million on November 28, 2003. The Special Drawing Rights have stood steady at US$ three million . It is worth to note that this rise in the forex reserve has been achieved despite prepayment of US$ 5 billion of external debt in 2003, outflows of around US$ 5.5 billion towards the redemption of SBI’s Resurgent India Bonds and a contribution of US$ 498 million to International Monetary Fund.

Developing countries have made substantial progress in the last decade. They have been able to achieve a stable and open macroeconomic environment dispite opening themselves to the flow of private capital and liberalized markets. As we advance in the reforms, the financial crises have turned to be a learning experience and a cost to developmental processes. Assessing crisis risk is never an exact science. A number of researchers have worked on so called early warning systems models of debt and exchange rate crises in emerging market countries. These statistical models incorporate factors such as exchange rate overvaluation and debt maturity structure to try to arrive at probabilistic predictions of financial crises. The models seem to work pretty well in isolations, in detecting vulnerabilities in countries that actually experienced crises. However, if the models are tuned broadly enough to the real life situations, they are unable to project crises and at tiles lead to a cry wolf in many cases where no crises may occur. Also, evidence on international capital flows suggests that FDI is less volatile than other financial flows. It has been widely recognized that both country-specific and global factors matter in explaining capital flows (Fernandez-Arias and Montiel 1996, Taylor and Sorno 1997).

Appendix I
Corporate Strategy of Spilling Over

Corporates have been known to use the strategy of growth and expansion to disguise the poor financial state of an organisation. They set up or bring in newer companies as subsidiaries showing expansionary phase, take loans and using these loans basically for repayments of previously held debts (as an internal roll over technique) or by issuing long term bonds which later float in the capital markets. This is good in the short run and in times of economic crisis for corporates as they would have these accounts balanced over future profits. Also the borrowing information of the corporates is kept a secret with the bank and not disclosed in banking institutional setup of most countries to any agency or institution, unless under situations of national emergency. The actual financial health of the organisations cannot be judged. From the outside, it may seem that they are in a very good shape, since these corporates are growing and expanding. Also the credit rating agencies are taken into confidence by such companies to depict good position. But in actual situations, these organisations may just use these expansionary companies to finance previously held debts. For keeping the positions clean, these organisations with the help of experts and accountants, window dress their balance sheets and move ahead. This strategy works very well in the short run. But those organisations, which use this strategy in the long run, can only survive if they have these subsidiaries or such companies sold off to other companies. The other companies are the ones, which are willing to takeover the companies do so for their growth positioning. The accounting tools of window dressing the balance sheets, stock market valuations and credit ratings for giving a bright picture of their companies are used to enhance there position for sale. In most such cases, the takeover companies happen to be either companies with huge monetary base as compared to previous companies or those which are not so well acquainted with the situations and find them very lucrative. Sometimes the takeover companies relax their takeover procedures, as they want to take benefit of short up or cheaper expansionary environment or are trying to diversify risk and profit portfolios. Thus, the transfer of financially debt-ridden and ill-health of an organisation is done. This makes the future owners of the companies to bear the risk and debt burden.

Spill-over Strategy:

Arrow flow chart2


1. _________, (1997) SE ASIA analysts see continuing currency volatility in region Market News, November 25th, 1997.

2. Agarwal, Aman (2000), E-finance is the key element today: In tune with E-commerce Times of India, July 3rd, 2000

3. Agarwal, Aman and Biswajit Barua (1998), Red Alert? Is it Asian or World Crisis, unpublished work

4. Agarwal, Aman, Muhammad Rao Aslam, Namita Datta, Hettiarchchige Don Bernard S. Perera, Tshewang Norbu and Venkiteswaran Ramakrishnan (2002), Impact of Governance on Economic Development in South Asian Region, Finance India, XVI No 2, June 2002. Presented at Columbia University, New York, USA, (November 2000).

5. Agarwal, J.D. and Agarwal, Aman (2001), Liberalization of Capital Flows, Banking System & Trade: Focus on Crisis Situations, International Review of Comparative Public Policy titled nternational Financial Systems and Stock Volatility Volume 13, pp. 151-212. Invited to present at 18th International Conference of Finance at Namur, BELGIUM (25th-28th June 2001), at Florida International University, Florida, USA (26th September 2001), discussed with FIU Finance faculty at Luncheon presentation, Florida, USA (27th September 2001), at Pontific Catholic University of Rio de Janerio, Rio de Janerio, BRAZIL (22rd October 2001). Also Discussed at few conferences in USA and UK in April and May 2001.

6. Agarwal, J.D., (2004a), Financial Developments in the World Economy delivered the late Professor K.S. Mathur Memorial Lecture, by University of Rajasthan on Saturday, 3rd January 2004 in Senate Hall of University of Rajasthan, Jaipur, INDIA; forthcoming Finance India Vol. XVIII Special Issue, 2004.

7. Agarwal, J.D., (2004b), Volatility of International Financial Markets: Regulation and Financial Supervision delivered as Keynote Address at the 4th International Conference in Finance organized by Faculty of Administration & Economics, University of Santiago de Chile, CHILE on 7th January 2004; forthcoming Finance India Vol. XVIII No. 1, March 2004.

8. Agarwal, Manju, Aman Agarwal & Biswajit Barua, (1998), Inflation: Study with respect to India, Finance India, Vol 12 No 2, June 1998.

9. Altback, Eric (1997), The Asian Monetary Fund Proposal: A Case Study in Japanese Regional Leadership Japan Economic Institute (JEI) Report, No. 47A, Dec. 19, 1997. P. 5; Appendix Table 3.

10. Barth, Marvin and Trevor Dinmore (1999), Trade Prices and Volumes in East Asia through the Crisis Board of Governors IFDP, No. 643, August.

11. Benink, Harald & Clas Wilborg, (2001), An unlevel playing field The Banker Supplement, Financial Times April 2001

12. Bernanke, Ben S. (2003) "A Perspective on Inflation Targeting" at the Annual Washington Policy Conference of the National Association of Business Economists, Washington, D.C., March 25, 2003; Federal Reserve Board, USA

13. Berola, Giuseppe and Allan Draze (1994), Will Government Policy Magnify Capital Flow Volatility?

14. Bordo & Eichengreen (2000) Is the Crisis problem becoming more severe?

15. Broda, Christian and Cedric Tille (2003) Coping with Terms-of-Trade Shocks in Developin Countries Current Issues in Economics and Finance, Federal Reserve Bank of New York, Vol 9 No 11, November 2003

16. Bullard, Nicoala, Walden Bello and Kamal Malhotra (1998), CIDSE Study - Taming the Tigers: The IMF and the Asian Crisis March 1998 (http://www.cidse.org/pubs/tamingtigers.html)

17. Caballero, Ricardo (2000) Macroeconomic Volatility in Latin America: A View and Three Case Studies., May 2000.

18. Chen, Zhaohui and Mohsin S Khan (1997) "Patterns of Capital Flows to Emerging Markets: A Theoretical Perspective" IMF Working Papers 97/13, January 1997, International Monetary Fund, Washington DC, USA

19. Chernow, Ron (1997), Grim Reckoning in Japan and Beyond New York Times, November 17, 1997: A29.

20. Cronin, Richard P.(1998), Asian Financial Crisis: An Analysis of U.S. Foreign Policy Interests and Options Specialist in Asian Affairs, Foreign Affairs and National Defense Division in the CRP Report to the Congress January 28, 1998

21. Ferguson, Jr., Roger W. (2003), "The Proposed U.S. Approach to Regulatory Capital: An Update" at the conference on The Changing Regulatory Capital Regime in Europe: A Challenging New Business Concept, Brussels, Belgium; Federal Reserve Board, USA

22. Fernandez-Arias, E. and Montiel, P.J. (1996) The surge of capital inflows to developing countries: an analytical overview, World Bank Economic Review, Vol 10 No. 1, pp 51-77.

23. Gelos, R. Gaston & Ratna Sahay, Financial market spillovers in transition economies Journal of the Economics of Transmission, Vol IX No1

24. Gerlach, Stefan and F. Smets (1995), Contagious Speculative Attacks European Journal of Political Economy, Vol 11, pp. 45-63.

25. Global Development Report, 2002, 2001, publication of World Bank

26. Greenspan, Alan (1997) The growing international financial system before the Committee on Banking and Financial Services U.S. House of Representatives, November 13, 1997

27. Greenspan, Alan (1997), Turbulence in world financial markets at the Joint Economic Committee, U.S. Congress, October 29, 1997.

28. Greenspan, Alan (2003) "Market Economies and Rule of Law" at the 2003 Financial Markets Conference of the Federal Reserve Bank of Atlanta, Sea Island, Georgia, April 4, 2003; Federal Reserve Board, USA

29. Greenspan, Alan (2004) "Risk and Uncertainty in Monetary Policy", Keynote address at American Economic Association, San Diego, California, January 3, 2004, Federal Research Board, USA

30. International Monetary Fund, International Financial Statistics Various issues.

31. Kaminsky and Reinhart, (1999) The Twin Crisis: The causes of Banking and Balance of Payments Problems

32. Kaminsky, Graciela L. and Carmen M. Reinhart (1998), On Crises, contagion, and confusion’, paper presented at the Duke University conference Globalisation, Capital Market Crisis and Economic Reform.

33. Kohn, Donald L. (2004) "The United States in the World Economy", Federal Reserve Board, USA, January 7, 2004

34. Kolodko, Gregorz W (2002), “Globalization and Catching-up in Emerging Market Economies”, WIDER Discussion Paper, WDP 2002/51, May 2002.

35. Mussa, Michael, (2001) “Open Doors: Foreign participation in financial systems of developing countries” dinner speech of Dr. Michael Mussa, Chief Economist, IMF on 20th April 2001.

36. Raghuram, Rajan, (2003), “Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Special Opportunity”, USA.

37. Rangarajan (2000), “Capital flows curbs tricky – Rangarajan” Financial Express, November 17th, 2000, at the Sir Purushottamdas Takhurdas Memorial lecture

38. Taylor, M.P. and L. Sarno (1997) Capital flows to developing countries: Long- and shortterm determinants, World Bank Economic Review, Vol 11 No 3, pp. 451-70.

39. Tett, Gillian, (2001), Markets shaken as Japanese bad bank loans claim is denied Financial Times, 27th July 2001

40. World Development Investment, 2003, 2002, publication of United Nations

41. World Economic Outlook, 2003, 2002, 2001, publication of IMF

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