Liberalisation of monetary policy creates environment for investment

Economists, governments and donor agencies like IMF and World Bank are giving necessary attention to flexible monetary and fiscal policy for developing nations to cope with the changing economic world ever since the process started from the Bretton Woods conference in early fifties. Even before the conference, Adam Smith said, "least governance is the good government". The IMF, World Bank, WTO and donor countries suggest that the developing nations establish socio-political stability to attract more Foreign Direct Investment (FDI). Donor countries are advising the developing countries that without the tariff and non-tariff barrier free trade system, open competition, and free convertibility of local currencies, they will not be able to attract foreign direct investment. On the other hand, developing countries are scared and cautious about opening their market, or liberalising currency management to protect domestic investment, and the balance of payment. How can these problems be solved? How can the developing countries liberalise their currency management to keep pace with the changing global scenario?

A popular belief in the developing nations is that currency management liberalisation can impose a huge burden on balance of payment and can generate serious devaluation of local currency. Most of the developing countries are characterised by larger imports than exports, and as a result a huge trade deficit exists in most of the developing countries. Naturally, the belief is that if such countries further soften their currency management by allowing free flow of currency, complete floating rates for currency conversion, and complete convertibility, it may ruin domestic investment, and increase import; subsequently, balance of payment may collapse. The query is whether this is true or not, how can currency management be liberalised by minimising risk of devaluation and pressures on balance of payment?

In most of the developing countries, foreign currency handlings are highly controlled. People can not move their funds freely to and from those countries. Conversion rates are determined by the government. As a result, a huge illegal trafficking of currency to and from the country exists in most of the developing countries, which actually happens to meet the finance for smuggling. One tends to think that if government authority can be diminished, those illegal movements of goods and funds may come under the formal banking channel; subsequently, it may cause explicit macro economic stability. The fear of increasing import, and thus of imbalance, can be overruled by an idea that the total import of a country will never cross the total demands for imports.

Two macro-economic variables are important in this discussion: i) Liberalised monetary policy and ii) economic stability. How can effective balance be maintained between these two factors, and how developing countries benefit from the flexible monetary policy.

Study reports show that the economies that are free would attract more investment and utilise their resources more efficiently. As a result they will grow more rapidly and achieve higher levels of income. The difference in terms of foreign direct investment are dramatic. For the top quintile (countries with top economic freedom), the annual foreign direct investment per worker averaged $2657 compared to $52 for the bottom quintile. The productivity of investment in economies with an economic freedom rating of 7.0 or higher was 13.6 percent higher than for economies with economic freedom ratings of between 5.0 and 7.0, and 30 percent more than for those with mean economic freedom ratings of less than 5.0 (Gwartney & Lawson, 2003).

On the contrary, without proper precautionary measures, monetary liberalisation in developing countries may bring economic instability. For example, Indonesia floated Rupiah on July 18, 1997 which fluctuated wildly and lost 75 percent of its value against the greenback. In consequence, chaos broke out, with people hoarding toilet paper, rice, and cooking oil (Hanke, 1998).

Bangladesh is facing the same problem after introduction of floating rate and limited convertibility of Taka recently. However, it has been proved in our case that floating rate is not the cause behind the devaluation of Taka.

If we examine the experience of Singapore and Hong Kong, it may be hypothesised that a liberalised monetary policy will reduce illegal trafficking of funds to and from developing countries, attract more FDI, and ultimately bring macro-economic stability and healthy environment for investment.

Liberalised monetary policy stops illegal trafficking of money, and creates friendly environment for investment. What we need is to be courageous and take some precautionary measures. More and more foreign investor will come to our country if we open our door.

Muhammad Ashraf Ali Faruk is Second Secretary, National Board of Revenue.