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THE RISKS AND FAILURES OF EXTERNAL FINANCING OF

DEVELOPMENT IN SMALL STATES – THE CASE OF BALTIC

STATES

Egert Juuse Tallinn University of Technology, Estonia

Abstract The article gives a synthetic overview of the financial, institutional and economic challenges external financing of development poses for small states and their development. The theoretical framework interrelates classical development economics traditions with Minsky-Kregel conceptual framework and institutional set-up of financial systems to analyze the financial fragility and crisis in the Baltic States that have been under the strong influence of neoliberal policies and Washington Consensus regime. As the inward FDI in the Baltic States has been concentrated in limited number of economic sectors and tend to finance the production of maturing products that face saturating markets and diminishing profits, FDI in the Baltic States is becoming mature in terms of both shrinking new FDI inflows and thriving FDI related income outflows. Furthermore, propensity to consume rather to invest and domestic market orientation of FDI have eroded the margin of safety by insufficient generation of foreign currency earnings to meet the external liabilities. Unrestricted capital inflows have been feeding monetary expansion in these countries, which led to inflationary trends and deteriorating real exchange currencies, all of which supported widening current account deficits. Both fixed exchange rate systems, including currency board arrangements in Estonia and Lithuania in the context of free capital flows that did not prevent high inflation, and overall liberal economic policies that left policy-makers only with traditional macroeconomic policies (taxes and expenditures) as the main tools to alleviate external imbalances, are to blamed in deteriorating financial conditions in the Baltic States. Governments have mainly relied on different fiscal policy measures before and after the crisis, while prudential capital-account controls, specific FDI policies, and more elaborated regulations on banking activity have been left aside.

Key Words: Development economics, FDI, exchange rate systems, macroeconomic policies, financial fragility and crisis.

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“Each crisis has its own story. And the crisis that we’re going for at the moment doesn’t really

have a clear end, to my mind, or a clear model from which to understand it.” /McCulley 2008/

INTRODUCTION

Throughout the contemporary history one can witness the emergence of several forms and sources of development financing: bilateral and multilateral official flows (official development assistance), and private flows, such as remittances, portfolio flows, foreign direct investments (FDI). The importance of high and stable capital flows from developed to developing countries is being continually stressed by international development policies, although the central role in the process has shifted from emphasis on multilateral and bilateral official flows to private flows, whereby FDI has been the most important source of external finance during the last two decades. (Kregel 2004a, 1-34; Kregel 2001: 1-7; Ocampo et al. 2007, 3)

However, there is strong evidence that indicates to the failure of external development financing, in particular with regard to „Washington Consensus” policies, applied in Latin-America over the last two decades of the 20th century. Developing countries are not protected against financial crises that result from negative net flows and unsustainable debt creation, even if they may experience positive net inflows by accompanying Washington Consensus adjustment policies. As external finance did not support resource mobilization in the 1990s, but instead triggered import booms and spending that outpaced the expansion of productive capacity, the growing reliance on external capital left many developing countries exposed to external policy shocks and facing increasing burden of debt-servicing. (Kregel 2004b, 1; UN 2003, I-XII; Ocampo et al. 2007, 107)

A decade later, in 2008, the subprime crisis in the US real estate market burst out, the roots of which can be found in over-leveraged and non-transparent capital market institutions and complex financial innovations that resulted in the cessation of credit to entire financial system. On top of it, households have consumed through increased borrowing, not by increased real wages (COST 2009; Kregel 2009a, 658-661). Thereby, due to inter-relatedness of US credit market and global financial markets, these negative developments in the US had a global contagion effect in both developed and developing countries that brought to the fore the aspect of high external exposure and financial fragility of small open economies, which have been either in transition or developing phase.

The current article tries to explain the role of external finances1 in engendering financial fragility and by that, reach an understanding of the roots and implications of financial crisis in small open states by using the case of three Baltic States. The question to be addressed is why external financial flows in the form of FDI have not contributed to sustainable economic development in the Baltic States, but have caused deepening financial instability?

Although the different forms of FDI (greenfield investments, mergers and acquisitions; equity capital flows; inter-company loans; and non-repatriated/reinvested earnings) may have varying effects on host economy, the impact of FDI on will be studied as a whole. Due to limited

1 Focus on FDI and bank lending activities.

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access to more detailed empirical data, the analysis will focus mainly on Estonian case, whereas general trends and patterns will be presented on all three Baltic States.

The analysis will be based on the middle-range theory2 approach that systematically combines and inter-relates different concepts into analytical framework or stylized conceptual model in order to find explanatory patterns and regularities. The theoretical perspective of the article is rather holistic with multifaceted, comprehensive framework that covers both the internal (intra-state) and external (cross-border), and micro- (mesa3) and macro-level dimensions. In order to evaluate the impact of external financing on development in small open states, such as the Baltic States, the combination of Minsky-Kregel conceptual framework and theoretical concepts from development economics will be used to study the impact of foreign capital on external and internal balance position, and also micro(mesa)-macro level developments. Both mentioned dimensions will be addressed in the context of specific Keynesian policy measures and possible responses that could have been enforced by these countries. The underlying theories form the basis for addressing the issue of domestic development process within international trade and capital flows. While balanced growth theory as a branch of development economics is used to explain the mechanisms behind economic development, and to analyze the effect of FDI on internal structure of economy, then Minsky-Kregel framework is applied for studying the impact of emerging structural patterns on financial stability and sustainable development in more detail. In this regard, the latter concept could be considered as an extension of balanced growth theory that describes the financing positions of these countries, which rely on external finances in their development. Therefore, the focus of the topic tends to be more general with an emphasis on simplicity rather than accuracy. The article endeavors to explain the dynamics in the economic and financial sphere of three Baltic States in the light of constructed theoretical framework.

The first part of an article is devoted to the presentation of main theoretical concepts and positions that explain the essence of external financing. Within this section the following topics will be covered: the impact of external finances on development, advantages and disadvantages of FDI, and negative effect of capital flows in terms of inducing financial crises. The outcome of theoretical reasoning on external financing is lessons to be learned for specific policy measures in preventing and dealing with deepening financial fragility as well as eventual crisis and regression in small open economies. The second part of the study focuses on the interpretation of empirical evidence and findings within the elaborated theoretical framework. Economic and financial situation in Central and Eastern European (CEE) region will be briefly presented and main macro-economic as well as FDI-related trends will be analyzed the Baltic States.

2 See Wyatt, Balmer 2007, 623-624; Geels 2007, 627-635 3 Mesa-level considered as sectoral level, while micro-level covers private entities (company, natural person)

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I EXTERNAL FINANCING OF ECONOMIC DEVELOPMENT

IN SMALL OPEN STATES4

Increasing value added, enhanced employment, and sound balance of payments would require a large division of labor and strong institutions together with diverse innovative manufacturing activities, subject to increasing returns that create synergetic mutual interdependences and spillover effects (Reinert, Reinert 2005, 9-12; Reinert 2004, 6-7; Kattel et al. 2009, 7). Hence, economic development can be attained by investing funds into the production of diversified goods that would acknowledge income elasticity and provide markets for each other. In other words, meaning balanced investments in horizontally diversified and mutually supporting industrial activities, which enlarge market size and increase real income per head. (Nurkse 1957a, 368-371; Nurkse 1957b, 334-335) Although technological innovations are the main driving forces behind economic development, they cannot succeed without financial capital that allows industries to advance the level of technological development (Kregel, Burlamaqui 2006, 3-16). However, since small developing countries have insufficient income levels to produce the savings required to finance large-scale investments, the straightforward solution would be to replace deficient domestic savings with foreign savings in the form of capital inflows, which is also supported by the belief that developing countries have higher prospective rates of return on domestic investment and lower incomes than more advanced industrial countries as an incentive to direct capital flows to developing countries (Kregel 2004a, 4). Rosenstain-Rodan (1943, 203) has admitted that industrialization in less developed economies depends mainly on foreign investments, as otherwise it would be slower and require more effort. Therefore, if outward-looking strategy is followed, i.e. economic growth and development are financed by external resources, countries have to engage in the establishment of competitive domestic manufacturing industries as well as exporting sectors to improve balance of payments and ensure debt sustainability. Debt sustainable development rests on three-stage development pattern, where in the first phase production and export capacities are built up together with positive net inflows, followed by the second stage of continuing export growth, but with diminished capital inflows, and the third stage of reversed capital flows due to a surplus of savings above investments, accompanied by increased external surplus and productivity. The end state of export surpluses to repay foreign debt, i.e. rate of increase of export earnings equaling or exceeding rate of interest, would require a policy of both export promotion and controlling foreign borrowing. (Kregel 2007b, 1-14; Kregel 2004a, 11-13; Kregel 2007c, 3-15)

4 Although it has been found that small states encompass specific characteristics, such as limited domestic resource base and market, sensitivity to external conditions, specialization on limited number of products, openness to international trade, and dependence on foreign capital and export earnings (Sutton, Payne 1993, 580-591; Raadschelders 1992, 27), there are different approaches, how to categorize small states vis-à-vis great powers, while even within the category small states, there are various ways for classifications according to size, development level and other parameters (Thorhallsson, Wivel 2006, 651-655). One can use either population, size of area or gross domestic product (GDP) as the criteria, but more importantly the category small states should be addressed within the spatio-temporal context (ibid. ). Hence, the article rests on more or less widely acknowledged features of small states, whereas general conclusions and universal solutions, based on the findings, are infeasible. In this study, the Baltic States are surveyed as small states. Thus, the conclusions might be extended to some extent to other European small states, which are in transition stage or at the same level of development – Croatia, Bosnia and Herzegovina, Montenegro, FYR Macedonia, Czech Republic, Slovakia, Slovenia, Hungary, Malta, (Georgia).

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Moreover, external financing could contribute to the development process5 in developing countries only if domestic resources are mobilized (Singer 1950, 481, 485) and complementary domestic investments are made through balanced growth, i.e. investments in a number of mutually supporting industries that create external economies in terms of technological progress and enlarged market size (Nurkse 1953, 110, 118-120). It is the forming backward and forward demand linkages between expanding input-supplying and output-using sectors that must be emphasized and supported (Rosenstein-Rodan, 1943, Hirschmann 1958 cited in Dutt 2005, 103-109). Thus, in the context of externally financed development, the goal of small states is to reap advantages by gaining high volume and experience in interrelated medium- and high-technology industries, subject to increasing returns, and to reach an end state in which net export surpluses of goods and services are sufficient to repay foreign borrowing6. In addition, in order to succeed, small developing countries must have the possibility to decide and direct investment decisions, when facing with the issue of external financing of their development. Otherwise, the country with undeveloped manufacturing sector and high reliance on imported capital goods will not achieve internal demand led growth and multiplier effects by implementing Keynesian economic policies via increased investments, as in that case economic gains would occur abroad (Kregel 2007b, 1-14).

Thus, countries that host FDI inflows can experience the contribution of FDI to their development process only, if these inflows go into manufacturing and production, technological innovations, or infrastructural sector (Dutt 2005, 124-125; Freeman, Perez 1988, 63-64). Besides creating employment, FDI is considered as an impetus for productivity rise in FDI hosting countries via technology, standards, skills and knowledge transfer, and an access to credit and international markets (Ocampo et al. 2007, 30; UNCTAD 2009; Van Beers 2003, 13, 52). Theoretically, such spillover effects should stem from the linkages between transnational companies and host country enterprises, but also by setting up production facilities, providing training, establishing quality standards, and expanding market reach, which would enable small open states to reap gains from economies of scale and scope (Landesmann, Richter 2003, 33-35; Gallagher, Zarsky 2006). Therefore, on the micro-level, new technologies, marketing opportunities, and managerial skills are expected to accompany FDI, while on the meso-level, average productivity and value-added per worker in the industry should increase (Javorcik 2006b, 207-208, 230). All these mentioned advantages of FDI in terms of technology and knowledge spillover effects through vertical integration or labor turnover would occur only in case of sound innovation systems with sufficient level of technological and absorptive capacity by local suppliers to internalize provided knowledge7. Another precondition is considered to be sustained growth per capita income (low inflation) and penetration in international markets. Otherwise, the country gets locked into labor-intensive assembly operations (maquiladoras). (Pack 2006, 32-33, 44-47; Djankov, Hoekman 2006, 162-165, 175; Ernst, Kim 2001, 1-3, 12)

5 South-Korea could be brought as an example of a country that has used foreign capital for domestic development (Yan 1999, 283). 6 Nurkse (1953, 197) held similar position, although his primary concern was to secure a return in the domestic currency. 7 With its national science and technology (S&T) policies and efficient national innovation system, Finland has managed to attract high technology TNC-s that cooperate with R&D institutes and establish backward linkages to Finnish suppliers. FDI inflows to selected industries (ICT, health, forest) have been encouraged by the organization „Invest in Finland“ with the benefits of highly educated and trained population, and income tax rebates on foreign personnel. (Van Beers 2003, 64, 66-67, 73-75)

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I. 1 THE CHALLENGES FOR SMALL OPEN STATES

It can be said that small economies are squeezed by two kinds of pressures: on the one hand they need to develop extensively R&D infrastructure to keep up with advanced economies, but on the other hand there is an intense cost-competitive pressure from countries that produce low- and medium technology products (Van Beers 2003, 10, 20-22, 33-36; Walsh 1987, 37, 40-41, 48-53, 56-61). By introducing knowledge-intensive and capital-using techniques in small states` markets, these economies face the challenge of reaping gains from scale economies of R&D, implying the need to expand the trade volumes by concentrating private flows into economic activities that meet the demand of foreign countries (UNCTAD 2009; Nurkse 1957, 366-371, 381; Handel 1981, 163), but at the same time export orientation calls for continuous adaptations in product lines and managing the risk of exchange rate fluctuations that affect prices (Walsh 1987, 48-53, 56-61). More importantly, as described in the previous section, a well-functioning national system of innovation is of high significance in effective absorption of external finances (Freeman, Soete 1997, 265-276, 302; Kattel, Anton 2004, 106-128). Thus, the main obstacle for development in backward countries stems from the incapacity to effectively exploit domestic resources and absorb foreign capital for investments due to the lack of both technological progress and external economies in terms of scientific and technological infrastructure. Furthermore, low levels of productivity, incomes, and savings discourage investments in high-technology industries and create insufficient domestic demand. (Kregel, 2004a, 4; Kregel 2009c, 39-44; Nurkse 1953, 103, 140-150) Due to technological, human capital and financial squeeze, small states have been forced to specialize in supplying inputs or final assembly under contractual agreements, which means that research, development, production, and marketing activities of TNC-s are located in geographically separate areas. Such dispersed allocation of activities has increased international integration instead of domestic horizontal and vertical integration of industries, causing fragmentation and external dependence. (Walsh 1987, 37, 40-41, 48-53, 56-61) These integrated global production networks with cross-border and –firm value chains can be explained by liberalization policies in the 1990s as well as with the concept of techno-economic paradigms8, currently dominated by information and telecommunication technologies (ICT). Within the current ICT-led paradigm, the globalization has been a natural outcome with complex production profiles, resulting from networking and decentralization that has been facilitated by information and telecommunication technologies. This has led to searching for comparative advantages and locating value chain processes according to cost profiles (see also Ernst, Kim 2001, 1-3, 12), which can be considered as one of the factors behind the spread of productive capital from core to peripheries in the form of outsourcing and off-shoring of production capacity to periphery countries via FDI. However, in search for cost advantages, the transferred maturing technologies and productive capital might provide growth for a certain length of time, but with insignificant innovation potential due to reliance on mass production, imported intermediate goods and standardized products. (Perez 2001, 109-129; Perez 2007, 20-23; Perez 2007a) Thus, the positive effect of FDI in low-technology sectors in terms of productivity gains tend to be short-term and mainly occur due to decreasing wages, as the investments made in maturing technologies and

8 The concept of techno-economic paradigms gives an insight into the best practice models within economic, social, organisational and institutional systems that have been affected by dominating generic technologies. During one or another techno-economic paradigm, which is divided into two periods – Installation and Deployment – and the turning point or bubble burst between them, new firms and industries are set up as well as existing traditional economic sectors are upgraded. (Perez 2007, 6-10)

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industries face decreasing profit rates and diminishing returns (Saggi 2006, 52-53, 58-60; Van Beers 2003, 33-36; Khan 2005, 75-76; Ros 2005, 91). As a result, the nature of resulting production capital in terms of investment patterns, knowledge, experience, and external networks would soon become mature and obsolete to cause a mismatch with financial capital, as maturing investments and obtained short-term gains would trigger financial capital outflows in search for better profits - it is fundamentally footloose and flexible (Perez 2007a).

Therefore, FDI tends to render the structure of host open economy less complex and knowledge-intensive, while the share of value added of both middle- and high technology industries tends to decrease (Tiits et al. 2003, 26). Even worse, foreign capital is leaned towards consumption financing9 rather than productive investments and does not generate positive returns or export surplus, which creates problems in servicing debt as well as interest payments. Excessive propensity to consume rather than produce results in inflationary pressures and balance-of-payment disequilibrium, which all together have a reverse effect on both attracting FDI and preserving financial stability in small open states. (Nurkse 1952, 91-92, 149-151; Nurkse 1953, 141-149; Gallagher, Zarsky 2006)

I. 1.1 NEGATIVE CONSEQUENCES OF EXTERNAL FINANCING (FDI)

Even if premature liberalization of domestic markets of transition or developing economies can incur economic growth by utilizing foreign capital inflows, automatic expansion of the demand for their exports cannot be expected, as domestic producers tend to loose competitiveness in international markets due to Vanek-Reinert effect10 (see Reinert 2008; Kregel 2002, 5). The presence of foreign companies exerts negative pressures on domestic enterprises in the same industry due to increased competition that can result in lost market share, lowered output, and diseconomies of scale. (Javorcik 2006a, 180-189, 201; Pack 2006, 32-33, 44-47; Djankov, Hoekman 2006, 162-165, 175) Moreover, FDI is able to undermine the linkages and coordination mechanisms between domestic enterprises and other institutions of national innovation system by displacing domestic producers, which imperils competition and price stability (Lederman, Maloney 2006, 305-331). Therefore, FDI is seen as a form of neo-colonial exploitation that explains the disappearance of domestic companies by the substitution effect, including in banking sector, where aggressive (and excessive) lending by domestic subsidiaries of foreign commercial banks can result in displacing of domestic banks11, which in turn raises the risk of pro-cyclical lending policy of foreign banks (Ocampo et al. 2007, 36-38; King 2008, 1-5).

Under the current techno-economic paradigm (ICT) and prevailing neo-liberal economic policies, FDI has locked some countries into specializing in low value added exports (assembly

9 One of the factors behind this the so-called „demontration effect“ that reduces the capacity to save due to declining relative real income levels in less advanced countries (see Nurkse 1953, 140-141). 10 Premature opening up of domestic markets of less developed economies to foreign competition causes the bankruptcy of the most advanced economic sectors (manufacturing industry) that operate under increasing returns and absorb large investments into technologies. The negative effect accrues from a cost advantage of foreign competitors that leads to the drop in output volume and sales of domestic producers (Reinert 2007, 166, 327). 11 In Argentina, the drawback of the concentration of banking system into foreign ownership was related to inaccessible credit for small and medium-size enterprises, as cheap foreign capital fed high income-elastic imports (O’Connell 2007, 51-63), while in both Korea and Taiwan, banks remained state-owned and had a critical role in development by channeling savings into targeted economic activities (O Riain 2004, 196-199, 201, 216, 229).

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activities) within international production networks, while core R&D activities tend to be located in FDI-originating countries12; the off-shoring of services has meant mainly the relocation of lower value-added functions. On the other hand, the decision of multinational companies to invest abroad with the aim to produce for host country markets aggravates balance-of-payments situation. Moreover, the propensity of FDI to increase foreign borrowing worsens external balance and augments debt service in terms of the repatriation of earnings in the form of dividends and interests. (Van Beers 2003, 13, 52; Ocampo et al. 2007, 32; UN 2003; Kregel 2007b, 16-22)

The are several other risks that are associated with FDI: 1) undermining of local savings, 2) displacement of domestic investments by borrowing in local financial markets (the result is deteriorated macroeconomic condition because of overvalued exchange rate due to increased interest rates), 3) balance of payments problems due to repatriated profits and increased imports, and 4) no backward linkages or stimulated innovativeness (Gallagher, Zarsky, 2006). The volatility of FDI in host economy stems from adverse internal and external developments, such as shrinking profits, plummeting stock prices, decreasing demand, or tightened credit conditions that might destabilize FDI inflows by inducing divestments and causing layoffs (UNCTAD 2009; Ocampo et al. 2007, 28-30). I. 1.1.1 PROBLEMS FROM THE PERSPECTIVE OF DEVELOPMENT

ECONOMICS

From the perspective of development economics, and in particular balanced growth theory, innovativeness would require participatory practices, user-producer interaction, and integrated learning that presumes a set of backward and forward linkages within indigenous economy. Even though backward and forward linkages support integrated learning, these linkages might turn out to be neither stable nor sustainable in liberalized economic environment due to mobile and volatile capital flows. (Andersen, Lundvall 1988, 11, 19, 22-33) At the same time, it is found that FDI hardly establishes any capacity in host economy through coupling or spin-off effects (Walsh 1987, 37, 40-41, 48-53, 56-61). During the current techno-economic paradigm, FDI into developing countries has enabled extensive outsourcing activities and geographical diffusion of production, but without significant backward or forward linkages between foreign affiliates and domestic economic agents13 (Ocampo et al. 2007, 28-30; Kattel 2009, 11-13). Even if there are any spillover effects in transition economies, these are usually backward spillovers in the form of knowledge transfer and product quality requirements, but not horizontal or forward (Javorcik 2006b, 208-213). As a rule, vertical spillovers have not occurred in case of wholly owned projects that involve sophisticated technologies, implying a negative relationship between R&D and the probability of shared ownership. Hence, medium- and high-technology sectors, where R&D intensity plays a major role, 12 Liberalization strategies have followed the principle that markets are the best mechanisms to allocate resources and investments. In Mexico, after the privatization and deregulation wave, locally-owned companies specialized into labor-intensive assembly that depended on foreign design and components. Brazil, on the other hand, has been implementing active policy to promote industries by constraining imports and FDI to protect indigenous infant industries. (Kraemer et al. 2001, 1199-1203) 13 For instance, in Ireland, interaction between foreign and domestic enterprises is insignificant and most of the jobs are created in low-skill assembly lines, while hardly any movement of labor between indigenous and foreign firms takes place, all of which has transferred multiplier effects of investments abroad. Even in high-technology sectors, Ireland has attracted only the production of low- and medium-technology parts. Thus, R&D spending and revenues of TNC-s have not yet contributed to developing of local capabilities, while their operations tend to add little value. (Walsh 1987, 37, 40-41, 48-53, 56-61; O Riain 2004, 40-45, 48, 54-56; Van Beers 2003, 67-68, 77-78)

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are dominated by wholly owned projects, whereas joint ventures are undertaken in less R&D-intensive industries. (Javorcik 2006a, 180-189, 201; Pack 2006, 32-33, 44-47; Djankov, Hoekman 2006, 162-165, 175)

Small developing countries tend to have dualistic economic structures: on one side, capital-intensive, highly productive industries that mainly export, and on the other side, domestic market targeting sectors with low productivity, which means that export-oriented sectors, dominated by foreign capital, have not become part of internal economic structures. The insufficient integration has had little impact on living standard and productivity of domestic economy. Furthermore, instead of procuring from local enterprises, these FDI-intensive industries tend to maintain high import content that adversely affects balance of payments position14. (Nurkse 1957b, 331, 334; Nurkse 1957a, 361-368; Singer 1950, 474-477; Javorcik 2006b, 231) FDI tends to be concentrated in the areas that respond to the capital exporting country's demand, implying a simple extension of lender's economy with little impact on host country's development. Thus, productivity gains and increased savings cannot be expected from FDI (Nurkse 1952, 158-163, 211). FDI-led industrialization in developing countries has transferred cumulative multiplier effects in the form of additional employment, capital, external economies, and know-how to investing countries due to specialization on low value added activities and low technologies that do not pose opportunities for technological upgrading and present deteriorating terms of trade. Thereby, industries` effects on each other are insignificant in terms of the creation of social benefits, new skills, demand, and inventiveness (Singer 1950, 474-477).

All things considered, FDI is not a panacea that enables to break off the vicious circle of poverty in small developing countries, as foreign companies have disincentives to invest in manufacturing sectors due to small markets and low productivity, but rather in primary producing and extracting sectors, which deteriorate terms of trade for developing countries (Dutt 2005, 124-125). Therefore, a strong domestic demand for the output of indigenous industries is needed to rectify vulnerabilities stemming from the reliance on foreign affiliates or subsidiaries and the unstable linkages created by them (Freeman, Lundvall 1988, 11, 19, 22-33).

I. 1.1.2 BALANCE OF PAYMENTS AND DEBT-DEFLATION PROBLEM –

MINSKY-KREGEL FRAMEWORK

Even if the financial liberalization has facilitated the capital flows to developing countries under the presumption of higher marginal productivity, the consequences have been over-borrowing, consumption volatility, pro-cyclicality of capital flows, and overvaluation of exchange rates in developing economies. Instead of higher growth, liberalized capital flows to developing countries

14 The deregulation of financial markets in India in terms of liberalization of ceilings on foreign shareholding and operation of FDI has resulted in skyrocketing inflow of FDI and greater expenditure of foreign exchange on imports, but without significant improvement in exports, implying the rapid increase in the ratio of imports to exports. In addition, profits as dividends have been repatriated, which all together will eventually cause the drain of foreign exchange and adverse effect of balance of payments position. The problem is aggravated even more by the domestic-market orientation of FDI companies in India that turns the foreign exchange impact of FDI negative. (Chandrasekhar, Ghosh 2009)

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engender increased consumption of imports that widen current account deficits15. In addition, the preference of foreign capital to finance non-tradable goods magnifies the risk of capital flight in the context of overvalued real effective exchange rate or pressures for devaluation of domestic currency, once the signs of some unexpected event occur. (O`Connell 2006, 3-20) Nurkse (1961, 1953 cited in Kattel et al. 2009, 10) has argued that reliance on foreign investments tends to finance private consumption, which causes negative financial flows and creates financial fragility in terms of balance of payment problems.

Therefore, the analysis of financial fragility can be conducted by using Minsky-Kregel analytical framework that proposes three financing positions for countries with regard to the balance between financial inflows and outflows. The size of margin of safety, calculated as a difference between cash incomes and outflows, determines the financing position of a firm or a country – hedge, speculative or Ponzi (Kregel 2008a). Entities in hedge financing position can meet all financial obligations by cash flow, while Ponzi units do not have sufficient cash inflows to repay principle or interest on debt, implying the need to borrow or sell assets (Minsky 1992, 1-8). According to Minsky-Kregel framework, endogenous financial fragility emerges as a result of prolonged period of stability, when heightened expectations increase leverage and debt-financed long-term positions that bring along overcapitalization, booms, and eventual financial crisis with asset liquidation and devaluation, once debt obligations exceed cash flows16 (Minsky 1991, 15-17; Pollock 2008). In the condition of prevailing optimistic expectations, investors and banks increase financial system's fragility by getting more indebted and involving in riskier practices that may end up in bank run and debt deflation once expectations change and agents try to re-establish their liquidity positions (Arestis 1996, 120-121). Moreover, such fragile system can be subverted by some unexpected event, such as increase in interest rates or devalued domestic currency that leads to inability of businesses to meet their financial commitments from trade, accumulated reserves, financial assistance, or capital inflows (Minsky 1991, 15-17; Kelso, Duman 1992, 232). The financial fragility condition implies a high concentration of speculative or Ponzi economic units - highly leveraged businesses, decreasing margins of safety in indebtedness, and low liquidity of economy17. Insolvency of investors and the resulting financial crisis are usually triggered by a rise in interest rates, as deepening fragility increases money demand. (Minsky 1975, 1984, 1985 cited in Kelso, Duman 1992, 226-230; Minsky, Whalen 1996, 2, 4-6, 14) However, the root causes of

15 In Mexico, the liberalization together with tight monetary policies engendered increased capital inflows and appreciated domestic currency in real terms, which brought about worsened trade balance. The new dynamic industries, such as chemistry, electronics, and automobile industry, depended on imports and did not create additional employment, while the increased competition and cheap imports repressed domestic small- and medium-sized companies. Foreign capital was used for consumption and lending to businesses at international interest rates, all of which resulted in fallen savings, low investment and growth, and rising unemployment. Thus, financial crisis in Mexico erupted due to credit bubble, bad loans to households, and high foreign currency exposure. (Kregel 1998a, 3; Matrin, Schumann 1999, 49-54, 149-152) 16 The current debt deflation crisis, in which decreasing prices raise debt burdens, is a result of insufficient margins of safety in the „originate and distribute“financial system with securitization of non-conforming adjustable rate mortgage loans. Adjustable-interest-rate (subprime) mortgages had inbuilt declining margins of safety due to declined value of a property or decreased ability to meet commitments as a result of non-respondent increase in income, implying a need for increased borrowing to meet higher interest costs. The overall expansionary environment has resulted in excess borrowing, overinvestment, and risk concentration that led to highly leveraged positions. (Kregel 2008c, 11-12, 17-23; Minsky cited in Wray, 2008; McCulley 2008 ) 17 Governments can erode cushion of safety and become eventually speculative or even Ponzi units as a result of the overexposure to foreign exchange positions or by overestimating future cash inflows and tax receipts (Ševic 2007b, 11-17).

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Minskyian financial fragility can be derived from wrong market signals that lead to inappropriate debt-financed investments in terms of distribution and amount because of excessive demand and speculation-led inflation. In that case, high concentration of speculative investments results in eventual collapse in asset prices and inability to service debt with sufficient cash flows, especially if there are many units trying to make a position by selling out positions. (Minsky 1991, 5-6, 9, 14)

The problems of external financing of development are related to unsustainable debt creation and eventual reversal of external capital flows, as growing capital inflows, accompanied by the rising share of interest payments in current account deficit, set in motion Ponzi financing scheme, where debt is sustained by ongoing borrowing. (Kregel 2002, 12; Kregel 2004a, 4-5, 11) It is evident that debt service, i.e. the payment of amortization, dividends, and interest as an outflow of capital from developing countries, approaches and eventually exceeds inflows in terms of new investments from developed economies within a short period18. Those firms that operate with high proportion of imported inputs or leverage and do not have sufficient margin of safety to absorb changes in cash flows due to some external shock, might end up in Ponzi financing position. Basically, this sets in motion debt-deflation process, where excessive supplies and falling prices19 are accompanied by declining demand due to decreased investments and consumption, which, in turn, is caused by diminished incomes and increased unemployment. (Kregel 1998b, 2-7, Palley 2001, 22-23)

The morale is that the development strategy built solely on foreign lending is a Ponzi scheme that cannot succeed on a long-term basis, because the ever-rising foreign lending translates into an ever-rising external debt for developing countries, whether interest rates are equal or below the rate of increase in inflows (Kregel 2004, 1-34). The Ponzi financing trap can be avoided if cash incomes of a borrower exceed commitments on loans and interest rates as well as asset prices remain stable (Kregel 2008a). There are several ways, how to cushion the lowering margins of safety, but the feasibility of different options, such as accumulated reserves, positive balance of trade, low interest rates or put options on foreign exchange in order to avoid inappropriate currency appreciation because of excessive capital inflows (Kregel 2004a, 5, 7-10), depends on contextual circumstances. Therefore, the Minsky-Kregel framework that explains the fragility of highly leveraged economic units and also proposes policy measures to alleviate negative consequences of externally financed development needs to be addressed in the context of broader financial system in terms of the impact of exchange rate systems on capital movements and their mutual interrelatedness.

I.1.2 SOUND FINANCIAL SYSTEM AND EXCHANGE RATE SYSTEMS

From the perspective of external financing of development it is important to deliberate on the potential effects of different exchange rate systems on country’s financial stability and effective use

18 Outward flow of foreign investment was also acknowledged by Nurkse, although he foresaw it as a gradual process – net repayment would occur once the fundamental conditions of creditor and debtor economies reverse in terms of saving propensity and investment needs (see Nurkse 1952, 196). 19 In East Asian case the financial fragility was engendered by cheap short-term capital inflows, which were negatively affected by unfavorable interest and exchange rates, and a failure to optimally allocate capital for productive use that created foreign exchange risk exposure. The resulting debt-deflation process reversed net present values of investments, decreased asset prices, and devalued currencies. Thus, leverage should be used to the extent that is compatible with economic stability, implying a need for controlling and rationing capital inflows. (Kregel 1998a, 4-15; Kregel 2000, 2-12)

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of external finances. The sound financial system should support innovations and also maintain the value of productive assets that enable enterprises to meet their liabilities and lower the risk of non-conformance of assets to liabilities (Drechsler et al. 2006, 20-21, 24-28). Managed, flexible exchange rate regimes enable to preserve competitiveness and positive export balance by targeting competitive effective exchange rates. In such system there is no need for foreign exchange rate reserves, as external imbalances would be adjusted by appropriate changes in exchange rates, which affect the prices of tradable goods. (Kregel 2004c, 2; O`Connell 2006, 36-41) Such maneuvering room is of vital importance for small countries in sustaining export earnings that determine their development potential, as these countries must acquiesce to changes in prices and trading possibilities in the world markets, implying their role as of price-takers (Handel 1981, 157-161, 164-165; Sanderson 2009, 45-49). On the premises of established and independent exporting sector, devaluation can restore external balance, although it deteriorates terms of trade, leading in the long run to import substitution at the expense of export industries` resources (Nurkse 1957, 361, 363-367, 375). Thereby, managed devaluation of domestic currency can operate as a hedging measure that cushions decreasing margins of safety, which are caused by external imbalances.

On the other hand, attachment to the fixed exchange rate regimes, such as currency board system can be explained by the limited capacities of central banks and incipient financial markets in small open economies. Fixed exchange rate system, including the currency board arrangement, should promote fiscal discipline that controls inflation and avoids both public debt and depletion of foreign reserves. The sources of money creation in currency board system are international reserves, which are related to balance of payments position. Therefore, emerging balance of payments deficit should trigger the contraction of foreign reserves and monetary base, the adjustment of which would require deflationary developments, especially in the context of destabilized (appreciated) real exchange rate.(Grigonyte 2003, 111-115, 128-129; Lewis, Ševic 2000, 286, 289-290) Thus, in theory, currency board system should automatically ensure internal and external balance by adjusting domestic absorption to generate required resource outflows that meet external liabilities (Kregel 2007c, 9). However, such reasoning is invalidated, if countries have liberalized financial markets, as capital inflows offset the current account deficit and decline in money supply, which could restore external balance and competitiveness by cutting down prices and wages (Kregel 2002, 7-9).

Under the fixed exchange rate regime, increasing foreign capital inflows, attracted by expanded consumption spending, generate expansionary effects through reserve accumulation and appreciated domestic currency, which worsens current account deficit due to differential inflation rates in trading countries, implying the capital-account pro-cyclicality and an adverse effect on the value of domestic currency in terms of country’s export competitiveness (Ocampo 2002, 2-4, 19; Palley 2001, 2-3, 15; Havlik et al. 2001, 1/10, 3/18). Thereby, unless prevailing external imbalances and pressures on exchange rate are not alleviated in countries with open external account and currency board system, deflationary developments threaten to deprive a country from liquidity in terms of depleted foreign reserves due to increased demand for foreign currencies (Vistesen 2009; Moses 2000, 31-43). From the point of view of foreign investor, who holds domestic assets, internal deflation, that in principle equals to devaluation, means a default on debt service20 (Kregel 2004a, 20 It is found that currency board arrangement contributed to investor panic in Hong Kong, once the currency had become overvalued and external balance deteriorated, as an investor was faced with either exchange rate or price collapse of financial assets, producing eventually capital flight to quality. In case of defending fixed exchange rate by selling foreign currency against domestic currency, money supply decreases, leading to higher interest rates and internal deflation, which would put under pressure banks that have been engaged in real estate lending (Kregel 1998a, 14).

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6). Thus, it is the combination of appreciating domestic currency and deepening current account deficits that cause financial instability and eventual collapse of fixed exchange rate in countries, operating under currency board arrangement and depending on foreign capital. Free movement of capital is simply incompatible with fixed exchange rate regimes21 (O`Connell 2006, 36-41; Krugman cited in Grabel 2004, 3).

Intrinsic vulnerability to the financial system of countries that operate with currency board arrangement stems from the system's inability to extend credit to government, banking system and borrowers, unless there is an inflow of foreign capital, as monetary base is linked to foreign exchange reserves. Under the currency board system, capital outflows and withdrawal of deposits threaten banking system (UNCTAD 1998, 105-106), whereas previously mentioned deflationary processes engender reduced asset earnings, which might also result in bank runs. Hence, it is the incompatible combination of deregulated, poorly supervised, and indebted banking sector with short-term liabilities that takes excessive risks by lending aggressively on the one side, and the promise of a government to act as a lender of last resort and to support fixed exchange rate on the other side, that poses problems for financial architecture of economy. Such multifaceted objectives contradict, and should domestic banks become illiquid in the system of fixed exchange rate, either currency or banking crisis occurs. (Marion 1999, 473-479, 486) Therefore, central banks in open economies can either try to save banks or maintain fixed exchange rate, as currency board system restrains from supplying additional liquidity to keep banks solvent (Chang and Velasco 1998 cited in Marion 1999, 483-486).

Under the regime of Washington Consensus, liberalization and deregulation of financial markets have driven exchange rates in wrong directions because of financial speculation. Capital inflows, high leverage, and asset bubbles that keep currency stable or overvalued have created a highly fragile ground, as reversal of such funds puts exchange rate under the pressure. Such negative developments are amplified by lax regulation and accounting standards that incur pro-cyclicality. (Wade 2008; Wade 2009, 551; Kregel 1998b, 9-10) When there are signs of devaluations, capital is withdrawn by multinational companies that produce mainly for developing country market (Persaud, 2003 in Ocampo et al. 2007, 25). A rush into foreign currency devalues domestic currency, while attempts to stabilize exchange rate by raising interest rates mark lowered creditworthiness and would eventually aggravate debt service and force assets liquidation, which accelerates debt deflation process and eventually leads to insolvency (UNCTAD 1998, 84-86).

I. 2 THE DYNAMICS BEHIND FINANCIAL CRISES

Considering the explanations behind deepening financial fragility in small states that operate with rigid exchange rate systems and depend on external finances, one can use already covered Minsky’s classification of financing units. In broader terms, the elaboration on the causes and essence of financial crises can also rest on the concept of techno-economic paradigms that describes how the eruption of casino economy during installation period leads to financial crisis - the installation period passes down distortions of economy in terms of tensions between paper and real economy in

21 There are several historical blueprint cases of badly managed policies in the context of fixed exchange rates, like the Chilean experience in 1980s, that have enabled large current account deficits, consumption boom, and real asset bubbles as a consequence of currency appreciation and unrestrained capital inflows in the form of international bank loans denominated in foreign currencies (UNCTAD 1998, 79-80).

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the context of overinvestment in technologies and infrastructure, high mobility of capital and pursuit of short-term financial gains (Perez 2006, 33-66). There is inadequate demand because of extreme income polarization, and inability to absorb investments in stock markets, even if industries grow at frenzy pace. Insufficient profit gains (returns on investments) and enabling ICT-s bring forth innovative financial instruments that contribute to gigantic credit creation and hyperinflation of assets due to their speculative and cumulative nature, leading eventually to bubble burst (Perez 2007a). The recent (financial) bubble was induced by low interest rates, excess liquidity, and the atmosphere of excitement in the financial system, which under the circumstances of complex and inadequately regulated financial instruments22, resulted in inflated assets - over-valued stocks (Perez 2009, 786-792).

Thus, the seeds of financial crises might be found in highly leveraged structures and extensive use of credit for economic expansion that lead to over-investments due to expectations of higher earnings and increasing value of collateral that mutually reinforce each other23. Such developments create also higher demand for external financing in both financial and non-financial sectors. However, once the expected revenues do not cover debt obligations as a result of drop in demand, the oversupplied structures lead to excessive volatility in the value of collateral due to massive liquidation of existing capital, and eventual capital outflow, implying debt deflationary financial crisis. (Veblen 1934, 1938, 1958 cited in Kelso, Duman 1992, 223-226; Eichengreen 2004, 254-260; Weller, Singleton 2004, 1-4, 8; Marion 1999, 473-479) Typical predictors of imminent financial crisis are:

• Debt accumulation – high leverage due to excess supply of cheap and volatile foreign capital;

• Worsening current account deficit; • Depletion of reserves; • Overspending and misallocated investments in excessive risk taking endeavors - speculative

real estate and stock markets; • Booming housing and equity prices; • Overvalued domestic currency; • Pro-cyclical policies and inadequate regulation; • Deepening currency and maturity mismatches; • Growing global imbalances and income inequalities (Reinhart, Rogoff 2008, 2, 11; Yan

1999, 277-279; Kregel 2009d, 4, 10; O´Connell 2006, 15, 32; UN 2009a, 12, 23-39; Weller, Singleton 2004, 1-4, 8).

All these indicators have a cumulative effect on balance of payments problems, decreasing FDI, and eventual withdrawal of funds together with declining asset values that induce falling exchange rate, bank failures, borrower default, rapid depletion of reserves, increased unemployment, and decreased output – the characteristics of the majority of financial crises in the 1990s (Cruz, Walters 2008, 665-673; Cohen 2008, 1-15; UN 2009b, 4-5; Ocampo et al. 2007, 143-145; Weller, Singleton 2004, 1-4, 8; Ocampo 2002, 4; O`Connell 2006, 36-41; Eichengreen 2004, 254-260).

22 Futures, hedge funds, securitized mortgages etc. 23 The combination of speculative bubble in securities and real estate market, uncontrolled credit expansion, mismanaged financial liberalization, and highly leveraged structures led to private sector indebtedness and eventually to economic crisis in Finland in 1990 (Ylä-Anttila, Lemola 2006, 85-86).

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On the other hand, the systemic risks, i.e. institutional immaturity, flawed economic structures, and opportunistic (speculative) behavior of foreign capital, should be addressed and juxtaposed with the inner dynamics of FDI, guided by the current techno-economic paradigm and transitional phase from its one development stage to another. From the perspective of Minsky-Kregel framework, FDI can be seen following the same logic that is behind the credit-driven business cycle, consisting of two succeeding phases (see Palley 2001, 23-24): period of increasing loan expenditures, incomes, and demand due to availability of cheap credit, that is followed by a period of contraction, as borrowings are to be repaid, i.e. income transfers from debtors to creditors outweigh expansionary impact of new loans, causing raised debt burdens, restricted investment possibilities, and fallen incomes. The same argument can be assigned to the three-stage model of FDI dynamics (see Hunya 2008, 18-21; Hunya 2009, 16-19). From developmental and financial stability perspective, FDI-related income (interest or dividends) of non-residents has a significant importance, as in the current account it is presented as an outflow from host country. Therefore, FDI dynamics can be categorized into three-stage model from the perspective of FDI-related income balance: 1) large FDI inflows with insignificant FDI-related income outflows and FDI outflows, 2) FDI-related income outflow, as the main source of current account deficit, matches FDI inflows in the form of reinvested profits, and at the same time marginal FDI outflows are detected, and 3) high FDI income outflow that exceeds FDI inflow, but FDI outflow equals FDI inflow, though income on FDI outflow is still lower than inward FDI income. In all cases, it is the income balance of the current account that has the relevance and needs to be accompanied by enhanced export capacities, i.e. positive trade balance, created by FDI. Otherwise, by covering current account deficits or financing domestic market-oriented projects, net FDI will not generate foreign exchange earnings that increase financial fragility. Therefore, reinvested profits should be directed into exportable, technologically more advanced, higher value-added, and R&D-intensive products.

In general, mature FDI countries attract less new FDI and loose more in terms of income to foreign owners in the form of higher shares of repatriated incomes - FDI becomes a source of income outflow and creates more current account deficit than it finances (ibid.). Thus, it is the issue of maturity of FDI and the way external finances are utilized, that define country’s position in Minsky’s classification of financing units. By contrasting the FDI income-related three-stage model with debt sustainable „debt-cum-growth“ three-stage model (see Kregel 2007c, 13-14), mutual relatedness and impact of both concepts on each other can be detected. Namely, successful completion of long-term cycle of debt sustainable development, which might take up to 50 years, would require the building up of adequate export sectors that generate sufficient returns on the use of foreign resources. However, the first stage of this long-term cycle might get disrupted by the reversal of capital flows in the form of repatriated FDI-related incomes, as the FDI income-related three-stage cycle tends to come to an end within much shorter period. Difficulties arise, if by the end of this period there are insignificant FDI outflows and weak export capacities exist. On the other hand, in a situation, where exports grow more rapidly than the overall economy, the success of exporting will attract more capital inflows and cause inappropriate exchange rate appreciation (Kregel 2004a, 13-14), implying the overall growth in foreign claims and accumulation of FDI-related incomes.

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I. 3 POLICY RESPONSES AND MEASURES

When considering the impact of economic liberalization in terms of external financing of development and the role of FDI, some mercantilist principles24 need to be taken into consideration (Reinert 2004, 7, 15). Even though the deregulation of capital flows, trade liberalization, and privatization were one of the cornerstones of Washington Consensus policies, some concessions were considered with regard to infant industry protection and the speed of opening domestic markets (Williamson 1990). On the other hand, for Nurkse (1952, 176-177) the priority was given to infant creation, rather than infant protection by tariffs and other means. Even so, in order to service accumulated foreign debt, priority should be given to continuous productivity growth and expanded export base of manufacturing sector that would improve terms of trade as well as hedging opportunities (Frisch 2003, 26-28; Saad-Filho 2005, 133-145; Sanderson 2009, 45-49). Furthermore, monetary authorities need to be granted mandates to implement prudential financial regulations, monetary policies, and capital controls in order to alleviate financial fragility (UNCTAD 1998, 87-89). For small states there is a wide range of policy measures in curbing deepening crisis and avoiding the next round of disturbances.

I. 3.1 PRUDENTIAL BANKING AND CAPITAL-ACCOUNT REGULATIONS

The promotion of financial stability in small countries would require the introduction of counter-cyclical measures in terms of time-varying capital-account and banking regulations. In general, policy-makers have the option to choose between three different, but over-lapping, interventionist modes:

• controls - price controls and quantitative restrictions on the allocation of bank portfolio in certain sectors; restrictions or ceilings on short-term inflows and outflows; restrictions on end use of foreign borrowings or even prohibition of some investment activities; controls over international inter-bank lending; regulations on foreign borrowing in foreign currency and by non-tradable sectors; taxes on foreign borrowing and debt securities; exit taxes on investments and capital gains; restrictions on convertibility of deposits; rules concerning repatriation;

• limits - limits on loan-to-collateral-value ratios on mortgage lending or rules on the valuation of collateral; limitation of scope for leveraged financing; limits on equity ownership of certain financial activities;

• requirements - adjustable capital adequacy ratio and risk weights, unremunerated reserve requirement for capital inflows, non-interest bearing liquidity requirements for banks, minimum stay period for foreign capital; imposition to use local currency in domestic transactions and denominate loans in domestic currency (UNCTAD 1998, 96-105; UN 2009a, 64-128; Ocampo 2002, 4-14, 19-20; Ocampo et al. 2007, 45-52; O`Connell 2006, 34-36; Wade 2008; Wade 2009, 548-550; Cruz, Walters 2008, 665-673).

The implementation of foregoing price- or quantity-based capital market regulations must be in accordance with economic cycles. During boom periods, these adjustable measures should avoid excessive indebtedness and risk-taking by suppressing rapid increase in lending, and deter currency

24 Include protection for industry-building, targeting and support to specific economic activities of increasing returns by providing cheap credit, and temporary monopolies.

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and maturity mismatches (Ocampo 2002, 4-14, 19-20). All these measures together with managed exchange rate can mitigate financial fragility by encouraging desirable investments, maintaining competitive exchange rates25, preventing capital flight, and avoiding the accumulation of excessive debt and FDI (UNCTAD 1998, 96-105).

I. 3.2 MACRO-ECONOMIC POLICIES – MONETARY AND FISCAL POLICIES

One of the policy responses to financial fragility has encompassed the accumulation of foreign exchange reserves26 to increase liquidity against output contractions, halted capital inflows, or capital flight (Cruz, Walters 2008, 665-673). However, when financial crises accrue from heavy indebtedness that involve a high concentration of both speculative or Ponzi finance, there is a need for counter-cyclical (budget deficits during recession) fiscal policies after the crisis has hit (Minsky 1991, 15-16, 26-29), as both Minsky and Keynes considered stable asset prices and income growth as essential economic targets (Parenteau 2008). Thus, fiscal and monetary policies should be aimed at supporting asset prices and demand, i.e. income and employment (Kregel 1998b, 11-14; Kregel 2008c, 24), while accumulated reserves do not meet this requirement due to high opportunity cost and thereby, negative impact on domestic demand. Thus, the rationale for flexible exchange rates emanates from no need for foreign capital accumulation, which would enable to secure monetary sovereignty and shift attention to domestic demand driven growth27 by the implementation of Keynesian policies (Kregel 2007a, 25-31).

When considering the implementation of income policies, governments must keep a tight rein on income growth in sheltered sector28 that can lead to cost-push inflation in whole economy and undermine price competitiveness of exposed sector in international markets. Under the currency board system, wage-cost increases must be absorbed as the losses in profitability or production level, because output prices are set in international markets and small countries are unable to affect international prices of tradable goods and services – these countries tend to be price-takers. (Fischer 2002, 4; Moses 2000, 26-28) Furthermore, as a result of inflow of cheap credit, propensity to consume rather than enhance productive capacity would lead to inflationary pressures, implying the need for a taxation of expenditures that would increase the propensity to save and cool off the economy29.

By following the strategy of reliance on external financing for domestic economic development, the leeway of using monetary policies depends on the presence of foreign investments in either tradable or non-tradable sectors, as currency fluctuations represent higher currency risk for investors in non-tradable goods and services that do not generate foreign exchange earnings (Ocampo et al. 2007, 30).

25 Central banks in Asian countries have been imposing capital controls to avoid appreciating domestic currencies and inflating asset prices by excessive liquidity (Roubini 2009). 26 After the Asian crisis in 1997-1998, developing countries have strived for strong external accounts that have reduced external debt ratios and increased foreign exchange reserves (Ocampo et al. 2007, 155). 27 Taiwan is an example of a small state that has subordinated fiscal and monetary policies to industrial concerns – exchange rate adjustments to lower costs of imported inputs and to increase domestic currency returns for exporting manufacturing sector; imposition of tariffs to promote exports and promotion of more specialization by sectoral allocating of foreign exchange and cheap credit (Wade 1992, 77-79, 85, 93-95). 28 Including sectors that focus on the production of non-tradable goods, where foreign investments might dominate. 29 Similar argument was used by Nurkse (1952, 204) for compulsory saving by fiscal methods in order to increase capital accumulation.

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As in the capitalist system the functioning of real economy and also financing of innovations rely on the lending activity of banks, prevailing debt-deflationary processes or economic recession freeze their activity on credit market. Thus, if central bank does not provide reserves for stable lending activity of banks, interest rates will rise and borrowing terms deteriorate, which may decrease credit and economic activity. Thus, the role of central bank as a lender of last resort cannot be underestimated in backing the asset prices. (Lavoie 1985, 843-848) In order to prevent poverty and involuntary unemployment, government should implement countercyclical expansionary macro-economic policies (cuts in discount rates or even money supply at 0-interest rates) once demand is constrained by liquidity preference as a result of deflationary processes (Minsky cited in Wray, 2008; Szentes 2005, 153-155; UN 2009b, 4-5; Kregel 2009b, 4; Eichengreen, O`Rourke 2009). In case of excess supply of labor and declined economic activity, public policies need to focus on directing finances towards productive investments and enhancing domestic demand by improving the distribution of income. If necessary, government should run a deficit (dis-save) by increased expenditures30 and/or reduced taxes or through employer of last resort program31 (Kregel 2009a, 662-663; Kregel 2009c, 46, 52; McCulley 2008). Otherwise, government’s inclination to save can have negative effects on economy, if there is a demand gap to be filled, whereas reduced government expenditures during the debt-deflation crisis increase the cost of borrowed stock, but more importantly, have negative effect on domestic demand, employment, and economic growth32 (Kregel 2002, 13-16; Kregel 2004c, 3-6; Kregel 2008b, 14-15; Nersisyan, Wray 2010).

As a rule, financial crises restrict the use of counter-cyclical policies in developing (and transition) countries due to shrinking tax revenues and constraints set by international agreements or institutions (e.g. Stability and Growth Pact, WTO, IMF etc.) (UN 2009a, 25, 67, 80-82, 102, 112; Papadimitriou 2008). However, more fundamental problem for small states with deregulated capital-account stems from the adversarial impact of Keynesian macroeconomic policies, i.e. both fiscal and monetary policies, on attaining both internal and external balance simultaneously, as demand and supply relations have cross-border characteristics and thereby, domestic demand targeting policies can have negative effect on external balance (Moses 2000, 31-43). The positive effect of Keynesian income and investment policies in confronting the scarcity of demand can be evaporated due to high income elasticity of demand for imports that leads to balance of payments difficulties (Arestis 1996, 119-121). On the other hand, taxes and interest rates as indirect measures, used to rectify external balance, limit the ability to direct internal economy (Moses 2000, 31-43), while direct measures, such as tariffs and exchange rate adjustments, cannot be enforced in countries that follow rigid exchange rate systems and have been bound by international (e.g. EU) legal framework or free-trade agreements set up by international organizations (e.g. WTO). Thus, in small open economies strong

30 The 1997-98 Asian crisss hit less hardly those South-East Asian countries, like South-Korea, Malaysia, Hong-Kong that implemented stabilization policies more vigorously (stimulus packages, currency depreciations, openness to FDI in R&D etc.) (UNCTAD 2009). 31 Although fiscal discipline and implicit disdain for Keynesian budget deficits were on Washington Consensus agenda, short-term deficits were acceptable for macroeconomic stabilization, especially, if public deficit expenditures were made in education, health, and infrastructure (Williamson 1990). 32 After the 2001 financial crisis in Turkey, the government followed IMF prescribed contractionary fiscal and monetary policies, which supported an overvalued exchange rate, inflow of speculative-led financial capital, and thereby deficits on trade and current account balance, but signaled a reduced political autonomy to deal with developmental issues, implying a jobless growth (Yeldan 2006, 1). Similarly, years before, during financial crisis in East Asia, the affected countries suffered from imprudent private sector that could not be cured with fiscal austerity measures and tighter monetary policies, as higher interest rates and reduced government expenditures would have had devastative effect on domestic demand and highly indebted firms, leading to bankruptcies (Stiglitz 2000).

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macroeconomic policies are of limited use, implying the pursuit for productive sector policies (Ocampo 2009, 723).

I. 3.3 FDI POLICIES

There are different aspects that specific FDI policies are ascribed to target - entry conditions and local procurement by transnational companies, creation of employment opportunities, distribution of production and revenues between local and foreign companies etc. (UNCTAD 2009). Development impact of FDI can be achieved with policies that are compatible with national development plans, promote forward and backward production linkages between foreign and domestic firms, encourage exports with higher value-added, enhance an access to foreign technology and knowledge, and ensure appropriate size and distribution of FDI to be self-financing. FDI could be linked to domestic economy through support to clusters33, the success of which depends on the existence of favorable investment climate, skilled labor and infrastructure. (Ocampo et al. 2007, 33-34; Kregel 2007b, 16-22) As technical change of productive sector, together with economies of scale and increasing returns, occur only, if higher investment expenditures are expected in the future, policies should be aimed at generating positive externalities by inducing complementary investments that are connected to FDI, and encouraging joint ventures by imposing restrictions on operation of wholly owned subsidiaries, as has been the case in Taiwan, Republic of Korea, and Japan. Thus, investment control mechanisms should be implemented to deal with the constraints that are related to insufficient innovation, unskilled labor force, lack of training, poor research etc. (Arestis 1996, 126-128; Pack 2006, 32-33, 44-47; Djankov, Hoekman 2006, 162-165, 175)

Thus, both human resource development and entrepreneurial capacity enhancement to absorb imported technologies and knowledge should be emphasized and linkages of domestic companies to international production networks promoted by public policies - aspects that have been left out in neo-classical economics. In addition, mergers and acquisitions that stall off domestic enterprises and eliminate linkages need to be hindered34. All in all, emphasis should be placed on policies that create incentives to channel FDI into projects that yield the highest return and restore current account balance.

33 In Hungary, there are several inward FDI supportive measures, such as creation of industrial parks and clusters, incubator houses, and R&D facilities, grants, interest subsidies, and loan guarantees. In addition, R&D expenditures are eligible for tax deduction and (Van Beers 2003, 63, 65-66, 69-72, 74, 79). 34 In East-Asian countries FDI inflows are strictly regulated, e.g. joint ventures are encouraged with domestic public and private companies, and exports must include a share of products that are produced by indigenous enterprises (Martin, Schumann 1999, 153-154).

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II EMPIRICAL FINDINGS AND EVIDENCE – THE CASE OF

THREE BALTIC STATES

The purpose of this chapter is to explain the nature and peculiarities of economic systems in three Baltic States, and to address the financial fragility in these countries by relying on the theoretical concepts that were presented in previous paragraphs. The presentation of explanatory patterns and regularities will be based on previously conducted studies about the presence of FDI in the Baltic States. In addition, by using and interpreting statistical data on FDI, capital flows, and investment activities, the analysis of three countries tries to compare the empirical findings with theoretical positions that explain the dynamics behind financial crises. However, author acknowledges that uneven coverage and insufficient revision of FDI-related legal frameworks of the mentioned countries could be criticized, and thereby, thorough conclusions cannot be made. At first, the region of Central and Eastern Europe (CEE) is to be observed, as in broader terms, historical and developmental parallels could be brought out between ten new European Union (EU) member states that joined the EU in 2004. Therefore, findings on CEE level are more or less deductible for the Baltic States.

On the whole, CEE countries have followed the path of FDI-led growth that can be explained by the reliance on Washington Consensus policies and the reasoning behind the current ICT-based techno-economic paradigm. Another element behind growing inflows of foreign capital has been relatively high nominal interest rates in CEE countries at the end of last decade (UN 2003, 11-16). Nevertheless, growing FDI in CEE countries has not engendered upgrading in economic structures. On the contrary, after the liberalization of capital markets and prices, demand for the products of domestic companies was cut down. This led to deindustrialization in terms of increased unemployment in industries and declined share of industries´ value added in GDP. In addition, the presence of FDI has negatively affected advanced industries, which has translated into reduced demand for R&D. There are no significant technology spillovers in CEE countries - producer-user chains are cross-border and circumvent domestic economic actors. By keeping pre- and post-production activities at home, transnational companies have specialized in host countries mainly in simple production activities at the lower end of value chain without significant linkages to domestic economy. In other words, the main motives for TNC have been to gain advantage from cheap labor and access to CEE markets. (Van Beers 2003, 63-66, 69-75) Thus, the problem for CEE countries is related to specialization in low- and medium-technology industries or low value-added production stages of value chains, i.e. outsourced labor-intensive economic activities that rely on imports, while high-wage jobs, scale effects, vertical integration, and new technologies have not been attained (Reinert et al. 2009, 16; Kattel et al. 2009, 6, 18; Kattel, Primi 2008, 10-14, 17-19; Drechsler et al. 2006, 20-21, 24-28) The afore-mentioned drawback is partly explainable by intrinsic deficiencies in CEE countries that hinder the efficient utilization of foreign capital and technologies for upgrading. These are: 1) fragmented institutions and lack of cooperation35, 2) emphasis on capital formation, not on knowledge creation, and 3) technology transfer process as linear dialogue between provider-receiver that does not have wider and large-scale spillover effects. (Saad et al. 2008, 431-432)

35 In Taiwan, Government has pursued the involvement of different stakeholders in policy formation, and bringing together domestic and foreign companies. Network institutions promoted cooperation and development, while fragmentation and low-skill subcontracting were avoided. (O Riain 2004, 196-199; Wade 1992, 90-91, 98)

21

However, despite its negative effects, FDI penetration has entailed higher productivity, salaries, and exports, when compared to domestic companies (Havlik et al. 2001, 3/28-3/32).

In the case of the Baltic States, the presence of foreign affiliates in Latvia and Lithuania has not established forward or backward linkages nor induced spillover effects to domestic companies because of the preference for imported intermediate goods. On the contrary, increased competition has negatively affected the performance of local companies in the same industry, thereby resulting in decreased output and diseconomies of scale. (Javorcik 2006a, 180-189, 201; Pack 2006, 32-33, 44-47; Djankov, Hoekman 2006, 162-165, 175) In Estonia, manufacturing industries have been locked into simple production activities in international value chains that lack creative innovations and assembly mature products for saturating markets. Enterprises in Estonia as subcontractors to Western companies have rather strategic linkages with Scandinavian partners than with each other domestically, implying the lack of user-producer relations and isolation. Moreover, high-technology industries have been decoupled from traditional spheres of Estonian economy, meaning lack of exchange of knowledge and skills (Högselius 2005, 264-266, 271-274; see also Tiits et al. 2006, 163) In general, the completion of privatization in the Baltic States, either through FDI or other means, has resulted in overall technological downgrading and decreasing share of medium as well as high technologies in manufacturing value-added (King, Hamm 2008, 12, 30; Kattel, Anton 2004, 106-128), which explains the export specialization of these countries in low value-added products, produced by simple assembly activities in labor-intensive low- or medium-technology industries (Havlik et al. 2001, iii-iv, Kattel 2009, 11-13). In addition, as FDI in CEE region is shifting towards services at the expense of manufacturing sector (except Slovakia, the Czech Republic, Hungary, which have strong exports by FDI companies) (Hunya 2008, 7-14, 21; Hunya 2009, 13), only few FDI-intensive branches account for the majority of manufacturing industry output (Havlik et al. 2001, iii-iv; 3/28-3/32). Three main manufacturing industry branches for inward FDI in Estonia and Latvia are: 1) food products, beverages and tobacco, 2) wood and wood products, and 3) non-metallic mineral products, while in Lithuania, chemicals, refined petroleum and nuclear fuel production, and food products absorb the majority of inward FDI in manufacturing sector (Hunya 2009, 73-81). The following charts define the distribution of inward FDI stock by economic activities in three Baltic States and by the formed proportions, it can be concluded that in more disadvantageous position is Latvia in terms of directing FDI into productive manufacturing sector. On the other hand, Lithuania's better position in terms of the ability to service foreign claims in the future can be explained by the highest share of FDI stock in manufacturing sector that has the potential to generate foreign currency earnings.

22

Chart 1: Inward FDI stock by economic activities in three Baltic States, 2008

ESTONIA

34%

26%

14%

12%

6%

3%2% 3%Financial intermediation

Real estate, renting & business

activities

Manufacturing

Wholesale, retail trade, repair of

veh. etc

Transport, storage and

communication

Electricity, gas and water supply

Construction

Other sectors

LATVIA

28%

21%

9%

14%

8%

4%

2%

14% Financial intermediation

Real estate, renting & business

activities

Manufacturing

Wholesale, retail trade, repair of

veh. etc

Transport, storage and

communication

Electricity, gas and water supply

Construction

Other sectors

LITHUANIA

16%

16%

23%

14%

14%

8%

2%7%

Financial intermediation

Real estate, renting & business

activities

Manufacturing

Wholesale, retail trade, repair of

veh. etc

Transport, storage and

communication

Electricity, gas and water supply

Construction

Other sectors

Source: Hunya, 2009.

23

By interpreting the data, presented on the charts above, it appears that the Baltic States are unable or unwilling to direct foreign capital away from investments that do not generate foreign currency earnings, but induce inflationary speculative-led growth. The majority of inward FDI stock is represented in the segments that target host country market by producing non-tradable goods. Furthermore, as already mentioned, the vulnerability for the Baltic States stems from narrow specializations in low value-added activities that form a weak basis for exports, while the limited number of exporting articles increases the sensitivity to fluctuations in external markets. Due to less complexity in economy and technologies, these states face deteriorating terms of trade, which exacerbate sustainable growth in foreign currency earnings. Hence, as the unaccomplished upgrading of economies with malfunctioning national innovation systems and liberal economic policies have made it unfeasible to pursue domestic demand-led growth, the Baltic States tend to remain dependent on debt- or at best export-led growth. In such circumstances, economic environment is prone to the realization of Minsky-Kregel moment of financial fragility and eventual crisis, once economic agents with high foreign exposure become illiquid due to cessation of inflowing foreign capital or other detrimental events, such as exchange rate fluctuations, changes in interest rates, internal deflation etc.

II. 1 MACRO-LEVEL DEVELOPMENTS

The most obvious signs of disorder in the financial structures of the Baltic States and impending turmoil came to the fore in 2008, when global financial crisis erupted. The U.S. sub-prime crisis and the following global credit crunch affected severely CEE region via financial channels (Ocampo 2009, 719-722), as the rate of repatriated incomes to non-residents started to increase, while the inflow of FDI into the region has been on a declining trend since 2008 because of stalling economic growth in export markets, falling demand, declining profits, excess capacities, and also internal problems in CEE countries. There have been production cuts and layoffs in financial services, automotive industry, and building materials, i.e. the sectors that have been carrying forward rapid economic expansion in CEE region. Furthermore, FDI inflows in the form of equity investments have lost momentum due to largely completed privatization, which infers to (over)reliance on reinvested profits and (bank) loans. For these reasons, the current dynamics of FDI reflect the features of maturing FDI in most of the CEE countries. (Hunya 2008, i, 7; Hunya 2009, i, 6)

24

Figure 1: FDI inflows in selected CEE countries, EUR mil, 2003-2009

-2000

0

2000

4000

6000

8000

10000

2003 2004 2005 2006 2007 2008 2009

Years

EU

R, m

il

Estonia

Latvia

Lithuania

Hungary

Czech Republic

Slovenia

Source: Hunya, 2009

As described in the chapter I.3, the balance between financial inflows and outflows can be determined by the level of maturity of FDI in host country, which also could be considered as an indicator of forthcoming financial turbulence. The high ratio of current account deficit to GDP, caused by growing share of out-flowing FDI-related income (interest or dividends) of non-residents in the current account, is considered to be one of the causes of financial instability. On the other hand, net FDI tends to cover current account deficits, as it has been in the case of Baltic States (Hunya 2008, 15, 18; Hunya 2009, 16). In more advanced new member states of the EU, like Slovenia, net FDI finances smaller part of current account deficit because of growing outward FDI. Nevertheless, as most of the new EU member states, including Czech Republic, Hungary, Slovakia, and Estonia, are reaching the stage of mature FDI, i.e. high FDI income outflow that exceeds FDI inflow, thriving outflows need to be accompanied by enhanced export capacities and positive trade balance, created by FDI. In ideal scenario, reinvested profits should be directed into exportable, technologically more advanced, higher value-added, and R&D-intensive products. However, the reality presents opposite picture, as already described in previous paragraph - FDI has gone mainly into domestic market oriented projects or weak export sectors, especially in Estonia and Latvia, while decreasing profits have precluded from reinvesting the profits. In general terms, by 2009 FDI has become a source of income outflow and creates more current account deficit than it finances in CEE region (Hunya 2008, 18-21; Hunya 2009, 16-19).

25

Figure 2: FDI inflows compared to FDI-related income outflow in selected CEE countries,

EUR mil, 2003-2008

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

11000

12000in

flow

inco

me

ou

tflo

w

inflo

w

inco

me

ou

tflo

w

inflo

w

inco

me

ou

tflo

w

inflo

w

inco

me

ou

tflo

w

inflo

w

inco

me

ou

tflo

w

inflo

w

inco

me

ou

tflo

w

Hungary Czech

Republic

Slovenia Estonia Latvia Lithuania

EU

R, m

il

2003

2004

2005

2006

2007

2008

Source: Hunya, 2009

As seen from figures 1 and 2, FDI inflows have gradually decreased, but more importantly, FDI income outflows have leveled FDI inflows or even exceeded, especially in more advanced CEE countries, like Hungary and Czech Republic. Latvia and Lithuania still experience higher FDI inflows than FDI-related income outflows. However, more important indicator of deepening fragility is the high ratio of repatriation of FDI-related income in FDI income outflow, given that a country is highly dependent on foreign capital, but faces decreasing FDI inflows. As it was already mentioned, mature FDI countries get little new FDI and loose in terms of income to non-residents. Hence, very high ratio could signal capital flight, triggered by decreasing profits or revenues. When comparing the positions of Latvia and Slovenia in the Figure 3, one must acknowledge that Slovenia's inward FDI stock as a percentage to outward FDI stock was 210% in 2008, while in Latvia the same percentage was 1073% (Hunya 2009), implying much better prospects for the conformity of FDI income outflow to inflow in Slovenia36.

36 In Estonia 244%, in Lithuania 645%.

26

Figure 3: Inward FDI stock as % of GDP, and share of repatriated FDI income in FDI income

outflow as %, in selected CEE countries, 2008

0

20

40

60

80

100

Hungary Czech

Republic

Slovenia Estonia Latvia Lithuania

%

Inward FDI stock as % of GDP

Share of repatriated FDI income in

FDI income outflow, %

Source: Hunya 2009, author's calculations

On the other hand, low level of repatriated profits and growing FDI inward stock refer to reinvestment activities by FDI companies. Nevertheless, the reliance on reinvested profits, especially, if these are made in the sectors that do not generate foreign currency earnings, make these economies very sensitive to domestic disturbances, as once the prospects deteriorate for continuing profits, disincentives for foreign investors emerge and the overall FDI stock plummets. So far, FDI inward stock has been steadily growing in all CEE countries (see figure 4), but that could be explained by the real appreciation of the currencies (see Figure 5) that have had a complementary effect on the increase of FDI stock in the context of waning inflows of new FDI.

27

Figure 4: FDI inward stock in selected CEE countries, EUR mil, 2003-2008

0

10000

20000

30000

40000

50000

60000

70000

80000

90000

2003 2004 2005 2006 2007 2008

Years

EU

R, m

il

Estonia

Latvia

Lithuania

Hungary

Czech Republic

Slovenia

Source: Hunya, 2009. Figure 5: Real effective exchange rates in selected CEE countries, index 1999 = 100

90

100

110

120

130

140

150

160

170

180

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Years

Ind

ex

Hungary

Czech

Slovenia

Estonia

Latvia

Lithuania

Source: Eurostat (2010a).

28

Uncompetitive exchange rates of the Baltic States could be considered as one of the factors behind deteriorating net trade balances until 2007/2008, as can be seen from the following figure. Improvement in the trade balances since 2008/2009 has had a positive effect on external balance, but in absolute numbers, both exports and imports have fallen, which in the context of growing debt burden is insignificant achievement.

Figure 6: Net trade balance in Goods and Service in the Baltic States, 2003-2009, EUR mil

-5000

0

5000

10000

15000

20000

25000

2003

2004

2005

2006

2007

2008

2009

2003

2004

2005

2006

2007

2008

2009

2003

2004

2005

2006

2007

2008

2009

Estonia Latvia Lithuania

EU

R,

mil Exports

Imports

Net trade balance

Source: Eurostat (2010a), Bank of Estonia, Bank of Lithuania, Bank of Latvia, author’s calculations

As already discussed, mature FDI countries tend to create current account deficit rather than finance it. The main explanation behind deteriorating current accounts in the Baltic States during previous years (see Figure 7) could be found in abolished trade restrictions and easy credit that drove economic expansion by financing consumption and real estate bubble (Lucas 2009; Hugh 2009). For years, foreign borrowing and aggressive lending policies of Scandinavian countries have deepened trade deficits, which have made these countries highly dependent on imported goods (Hudson 2008, 74). Additionally, appreciating currencies and unsustainable wage growth (see IMF 2009, 9; Hugh 2009) have aggravated current account balances in the Baltic States by evaporating the competitiveness of export products. In general, foreign capital in Estonia, Latvia, and Lithuania has caused distress from both real exchange rate appreciations, as wages have been growing faster than productivity, and worsening current account deficits that have deteriorated overall balance of payments position (Kattel, Primi 2008, 10-14, 17-19; Havlik et al. 2001, i-ii).

29

Figure 7: Current account (bars) and net FDI inflow (lines) as % of GDP in selected member

states, 2000-2008

-30

-20

-10

0

10

20

30

40

50

60

2003 2004 2005 2006 2007 2008 2009

Years

% o

f G

DP

2003 2004 2005 2006 2007 2008 2009

Estonia

Latvia

Lithuania

Czech Republic

Hungary

Slovenia

Estonia

Latvia

Lithuania

Czech Republic

Hungary

Slovenia

Source: Eurostat (2010a), World Bank 2010.

By comparing the current account balance with net FDI position as percentages of GDP in the Baltic States, we can observe the non-compliance of these indicators in terms of much wider current account deficit that cannot be covered by net FDI, implying the reliance on other sources, i.e. capital flows as loans and portfolio investments, in financing negative current account. Thus, the essential problem of the Baltic States derives from unsustainable debt-led growth, as the ratio of gross external debt to GDP, an indicator often used to assess country's indebtedness, has increased in all three Baltic States since 2003 and the annual growth rate of external debt has been positive until 2009 (see Figure 8). The vulnerability to the stability of financial system is added by non-corresponding increases in foreign reserves, as in the context of increasing external indebtedness, the ability to service debt with foreign official reserves has declined or at best stagnated (see Figure 9). Even though the relative official reserves in Estonia and Latvia have been improving during last two years, the worrisome is their relatively low level.

30

Figure 8: Gross external debt as % of GDP (bars) and annual growth rate of gross external

debt as percentage change on previous year (lines) in the Baltic States, 2003-2008

-20%

0%

20%

40%

60%

80%

100%

120%

140%

160%

2003 2004 2005 2006 2007 2008 2009

Years

Estonia

Latvia

Lithuania

Estonia

Latvia

Lithuania

Source: Bank of Estonia, 2010, Bank of Latvia, 2010, Bank of Lithuania, 2010, author's calculations

Figure 9: Foreign official reserves as % of gross external debt in the Baltic States, 2003-2008,

annual base

0

5

10

15

20

25

30

35

40

45

2003 2004 2005 2006 2007 2008 2009

Years

%

Estonia

Latvia

Lithuania

Source: Bank of Estonia, 2010, Bank of Latvia, 2010, Bank of Lithuania, 2010, Eurostat (2010a), author's calculations These negative developments in terms of rapid increase in foreign indebtedness have been made possible by negative real interest rates (see Figure 10) in three Baltic States prior to the global financial crisis at the end of 2008 that made it cheap to borrow, and in particular in foreign currency, as all these countries have pegged their currencies to Euro.

31

Figure 10: Money market interest rates and inflation rate in the Baltic States, 2003-2009,

Quarterly data

ESTONIA

-4

-2

0

2

4

6

8

10

12

14

Ja

n

Ap

r

Ju

l

Oct

Ja

n

Ap

r

Ju

l

Oct

Ja

n

Ap

r

Ju

l

Oct

Ja

n

Ap

r

Ju

l

Oct

Ja

n

Ap

r

Ju

l

Oct

Ja

n

Ap

r

Ju

l

Oct

Ja

n

Ap

r

Ju

l

Oct

2003 2004 2005 2006 2007 2008 2009

Months, Years

%

money market interest rates inflation rate

LATVIA

-4

-2

0

2

4

6

8

10

12

14

16

18

20

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

2003 2004 2005 2006 2007 2008 2009

Months, Years

%

money market interest rates inflation rate

LITHUANIA

-4

-2

0

2

4

6

8

10

12

14

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

Jan

Apr

Jul

Oct

2003 2004 2005 2006 2007 2008 2009

Months, Years

%

money market interest rates inflation rate

Source: Eurostat (2010a), EBRD, 2010.

32

The same figure brings out very fast growth in price levels that has been accompanied by rising wages, but with no productivity growth. Thus, Baltic economies can be characterized as bubble economies, where foreign capital has been directed into services, financial intermediation, real estate, and other businesses that target domestic markets, tend to generate imports, and boom via inflating prices. (Hunya 2008, 7-14, 21; Hunya 2009, 13; Kattel 2007)

II. 2 THE FINANCIAL FRAGILITY IN THE BALTIC STATES

Based on empirical evidence and theoretical propositions, it can be concluded that one of the main causes behind the financial fragility in the Baltic States, in particular in Estonia and Latvia, are the asymmetrical relationships between these countries and the rest of the EU in terms of economic integration, trading patterns, and exchange rate alignments. Industrialized EU countries have kept a tight hold on research, design, development, finance, and ownership of intellectual property, whereas the Baltic States have been engaged in lower end activities of value chain, implying the provision of manufacturing contracting, and have to cope with the outflow of profits and wealth in exchange for FDI (Lane 2008, 5, 8-15). While these elements were rooted already in the 1990s, the effects of mentioned asymmetries took much larger magnitude after the EU enlargement in 2004, as the implementation of EU legislation and liberal economic policies on national level (no property tax, abolished trade and capital restrictions, flat tax) enabled capital inflows to increase very rapidly. The presence of foreign capital in small Baltic States has not contributed to sustainable economic development by supporting innovative manufacturing activities, subject to increasing returns that create synergetic mutual interdependences and spillover effects37. The logic behind balanced growth has not been pursued and the integration of FDI companies into the host economy has not been achieved. On the contrary, the specialization in labor-intensive assembly operations and low value-added products in low- or medium-technology industries has meant the transfer of cumulative multiplier effects in terms of additional employment, productivity, externalities, and know-how to home countries of FDI (see Kattel, Anton 2004, 106-128). In the long term these maturing technologies have to face with decreasing potential for innovation and diminishing foreign currency returns. Baltic economies are also made vulnerable by the displacement of domestic producers as a result of high concentration of foreign capital in certain sectors, e.g. commercial banking sector.

Above all, the core reason behind deepening financial fragility in the Baltic States could be ascribed to prolonged period of stability, as in the context of lowered risk-perception and aggressive lending activity by foreign banks, markets gave wrong signals that resulted in leveraged structures and extensive use of credit for inappropriate debt-financed investments in terms of distribution and amount. Because of excessive demand and easy credit (see Figure 11), external financing concentrated in limited number of economic activities that triggered speculation-led inflation. As a result, Estonia and other Baltic States have witnessed skyrocketing asset prices and private consumption along with increased wages that have enabled debt-led growth with current account deficits (Lucas 2009; Kattel 2009, 11-13).

37 In East Asian case state-led industrialization together with feedback linkages and positive externalities played a major role in the development process (Kattel et al. 2009, 14).

33

Figure 11: Domestic credit to household as % of GDP in the Baltic States, 2003-2008

0

5

10

15

20

25

30

35

40

45

50

200

3

200

4

200

5

200

6

200

7

200

8

200

3

200

4

200

5

200

6

200

7

200

8

200

3

200

4

200

5

200

6

200

7

200

8

Estonia Latvia Lithuania

% o

f G

DP

other credit

mortgage

Source: EBRD, 2010 In the context of liberalized capital markets and lax banking regulations, one of the main factors behind such worsening economic conditions is the exchange rate systems that have been adopted in the Baltic States. Currency board arrangements in Estonia and Lithuania, and rigid pegged exchange rate in Latvia have not been able to adjust external imbalances with the contraction of monetary base, as capital inflows offset both current account deficit and decline in money supply. Estonian currency board arrangement has entailed enormous per capita FDI, as liberalized economy with completely free capital movements and without any restriction on the flows of currency and capital, or restrictive provisions on depositing currency and interest rates on loans or deposits resulted in relatively high growth of money supply due to large capital inflows (Sõrg, Vensel 2002, 37-38). Such expansionary effects, i.e. escalating inflation, fed by increased money supply, resulted in the ongoing real appreciation of domestic currencies that worsened current account balances. Hence, either deflationary developments or capital outflows threaten the economic systems, especially banking sector, in the Baltic States, as in both scenario countries could get deprived from liquidity in terms of depleted foreign reserves due to increased demand for foreign currency. As of 2008, banks` liabilities to non-residents in Estonia had reached 70% of GDP and the share of loans in banks` assets 76% of GDP (Hugh 2009). Thereby, should Estonian indebted banking sector become illiquid in the system of currency board, either currency or banking crisis occurs.

Sooner or later the payment of amortization, dividends, and interest as an outflow of capital from developing countries approaches and eventually exceeds inflows. Even though capital outflow is not on the agenda at the moment, there are first signs of trouble. The most distinct indicator of financial problems in the Baltic States is the worsening net international investment position that was -81,8% of GDP, -95,3% of GDP in Latvia, and -61,2% of GDP in Lithuania in 200938. In addition, at least Estonia has to cope with maturing FDI, where FDI-related income outflow has reached the level of FDI inflows. The problem is related to the structural composition of FDI-

38 author’s calculations, based on data provided by National Banks of the Baltic States.

34

dominated manufacturing sector that poses the danger of insufficient foreign exchange earnings in the long run or capital flight before the first stage of long-term debt sustainable development is concluded, as matured low- or medium-technologies face the saturation of markets, low profit margins, and decreasing demand. Thus, the Minsky moment of financial fragility and eventual crisis can be realized by the drop in FDI stock due to shrinking profits and plummeting stock prices that would induce divestments and, in turn, result in increased unemployment and pressures on fixed exchange rates. Furthermore, massive sale-offs would have a contagion effect that leads to decreasing value of assets and shareholders` equity, implying the typical Minsky's Ponzi position, where liabilities of indebted private entities cannot be met. In the current global economic recession the stock prices have also declined in CEE countries, such as Estonia and Hungary, where FDI inward stock has been the largest as a proportion to GDP (Hunya 2009, 13). In Estonia such downtrend developments in stock markets would severely affect households, as 70,2% of their financial assets are held in equities (Zirnask 2009).

By considering the second risk, namely deflationary developments, it can be observed from Figure 10 that deflation hit the Baltic economies already in the middle of 2008 before the global financial crisis. The consumption and investments fell that led to decreased demand and wages in all sectors of economy (Kattel 2009, 11-13; Key indicators... 2010). For oversupplied and leveraged sectors (real estate) it has meant the volatility in the value of assets due to liquidation of existing capital to cover debt obligations, which set off debt deflation process.

Adjunct fundamental element behind the financial fragility in the Baltic States is low interest rate on euro denominated loans and mortgage credit that has overleveraged private sector and outpaced loans, denominated in local currencies39 (Vistesen 2008; Hudson 2008, 71; Hugh 2009). These loans have been used for consumption or economic activities, e.g. construction, financial services, and real estate that target domestic markets and generate local currency earnings. Moreover, commercial banking sector in Estonia has been funded by short-term borrowing in foreign currencies, which has been used to fund long-term euro-denominated mortgages at high loan-to-value ratios and floating rates (IMF 2009, 5, 11-16). Thus, both commercial banks and indebted private entities carry the risk of currency and maturity mismatch40. The difficulty stems from decreasing margins of safety in terms of reduced capacity to service loans, as the ratio of official foreign reserves to gross external debt is falling41. Thereby, should exchange or interest rates move in unfavorable direction, non-export oriented sectors and indebted economic agents would be severely affected in servicing their loans, which brings to the fore the external dimension of Minskyian moment of financial fragility.

Pressures on fixed exchange rates would emerge, once reserves are depleted, asset values decline, and capital is withdrawn from economy. However, for indebted economic agents, depreciation of the currency in the form of devaluation or internal deflation would mean becoming Ponzi financing unit.

Thus, it is the combination of several factors that has driven deepening financial fragility in the Baltic States, the essence of which could be ascribed to typical elements that were brought out in the chapter I.3:

39 Foreign currency loans as a percentage of total loans was 87,5% in Estonia in 2009, 89,5% in Latvia in 2009, and 70,4% in Lithuania in 2009 (Bank of Latvia, Bank of Lithuania, Bank of Estonia, author’s calculations). 40 In Latvia, external debt with original maturity below 1 year exceeded 50% of GDP in 2007 (Key indicators...2010). 41 Another indicator of deteriorating capacity to service debt, is loans as a percentage of deposits – 173,2% in Estonia in 2009, 279,6% in Latvia in 2009, and 175,3% in Lithuania in 2009 (Bank of Latvia, Bank of Lithuania, Bank of Estonia, author’s calculations).

35

• highly leveraged economic units; • appreciating currencies in real terms that deteriorated the competitiveness of exports; • worsening current account deficits; • diminishing capacity to service debt due to non-corresponding amount of reserves; • inflating assets and increasing wages without productivity gains; • inappropriate distribution of FDI – financing of non-tradable goods; • lost risk-perception that led to endogenous fragility; • currency and maturity mismatches; • growing capital outflow by FDI related income.

II. 2.1 POLICY REPSONSES

Once financial risks and vulnerabilities are identified, there should be responsive policies induced to change the context and mitigate risks. However, failure in preventive stage would require an effort for post-crisis stabilization. The discussion on policy measures that have been implemented to forestall financial crisis or alleviate systemic risks is rather primitive and focuses mainly on dominating political stance before and after the 2008 global financial crisis. The reason for that is simple: when considering the toolbox of policy-measures that are designed to mitigate or deal with the consequences of crises, it is evident that in the context of liberalized economy, where no restrictions on capital and currency flows or provisions on currency transactions and interest rates are enforced, the main tools that are available for policy-makers include traditional macroeconomic (fiscal) or FDI policies. Although some of the banking regulations have been applied in Estonia, e.g. reserve requirement, none of the options under the sections „controls“ or „limits“, presented in chapter I.3, has been employed. Thus, the analysis on the imposition of time-varying capital-account controls or wide-range of limits and requirements for banking sector in financial intermediation can be excluded. Nevertheless, even the implementation of narrow-range regulations have been pro-cyclical by the nature and thereby, contributed to deteriorating financing positions of economic agents. During boom periods, policy measures should have avoided excessive indebtedness and risk-taking by suppressing rapid increase in lending as well as deterring currency mismatches. Instead, poor accounting and inadequate legal framework for lending have enabled real estate financing with a loan-to-value ratio of 90%, which could have been avoided by tightened control of banking system and stricter loan conditions, e.g. lower income multipliers on loans and loan-to-value ratio, more profound documentation (Hugh, 2009). Furthermore, the risk weights on different assets have been lowered (now 60% on mortgage) (IMF 2009, 9, 18). The absence of property tax afforded to capitalize incomes from property sales into bank loans, which amplified lending activity (Hudson 2008, 76-77), whereas income-tax exemption of interest payment on housing loans has been a stimulus behind increased borrowing and could be seen as a pro-cyclical measure.

One way to avoid inflationary economic growth that erodes export competitiveness and worsens current account balance would be to enforce counter-cyclical fiscal policies, i.e. higher taxation of consumption that would induce propensity to save and “sterilize” financial inflows into reserves. Moreover, the overheating of economy needs to be impeded by reduced government expenditures in spheres that lead to cost-push inflation, e.g. controls on incomes in public sector. By taking a look at the fiscal budgets of the Baltic States within the period of 2006-2009, one can observe that in Latvia and Lithuania, governments ran deficit budgets before and after the crisis,

36

while in Estonia, government budget was in surplus only in 2006 and 2007 (see Figure 12). Nevertheless, exactly during these years (2006 and 2007), the capacity to service gross external debt with foreign official reserves decreased significantly, implying the insufficient effort for the stabilization of economy by absorbing excessive capital inflows. Furthermore, income tax was gradually reduced in Estonia during the boom years from 2005 onwards by 1% per year (EMTA 2010), while labor costs, covered with finances from government budget, increased significantly. In all three countries the second largest increase in government expenditures took place in the category of compensations of employees that facilitated inflationary trends in all sectors of economy. If in other CEE countries, labor costs increased by 13,8% on average during the period of 2006-2008, then in Estonia, Latvia, and Lithuania these figures were 32,1%, 42,4%, and 31,5% respectively42. In Latvia and Lithuania, fiscal discipline was not followed before as well as after the crises, which might be one of the causes for a sudden increase in fiscal deficit in 2009, as reserves had been decreasing since 2006 in relative terms. Moreover, unlike Estonia, Latvian and Lithuanian governments have accumulated a significant government debt burden with a ratio of 36,2% and 29,3% of GDP respectively, which contribute to the financial instability in these countries. All these mentioned fiscal policy measures reflect the pro-cyclical nature that contributed to deepening financial fragility in direct or indirect way.

Figure 12: Fiscal Balance as % of GDP in the Baltic States, 2006-2009

-10

-8

-6

-4

-2

0

2

4

2006 2007 2008 2009

Years

% o

f G

DP

Estonia

Latvia

Lithuania

Source: Eurostat (2010b) On the other hand, counter-cyclical expansionary macro-economic policies would be required to deal with constrained demand, after the crisis had hit the countries. Liquidity preference as a result of deflationary processes justifies the role of the government as dis-saver. Although the figure above might reflect the adherence to this logic, it does not tell the whole story. Even if the governments of Latvia and Lithuania have followed the principles of Keynesian economics by running budget deficits during economic recession, in absolute numbers, both revenues and expenditures have significantly decreased (see Figure 13). More importantly, most of the budget cuts were made in

42 Calculations based on data from Eurostat (2010c).

37

intermediate consumption43 and capital investments. In Latvia, annual decline in capital investments was 80,9% in 2009 (Eurostat 2010c). On top of it, Latvia has been given a conditional loan of 7,5 billion Euros by IMF, EU, and Sweden that stipulates to implement fiscal austerity in terms of increased taxes and limits on budget deficits (Green 2009). Although in the short run the financial support improves the current account balance as a percentage of GDP – from minus 13% in 2008 to 9,4% in 2009 -, in the long term it raises gross debt burden.

Figure 13: Fiscal revenues and expenditures in the Baltic States, 2006-2009, EUR mil

0,00

2000,00

4000,00

6000,00

8000,00

10000,00

12000,00

14000,00

2006 2007 2008 2009 2006 2007 2008 2009 2006 2007 2008 2009

ESTONIA LATVIA LITHUANIA

EU

R, m

il

Revenues

Expenditures

Source: Eurostat 2010b In order to cool down overheating economy and on the other hand, to stimulate economy in case of excess supply of labor and declined economic activity, governments should run counter-cyclical macro-economic policies by being a dis-savers in the latter case. However, unwillingness or inability by the governments in the Baltic States to act in this manner can be explained by two factors. First, currency board arrangements in Estonia and Lithuania do not allow the financing of fiscal deficits. Second, the aspiration to join Euro has set criteria for candidate countries that enforce limits on budget deficits. On the other hand, even if the expansionary policies are executed to rectify internal imbalance, the desired effect might get evaporated due to cross-border supply and demand relations. There is a risk that stimulus policies for internal stabilization feed external imbalances as a result of income elasticity of demand for imports. Furthermore, public procurement regulations within the EU create the conditions for tendering opportunities by external competitors, which jeopardizes the positive effects of liquidity shot into domestic economy. Thus, the Baltic States have limited possibilities to use either monetary or fiscal policies to stimulate sinking internal and external demand, leaving internal devaluation via wage cuts as the only option to improve external balance and attract new investments (Lucas 2009). Accompanied by reduced government expenditures these deflationary developments have a negative effect on domestic demand,

43 The value of goods and services, used as inputs for production process (Commission Regulation (EC) No 1500/2000 of 10 July 2000 implementing Council Regulation (EC) No 2223/96 with respect to general government expenditure and revenue).

38

employment, and economic growth, which all together increase the cost of borrowed stock for indebted entities44.

Currency board arrangement has stymied the functioning of monetary authorities as lenders of last resort and providers of additional liquidity, if needed (IMF 2009, 11), which is of high importance, when asset prices need to be backed and economic activity upheld with extra credit. Thus, the system of currency board arrangement can be maintained only, if capital inflows, current account deficits and bank lending are held under the control. None of these criteria have been achieved in Estonia and to less extent in Lithuania for effective functioning of currency board system. By setting low taxes and providing subsidies, the Baltic States have attracted inflows of FDI and extensive credit that has been used rather on rent-seeking purposes than investments (Reinert, Kattel 2007, 1-2, 24-25; Hudson 2008, 75-76). On the other hand, the prospect of growing FDI income outflows should be addressed through fiscal policies, i.e. taxation of either dividends or interest earnings. If we take a look at the dynamics of FDI income outflows and the share of repatriated profits (Figures 2 and 3), it seems that the negative effect of FDI on countries` balance of payments is something that governments have not yet acknowledged. Thereby, countries with currency board system and open external account should consider the application of either direct measures, such as quantitative controls on FDI flows, or indirect measures, such as targeted subsidies or other incentives to invest in exposed sector that enable to alleviate prevailing external imbalance and pressures on exchange rate. When considering specific FDI policies, then in the 1990s there were some restrictions in Estonia on FDI in terms of special licenses required to get involved in some industries, such as energy, mining (Sakkeus 2001, 11-12). Currently, no active policies have been activated to direct foreign investments in accordance with national development strategy. Public policies in Estonia have not paid enough attention to the role of FDI in transferring knowledge, evoking new high-technology industries, and creating spillover effects45, but have relied mainly on fiscal policy instruments, e.g. tax burden reduction (Tiits et al. 2006, 158, 162-163).

Conclusion Throughout the contemporary history, i.e. since the second part of the 20th century, there have been several forms of external financing of economic development that have re-emerged time after time. Since the 1990s FDI-led economic growth and industrialization in less developed countries obtained more importance in Latin-America as well as post-soviet small states in Central and Eastern European region. The reasons for FDI-led growth could be found primarily in general bias of developing countries to adhere to so-called Washington Consensus policies, but also in the concept of techno-economic paradigms. Although there are several theories in the tradition of classical development economics that explain the mechanisms behind economic development, the cornerstone of economic and technological progress lies in the capital formation and industrialization, i.e. manufacturing industries with synergetic interdependences, spillover effects, and increasing returns. Thus, the 44 Nersisyan and Wray (2010) have found that the imposition of fiscal austerity by nonsovereign nations with fixed exchange rates puts breaks on the economy, which eventually leads to fallen tax revenues and risen spending on the social security. 45 In case of FDI, there have been several entry requirements, such as enabling access to foreign new technology, training of Taiwanese engineers, local content and expanding exports requirement for foreign companies or their subsidiaries, access to certain industries that are important for growth, enforced agreements with local suppliers, and performance requirements (Wade 1992, 77-79, 85, 93-95).

39

contribution of FDI to the sustainable development in host economy would require the integration of foreign capital into indigenous economy by established supply-demand linkages and mutual interrelatedness between domestic and foreign producers. Moreover, dependence on foreign investments underlies the importance of building up exporting sector in order to pursue debt sustainable development. Country can benefit from inward foreign investments by gaining an access to foreign markets, technologies, and knowledge. However, FDI tends to create enclaves in host countries by focusing on narrow-range exporting articles, invest in non-tradable sectors, and increase imports that do not have any significant positive impact on long-term development in host economy. Thus, by exploiting cheap labor, foreign investors have laid an emphasis on maturing low- or medium-technology industries and low value-added production stages that tend to transfer cumulative multiplier effects abroad. In this respect, the main motives of FDI are efficiency- and market-seeking that would yield short-term gains. On the other hand, in small developing states such inauspicious developments can be explained by malfunctioning innovation systems and small markets to reap gains from scale and external economies. While FDI per se has a tendency to aggravate the financial and economic conditions, host economies can easily contribute to the subversion of financial stability by implementing flawed economic policies and setting up institutional framework that undermine the ability to service foreign claims, leading to Minskyian Ponzi financing position in terms of insolvency. FDI by definition is a debt that needs to be repaid, the ability of which is determined by the soundness of financial system and exchange rate systems. In case of fixed exchange rates and deregulated financial flows, the financial stability is seriously jeopardized, which might affect negatively both internal and external balance of a country. In order to mitigate financial turmoil or to deal with the consequences of crisis, there are different policy measures, both direct and indirect, that are required to be counter-cyclical in nature, when implemented. Thus, the purpose of the current article was to outline the economic and financial developments in the Baltic States by trying to explain the financial fragility and susceptibility to crises in these countries within the established theoretical framework. As the inward FDI in the Baltic States has been concentrated in limited number of economic sectors and tend to finance the production of maturing products that face saturating markets and diminishing profits, FDI in the Baltic States is becoming mature in terms of both shrinking new FDI inflows and thriving FDI related income outflows. Furthermore, propensity to consume rather to invest and domestic market orientation of FDI have eroded the margin of safety by insufficient generation of foreign currency earnings to meet the external liabilities. Unrestricted capital inflows have been feeding monetary expansion in these countries, which led to inflationary trends and deteriorating real exchange currencies, all of which supported widening current account deficits. Both fixed exchange rate systems, including currency board arrangements in Estonia and Lithuania in the context of free capital flows that did not prevent high inflation, and overall liberal economic policies that left policy-makers only with traditional macroeconomic policies (taxes and expenditures) as the main tools to alleviate external imbalances, are to blamed in deteriorating financial conditions in the Baltic States. Governments have mainly relied on different fiscal policy measures before and after the crisis, while prudential capital-account controls, specific FDI policies, and more elaborated regulations on banking activity have been left aside. On the other hand, the effectiveness of such indirect measures (taxes) is disputable, as the immediate sources of financial fragility might be left untouched and fiscal policies tend to have adversarial impact on attaining simultaneously both internal and external balance in small states. Moreover, economic policy measures in the Baltic

40

States have had a pro-cyclical inclination46. Thus, the internal devaluation via wage cuts is seen as the only option to improve external balance and attract new investments, which under the conditions of high indebtedness and reduced government expenditures have a negative effect on domestic demand, employment, and economic growth. It is the combination of indebtedness, internal deflation, current account deficits, pro-cyclical policy measures, and declining demand due to high unemployment that results in Minskyian Ponzi financing position, i.e. being in essence insolvent, the Baltic States have to face. And even if the financial crisis and the following economic recession in Estonia, Latvia and Lithuania were triggered by adverse external developments – one of the risks that Ponzi units need to bear -, the elements of financial fragility and eventual crisis were seeded in the Baltic States during the boom years.

ACKNOWLEDGMENTS The research was undertaken with funding from the Estonian Science Foundation (grant no. ETF8097, Innovation Policy and Uneven Development)

The author is grateful to prof. Dr. Rainer Kattel (Tallinn University of Technology) and prof. Dr. Jan Allen Kregel (Levy Economics Institute of Bard College; Tallinn University of Technology) for their invaluable guidance and assistance!

46 Even though the policy measures, implemented in the Baltic States bear resemblance to Washington Consensus policies, there are elements in economic policies that have deviated for the worse, if we consider tax reforms, trade policy, and exchange rates.

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