To the Editor:
Martin N. Baily, Diana Farrell, and Susan Lund rely on two widely accepted propositions ("The Color of Hot Money," March/April 2000). First, lending by private banks to developing countries, rather than hedge-fund trading, has been the principal cause of the recent bouts of global financial instability. Second, this serious problem can be solved by developing capital markets, which would reduce dependence on short-term bank lending as the principal source of financing in developing countries, thereby making international capital flows less volatile. But why has their rather obvious prescription -- capital market development -- proven unattainable in all but a handful of developing countries?
An extraordinary amount of expertise and financial resources has been devoted to solving the problem. Hundreds of technical-assistance missions have been launched in the past two decades or so by the International Monetary Fund, the World Bank, the International Finance Corporation, and virtually every other development institution. Parallel to the work of these financial-sector experts, the same institutions have extended hundreds of millions of dollars in loans to develop capital markets. The results have been disappointing by any standard.
The question, of course, is why countries fail to develop their capital markets. At the top of the list of explanations is the absence of political will to follow through with recommended reforms, since they typically involve regulatory liberalization and other measures that will alter the traditional competitive landscape. These proposals often raise political hackles and threaten formidable coalitions of private- and public-sector stakeholders. Although public officials may pay lip service to the obvious benefits of capital market development, more often than not they are reluctant to expend the political capital necessary for reform, particularly when it requires legislative battles or confrontations with entrenched business interests.
Second, creating the essential legal and private-sector infrastructure for public securities markets is far more complex, demanding, and disruptive than establishing the necessities for a banking system. Entire new businesses must be created. The recruitment and training alone of a new class of skilled professionals is a daunting task. And capital markets develop only when credible legal and regulatory frameworks are in place, combined with effective enforcement that establishes standards of behavior and defines the rights and responsibilities of all parties involved in financial transactions. When one considers that the U.S. Congress took more than 15 years to pass a banking reform bill, the magnitude of the political challenge becomes clear.
Third, capital markets develop only as fast as the demand for funds by a credible class of issuers within the country. But to gain market access, those who seek investment capital must first adopt corporate governance practices that instill confidence in prospective investors, such as standardized financial accounting and reporting procedures, the protection of minority shareholder rights, and the acceptance of independent boards of directors. Here again, traditional stakeholders are understandably suspicious of unfamiliar changes that require a level of transparency and accountability that runs counter to deeply embedded business practices.
Too often, experts give short shrift to the political and cultural obstacles to their recommendations, as well as the massive requirements for educating and training a new class of professionals. Prescribing remedies for poorly developed capital markets is the easy part. Making them happen has proven more difficult.
Professor and Director, Center for International Business and Public Policy, Paul H. Nitze School of Advanced International Studies, Johns Hopkins University