The Asian crisis was the world economy's closest shave since the Latin American debt crisis of the early 1980s and, arguably, since the Great Depression of the 1930s. A combination of currency and financial crises which erupted in east Asia during mid- and late 1997 rapidly developed into a global disturbance, engulfing not only most Asian newly industrialising economies but also Russia, South Africa and some Latin American countries. These systemic disruptions were major, but were not the only examples of financial volatility in recent years. The Asian crisis has been followed by further difficulties in Turkey and Latin America, and at time of writing it remains to be seen what the full effects of 11 September 2001 will be. Indeed, more than seventy financial and monetary crises of different proportions and characteristics have occurred in both developed and developing countries over the past two decades. Large and growing amounts of public money have been committed to tackling the financial crises and their socioeconomic consequences.

A common background to these developments is the intensifying process of global financial liberalisation and integration. Starting with the introduction of floating exchange rates and financial market deregulation from the 1970s onwards, the global monetary and financial system has undergone a radical transformation. Whereas national governments were once effective at shaping socioeconomic policies and development strategies in line with the imperatives of domestic political stability and legitimacy, there is now an increasingly market-oriented and integrated global system.

One of the striking features of the Asian crisis is that some countries, including India, were largely unaffected by it and the contagion that followed. This chapter argues that capital account controls are critical in explaining India's stability, a conclusion that should reinforce the second thoughts that have begun to emerge as regards the desirability of capital account convertibility (CAC) as an integral element of the redesign of the international financial architecture. Section one of this chapter describes India's capital account controls and their place in the country's payments regime. Section two examines various episodes of balance-of-payments strain in the 1990s and the role played by capital controls in managing them. Section three analyses why India escaped the Asian crisis and contagion and highlights the importance of capital controls in this context. Section four discusses the political economy of India's resistance to the adoption of CAC. Section five considers the desirability of adopting CAC in India in the near future. Section six offers some concluding remarks.

India's payments regime: managed floating and capital controls

India's capital controls operate within the framework of a payments regime, inaugurated in March 1993, that is officially described as a ‘market determined unified exchange rate’. The de facto position is different. ‘Market determined’ should not be understood to mean a clean float. There is active, sometimes heavy, intervention by the Reserve Bank of India (RBI) in the foreign exchange market.

The failure to manage the Asian crisis, to understand the mistakes and to institute reforms with any meaning for crisis-vulnerable countries, restates the importance of local, national and regional responses to financial globalisation.

The crisis which began when Thailand floated its currency on 2 July 1997 became a regional crisis and then a global crisis. The focus of subsequent analysis has, quite rightly, been on the international implications of the event. Thailand became a side-show in a much larger global drama. Yet the course of the crisis in the affected countries contains important lessons. Developing countries whose GDPs represent a minute fraction of the world economy are especially vulnerable to financial volatility. The discussion of reform in the international financial system petered out in 1999 once the crisis was contained in eastern Europe and Latin America. Proposals that the international financial institutions should have a duty to control volatility had already been struck off the agenda before this time. While the dangers of capital account liberalisation without appropriate monetary and regulatory policies are now well understood and thus unlikely to be repeated, the underlying vulnerability to volatility remains.

The lessons from the Thai case are obscured because early interpretations of the Thai crisis were highly ideological, and because the IMF has been intent on claiming credit for successful crisis management. In 1999, Michel Camdessus, the then Managing Director of the IMF, announced that Thailand has ‘graduated from the IMF University summa cum laude … graduation means victory … the job is done’.

Why don't emerging-market economies make more use of capital controls? Not long ago, in the wake of Asia's great financial crisis, limitations on capital mobility appeared about to make a comeback. At the intellectual level, scholars began to accord new respectability to the old case for controls as an instrument of monetary governance. At a more practical level, one country – Malaysia – imposed comprehensive restraints and, with seeming success, survived to tell the tale. As I wrote soon after the crisis broke: ‘The tide … is starting to turn. Once scorned as a relic of the past, limits on capital mobility could soon become the wave of the future.’ Yet in reality governments in the newly industrialising economies still hesitate to raise or restore impediments to the free flow of capital. Controls remain the neglected option. The question is: why?

Elsewhere, I have suggested that the explanation has much to do with the prominent role of the United States, the still dominant power in international finance. Washington, both directly and through the IMF, has brought its considerable power to bear to resist any significant revival of controls. Reflection suggests, however, that international politics is at best only part of the story; domestic politics too must be involved, in a mutually reinforcing interaction with the pressure of outside forces. The purpose of this chapter is to highlight the critical domestic side of the story.

In order to have a rational discussion of what should be done to redesign the international financial architecture, it seems natural to start by making sure that we all agree on the basic analytical framework, on what we mean by financial globalisation and what we judge the qualitative nature of its costs and benefits to be. That is what I shall take as my terms of reference in this chapter.

The term ‘financial globalisation’ is generally taken to mean the integration of capital markets across countries, and, specifically, the belief that this now encompasses most of the world. It does not include monetary globalisation, meaning the global use of a single currency. In fact, outside Europe, there has until recently been almost no sign of monetary integration. It remains to be seen whether the current flurry of interest in dollarisation will translate into the beginning of a widespread movement to curtail the number of currencies.

But for the moment it is the bond market rather than the money market that is unified, in the sense that agents in one political jurisdiction have become willing to hold an unlimited proportion of their portfolio in securities issued in a different country. Similarly, borrowers have become willing to see an unlimited proportion of the securities they issue held by the residents of a different political jurisdiction.

Over the past two and a half decades, increases in the international mobility of financial capital have generated pressures for the international harmonisation of financial sector regulations and practices. As finance capital has become increasingly mobile, controllers of financial capital have sought harmonisation of these regulations and practices in order to facilitate access to and exit from foreign markets and thereby reduce the risk and increase the profits associated with foreign investments. With enhanced mobility, controllers of financial capital have been able to threaten states that they will relocate their capital to alternative jurisdictions if they do not comply with demands for harmonisation. States have thus been severely constrained in terms of their policy options: if they do not pursue harmonisation they risk reduced access to international financial markets and the economic benefits that go with it.

One area in which these pressures have produced change has been accounting. Since its establishment in 1973, the International Accounting Standards Committee (IASC), a private sector policy-making body that is backed by a range of financial market players and other multinational corporations, has issued forty international accounting standards (IASs). Whilst this organisation does not have the formal authority to require countries to adopt its standards, it has had considerable success in persuading them to do so, especially in the developing world. Although the extent to which developing countries have adopted IASs has varied from country to country, there has nevertheless been a broad shift towards harmonisation throughout the developing world.

Two sets of explanations have dominated academic discussions of the causes of the Asian financial crisis. One has attributed the crisis to external factors, and the other has converged on weaknesses of economic fundamentals as the major causal factors. What has largely been neglected in these explanations, however, is the role of domestic political factors. This chapter examines how one such variable – the changing balance of power between private interests and public authority – contributed to the onset of the financial crisis and affected its management. Focusing on South Korea and Thailand, we argue that the growing private capture of public policy processes not only led to an unsuccessful process of financial reform and to structural weaknesses which sowed the seeds of the crisis, but also generated serious problems of policy management in the lead-up to the outbreak of the crisis.

We begin by briefly outlining the argument concerning the institutional variables which shape the balance of private preferences and power versus public interests and authority with regard to public policy making in the domain of the financial system. We then develop this argument through a more detailed comparative examination of the financial crises in South Korea and Thailand. Our purpose is not to provide comprehensive accounts of what occurred in the two countries during the 1997–8 period, as such accounts can be found in more synoptic studies in this volume, but to explore the impact of institutional variables on the process of financial reforms and crisis management.

Before Asia's financial crisis there was general agreement within the broad neo-liberal camp that deregulation, not least in the financial sector, was the key ingredient of effective market reform. Western governments, their aid agencies and international financial institutions, notably the IMF and the World Bank, enthusiastically pressed for the opening of capital markets and the removal of state control and ownership in domestic financial and banking sectors. But the crisis was to change all that, setting in train a bitter debate over whether these reforms had, ironically, been at the heart of the crisis.

For hardline neo-classical economists within the IMF and elements of the economic press, the crisis was confirmation that economies built around systems of state-managed markets were not sustainable in the long term. For these hardliners, the Asian economies that collapsed in 1997 fell under the weight of their own inherent inefficiency and dysfunction. The crisis was a reminder that deregulation had not gone far enough and that economies must embrace the natural efficiencies of the market.

Others within the neo-liberal camp were, however, to propose that the roots of the crisis were to be explained in terms of panic and speculation in open global financial markets and an ensuing rush for the exits when confidence collapsed. Such interpretations led naturally to policy prescriptions centring on reform in global financial architecture rather than a reconstruction of domestic economic and political regimes.