Feature

Can India Overtake China?

What's the fastest route to economic development? Welcome foreign direct investment (FDI), says China, and most policy experts agree. But a comparison with long-time laggard India suggests that FDI is not the only path to prosperity. Indeed, India's homegrown entrepreneurs may give it a long-term advantage over a China hamstrung by inefficient banks and capital markets.

Walk into any Wal-Mart and you won't be surprised to see the shelves sagging with Chinese-made goods -- everything from shoes and garments to toys and electronics. But the ubiquitous "Made in China" label obscures an important point: Few of these products are made by indigenous Chinese companies. In fact, you would be hard-pressed to find a single homegrown Chinese firm that operates on a global scale and markets its own products abroad.

That is because China's export-led manufacturing boom is largely a creation of foreign direct investment (FDI), which effectively serves as a substitute for domestic entrepreneurship. During the last 20 years, the Chinese economy has taken off, but few local firms have followed, leaving the country's private sector with no world-class companies to rival the big multinationals.

India has not attracted anywhere near the amount of FDI that China has. In part, this disparity reflects the confidence international investors have in China's prospects and their skepticism about India's commitment to free-market reforms. But the FDI gap is also a tale of two diasporas. China has a large and wealthy diaspora that has long been eager to help the motherland, and its money has been warmly received. By contrast, the Indian diaspora was, at least until recently, resented for its success and much less willing to invest back home. New Delhi took a dim view of Indians who had gone abroad, and of foreign investment generally, and instead provided a more nurturing environment for domestic entrepreneurs.

In the process, India has managed to spawn a number of companies that now compete internationally with the best that Europe and the United States have to offer. Moreover, many of these firms are in the most cutting-edge, knowledge-based industries -- software giants Infosys and Wipro and pharmaceutical and biotechnology powerhouses Ranbaxy and Dr. Reddy's Labs, to name just a few. Last year, the Forbes 200, an annual ranking of the world's best small companies, included 13 Indian firms but just four from mainland China.

India has also developed much stronger infrastructure to support private enterprise. Its capital markets operate with greater efficiency and transparency than do China's. Its legal system, while not without substantial flaws, is considerably more advanced.

China and India are the world's next major powers. They also offer competing models of development. It has long been an article of faith that China is on the faster track, and the economic data bear this out. The "Hindu rate of growth" -- a pejorative phrase referring to India's inability to match its economic growth with its population growth -- may be a thing of the past, but when it comes to gross domestic product (GDP) figures and other headline numbers, India is still no match for China.

However, the statistics tell only part of the story -- the macroeconomic story. At the micro level, things look quite different. There, India displays every bit as much dynamism as China. Indeed, by relying primarily on organic growth, India is making fuller use of its resources and has chosen a path that may well deliver more sustainable progress than China's FDI-driven approach. "Can India surpass China?" is no longer a silly question, and, if it turns out that India has indeed made the wiser bet, the implications -- for China's future growth and for how policy experts think about economic development generally -- could be enormous.

The Stifling State

The fact that India is increasingly building from the ground up while China is still pursuing a top-down approach reflects their contrasting political systems: India is a democracy, and China is not. But the different strategies are also a function of history. China's Communist Party came to power in 1949 intent on eradicating private ownership, which it quickly did. Although the country is now in its third decade of free-market reforms, it continues to struggle with the legacy of that period -- witness the controversy surrounding the recent decision to officially allow capitalists to join the Communist Party.

India, on the other hand, developed a softer brand of socialism, Fabian socialism, which aimed not to destroy capitalism but merely to mitigate the social ills it caused. It was considered essential that the public sector occupy the economy's "commanding heights," to use a phrase coined by Russian revolutionary Vladimir Lenin but popularized by India's first prime minister, Jawaharlal Nehru. However, that did not prevent entrepreneurship from flourishing where the long arm of the state could not reach.

Developments at the microeconomic level in China reflect these historical and ideological differences. China has been far bolder with external reforms but has imposed substantial legal and regulatory constraints on indigenous, private firms. In fact, only four years ago, domestic companies were finally granted the same constitutional protections that foreign businesses have enjoyed since the early 1980s. As of the late 1990s, according to the International Finance Corporation, more than two dozen industries, including some of the most important and lucrative sectors of the economy -- banking, telecommunications, highways, and railroads -- were still off-limits to private local companies.

These restrictions were designed not to keep Chinese entrepreneurs from competing with foreigners but to prevent private domestic businesses from challenging China's state-owned enterprises (SOEs). Some progress has been made in reforming the bloated, inefficient SOEs during the last 20 years, but Beijing is still not willing to relinquish its control over the largest ones, such as China Telecom.

Instead, the government has ferociously protected them from competition. In the 1990s, numerous Chinese entrepreneurs tried, and failed, to circumvent the restrictions placed on their activities. Some registered their firms as nominal SOEs (all the capital came from private sources, and the companies were privately managed), only to find themselves ensnared in title disputes when financially strapped government agencies sought to seize their assets. More than a few promising businesses have been destroyed this way.

This bias against homegrown firms is widely acknowledged. A report issued in 2000 by the Chinese Academy of Social Sciences concluded that, "Because of long-standing prejudices and mistaken beliefs, private and individual enterprises have a lower political status and are discriminated against in numerous policies and regulations. The legal, policy, and market environment is unfair and inconsistent."

Foreign investors have been among the biggest beneficiaries of the constraints placed on local private businesses. One indication of the large payoff they have reaped on the back of China's phenomenal growth: In 1992, the income accruing to foreign investors with equity stakes in Chinese firms was only $5.3 billion; today it totals more than $22 billion. (This money does not necessarily leave the country; it is often reinvested in China.)

The Mogul as Hero

For democratic, postcolonial India, allowing foreign investors huge profits at the expense of indigenous firms is simply unfeasible. Recall, for instance, the controversy that erupted a decade ago when the Enron Corporation made a deal with the state of Maharashtra to build a $2.9 billion power plant there. The project proceeded, but only after several years of acrimonious debate over foreign investment and its role in India's development.

While China has created obstacles for its entrepreneurs, India has been making life easier for local businesses. During the last decade, New Delhi has backed away from micromanaging the economy. True, privatization is proceeding at a glacial pace, but the government has ceded its monopoly over long-distance phone service; some tariffs have been cut; bureaucracy has been trimmed a bit; and a number of industries have been opened to private investment, including investment from abroad.

As a consequence, entrepreneurship and free enterprise are flourishing. A measure of the progress: In a recent survey of leading Asian companies by the Far Eastern Economic Review (FEER), India registered a higher average score than any other country in the region, including China (the survey polled over 2,500 executives and professionals in a dozen countries; respondents were asked to rate companies on a scale of one to seven for overall leadership performance). Indeed, only two Chinese firms had scores high enough to qualify for India's top 10 list. Tellingly, all of the Indian firms were wholly private initiatives, while most of the Chinese companies had significant state involvement.

Some of the leading Indian firms are true start-ups, notably Infosys, which topped FEER's survey. Others are offshoots of old-line companies. Sundaram Motors, for instance, a leading manufacturer of automotive components and a principal supplier to General Motors, is part of the T.V. Sundaram group, a century-old south Indian business group.

Not only is entrepreneurship thriving in India; entrepreneurs there have become folk heroes. Nehru would surely be appalled at the adulation the Indian public now showers on captains of industry. For instance, Narayana Murthy, the 56-year-old founder of Infosys, is often compared to Microsoft's Bill Gates and has become a revered figure.

These success stories never would have happened if India lacked the infrastructure needed to support Murthy and other would-be moguls. But democracy, a tradition of entrepreneurship, and a decent legal system have given India the underpinnings necessary for free enterprise to flourish. Although India's courts are notoriously inefficient, they at least comprise a functioning independent judiciary. Property rights are not fully secure, but the protection of private ownership is certainly far stronger than in China. The rule of law, a legacy of British rule, generally prevails.

These traditions and institutions have proved an excellent springboard for the emergence and evolution of India's capital markets. Distortions are still commonplace, but the stock and bond markets generally allow firms with solid prospects and reputations to obtain the capital they need to grow. In a World Bank study published last year, only 52 percent of the Indian firms surveyed reported problems obtaining capital, versus 80 percent of the Chinese companies polled. As a result, the Indian firms relied much less on internally generated finances: Only 27 percent of their funding came through operating profits, versus 57 percent for the Chinese firms.

Corporate governance has improved dramatically, thanks in no small part to Murthy, who has made Infosys a paragon of honest accounting and an example for other firms. In a survey of 25 emerging market economies conducted in 2000 by Credit Lyonnais Securities Asia, India ranked sixth in corporate governance, China 19th. The advent of an investor class, coupled with the fact that capital providers, such as development banks, are themselves increasingly subject to market forces, has only bolstered the efficiency and credibility of India's markets. Apart from providing the regulatory framework, the Indian government has taken a back seat to the private sector.

In China, by contrast, bureaucrats remain the gatekeepers, tightly controlling capital allocation and severely restricting the ability of private companies to obtain stock market listings and access the money they need to grow. Indeed, Beijing has used the financial markets mainly as a way of keeping the soes afloat. These policies have produced enormous distortions while preventing China's markets from gaining depth and maturity. (It is widely claimed that China's stock markets have a total capitalization in excess of $400 billion, but factoring out non-tradeable shares owned by the government or by government-owned companies reduces the valuation to just around $150 billion.) Compounding the problem are poor corporate governance and the absence of an independent judiciary.

Dollars and Diasporas

If India has so clearly surpassed China at the grass-roots level, why isn't India's superiority reflected in the numbers? Why is the gap in GDP and other benchmarks still so wide? It is worth recalling that India's economic reforms only began in earnest in 1991, more than a decade after China began liberalizing. In addition to the late start, India has had to make do with a national savings rate half that of China's and 90 percent less FDI. Moreover, India is a sprawling, messy democracy riven by ethnic and religious tensions, and it has also had a longstanding, volatile dispute with Pakistan over Kashmir. China, on the other hand, has enjoyed two decades of relative tranquility; apart from Tiananmen Square, it has been able to focus almost exclusively on economic development.

That India's annual growth rate is only around 20 percent lower than China's is, then, a remarkable achievement. And, of course, whether the data for China are accurate is an open question. The speed with which India is catching up is due to its own efficient deployment of capital and China's inefficiency, symbolized by all the money that has been frittered away on SOEs. And China's misallocation of resources is likely to become a big drag on the economy in the years ahead.

In the early 1990s, when China was registering double-digit growth rates, Beijing invested massively in the state sector. Most of the investments were not commercially viable, leaving the banking sector with a huge number of nonperforming loans -- possibly totaling as much as 50 percent of bank assets. At some point, the capitalization costs of these loans will have to be absorbed, either through write-downs (which means depositors bear the cost) or recapitalization of the banks by the government, which diverts money from other, more productive uses. This could well limit China's future growth trajectory.

India's banks may not be models of financial probity, but they have not made mistakes on nearly the same scale. According to a recent study by the management consulting firm Ernst & Young, about 15 percent of banking assets in India were nonperforming as of 2001. India's economy is thus anchored on more solid footing.

The real issue, of course, isn't where China and India are today but where they will be tomorrow. The answer will be determined in large measure by how well both countries utilize their resources, and on this score, India is doing a superior job. Is it pursuing a better road to development than China? We won't know the answer for many years. However, some evidence indicates that India's ground-up approach may indeed be wiser -- and the evidence, ironically, comes from within China itself.

Consider the contrasting strategies of Jiangsu and Zhejiang, two coastal provinces that were at similar levels of economic development when China's reforms began. Jiangsu has relied largely on FDI to fuel its growth. Zhejiang, by contrast, has placed heavier emphasis on indigenous entrepreneurs and organic development. During the last two decades, Zhejiang's economy has grown at an annual rate of about 1 percent faster than Jiangsu's. Twenty years ago, Zhejiang was the poorer of the two provinces; now it is unquestionably more prosperous.

India may soon have the best of both worlds: It looks poised to reap significantly more FDI in the coming years than it has attracted to date. After decades of keeping the Indian diaspora at arm's length, New Delhi is now embracing it. In some circles, it used to be jokingly said that NRI, an acronym applied to members of the diaspora, stood for "not required Indians." Now, the term is back to meaning just "non-resident Indian." The change in attitude was officially signaled earlier this year when the government held a conference on the diaspora that a number of prominent nris attended.

China's success in attracting FDI is partly a historical accident -- it has a wealthy diaspora. During the 1990s, more than half of China's FDI came from overseas Chinese sources. The money appears to have had at least one unintended consequence: The billions of dollars that came from Hong Kong, Macao, and Taiwan may have inadvertently helped Beijing postpone politically difficult internal reforms. For instance, because foreign investors were acquiring assets from loss-making SOEs, the government was able to drag its feet on privatization.

Until now, the Indian diaspora has accounted for less than 10 percent of the foreign money flowing to India. With the welcome mat now laid out, direct investment from nonresident Indians is likely to increase. And while the Indian diaspora may not be able to match the Chinese diaspora as "hard" capital goes, Indians abroad have substantially more intellectual capital to contribute, which could prove even more valuable.

The Indian diaspora has famously distinguished itself in knowledge-based industries, nowhere more so than in Silicon Valley. Now, India's brightening prospects, as well as the changing attitude vis-a-vis those who have gone abroad, are luring many non-resident Indian engineers and scientists home and are enticing many expatriate business people to open their wallets. With the help of its diaspora, China has won the race to be the world's factory. With the help of its diaspora, India could become the world's technology lab.

China and India have pursued radically different development strategies. India is not outperforming China overall, but it is doing better in certain key areas. That success may enable it to catch up with and perhaps even overtake China. Should that prove to be the case, it will not only demonstrate the importance of homegrown entrepreneurship to long-term economic development; it will also show the limits of the FDI-dependent approach China is pursuing.

Feature

The IMF Strikes Back

Slammed by anti-globalist protesters, developing-country politicians, and Nobel Prize–winning economists, the International Monetary Fund (IMF) has become Global Scapegoat Number One. But IMF economists are not evil, nor are they invariably wrong. It’s time to set the record straight and focus on more pressing economic debates, such as how best to promote global growth and financial stability.

Vitriol against the IMF, including personal attacks on the competence and integrity of its staff, has transcended into an art form in recent years. One bestselling author labels all new fund recruits as "third-rate," implies that management is on the take, and discusses the IMF’s role in the Asian financial crisis of the late 1990s in the same breath as Nazi Germany and the Holocaust. Even more sober and balanced critics of the institution -- such as Washington Post writer Paul Blustein, whose excellent inside account of the Asian financial crisis, The Chastening, should be required reading for prospective fund economists (and their spouses) -- find themselves choosing titles that invoke the devil. Really, doesn’t The Chastening sound like a sequel to 1970s horror flicks such as The Exorcist or The Omen? Perhaps this race to the bottom is a natural outcome of market forces. After all, in a world of 24-hour business news, there is a huge return to being introduced as "the leading critic of the IMF."

Regrettably, many of the charges frequently leveled against the fund reveal deep confusion regarding its policies and intentions. Other criticisms, however, do hit at potentially fundamental weak spots in current IMF practices. Unfortunately, all the recrimination and finger pointing make it difficult to separate spurious critiques from legitimate concerns. Worse yet, some of the deeper questions that ought to be at the heart of these debates -- issues such as poverty, appropriate exchange-rate systems, and whether the global financial system encourages developing countries to take on excessive debt -- are too easily ignored.

Consider the four most common criticisms against the fund: First, IMF loan programs impose harsh fiscal austerity on cash-strapped countries. Second, IMF loans encourage financiers to invest recklessly, confident the fund will bail them out (the so-called moral hazard problem). Third, IMF advice to countries suffering debt or currency crises only aggravates economic conditions. And fourth, the fund has irresponsibly pushed countries to open themselves up to volatile and destabilizing flows of foreign capital.

Some of these charges have important merits, even if critics (including myself in my former life as an academic economist) tend to overstate them for emphasis. Others, however, are both polemic and deeply misguided. In addressing them, I hope to clear the air for a more focused and cogent discussion on how the IMF and others can work to improve conditions in the global economy. Surely that should be our common goal.

The Austerity Myth

Over the years, no critique of the fund has carried more emotion than the "austerity" charge. Anti-fund diatribes contend that, everywhere the IMF goes, the tight macroeconomic policies it imposes on governments invariably crush the hopes and aspirations of people. (I hesitate to single out individual quotes, but they could easily fill an entire edition of Bartlett's Quotations.) Yet, at the risk of seeming heretical, I submit that the reality is nearly the opposite. As a rule, fund programs lighten austerity rather than create it. Yes, really.

Critics must understand that governments from developing countries don't seek IMF financial assistance when the sun is shining; they come when they have already run into deep financial difficulties, generally through some combination of bad management and bad luck. Virtually every country with an IMF program over the past 50 years, from Peru in 1954 to South Korea in 1997 to Argentina today, could be described in this fashion.

Policymakers in distressed economies know the fund will intervene where no private creditor dares tread and will make loans at rates their countries could only dream of even in the best of times. They understand that, in the short term, IMF loans allow a distressed debtor nation to tighten its belt less than it would have to otherwise. The economic policy conditions that the fund attaches to its loans are in lieu of the stricter discipline that market forces would impose in the IMF's absence. Both South Korea and Thailand, for example, were facing either outright default or a prolonged free fall in the value of their currencies in 1997 -- a far more damaging outcome than what actually took place.

Nevertheless, the institution provides a convenient whipping boy when politicians confront their populations with a less profligate budget. "The IMF forced us to do it!" is the familiar refrain when governments cut spending and subsidies. Never mind that the country's government -- whose macroeconomic mismanagement often had more than a little to do with the crisis in the first place -- generally retains considerable discretion over its range of policy options, not least in determining where budget cuts must take place. At its heart, the austerity critique confuses correlation with causation. Blaming the IMF for the reality that every country must confront its budget constraints is like blaming the fund for gravity.

Admittedly, the IMF does insist on being repaid, so eventually borrowing countries must part with foreign exchange resources that otherwise might have gone into domestic programs. Yet repayments to the fund normally spike only after the crisis has passed, making payments more manageable for borrowing governments. The IMF's shareholders -- its 184 member countries -- could collectively decide to convert all the fund's loans to grants, and then recipient countries would face no costs at all. However, if IMF loans are never repaid, industrialized countries must be willing to replenish continually the organization's lending resources, or eventually no funds would be available to help deal with the next debt crisis in the developing world.

A Hazardous Critique

Of course, in so many IMF programs, borrowing countries must pay back their private creditors in addition to repaying the fund. Yet wouldn't fiscal austerity be a bit more palatable if troubled debtor nations could compel foreign private lenders to bear part of the burden? Why should taxpayers in developing countries absorb the entire blow?

That is a completely legitimate question, but let's start by getting a few facts straight. First, private investors can hardly breathe a sigh of relief when the fund becomes involved in an emerging-market financial crisis. According to the Institute of International Finance, private investors lost some $225 billion during the Asian financial crisis of the late 1990s and some $100 billion as a result of the 1998 Russian debt default. And what of the Latin American debt crisis of the 1980s, during which the IMF helped jawbone foreign banks into rolling over a substantial fraction of Latin American debts for almost five years and ultimately forced banks to accept large write-downs of 30 percent or more? Certainly, if foreign private lenders consistently lose money on loans to developing countries, flows of new money will cease. Indeed, flows into much of Latin America -- again the current locus of debt problems -- have been sharply down during the past couple of years.

Private creditors ought to be willing to take large write-downs of their debts in some instances, particularly when a country is so deeply in hock that it is effectively insolvent. In such circumstances, trying to force the debtor to repay in full can often be counterproductive. Not only do citizens of the debtor country suffer, but creditors often receive less than they might have if they had lessened the country's debt burden and thus given the nation the will and means to increase investment and growth. Sometimes debt restructuring does happen, as in Ecuador (1999), Pakistan (1999), and Ukraine (2000). However, such cases are the exception rather than the rule, as current international law makes bankruptcies by sovereign states extraordinarily messy and chaotic. As a result, the official lending community, typically led by the IMF, is often unwilling to force the issue and sometimes finds itself trying to keep a country afloat far beyond the point of no return. In Russia in 1998, for example, the official community threw money behind a fixed exchange-rate regime that was patently doomed. Eventually, the fund cut the cord and allowed a default, proving wrong those many private investors who thought Russia was "too nuclear to fail." But if the fund had allowed the default to take place at an earlier stage, Russia might well have come out of its subsequent downturn at least as quickly and with less official debt.

Since restructuring of debt to private creditors is relatively rare, many critics reasonably worry that IMF financing often serves as a blanket insurance policy for private lenders. Moreover, when private creditors believe they will be bailed out by the IMF, they have reason to lend more -- and at lower interest rates -- than is appropriate. The debtor country, in turn, is seduced into borrowing too much, resulting in more frequent and severe crises, of exactly the sort the IMF was designed to alleviate. I will be the first to admit the "moral hazard" theory of IMF lending is clever (having introduced the theory in the 1980s), and I think it is surely important in some instances. But the empirical evidence is mixed. One strike against the moral hazard argument is that most countries generally do repay the IMF, if not on time, then late but with full interest. If the IMF is consistently paid, then private lenders receive no subsidy, so there is no bailout in any simplistic sense. Of course, despite the IMF's strong repayment record in major emerging-market loan packages, there is no guarantee about the future, and it would certainly be wrong to dismiss moral hazard as unimportant.

Fiscal Follies

Even if IMF policies are not to blame for budget cutbacks in poor economies, might the fund's programs still be so poorly designed that their ill-advised conditions more than cancel out any good the international lender's resources could bring? In particular, critics charge that the IMF pushes countries to increase domestic interest rates when cuts would better serve to stimulate the economy. The IMF also stands accused of forcing crisis economies to tighten their budgets in the midst of recessions. Like the austerity argument, these critiques of basic IMF policy advice appear rather damning, especially when wrapped in rhetoric about how all economists at the IMF are third-rate thinkers so immune from outside advice that they wouldn't listen if John Maynard Keynes himself dialed them up from heaven.

Of course, it would be wonderful if governments in emerging markets could follow Keynesian "countercyclical policies" -- that is, if they could stimulate their economies with lower interest rates, new public spending, or tax cuts during a recession. In its September 2002 "World Economic Outlook" report, the IMF encourages exactly such policies where feasible. (For example, the IMF has strongly urged Germany to be flexible in observing the budget constraints of the European Stability and Growth Pact, lest the government aggravate Germany's already severe economic slowdown.) Unfortunately, most emerging markets have an extremely difficult time borrowing during a downturn, and they often must tighten their belts precisely when a looser fiscal policy might otherwise be desirable. And the IMF, or anyone else for that matter, can only do so much for countries that don't pay attention to the commonsense advice of building up surpluses during boom times -- such as Argentina in the 1990s -- to leave room for deficits during downturns.

According to some critics, though, a simple solution is staring the IMF in the face: If those stubborn fund economists would only appreciate how successful expansionary fiscal policy can be in boosting output, they would realize countries can simply wave off a debt crisis by borrowing even more. Remember former U.S. President Ronald Reagan's economic guru, Arthur Laffer, who theorized that by cutting tax rates, the United States would enjoy so much extra growth that tax revenues would actually rise? In much the same way, some IMF critics -- ranging from Nobel Prize–winning economist Joseph Stiglitz to the relief agency Oxfam -- claim that by running a fiscal deficit into a debt storm, a country can grow so much that it will be able to sustain those higher debt levels. Creditors would understand this logic and happily fork over the requisite extra funds. Problem solved, case closed. Indeed, why should austerity ever be necessary?

Needless to say, Reagan's tax cuts during the 1980s did not lead to higher tax revenues but instead resulted in massive deficits. By the same token, there is no magic potion for troubled debtor countries. Lenders simply will not buy into this story.

The notion that countries should reduce interest rates -- rather than raise them -- to fend off debt and exchange-rate crises is even more absurd. When investors fear a country is increasingly likely to default on its debts, they will demand higher interest rates to compensate for that risk, not lower ones. And when a nation's citizens lose confidence in their own currency, they will require a large premium to accept debt denominated in that currency or to keep their deposits in domestic banks. No surprise that interest rates in virtually all countries that experienced debt crises during the last decade -- from Mexico to Turkey -- skyrocketed even though their currencies were allowed to float against the dollar.

The debate over how far interest rates should be allowed to rise in defending against a speculative currency attack is a legitimate one. The higher interest rates go, the more stress on the economy and the more bankruptcies and bank failures; classic cases include Mexico in 1995 and South Korea in 1998. On the other hand, since most crisis countries have substantial "liability dollarization" -- that is, a lot of borrowing goes on in dollars -- an excessively sharp fall in the exchange rate will also cause bankruptcies, with Indonesia in 1998 being but one example among many. Governments must strike a delicate balance in the short and medium term, as they decide how quickly to reduce interest rates from crisis levels. At the very least, critics of IMF tactics must acknowledge these difficult trade-offs. The simplistic view that all can be solved by just adopting softer "employment friendly" policies, such as low interest rates and fiscal expansions, is dangerous as well as naive in the face of financial maelstrom.

Capital Control Freaks

Although currency crises and financial bailouts dominate media coverage of the IMF, much of the agency's routine work entails ongoing dialogue with the fund's 184 member countries. As part of the fund's surveillance efforts, IMF staffers regularly visit member states and meet with policymakers to discuss how best to achieve sustained economic growth and stable inflation rates. So, rather than judge the fund solely on how it copes with financial crises, critics should consider its ongoing advice in trying to help countries stay out of trouble. In this area, perhaps the most controversial issue is the fund's advice on liberalizing international capital movements -- that is, on how fast emerging markets should pry open their often highly protected domestic financial markets.

Critics such as Columbia University economist Jagdish Bhagwati have suggested that the IMF's zeal in promoting free capital flows around the world inadvertently planted the seeds of the Asian financial crisis. In principle, had banks and companies in Asia's emerging markets not been allowed to borrow freely in foreign currency, they would not have built up huge foreign currency debts, and international creditors could not have demanded repayment just as liquidity was drying up and foreign currency was becoming very expensive. Although I was not at the IMF during the Asian crisis, my sense from reading archives and speaking with fund old-timers is that although this charge has some currency, the fund was more eclectic in its advice on this matter than most critics acknowledge. For example, in the months leading to Thailand's currency collapse in 1997, IMF reports on the Thai economy portrayed in stark terms the risks of liberalizing capital flows while keeping the domestic currency (the baht) at a fixed level against the U.S. dollar. As Blustein vividly portrays in The Chastening, Thai authorities didn't listen, still hoping instead that Bangkok would become a financial center like Singapore. Ultimately, the Thai baht succumbed to a massive speculative attack. Of course, in some cases -- most famously South Korea and Mexico -- the fund didn't warn countries forcefully enough about the dangers of opening up to international capital markets before domestic financial markets and regulators were prepared to handle the resulting volatility.

However one apportions blame for the financial crises of the past two decades, misconceptions regarding the merits and drawbacks of capital-market liberalization abound. First, it is simply wrong to conclude that countries with closed capital markets are better equipped to weather stormy financial markets. Yes, the relatively closed Chinese and Indian economies did not catch the Asian flu, or at least not a particularly bad case. But neither did Australia nor New Zealand, two countries that boast extremely open capital markets. Why? Because the latter countries' highly developed domestic financial markets were extremely well regulated. The biggest danger lurks in the middle, namely for those economies -- many of which are in East Asia and Latin America -- that combine weak and underdeveloped financial markets with poor regulation.

Moreover, a country needs export earnings to support foreign debt payments, and export industries do not spring up overnight. That's why the risks of running into external financing problems are higher for countries that fully liberalize their capital markets before significantly opening up to trade flows. Indeed, economies with small trading sectors can run into problems even with seemingly modest debt levels. This problem has repeatedly plagued countries in Latin America, where trade is relatively restricted by a combination of inward-looking policies and remote location.

Perhaps the best evidence in favor of open capital markets is that, despite the international financial turmoil of the last decade, most developing countries still aim to liberalize their capital markets as a long-term goal. Surprisingly few nations have turned back the clock on financial and capital-account liberalization. As domestic economies grow increasingly sophisticated, particularly regarding the depth and breadth of their financial instruments, policymakers are relentlessly seeking ways to live with open capital markets. The lessons from Europe's failed, heavy-handed attempts to regulate international capital flows in the 1970s and 1980s seem to have been increasingly absorbed in the developing world today.

Even China, long the high-growth poster child for capital-control enthusiasts, now views increased openness to capital markets as a central long-term goal. Its economic leaders understand that it's one thing to become a $1,000 per capita economy, as China is today. But to continue such stellar growth performance -- and one day to reach the $20,000 to $40,000 per capita incomes of the industrialized countries -- China will eventually require a world-class capital market.

Even though a continued move toward greater capital mobility is emerging as a global norm, absolute unfettered global capital mobility is not necessarily the best long-term outcome. Temporary controls on capital outflows may be important in dealing with some modern-day financial crises, while various kinds of light-handed taxes on capital inflows may be useful for countries faced with sudden surges of inflows. Chile is the classic example of a country that appears to have successfully used market-friendly taxes on capital inflows, though a debate continues to rage over their effectiveness. One way or another, the international community must find ways to temper debt flows and at the same time encourage equity investment and foreign direct investment, such as physical investment in plants and equipment. In industrialized countries, the pain of a 20 percent stock market fall is shared automatically and fairly broadly throughout the economy. But in nations that rely on foreign debt, a sudden change in investor sentiment can breed disaster.

Nevertheless, financial authorities in developing economies should remain wary of capital controls as an easy solution. "Temporary" controls can easily become ensconced, as political forces and budget pressures make them hard to remove. Invite capital controls for lunch, and they will try to stay for dinner.

Striking a Global Bargain

Should the international community just give up on global capital mobility and encourage countries to shut their doors? Looking further ahead in the 21st century, does the world really want to adopt greater financial isolationism?

Perhaps the greatest challenge facing industrialized countries in this century is how to deal with the aging bulge in their populations. With that in mind, wouldn't it be more helpful if rich countries could find effective ways to invest in much younger developing nations, and later use the proceeds to support their own increasing number of retirees? And let's face it, the world's developing countries need funds for investment and education now, so such a trade would prove mutually beneficial -- a win-win. Yes, recurring debt crises in the developing world have been sobering, but the potential benefits to financial integration are enormous. Full-scale retreat is hardly the answer.

Can the IMF help? Certainly. The fund provides a key forum for exchange of ideas and best practices. Yes, one could go ahead and eliminate the IMF, as some of the more extreme detractors wish, but that is not going to solve any fundamental problems. This increasingly globalized world will still need a global economic forum. Even today, the IMF is providing such a forum for discussion and debate over a new international bankruptcy procedure that could lessen the chaos that results when debtor countries become insolvent.

And there are many other issues where the IMF, or some similar multilateral organization, seems essential to any solution. For example, the current patchwork system of exchange rates seems too unstable to survive into the 22nd century. How will the world make the transition toward a more stable, coherent system? That is a global problem, and dealing with it requires a global perspective the IMF can help provide.

And what of poverty? Here, the IMF's sister organization, the World Bank, with its microeconomic and social focus and commensurately much larger staff, is appropriately charged with the lead role. But poor countries in the developing world still face important macroeconomic challenges. For example, if enhanced aid flows ever materialize, policymakers in emerging markets will still need to find ways to ensure that domestic production grows and thrives. Perhaps poor nations won't need the IMF's specific macroeconomic expertise -- but they will need something awfully similar.