Monday, April 11, 2011

Capital: Control or Free Flow

It was not so long ago when economic theorists argue that it was OK for people and capital to flow freely around the world, in the belief that it would be favourable for economic growth as well as economic welfare. Economic growth because these people and capital have to work hard to find the extra gain from existing resources - meaning more output and more output. Economic welfare because these people and capital owners have income or extra income and that by things getting cheaper the welfare of the average consumer is improved.

With globalisation and the ICT whereby the flow of people and capital can be made almost instantaneously, the free flow of people and capital can be likened to the unfortunate but relevant image of the tsunami where an extraneous force comes strongly into the domestic system, and leaves just as quickly but in that quick second, the end result is devastation. No matter how strong or how stable, no man-made system can withstand such violent forces.

The unleashing of the manpower of the Chinese people from the grips of authoritarian control to one of a freedom to negotiate and trade has caused an explosion in the manufacturing world where there is little room for the less than competitive. Either you are competitive or not competitive. The export of competitively priced goods by China has made the Chinese people the sloggers for the whole world, with very little for themselves except for the opportunity to work. The capital owners were happy to make that extra cash and they continue to pour capital in enterprises in China. In the meantime, the costs of raw materials rise around the world because of the unprecedented prolonged of China and this is causing the cost of living to rise around the world including China. While the standard of living of Chinese workers can be adjusted by raising their nominal wages, workers in other parts of the world whose livelihoods have been devastated because of their lack of competitiveness have no choice but to look for new political leadership blaming their day-to-day difficulties on corruption of the ruling elite.

US, which has the unique privilege of unlimited printing of its paper money, solves its problem of lack of competitiveness by printing still more money. As China and other parts of Asia as well as some parts of Europe and Africa benefit from the slog of the Chinese workers, those who have managed to obtain the cash that the US is printing choose to invest for short-term gains in those investments without them sinking one cent into a real piece of machinery. These are the short-term capital investors, the investors of portfolios on the stock market. These are the ones that cause havoc on the foreign markets when they come in and out, on the stock market when they come in and out, on the property market when they come in and out.

Economists have long thought hard and long on what to do with these short-term capital flows. Most economists, if not all, have decided against them. How to prevent these short-term capital flows from having a bad impact on the local economy. Sterilisation - how to remove these short-term flows from the banking system. Rise in the reserve ratio of banks - so that banks can create less credit out of these short-term funds. Capital controls - these are the most drastic, how not to allow them to enter the economy at all.

In some countries in the past, Peru, I think - they even try to prevent the entry of long-term borrowings by private companies because eventually they will have to repay and they will chew up their foreign reserves and hence cause a decided deterioration in their exchange rate.

In Malaysia, there was an attempt to sterilise the short-term flows in the 1990s but failed because the central bank wanted to be nice and pay depositors their market deposit rates, and its attempt to recoup from the forex market failed. The second mistake was to use those short-term funds in the stock market for long-term investments. When the funds pulled out, the capital market collapsed. The third mistake was to capital controls to stop funds from getting out of the economy. This mistake was big. It removed all confidence investors has on the government to conduct policies properly. There is nothing wrong with capital controls. If you do not want funds to come in, don't let them in in the first place. If you let funds in in the first place, you cannot trap them and prevent them from leaving. There were other mistakes as well, such as taking the currency out of international trading and not understanding the sophisticated on the forex market. The short-selling that was pushing down the ringgit had to be covered later, and when that happened, the ringgit would have recovered to near its equilibrium which was fairly high because of the fundamental surplus on the trade balance. In any case, Malaysia screwed up and we have not properly recovered since.

The many discussions on the capital flows or controls are interesting but they are by no means simple. It is a sign of the times, that things have been cheapened by their apparent plentifulness - everywhere, things are piling all around us. The only thing we do not seem to have sufficient is green environment for healthy food for us to eat.

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