INTRODUCTION

Ashwini Deshpande

Department of Economics, Delhi School of Economics

The introduction to this volume was first written in August 2008 with this opening paragraph: 'The global economy is reeling under one of the severest crises since the Great Depression of the 1930s, with record high oil prices, the global food crisis and a financial crisis, reverberating across the globe. As the US economy slides deeper towards a full-fledged recession, precipitated by the sub-prime mortgage crisis, the ability of financial markets to play havoc with the "real" economy could not have been more apparent. While some commentators, especially those associated with the mainstream media, are still debating the extent of the downturn in the US economy and defending the innovative aspects of financial markets, inside the US, the grim reality seems to have hit home. The implications of the collapse of the housing boom, the associated collapse of major banks with high exposure in the housing markets, coupled with the financial burden of the Iraq war has meant rising unemployment, cut back in consumer spending and overall economic downturn, with no signs of reversal in sight. These events bring to the fore the myriad connections between the "real" and the "financial" – and point to the urgency of understanding these connections, especially in the present era of globalization and financial deregulation.'

Exactly a year later, with a series of bank collapses, as the developed economies grapple with stimulus/rescue packages and bail-out measures to counter the cascading impact of lay-offs and closures, the debate is not whether this is a recession but on how bad it will get before it starts to get better. The terms of the discussion have shifted decisively: kudos to financial innovation have given way to demands for prudential regulation that ensure safety of investors' savings; an active role of the government in the economy is no longer seen as anathema as creation of new jobs to counter the increasing unemployment takes utmost priority; indeed, a wider role of the state in ensuring a welfare safety net is seen as inescapable. This enormous shift in the terms of the debate, several aspects of which validate the concerns of the ACDC, would not have been possible without this deep crisis.

While the spread and depth of the current events was not foreseen at the conference, all the participants, as is evident in the selection of studies that follow, were concerned about the implications of under-regulated financial flows and were very aware of the possible adverse consequences of a financial crisis on the real economy. At the time, some of these commentaries could have been dismissed as the usual anti — globalization rhetoric. However, given the turn of events in the real economy, when several of the pro-globalizers too are now raising questions about the implications of unbridled globalization and deregulation and are especially concerned about governance issues, the concerns raised by the collection in this volume not only stands up to scrutiny, but in fact, highly relevant.

The title of Gabriel Palma's chapter sums up the central concern of the volume: How Financial Liberalization Led in the 1990s to Three Different Cycles of 'Manias, Panic and Crashes' in Middle Income Countries. He focuses on four major financial crises that hit middle income countries since the 1982 debt crisis: Mexico 1994, East and South East Asia 1997, Brazil 1999 and Argentina 2001. The common characteristic of these crises was that all these countries had recently opened up their capital accounts at a time when international liquidity was high and the investment options in the OECD countries were limited. Palma identifies three different routes that these countries followed to absorb the sudden and large increase in inflows and shows that each of these routes ended up in a financial crisis in the recipient country. We can call this the crisis of absorption. He contrasts these crises with the better experience of India, China and Taiwan: countries that avoided financial crises due to their cautious and selective approach to opening up their capital accounts and integration with international financial markets.

Under Route 1, characterized by Mexico (1988–1994), the surge in inflows led to a pro-cyclical revaluation of the real exchange rate, explosion of credit to the private sector, consumption boom, asset bubbles and a massive deterioration in the current account. Route 2, characterized by Brazil (1994–1999), resulted in high interest rates and an aggressive sterilization of inflows led to fragilities in the banking system and public sector finance. Route 3, seen in Korea (1988–1997), led to very high corporate debt-equity ratios and made the balance sheets of banks vulnerable to currency depreciation. As was the case during the 1970s surge of international lending, Palma discusses how these high volumes of inflows (in Brazil, for example, as high as 129 percent of its exports in 1998) were a result of a combination of push and pull factors.

What needs to be noted and understood, especially in retrospect, is that during the time that a surge in lending/capital inflows is taking place, mainstream contemporary commentaries see it as yet another indicator of global integration, of soundness of markets and of 'good fundamentals' in the recipient countries. In this phase of mania, those who advocate a more cautious and/or a regulatory approach to financial inflows are branded as doomsayers and Cassandras. The other point worth noting is that despite the different end uses to which the inflows are directed, any 'excessive' volume of inflows is bound to create absorption problems and therefore is...