Alongside
trade and payments liberalization, the rapid integration
of financial markets in the 1990s has hastened the process
of globalization in international trade and finance. Total
capital flows to the developing world soared to US$ 303
billion in 1996 from US$ 237 billion in the previous year,
thanks to a sharp rise in private flows to a record US$
234 billion (up from US$ 160 billion in 1995). And nowhere
has this phenomenon of increased access to international
capital markets been more notable than in the rapidly growing
economies of East Asia.
Under perfect market conditions, it is
contended that the potential benefits of free capital movements
(facilitating an efficient global allocation of resources
and channelling them into the most productive uses) outweigh
the costs (increased vulnerability of an economy to swings
in investor confidence). The magnitude and composition of
inflows and their productive deployment in the economy may
be beyond the control of national governments, in economies
where the private sector has become dominant. The latter
is typically allowed unrestricted access to external finance
in the belief that it has the capacity to assess carefully
the costs and benefits on which borrowing and investment
decisions are made. However, when the market’s judgement
is impaired by the existence of market failures (the existence
of asymmetric information, incompleteness of contingent
markets), it can lead to excessive borrowing from abroad,
or excessive lending by international financial markets
which may eventually undermine macroeconomic stability.
If the first best option of removing market
imperfections is not feasible, then the desirability or
otherwise of opening the capital account rests on the perceived
ability of governments to deal with capital flows. An increased
inflow of capital confronts governments with its own set
of problems, including whether to accept or resist such
capital inflow, or how much to accept and how much to resist.
The impressive growth performances of the East Asian economies,
driven by a surge in foreign capital inflows in the 1990s,
were regarded as successful examples of macroeconomic management.
In the aftermath of the financial crises of 1996/97, the
policy-mix adopted by most East Asian economies has come
under criticism – particularly the adoption of a virtually
fixed rate of exchange. Together with weak financial sectors,
they can be identified as the main reasons for the crisis
that engulfed the region.
In Sri Lanka, foreign capital inflows to
bolster investment and hence the rate of growth is regarded
as an even greater necessity in the context of a low rate
of savings in the country. Is a free and open capital account,
however desirable in the light of the East Asian experience?
Do policymakers have the necessary manoeuvrability and the
flexibility to fine-tune economic policy to deal with the
macroeconomic consequences of large and sustained capital
inflows? And even if Sri Lanka were to adopt an open capital
account regime, would it necessarily lead to an increase
in foreign capital inflows and if so, what type of inflows
are likely to occur or is an outflow of capital more likely?
This paper examines the underlying causal
factors that combined to produce the East Asian financial
crisis and attempts to draw useful lessons for Sri Lanka
as it endeavours to emulate their development experience.
Section 2 discusses the changing trends in foreign capital
flows in the 1990s that underlay the emergence of instability
in capital movements across borders and the means open to
governments to deal with a surge in foreign capital flows.
Section 3 discusses the financial crisis in East Asia with
particular attention to the role of the financial sector;
Section 4 examines Sri Lanka’s past experience in
dealing with a surge in capital inflows and the lessons
to be learnt from the East Asian experience; and Section
5 summarizes with the concluding remarks.
Table of Contents:
- Introduction
- Capital Inflows to East Asia: causes and trends
- Financial Crises in East Asia
- The Sri Lankan Experience in Managing Capital Inflows
- Conclusion
- References
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