Authorities in a developing country face difficult policy choices when simultaneously confronted with slow growth, rapid inflation, and external balance problems. Restrictive monetary and fiscal policies usually result in improvements in the rate of inflation and the balance of payments at the expense of even slower growth. Thus, it is not surprising that in the past decade there have been several attempts to improve on the tradeoff between growth and inflation by combining traditional stabilization policies with trade and financial market reforms. It has been argued that these reforms will raise the rate of growth by stimulating exports, investment, and savings and lower inflation by increasing the supplies of foreign and domestic goods. While these programs have encompassed many structural and institutional changes, the most common themes have been the elimination of trade restrictions (e.g., quotas), a substantial depreciation of any overvalued exchange rate, and the relaxation or elimination of ceilings on nominal interest rates.
This mix of reform and stabilization policy has generally proved successful over the medium term, but one unanticipated side effect often has been a substantial capital inflow which has made it difficult for the authorities to control monetary growth; this has occurred despite the fact that capital controls and weak domestic capital markets have traditionally allowed developing countries to operate in a world of capital immobility. These experiences raise the question of what steps the authorities can take to retain control over domestic monetary aggregates. It has been suggested that these inflows be managed by either capital controls, taxes on capital account transactions, or a move to a flexible exchange rate. The objective of this paper is to show that if capital inflows are properly anticipated they can be made a beneficial part of stabilization and reform programs. In fact, it will be argued that stabilization programs which incorporate capital inflows not only will generate a less disruptive financial reform program but also will yield a more rapid reduction in inflation and a higher rate of growth than programs which attempt to eliminate these inflows. Capital inflows will have this beneficial effect, however, only if exchange rate policy and interest rate decontrol are carefully coordinated.
This paper is divided into five sections. The first section presents a simple macroeconomic model of a developing economy which focuses on the linkages between capital flows, exchange rate movements, financial reform, growth, and inflation. The model is used in the second and third sections to analyze the problems of integrating trade and financial reform with stabilization policy to minimize the departures of the rate of inflation and rate of growth from their target values. In the fourth section, these results are used as general criteria for analyzing the experience of Korea with financial reform and capital flows. A summary of conclusions is presented in the fifth section.
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Mr. Mathieson, economist in the Financial Studies Division of the Research Department, holds degrees from the University of Illinois and Stanford University. He has taught at Columbia University.
An earlier version of this paper was presented at the Fifteenth Meeting of Central Bank Technicians of the American Continent, Port of Spain, Trinidad, November 19-24, 1978.
The model in this section is an open-economy version of that used in Mathieson (1978). See the Appendix for a summary of notation.
These assumptions rule out any change in the relative returns to capital and labor.
P represents a price index for domestic goods. For simplicity, the relative prices of all domestic goods are fixed.
A dot (•) above a variable denotes the time derivative.
The level of foreign income is fixed.
While τ3 has been assumed to be positive, there is empirical evidence that τ3 could be negative, reflecting the fact that a higher expected rate of inflation is associated with greater uncertainty and thereby greater savings. Since later results depend only on the assumption that 1 – τ3 ψ > 0, it would be quite easy to allow τ3 to be negative.
For simplicity, α is fixed. In a general analysis, would be α function of the proportion of total expenditures on domestic goods.
Real working capital is assumed to consist of inventories of raw materials and goods in process and advances to workers prior to actual sales.
The same constant, θ, applies to borrowing for both physical and real working capital holdings. A more detailed analysis would involve separate 0’s for each type of borrowing and would specify the determinants of using bank borrowing versus retained earnings.
rK will equal the marginal product of capital, which is a constant in the model.
With fixed proportions, F/K = λ. This means that
The analysis would not be greatly altered if it was assumed that capital flows were undertaken by foreign rather than domestic nationals. The presence of capital mobility, rather than who undertakes the capital transfers, is the important issue.
If one assumed that foreign as well as domestic nationals undertook capital flows, the f function given in equation (7) would be composed of a weighted sum of the f functions for domestic nationals (fd) and for foreign nationals (ff), with the weights being the proportion of deposits held by each type of investor. In this situation, even if foreigners held only a small proportion of domestic deposits, the overall f function might still be quite sensitive to changes in the yield on foreign assets if ff were highly sensitive to this yield.
For a discussion of the importance of this shortage of real working capital in developing countries, see McKinnon (1973) and Morley (1971). For simplicity, the effects of the substitution out of financial assets into real capital are ignored on the grounds that this substitution effect would be swamped by the financial repression effects on the general availability of real credit.
The path for R will thus be determined by the growth in the demand for base money and the path the authorities select for DC.
This reflects the fact that, although rational forecasts could differ from actual price movements in stochastic models, rational expectations are equivalent to perfect foresight in deterministic models.
A discussion of the conditions under which these targets will be consistent is available upon request from the author, whose address is Research Department, International Monetary Fund, Washington, D.C. 20431.
It is assumed that the banking system is privately owned or, if state owned, that the authorities wish to earn at least a normal level of profits on resources devoted to the financial system. This analysis ignores the effect of this interest rate behavior on the distribution of income or the role of financial system profits as a source of government revenues.
A normal level of profits is implicit in the fixed and variable cost term.
This ambiguity arises for two reasons. First, the deposit/income ratio is a positive (negative) function of the expected real yield on domestic (foreign) assets. Second, we know that the deposit/income ratio must be equal to θ/σ (1 – k) if credit market equilibrium is to be maintained. These two factors imply that rD must be increased (decreased) whenever a higher Π or x reduces (increases) the demand for money relative to income, but it is unclear whether an increase in Π or x will raise or lower the deposit/income ratio. If the deposit/income ratio is most sensitive to changes in the domestic asset yield (1 + η > 0), then a higher Π or x will lower the deposit/income ratio, and the nominal deposit rate will have to increase to maintain money and credit market equilibrium.
Just how good an approximation this solution will be to the true paths for r1, rD, and x will depend on how far the economy is from its steady-state growth path.
A bar (–) above a variable denotes the steady-state value.
For stability, 1 – τ3ψ must be greater than zero; otherwise, an initial excess demand for goods would lead to an explosive rise in the price level.
The ambiguity of ∂n/∂Π reflects the fact that a higher θ may either raise or lower the real loan rate (rL – ΠG) and thereby reduce or increase the real rate of growth. An increase in Π will work to raise both the expected overall rate of inflation (ΠG) and the nominal loan rate.
In an earlier version of this paper, which is available upon request from the author (see n. 15), it is shown that if k <|η|, then ∂n/∂Π > 0.
This provides a further justification for assuming that k < | η |.
The derivation of these optimal paths is available upon request from the author (see n. 15).
The increase in rD will still establish a positive real deposit rate.
Whether the f2 curve lies above or below the
It must be emphasized that reference is to only a temporary rise in n above
If the objective function included a positive weight for the rate of growth as well as for the departure of n from
A discussion of the mathematics of this case is available upon request from the author (see n. 15).
A more detailed discussion of the Korean experience and that of Argentina is available upon request from the author (see n. 15).
On this point, Brown (1973) concluded that “After the interest rate reform made foreign credits much less expensive than domestic bank credits, Korean businessmen always sought foreign credits if these were a possible alternative to commercial bank loans or other more expensive domestic credits. The interest-rate-stimulated ‘demand-pull’ for foreign credits coincided with government desires dating from at least 1962 to obtain such credits in order to speed investment and growth” (p. 218).
This system was replaced by commercial bank guarantees in December 1965.
Brown (1973) argued that the appropriate way for the authorities to curb the capital inflow would be a devaluation of the won in line with the rate of inflation: “Of the policies other than the interest rate reform which led to such a large inflow of foreign credit, perhaps the most important was the failure (until 1971) to allow the exchange rate to decline nearly as rapidly as the rise in domestic inflation. If the exchange rate had been changed to reduce the value of the won more nearly in step with the rate of inflation, the estimated cost of foreign borrowing would have been higher and the desire to borrow abroad reduced” (p. 219). There are two problems with this argument. First, it assumes that interest rates were at the appropriate level. Second, it is essentially arguing that the way to eliminate a balance of payments surplus is to devalue the domestic currency!
The exception to this policy mix would have been to sharply increase the interest rates on special preference loans.