Sen (ed ) financial fragility, debt and economic reforms (1996)

FINANCIAL FRAGILITY, DEBT AND
ECONOMIC REFORMS


Also by Sunanda Sen

COLONIES AND THE EMPIRE: INDIA, 1890-1914


Financial Fragility, Debt
and Economic Reforms

Edited by

Sunanda Sen

Professor of Economics
Jawaharlal Nehru University
New Delhi


First published in Great Britain 1996 by

MACMILLAN PRESS LTD

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from the British Library.
ISBN 978-1-349-13801-2 (eBook)
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First published in the United States of America 1996 by

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Library of Congress Cataloging-in-Publication Data
Financial fragility, debt and economic reforms / edited by Sunanda
Sen.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-312-16225-2
1. Monetary policy. 2. Structural adjustment (economic policy)-Developing countries. 3. International finance. I. Sen, Sunanda.
HG230.3.F553 1996
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Contents
vi

Preface
Notes on the Contributors

viii

Introduction

viii

viii Financial Globalisation, Systemic Risk and Monetary
Control in OECD Countries Michel Aglietta

13

On Financial Fragility and its Global Implications

Sunanda Sen

35

3

Financial Markets and the Real Economy Laurence Harris

60

4

Fluctuations in Global Economy: Income, Debt and Terms
of Trade Processes Amiya Kumar Bag chi

73

2

5
6
7
8
9
10
11

Alternative Approaches to Adjustment and Stabilisation
Hans W. Singer

103

The Appraisal and Evaluation of Structural
Adjustment Lending: Some Questions of Method John Toye

111

Trading Off Investment for Exports: African Adjustment
Experiences Jean-Marc Fontaine

133

Emerging Markets, Industrialisation and Development
Ajit Singh

153

Regulatory Implications of Global Financial Markets
Stephany Griffith-Jones

174

External Adjustment: the Proper Role for the IMF
Richard N. Cooper

198

Inflation and Transition: from Soviet Experience to
Russian Reality Jacques Sapir

204
237

Index

v


Preface
The present volume concentrates on some relatively untrodden areas of
research in the field of international finance. Attention, in particular, is
drawn to the tendencies for volatility in the international capital markets
and the dominance of finance in the global economy. In the process,
finance of late has remained far removed from real transactions, in particular in the industrialised countries. International financial flows to the
developing countries, controlled by the official multilateral and private
financial institutions, have been regulating the pace and pattern of the
structural adjustment policies which form the core of economic policies in
these debtor economies. The present volume seeks to unfold and analyse
the links between international finance and national economic management; the fragility of finance, the evolving pattern of developing country
debt and the impact in terms of economic reforms in both the developing
and the transitional economies.
My involvement in the present volume started in 1992 when I was
requested by the Maison des Sciences de I' Hommes of Paris to organise a
colloque on international debt. The colloque took place in November 1992
and the practical hurdles in collecting a set of new or updated versions of
papers presented by the authors in the Paris Colloque was overcome as I
went back to England in 1994 with an invitation from the University of
Cambridge.
I owe a large debt to many of my colleagues and to institutions at home
and abroad in this venture of editing the present collection. I would like to

thank Geoff Harcourt for his initiatives and advice without which the book
would never have seen the light of day. Amiya Bagchi and Ajit Singh,
two contributors to the present volume, have extended strategic help
whenever necessary. I obtained institutional support in terms of secretarial
help and office facilities from the Faculty of Economics and Politics at the
University of Cambridge and the South Centre at Geneva during the
difficult days of editing and processing the manuscript. The Maison des
Sciences de I' Hommes at Paris was generous in inviting me, as a Directeur
d'Etudes, to host and to lend their secretariat for organising the colloque in
Paris where the authors met each other and presented their papers in a congenial atmosphere. My colleagues at the Centre for Economic Studies and
Planning at Jawaharlal Nehru University allowed me to be on long leave
from the university which made it possible to take time off from teaching.
vi


Preface

vii

The Nehru Memorial Library and Museum at New Delhi provided me a
Senior Fellowship and the requisite freedom to work on this project during
1992-4. Suparna Karmakar assisted me in correcting the proofs. I would
like to thank all of these institutions and individuals for the help received.
Sunanda Sen
New Delhi


Notes on the Contributors
Michel Aglietta is a professor at the University of Paris-X Nan terre and a
scientific adviser for the Centre for International Studies and Forecasting

(CEPII). He also acts as a consultant to the Banque de France. Aglietta's
major work is The Theory of Regulation of the Capitalist Economy ( 1974).
Amiya Kumar Bagchi is currently the Director of the Centre for Studies
in Social Sciences at Calcutta. He has also taught in Presidency College,
Calcutta and at the University of Cambridge, UK. He has published
Private Investment in India 1900-1939 (1972), Political Economy of
Underdevelopment (1982) and Presidency Banks and the Indian Economy
1876-1914 (1989). Books edited by Bagchi include Democracy and
Development (1995), UN, Journal of Development Planning (1994)
(Special Issue on the Teaching of Economics in Developing Economies)
and Political Economy: Studies in the Surplus Approach (1987) (Special
Issue on East Asian Capitalism).
Richard N. Cooper is currently the Maurits C. Boas Professor of
International Economics at Harvard University. He has earlier taught at
Yale University and has worked with the Bank of Boston, US Department
of State and the US Council of Economic Advisers. His publications
include The Economics of Interdependence (1968), The International
Monetary System (1987), Economic Stabilization and Debt in the
Developing Countries (1992) and International Finance (ed.) (1971).
Jean-Marc Fontaine is Director, Centre de Recherche economique
IEDES at the University of Paris I (Sorbonne). He has edited a book titled
Foreign Trade Reforms and Development Strategy (1992), Reforms du
Commerce Exterieur et Politiques de Developpement, ( 1992) and authored
Mecanismes et Politiques de Developpement Economique (1994).
Stephany Griffith-Jones is a senior fellow at the Institute of Development
Studies in the University of Sussex. She has worked for the Central Bank
of Chile, for the ECLAC and for various international organisations. Her
recent books include Financial Sector Reform in Central and Eastern
Europe (1994) and Surges in Capital Flows to Latin America (1995).
Laurence Harris is Professor of Economics at the SOAS in the

University of London. He has previously taught at the LSE and Birbeck
viii


Notes on the Contributors

ix

College, London University and at the Universities of California and
Zimbabwe. His books include Monetary Theory (1981), Rereading
Capital (1981), City of Capital (1983) and New Perspectives on the
Financial System (co-edited) (1988).
Jacques Sapir is a vice-professor at the Ecole des Hautes Etudes en
Sciences Sociales and at the University of Paris-X Nanterre at Paris. He is
a specialist in the economics of the former Soviet Union and has been
active in France and abroad organising research in the area. He has
recently authored two books on Soviet experiences and the issues of
Russian transition.
Sunanda Sen is a professor at the Centre for Economic Studies and
Planning, Jawaharlal Nehru University, New Delhi. She has taught earlier
at Jadavpur University, Calcutta and the University of Grenoble, France.
Her recent work includes Colonies and the Empire (1992) and India's
External Economy (forthcoming 1996).
Ajit Singh is currently Fellow and Director of Studies in Economics at
Queens College, Cambridge University, UK. He also holds a visiting
Chair in Economics at the University of Notre Dame in the US. His publications include Take-overs: Their Relevance to the Stockmarket and the
Theory of the Firm (1971), Growth, Profitability, and Valuation (1968)
(co-authored), Corporate Financial Structures in Developing Countries
(1992), Economic Crisis and Third World Agriculture (1993) (co-edited)
and State, Markets and Development (1994).

Hans W. Singer is a professorial fellow at the IDS and Emeritus
Professor at the University of Sussex. He has been a member of the UN
Secretariat during 1947-69. Recent work includes Economic Progress and
Prospects in the Third World (1993) and New Patterns of Macroeconomic Governance (1994).
John Toye is currently a professor and the Director of the Institute of
Development Studies at the University of Sussex. He has earlier taught at
the Universities of Swansea and Cambridge in the UK. He has also been
associated with the British Treasury and the ODA in the UK. His publications include Public Expenditure and Indian Development Policy I960-70
(1981), Does Aid Work in India? (1990) (co-edited/authored) and Aid and
Power (1991).


Introduction
The collection of essays in the present volume expresses a state of concern
with the destabilising and growth-retarding effects of world finance relations, both in the advanced and in the less-developed regions of the world
economy. The emphasis laid in this volume on finance can be justified in
terms of its growing influence on the real as well as the financial spheres
of activity, encompassing the spate of economic reforms in debtor
economics.
The three significant developments in the realm of private international
credit flows during the post-war era include, in chronological order, the
bank credit boom of the 1970s, its collapse by the early 1980s and a simultaneous expansion of the security sector during the same decade (which
more than compensated the shortfall in bank lending) and, finally, a proliferation of the high-risk financial transactions since the late 1980s which
relies, as sources of profits, on the rather uncertain movements in
exchange rates, interest rates and security prices in the advanced
economies. In the process, finance of late has remained far removed from
real transactions.
A study of the pattern of capital flows has of late been of high priority
in the agenda for research on the international economies, in particular
with the forces creating frequent disruptions in the international capital

markets. An explanation of the latter can be traced back to the pattern of
functioning of the industrialised economies, which by and large absorb
most of the gains and losses of financial intermediations. The pattern of
international capital flows also relates to the developing countries, the
majority of whom have of late been forced to accept packages of loan conditionalities, along with absolute declines in the flow of external finance.
For these countries, the impact has generally been one of a reversal in the
pace of accumulation and development, arising out of a process of
financial repression, as was inflicted by the international financial institutions and donors. A conditional tie-up, between the flow of finance to the
debtor countries in the developing area and their economic policies is
often in order, in order to induce the implementation of economic reforms
in their domestic economies. The process reflects the accepted doctrines as
well as the economic philosophy preached in the policies recommended by
the lending agencies.

1


2

Introduction

FRAGILE FINANCE, SYSTEMIC RISKS AND FICTITIOUS
CAPITAL
Financial instabilities in the international economy can be related to the prevailing pattern of these risk-prone transactions. The functioning of today's
financial system seems to contain symptoms of 'systemic risks', the sources
of which are endemic to the system. Factors which reinforce these tendencies include the volatility of interest and exchange rates, both of which put
pressure on the prices of financial assets. Similarly, frequent runs on bank
deposits and sudden brakes on the supply of bank credits (which result from
overstretching of debt with underpricing of risks by banks) also create situations of chaos in the financial system. Risks rather than real return thus
work as prime movers for the world system of finance which seems to

survive through its own turbulence. The end result is not only paradoxical
but also beset with the hazards of recurrent instabilities.
With risk taking providing the major source of profits to financial flows
in the world economy, there has been a proliferation of what could be
characterised as 'fictitious' capital, processes which have no basis whatsoever to 'real' capital formation. With deregulation sweeping the major
financial markets during the 1970s, risk-prone business soon became the
chief source of financial intermediation. Of the different strategies in the
international financial market, non-bank financial intermediation emerged
as a major form of activity, pushing aside the traditional operations of
banks at the interbank as well as corporate finance-industry level. A
myriad of off-balance sheet activities were innovated, offering derivative
financial instruments such as warrants, asset-based securities (ABS) and
over the counter (OTC) transactions. Institutional investors, including
pension and the mutual funds had a phenomenal spurt in Germany, as well
as in Japan where household savings responded favourably to a set of
demographic-cultural factors. The institutional investors intermediated a
significant share of the increments in household savings, displacing the
banks which had so long held the households as their major customers.
A contrast however is visible between the banking systems in the major
industrial countries. Thus, in the US and the UK semblances of universal
banking worked out as more permissive than similar systems in Germany
and Japan which always had much closer ties between finance and real
economy. Finance was more fragile in these Anglo-Saxon countries,
imparting shock waves through the stock market to the financial sector as
well as to the real economy.
As the booming financial flows were increasingly dissociated from the
real sector, with low growth rates of gross domestic product (GDP) in the


Introduction

3

Organization for Economic Co-operation and Development (OECD) countries, tendencies arose for banks to finance myriads of activities including
corporate mergers as well as acquisitions and real estate transactions in
these countries. The scene could be characterised as 'ponzi finance', one
where the rate of returns was not proportionate to the risks undertaken. As
returns on money capital could only be maintained by the creation of debt,
finance sought outlets beyond industry, in particular since the latter failed
to respond to growth in finances. The result was a multilayered proliferation of financial transactions, which continued on its own, without corresponding spurts in the real sector. Evidently speculation, involving a high
degree of risks in the economy, generated the demand for a substantial
part of the financial flows in the region.
It is important at this point not to miss out the typical circuits of the
risk-prone speculatory activities in the international financial markets.
Under uncertainty the externalities of agent actions tend to generate
further instabilities, hovering around an unstable equilibrium in such
markets. Some of the lapses, as pointed out earlier, include runs on bank
deposits, underpricing of risks and overextended debt, bringing in a collapse of financial asset prices. A dilemma, involving a choice between
competition (for microefficiency) and regulation (for macroefficiency),
seems to remain as an unresolved issue for the financial system as a whole.
With financial turbulence posing a threat to the functioning of the
advanced economies it was one of the natural responses on the part of the
capitalist state to reactivate, by the mid-1980s, the 'safety net' of state
regulatory systems. According to the post-Keynesians the failure of these
'safety net' arrangements explains a large part of the growing vulnerability
of these economies. An early beginning was made by the lender institutions and governments during the mid-1980s with debt management policies providing some relief to such debt as was non-serviceable. These
official moves were responsible for the Paris Club negotiations, the
Baker Plan and the Brady Plan initiatives. Monetary authorities in the US
sought to ensure financial stability by continuing with the prevailing
Glass-Steagal Act which insulated the domestic banks from adopting universal banking. However, with giant conglomerates cutting across banks

and industries, a watertight separation between banking activities and
those involving trade in securities was rendered difficult. As banks were
holding assets which often had their origin in security-related speculatory
activities, central banks often found it difficult to exercise their lender of
last resort (LLR) roles with bank assets, both heterogeneous and of inferior quality. Banks preferred to borrow short in order to lend long, which
in effect dampened their net profits on assets. Recent attempts by the Bank


4

Introduction

for International Settlements (BIS) has launched a drive to initiate safeguards against hazardous banking by setting the norms for a minimum
capital adequacy ratio. The move reflects official concerns on the state of
the banking industry at an international level. Attempts to institute capital
adequacy norms for the security sector have also been launched, though
with little success so far, as revealed in the recently held International
Organization for Securities Commission (IOSCO) meeting of the
European Commission (EC) at Toronto. Prudential and supervisory
banking legislations enacted at a national level included the Regulation K
and ,the FIRREA in the US which applied to the insurance companies and
also to the Savings and Loan Associations. The Ministry of Finance
(MOF) in Japan continued to monitor the flows of international capital
while in Britain the monetary authorities maintained their stance vis-a-vis
the upheavals of the financial market since the big bang. Much of the
above national regulatory measures were, again, of limited avail since a
major part of the international financial flows lay outside the regular circuits of financial institutions. As international capital markets were
unified, the respective powers of the nation states to influence the functioning of these markets went through a relative set-back. It was thus logically impossible that an internationally coordinated system could prevail
upon the actual financial flows. Failures to arrive at internationally coordinated solutions, at the level of the official Group of Five (G-5) negotiations, continue to constrain similar negotiations on the question of
international private capital flows. Such difficulties also mar the attempts,

at a private level, to internationally coordinate an accepted system for
exercising controls on these private capital flows. It is difficult not to
recognise the fact that with the emergence of finance as a supranational
force, the international capital market actually operates on a fragmented
basis. The nation state in the major countries, however, maintains a considerable degree of influence on the profitability of these operations. As
international finance has of late dissociated itself from its base in real
activities, the situation however is rendered difficult for the nation state to
reinforce, through its control on the real sector, a parallel pace of surveillance of finance. Symbiosis, at a national level, between finance and industry has thus been a feature of the past.

DEBT AND ECONOMIC REFORMS
It is logical to draw attention, as a supplement to observations made above
on the global financial system, to the plight of developing countries


Introduction

5

seeking an access to the latter. While the flow of net finance to these areas
has of late declined, their links with the capital market has been imparting
shocks which are of growing intensity. Looking more closely at the geographic direction of the international capital flows, one notices an underlying asymmetry in the pattern of international transmissions of income
adjustments at national levels. For the US, the relatively larger size of the
domestic economy allows the country to generate expansionary/contractional income repercussions in the rest of the world, in particular in the
outlying areas by means of her own fiscal expansion/contraction.
Misaligned OECD policies have in the past led to excessively high real
interest rates and overvalued dollar exchange rates, leaving a disproportionate share of the adjustment burden on the developing debtors. These
countries have also faced the negative repercussions of other adjustment
processes which include global debt deflation and the terms of trade
losses for the primary and light manufacture exporting nations in the
developing areas. The customer-banking practices of the banking industry

eroded during the 1980s and the LLR functions of central banks were
severely constrained, in particular with high real interest rates exceeding
the productive returns in the debtor economies and the speculatory bubbles
of real estates which affected both the savings and loan associations and
the capital market. The debt deflation led to the collapse of many small
creditor agencies in the north, thus leading to a concentration of assets
with the large banks. A breach in customerised banking was accompanied
by a growing disparity in the bargaining strength between the cartelised
industrial country lenders and the individual developing country borrowers. With debt adjustments in different economies, the US, the largest
debtor amongst the advanced economies, hardly ever felt the pressure of
similar adjustments! Excess liquidity in the industrial country credit
markets continued to circulate along the channels of a securitised credit
market, which often aimed at goals of short-term profit maximisation
rather than for long-term improvements in productivity and growth.
With the debt difficulties experienced by the developing countries
during the 1980s a leading role was taken by the multilateral financial
institutions (the International Monetary Fund (IMF) and the World Bank)
in financial intermediations between the Third World debtors, on the one
hand and the private as well as official creditors, on the other. In terms of
one view, the actions of these institutions amounted to a 'beggar-thydebtor' policy, with distinct recessionary effects on the debtor economies.
The IMF is even held partly responsible for the debt build-up during the
1970s since it actively encouraged the recycling of the Organization of
Petroleum Exporting Companies' (OPEC) surpluses through the commercial banks. Structural adjustments and other conditionalities imposed by


6

Introduction

these international institutions on indebted nations tended to aggravate situations of a trade-off between growth in real output and financial stability in

these areas; in particular since emphasis was laid in curing the external
deficits. Incidentally the arguments in favour of export promotion (which
is an adjunct to the structural adjustment policies followed by the debtor
countries), are often subject to a fallacy of composition, with each debtor
trying to expand its own share in a world market which itself is stationary.
Global problems in persuading the debtors to follow trade-competing policies in terms of export promotion are not considered in the country-bycountry approach of the conditional loan packages. The role played by the
LDCs in providing a palliative to global recession during the 1970s by
recycling the petrodollars has generally been lost sight of, as is evident in
the deflationary policy packages prescribed by international financial institutions and creditor governments to the debtor nations during the 1980s.
This emphasis on stabilisation and deflationary adjustments may rob the
prospects of achieving growth in these debtor economies via structural
adjustments. One can thus dispute prospects of economic reforms to fetch
efficiency gains through an improved allocation of resources in these
economies. Aspects as above are ignored in the IMF-World Bank-initiated
programmes which hardly allow for any sequencing of the policies.
Programmes are often evaluated in terms of their consistency with instruments rather than targets. Such approaches, as is pointed out, are bound to
be self-defeating in terms of fulfilling their own goals.
Methodological and empirical problems of evaluating structural adjustment !endings (SAL) by the two Bretton Woods institutions, namely the
World Bank and the IMF to the developing countries seem to entail
complex issues which are even more compounded once judged by the criteria set up by the social indicators. In sub-Saharan Africa, the SAL seems
to have improved export sales (at least in terms of volume) and also
reduced fiscal deficits. No improvement however was visible in investment and output growth rates. Instead of reconciling to the 'investment
pause' argument of the World Bank which explains these shortfalls in
terms of the delays in implementation and uncertainty factors, problems
with implementing the outward looking policies need to be looked at. The
latter include the depressive effects, in the domestic economy, of an export
drive when the country is at a disadvantage in terms of its ability to sell
goods having better market prospects.
Servicing of debt and its repayment are thus anathema to the development process, in particular as one compares the outflow of debt-related
liabilities of developing nations to what remain there as investible surpluses. Reproduction of existing capital stock or its further accumulations

Introduction

7

are rendered difficult in these areas as debt charges siphon off a large part
of the investible surpluses. Use of capital-intensive technology, in complete disregard to the low wages prevailing in these nations, further
reduces the surpluses as are left for investment. However, as investible
surpluses are transferred from the debtor nations to the creditor institutions and governments, additions to investment often fail to materialise in
creditor nations, largely due to the domestic investment climate. A redistribution of resources with net transfers to the debtor countries may thus
generate higher growth rates in the world economy, both by means of the
immediate supply responses in the LDCs and later in the long run, by
second-round multiplier effects which generate global demand.
Arguments, which claim that it is impossible to generate growth in
debtor countries unless there is debt relief, have been sometimes disputed
by citing examples of success stories such as South Korea, Thailand and
Indonesia. The South Korean miracle however could be replicated only if
the favourable circumstances experienced by the country prevailed for
others. These include the high export growth in manufacturing, the high
rate of profits in the domestic export industries, diffusion of technology to
the rest of the economy, low real rates of interest, low real wages relative
to productivity in export industries, adoption of technology which is suited
to the domestic factor availabilities, and so on. An expectation that the
debtor nations can continue as exporters of primary products has been
questioned in some circles, in particular due to the terms of trade losses. It
has been equally difficult for the exporters of manufactured products from
amongst the debtor countries to fetch attractive prices for their wares
which typically consist of light manufacturers facing a shrinking market in
the industrialised countries. The debt problem, in terms of other critiques

of mainstream positions, should be considered in all its dimensions. This
should include not only the problems for the lender banks but also those
faced by debtor nations in maintaining their long-term trend rates of
growth and in achieving a re-entry to the international credit market. Most
debtors, it has been pointed out, have failed to sort out these problems,
while the banks have generally been successful in shelving aside the debt
problem.
Endogenous and exogenous forces seem to have interplayed in the debtridden economies as international financial institutions had complicity
with the local elite, who were often responsible for capital flights from
these countries. The legal as well as the moral basis of debt forgiveness
can, however, be questioned on grounds of tendencies for capital flight
which involves an international transfer of money from tax payers in the
lender country to the elite in debtor economies who can evade taxes


8

Introduction

through these capital flights. While the class basis of the domestic elite in
manoeuvring the capital flows can be treated as an endogenous factor,
shocks, as arise from these capital flights abroad and from refusals on the
part of the lending institutions to intervene, both indicate exogenous circumstances. Indeed, as it has been observed in some empirical studies, the
international credit ratings which influence the loan supply to debtor
nations hardly bears on the economic conditions of the individual debtor
countries. Global economic and political factors which are exogenous to
the debtor economy provide better explanations of actual debt flows.
The role of the IMP in the debt process has been a controversial one,
drawing the attention of economists of diverse convictions. Surveillance
of the IMP, which has been rather pervasive in the debtor economies,

has been attacked on some grounds, including that of violating the economic sovereignty of debtor nations. Taking a legalistic position, it is
possible to distinguish between the warranted goals of the IMP, which
include the smoothening out of short-term payments difficulties by
encouraging current account convertibility and unification of exchange
rates and those which go beyond by seeking fiscal reforms and stabilisation. The distinction may be found useful if it can generate more of a
consensus amongst the IMP and the debtor nations. A standard reply
from the IMP, however, could be that the debtor nations would fail to
maintain the desired degrees of international integration (through current
account convertibility and unified exchange rates) unless supplemented
by fiscal-monetary reforms. Incidentally, the package of economic policies, offered in terms of the related policies behind the SAL and stabilisation policies normally rests on a philosophy which is far removed from
these fine distinctions.
The composition and the magnitude of international capital flows to the
developing countries have been subject to changes during the last decade.
Flows of syndicated bank credit to these areas which nearly collapsed has
not been restored. With deregulation and a greater degree of integration in
domestic financial markets, flows of finance have gained momentum and
hurdles to transfers across the market have been much less since the dropping of Regulation S and rule 144A in the US over the last decade.
Emergence of the institutional investors as major non-bank financial intermediaries has strengthened the non-bank, securitised sector of the international capital market. A recent spurt in capital flows to some of the major
debtors in Latin America, such as Mexico, Argentina, Chile and Brazil
and to the Highly Performing Asian Economies (HPAEs) has led to speculations whether this return flow reflects a success of the SAL and other
economic reforms. A few observations, however, are in order. First, that


Introduction

9

the new wave of private investment has touched some nations which were
outside the Brady deal. Second, that the flow to some countries, such as
Brazil, was purely short-term, possibly indicating a liquidity preference

for investors who shifted their funds out of the US as a result of cuts in the
US short-term rates. Third, that bonds were prominent in the flows to the
Latin American countries, including Mexico and Chile, both of which
gained considerably from factors including their own open economy policies as well as the external factors. The latter covers the general recession
in the industrialised countries and added market credibility of borrowers as
a result of a move by one of the major investing countries, Japan, to lower
the minimum credit standing for public bonds in the Samurai market from
A to triple B. Fourth, the return flow needs to be recognised as nett of the
continuing outflows as accrue from the debt stock which is still substantial. Thus, a net inflow of less than $7 billion to Latin America and the
Carribean during 1991 seems to be smaller than the net inflow of $8.7
billion which prevailed in 1975. In the absence of a detailed analysis of the
projected external liabilities as would result from these new inflows it
would be hasty to conclude that the positive flow of international capital as
has emerged during the 1990s will continue for Latin America. Moreover,
the revived flow of private capital to Latin America and the Highly
Performing Asian Economies (HPAEs) include, in addition to the bond
and the equity flows, a large dose of direct foreign investment (DFI) which
was heavily concentrated in a few countries.
Tendencies for a revival of foreign portfolio and equity investments in
the developing countries of Latin America and Asia open up the issues
connected with the functioning of stock markets. Counting on the experiences of the developed countries, stock markets have not necessarily been
successful in improving the savings propensities and/or investment climates in the host economies. Nor have these markets succeeded in ushering in rapid technological advancements, as is evident with the slow
technological changes in the two industrial economies, the UK and the US
where stock markets dominate. One can contrast the technological strides
in Japan and Germany, countries where industries depend more on banks
rather than stock markets as sources of finance. The spate of hostile takeovers, leverage buyouts and mergers which dominate the stock markets of
the UK and the US were virtually absent in Germany and Japan. The
typical short-termism as is likely to result from the hostile take-overs was
also responsible for the uneven competitive strength between the technologically advanced Japanese and German industries, on the one hand and
the relatively backward units in the UK and the US, on the other. The

stock markets have been volatile, to an extent which sometimes can be


10

Introduction

described as 'casino capitalism'. With uncertainties and asymmetric information channels leading the way to insider trading and credit rationing,
characterised as a principal-agent relationship, credit allocated through the
stock markets typically was rationed, in favour of groups who are not necessarily more efficient. Stock markets have thus failed to perform in the
industrially advanced economies as a guide to efficient credit allocations.
Neither stock prices nor the take-overs have served as indicators of
efficiency in individual industries. As a contrast, credit in Germany and
Japan had been forthcoming from banks, having links to industry on an
individualised customer basis. This contrasts the position held in some
circles that financial deepening provides a permissive atmosphere in the
capitalist economies and encourages (via stock markets) private savings as
well as efficient resource allocation. The view is hardly sustained by the
experience of the two large industrial economies where the stock markets
have been prominent. Lessons drawn from these nations may lend a note
of caution to the developing economies some of which recently witnessed
burgeoning stock markets at horne. While volatility is no less prominent in
these newly opened stock markets attempts at convertibility of current
account transactions may raise additional problems by encouraging the
stock markets to stern capital flights across nations. Bank finance, in turn,
has also been subject to serious shortcomings, under 'crony capitalism' or
under rnonopoloid or oligopolistic controls over industry-finance links in
the economy. To avoid the vagaries of the banking sector in their respective domestic economies the nation states thus have to assume an active
role, in order that they can insulate the real activities from the global tendencies of instability.
Lessons drawn from the experiences of the former Soviet Union and

the newly founded CIS provide some basis for assessing the impact of
financial liberalisation and other economic reforms on growth and economic stability in the domestic economy. Attempts, in the recent past, to
initiate a one-shot liberalisation in the economy failed to deliver the muchexpected drop in prices and rise in output growth rates. Despite the rise in
interest rates, the flow of short-term credit to the large state and other
enterprises continued, primarily as a custornerised channel of finance. The
inelastic credit demand from these enterprises continued to feed the
deficits faced by the latter. The outcome was a cost-push inflation which
was combined by a depressionary spiral of output. Shortages, both
economy wise and spatial as well as sectoral, blocked the mainstream
expectations of smooth quantity movements, responding to changes in the
relative price matrix. Instead it was the relative shortage matrix which was
a major force in the segmented economy, which obfuscated the efficacy of


Introduction

11

macroeconomic stabilisation policies. Output in the former Soviet Union
fell by 25 per cent during the year which ended in September 1992.
During the preceding calendar year the decline was around 8 per cent.
Economic reforms initiated since 1990-1 were clearly ill-designed or
inadequate to reverse the processes.
The first three chapters of the present volume analyse the prevailing
pattern of financial upheavals in the advanced economies, much of which
had its origin in the internationally integrated capital markets. Michel
Aglietta's characterisation of the 'systemic risk' in such markets (Chapter
I) is followed by an account of 'financial fragility' by Sunanda Sen
(Chapter 2), supplemented by an analysis of 'fictitous capital' by Laurence
Harris (Chapter 3) which brings to the fore the question of national identity or autonomy in the presence of these capital flows.

The remainder of the volume offers eight chapters, on the pattern of
adjustment brought about by the debt process. A characterisation of the
asymmetries in terms of the 'income repression', the terms of trade losses
and the 'debt-deflation' in the developing debtor regions is provided by
Amiya Bagchi (Chapter 4), followed by Hans Singer's observations on the
adverse consequences of the IMP-World Bank-initiated loan programmes
on development processes in the developing countries (Chapter 5). In
Chapter 6 John Toye provides a scheme for an evaluation as well as an
appraisal of these programmes, in terms of their consistency with the targeted goals. Such appraisals of the IMP-World Bank programmes also
provide the starting point of Jean-Marc Fontaine's analysis (Chapter 7) of
the alternative theoretical formulations to explain the observed declines in
the rate of investment and output growth in debt-ridden sub-Saharan
Africa under adjustment programmes. The story of upheavals in the
financial markets is brought back by Ajit Singh (Chapter 8) debating the
prospects of a stock market-led boom for the developing countries.
Evidence relating to the disruptive effects of stock market volatility on
saving, real growth and allocative efficiency in the advanced economies
discounts the possibility that these financial markets would do any better
in the developing countries. In Chapter 9 Stephany Griffith-Jones draws
attention to the recent revival of regulatory measures in the security
markets. This is followed by an analysis of the Third World debt by
Richard Cooper (Chapter 10) who spells out the rather limited role of the
IMF as far as is possible to defend both in terms of its original conceptions
and the notion of national sovereignty for the debtors. The observations
prompt Cooper to criticise the excesses at the level of the standard IMF
conditionality clauses much of which go beyond the original IMF target of


12

Introduction

providing short-term balance of payments support to the member nations.
The volume ends with an analysis provided by Jacques Sapir (Chapter 11)
on economic reforms in the former Soviet Union, which provides a rich
ground for comparing the reform experiences in the East to the structural
adjustment measures accepted by the South. The thematic unity of the 11
chapters of the volume rests on their concern with finance, providing
insights into the current scenario of financial fragility, debt and economic
reforms in the world economy.
The issues raised in this volume on the pattern of finance and its impact
on growth and stability in the world economy dwell on an area of economic research which has wide-ranging significance. The volume
addresses some pertinent questions as were raised in a colloque, by concerned scholars who felt the urge to address these issues, with a hope that
the deliberations would be useful for policy purposes.


1 Financial Globalisation,
Systemic Risk and
Monetary Control in OECD
Countries
MICHEL AGLIETTA
The present situation of the world economy is difficult, intriguing and perilous. It is forcing the economic profession to question its common
wisdom without complacency. The tide of monetarism is receding with
the main exception of its German stronghold where it does no good for
Europe. The real business cycle theory appears almost ludicrous in the
midst of a financially induced recession. The war against inflation has
been blurred by the laxity of the monetary authorities towards asset price
inflation. Their subsequent powerlessness to lead the economies of the
industrial countries out of recession is largely due to their inappropriate
perception of the magnitude of the financial adjustment in the private

sector.
The unease with the state of the world economy is not surprising
however. We have experienced tremendous structural changes for two
decades, above all in the financial sphere. These changes have not been
frictionless because neither microeconomic behaviour nor government
policy can adjust smoothly to new conditions that are disruptive to their
environment. There are many kinds of imperfections, externalities, and
limited knowledge under uncertainty, which convert structural shocks into
destabilising dynamics or determine multiple equilibria, some of which
are very unsatisfactory.
In this chapter I want to stress some of the interactions between structural changes and macroeconomic adjustments. Some of them are related
to the concept of financial fragility which leads to systemic risk. Some
come from the excesses of competition which can foster overindebtedness
and risk underpricing. Some are induced by the role of real interest rates in
a liberalised financial system, in contrast with its function in an administered system.

13


14

Financial Globalisation

To provide some insight, I will first state what I see as the main features
of the global financial economy. Then, in the second section, I ask what
are the trends of financial liberalisation which are pervasive and have a
lasting influence on the global economy. Finally, in the last two sections, I
try to estimate the overall performance of competing financial systems and
I examine the tough task the monetary authorities have in dealing with
systemic risk and in reassessing the objectives of monetary policy.

MAIN FEATURES IN THE FINANCIAL SPHERE

Secular Trends in Finance
Generally economists do not have long memories. Either they refer to the
growth in real wealth and the growth in indebtedness, closely linked
together for the years 1950-90 or, if they are pessimistic, they emphasise
common clues between the present situation and the 1930s, being haunted
by the financial breakdown of that time. This is not the proper alternative.
A longer view proyides another picture.
Financial developments are not monotonous. They go through long
stages: financial indebtedness, low real interest rates and high investment,
on the one hand and financial consolidation and cautious risk assessment,
high real interest rates and thwarted growth of investment, on the other.
Therefore a more adequate basis of comparison for the present situation is
the late nineteenth century (1873-97) when:
I.

2.

Real long-term interest rates were permanently higher than growth
rates in the most advanced countries of the time. Therefore business
faced hard financial constraints. The average rate of growth of fixed
productive resources was limited to the growth of equity capital. Any
attempt to go further into debt depressed profits since financial costs
increased faster than the income produced by the firms. Therefore, a
stage of financial deflation is characterised by a financial transfer from
borrowers to lenders. It creates an obstacle to growth and makes
financial consolidation a lengthy and weary process for private and
public borrowers alike.

The long-run depressive trend did not impede financial liberalisation
and international capital mobility. But there were conflicting national
interests, incentives to build up trade areas and world-wide financial
integration but trade segmentation and contests.


Michel Aglietta

15

It follows that the financial restructuring now in process might cause a
lasting change in the financial behaviour of economic agents. If they want
to reduce their desired level of indebtedness relative to income, the adjustment would not only entail the cancellation of transitory unsustainable
financial positions. It would be a trend change from higher to lower
desired debt ratios in the balance sheets.

A Reversal in the Investment-savings Mechanism
The shift from a low to a high real interest rate is not just quantitative. It
involves opposing adjustments to absorb macroeconomic disequilibria and
brings about different types of equilibria.
In a regulated financial system, nominal interest rates are rigid, either
because they are controlled by the monetary authority or because they are
determined by a bank oligopoly. If a disequilibrium occurs between the
total of planned investment expenditures and the total of voluntary
savings, say an ex ante excess of investment, credit demand will soar. A
speed up of inflation will ensue, provoking a decline in the real interest
rate. Investment expenditures are kept up and nominal income is
increased, generating higher savings which match investment expenditures. The macroeconomic adjustment enables real growth to be stable
and shocks in effective demands to be absorbed via variable rates of
inflation.

In a deregulated financial system the same ex ante disequilibrium triggers an opposite adjustment. Because an increase in the rate of inflation is
transferred into higher nominal interest rates as soon as it is expected, an
excess of investment demand will carry a higher real interest rate. Because
investment is more sensitive than savings to the change of the real interest
rate, the adjustment proceeds through a marginal curtailment of investment expenditures. The rate of inflation is stable because deregulated
financial markets have an in-built mechanism to check inflation. However,
the rate of investment is more volatile, more sensitive to the conditions of
credit and to the level of indebtedness.
Therefore, if they focus exclusively on an objective of price stability
narrowly defined, that is excluding assets prices, the monetary authorities
do not acknowledge the basic change of mechanism which achieves the
investment-savings balance. They can be induced to wage an outdated
war, while the main problem is to get out of long recessions and to keep
weak recoveries alive.