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World Capital: The Need & the Risks

1.

The recent weakness and volatility of financial markets here and abroad have been perplexing. Since the US economy has been growing fairly steadily, the markets, which had fallen in value by as much as 10 percent since February, evidently do not reflect the state of the economy. The recent increases in interest rates imposed by the Federal Reserve to prevent inflation have been criticized for threatening the economic recovery, especially since inflation has barely increased. In any case while the costs of some loans, particularly mortgages,have risen, they cannot possibly just by themselves have a large economic effect, even though sharp turns in the market are attributed to them. 1 The explanation for the shaky condition of the financial markets has to be found elsewhere.

Some clues to the recent weakness of the markets can be found in the international controversies of the last seven years or so. In October 1987, the US government publicly criticized Germany for maintaining what the US considered artificially high interest rates. Some investors feared that the longstanding German-American relationship was about to come apart and that this would have unfortunate consequences for financial stability generally. Two days later the Dow-Jones Industrial averages fell by over 500 points and the financial system itself seemed in danger. While other factors were undoubtedly involved in this collapse, the quarrel between the US and Germany appears to have been critical. What also soon became clear as well is that technical innovations such as “computerized program trading” and “portfolio insurance” could result in sudden sales of enormous numbers of shares and turn downward market pressures into panic.

In February 1994, the talks between the US and Japan, which were intended to resolve differences on trade issues, broke down acrimoniously. The international managers of the “hedge funds” that control the investment of hundreds of billions of dollars evidently feared that the US, in carrying out a policy of retaliation against Japan, might depress the value of the dollar to make US exports more attractive. The result was that speculative holdings of investments in foreign bonds and foreign currencies-particularly investments of traders who had bet against the yen-were sold, disrupting financial markets throughout the world. The abrupt decline in the bond markets caused a general rise in interest rates. While US markets were relatively unscathed, markets in East Asia and Latin America were harshly affected, and European bond markets were so weakened that some dealings in French government bonds were temporarily suspended. In Spain, Italy, and Scandinavia, sellers were unable to find buyers for relatively routine bond transactions for a few days. As in October 1987, there were more factors in play than just the breakdown of the US-Japanese talks-the recent tightening of interest rates by the Federal Reserve being perhaps the most important among them. But there seems to me no doubt that the event that set off tremors in financial markets was the quarrel between Japan and the US.

It is worth remembering these events as we assess President Clinton’s recent decision (which Isupport)to continue China’s most favored nation status. Political developments which were traditionally a matter of foreign policy have combined with the instability caused by speculation to pose enormous financial risks. Denying MFNstatus to China would undoubtedly have shaken financial markets that were already fragile. A further recent example was the reaction to the assassination in Mexico of presidential candidate LuisDonaldo Colosio. Only the immediate closing of the Mexican securities markets, combined with a much publicized grant of $6 billion credit to Mexico from the US Treasury, kept world markets from being seriously disrupted. Still, US securities markets moved sharply downward in reaction to the killing.

The “New World Order” that was once thought to follow the collapse of communism has turned out to be anything but orderly. The Europe envisaged in the Maastricht Treaty is still far in the future; the transition of the former Soviet countries to market economies and democracy may be even further off; North Korea flirts with nuclear weapons, the former Yugoslavia slides back into the Dark Ages, and the Middle East remains full of dangers. However, despite the threats and conflicts within different regions, one development has gone ahead relentlessly throughout the world: the growth of global capital markets. A genuine worldwide market in stocks, bonds, currencies, and other financial instruments has emerged, tied together by modern data-processing and communications technology, and operating twenty-four hours a day, seven days a week. The continued growth and stability of this market is vital for the growth of the developing world as well as for the Western countries. For the last fifty years, the Bretton Woods institutions, the World Bank and the IMF, have been directly involved in financing economic development in the emerging economies. This role will, more and more, be taken over by the global capital markets. The cold-blooded selection process by which world capital is invested will determine the economic progress of many developing countries.

Without rapid growth in the developing world, the West itself will be in great difficulty. The need for such growth has been little noticed, but it becomes clear when one considers how much demand for US exports depends on countries outside Europe, and other than Canada and Japan. During the past three years, exports to the other countries that make up the G-7-Japan, Germany, Canada, the UK, France, and Italy-have grown at an annual rate of only 0.6 percent. By contrast, shipments of US goods to the rest of the world have risen at a rate of 7.6 percent. 2 Although Europe and Japan are likely to recover eventually, the differences in the rate of growth are likely to continue.

The economist Henry S. Rowen recently published an article in The Wall Street Journal estimating growth rates between 1990 and 2020 in what he called “Rich Countries”-the G-7 and countries like Switzerland with comparable income levels-and the “Non-Rich Countries,” including, for example, India, China, Indonesia, and Russia. Rowen estimated that the output of the rich countries would grow from $13 to $24 trillion during the period for an average annual growth rate of less than 2 percent per year. The output of the “non-rich” countries is expected to grow from $9 trillion to $34 trillion over the same period; that is, at about 4.5 percent per year.

These estimated growth rates are hardly exact, but when considered along with other relevant data, such as the sources of demand for US exports, they clearly show that strong growth in the poorer parts of the world will be needed to sustain enough growth in the West to maintain adequate levels of employment and to enable Western governments to deal with their pressing social problems. It is also obvious that if added output of over $25 trillion is to be produced in the “non-rich” part of the world, huge amounts of capital will be required.

The projections of Rowen and others implicitly assume that the capital necessary to make them a reality will be available, but this is a large and arguable assumption. Investment in all developing countries, whether from domestic or foreign sources, averaged 25 percent of their GDP in 1992 and it is forecast to rise to 27 percent by 1998.3 But the public and private needs of a modernizing economy-particularly for infrastructure such as transportation and communications-are more and more dependent on the supply of capital, and the ratio of investment to GDP is therefore likely to rise. If we were to assume that the equivalent of 35 percent of the GDP of the “non-rich” nations would be invested between 1990 and 2020, then approximately $300 billion per year (or an aggregate of about $10 trillion) above the present levels would have to be invested in them to produce the expected growth in output.

This amount will have to come from a combination of foreign capital investment and domestic savings. According to OECD estimates, total private capital flows-including both investments and bank lending-to developing countries rose gradually from $45 billion in 1989 to $62 billion in 1991 before surging to $100 billion in 1992. This investment consists of purchases of stocks and bonds of local businesses (i.e., “portfolio investments”) as well as bank loans and other forms of direct investments in businesses and government agencies. The total is far below the $300 billion per year of additional investment which seems likely to be required and which would represent almost half the total annual savings by the US economy in 1993-about $700 billion.

Secretary Lloyd Bentsen’s recent estimate that, Japan apart, East Asian countries plan to spend $1 trillion on transport, communications, and other infrastructure alone during the next decade underlines the need for huge amounts of development capital. Obviously, if the capital is not available in appropriate amounts and at reasonable rates, these expectations for local investment will have to be cut back and, along with them, the related exports from Western countries.

2.

When we consider the prospects of finding capital for foreign investment, it is worth remembering that the original Marshall Plan consisted of $16 billion, which was to be disbursed over a four year period; this is about $100 billion in today’s dollars or $25 billion per year. In view of the slow growth and budgetary constraints of Western countries, no combination of Western public and private investment can provide more than a fraction of the required amounts. However, if political conditions are sufficiently stable, liberal Western trade and investment policies could help China, India, and the other large developing countries to generate much of the needed capital from within their own economies. Thanks to recent developments in computer software and in manufacturing methods, it is now more possible than ever before for advanced countries to transfer technology to countries that have labor forces and management that can make use of it.

Therefore creating adequate domestic capital markets is an absolute necessity for developing countries, whether they take the form of local stock and bond markets, or local banks that can lend and invest, or other channels by which foreigners can confidently put money into enterprises and basic facilities such as telephone systems and utilities. Most of these countries have already set up such markets, or plan to do so, but on the whole they still are not reliable enough, or safe enough, to attract the amounts of long-term investment that are likely to be needed. If they can become more efficient and secure they will make it possible for the developing countries to tap much deeper into the global savings pool that is represented by the rest of the world’s capital markets. We have to hope that a global competition for capital will encourage the countries urgently in need of capital to make economic and political reforms, which in turn will mobilize domestic and foreign savings.

  1. 1

    In any case the effects of the Federal Reserve actions have been variable: the markets declined sharply with the first two boosts in interest rates by the Federal Reserve, but they rose after one on May 17.

  2. 2

    Business Week, April 4, 1994.

  3. 3

    International Monetary Fund, World Economic Outlook, October 1993.

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