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Capital flight or portfolio diversification?


RECENT pronouncements on the so-called “shortage” of foreign exchange have often referred to the phrase “capital flight.” I am not so sure that the use of this term is appropriate in the current environment. If I am correct in this view then any appropriate response to the present “shortage” must be fashioned with the current environment in mind. I wish to take this opportunity to explain.

The term of “capital flight” was characteristic of the protectionist decades of the seventies and eighties. During that era, which saw state control as the key driver in the course of economic development and which characterized much of the developing world there were a host of restrictions on hard currency inflows and outflows. These restrictions included exchange controls. Investment in foreign currency assets was not allowed except in very rare cases. In order to make foreign currency investments abroad, Central Bank approval was required. To do otherwise was illegal and was dealt with as such.

Since the early nineties however, most controls were removed and citizens were legally allowed to hold investments abroad. In other words, Trinidad and Tobago moved to a more liberalized system of trade and exchange rate determination. Under present arrangements it is legal to hold foreign currency accounts at home or abroad and to invest in foreign currency instruments. Citizens and companies alike have been taking such options, driven by a range of motivations one of which is the need to diversify their investment portfolios.

This means that as a result of the consideration of a number of current and expected factors – economic, financial and political – individuals make decisions with regard to risks and with regard to returns on the assets that they hold in their investment portfolios. They, explicitly or implicitly, consider such factors as interest rates, exchange rates, inflation etc. both in Trinidad and Tobago and abroad. With respect to rising inflationary expectations, investors assess a range of investment opportunities. If these are in short supply, say only real estate in Trinidad and Tobago, they then look elsewhere.

Key to making investment decisions as well, is actual or perceived volatility. If investors consider TT dollar assets to be volatile because of crime, rising inflation – induced by too strong Government spending or political restlessness or whatever – then the logical tendency will be to hedge these exposures. One way in which they might do this is through a reduced weighting of TT dollar assets in their portfolio, in favour of US dollar assets or simply put, shifting funds out of TT dollar assets into foreign assets. In this scenario then how realistic is it to speak of capital flight when our present laws and rules allow for these actions?

Let us be clear that investment by Government or citizens in foreign assets has several positive attributes. Not only does this reduce some potential inflationary pressures at home but it also reduces risks by broadening the range of income earning-assets belonging to citizens of this country. The big question here is, will the resulting income be brought back home? Again, quite consistent with our new and open system, returns will normally be repatriated so long as a favourable environment exists. Let us remember that the creation of such an environment is a pre-requisite in any movement towards developed country status. It is the challenge of all administrations to maintain such an environment!

It should be clear to all that there is no weakness in this country’s present foreign

exchange position. The country’s stock of foreign reserves has been building up in every year of the last ten years or so. Gross foreign exchange reserves now stand at around US$4.2 billion and the short and medium term prospects are quite positive, with upbeat forecasts for oil and gas investments, prices and production. If anything then, a good case can be made for an appreciation of the exchange rate as in the final analysis overall supply has been outstripping demand – which is why foreign reserves continue to accumulate.

So what then is the problem? The problem is that there is a short-run challenge in managing lumpy inflows of tax payments and more steady outflows of foreign exchange. Indeed the nature of these flows is one of the unique phenomenon of this country’s foreign exchange market. It is the inability to manage this situation properly that gives rise to some anxiety. The truth is that we have had a fair amount of time to adequately address this, remembering that we shifted to a managed float since April 1993.

What can we do? Simply put, a slowing down of net fiscal injections by Government will go a long way in helping the Central Bank manage excess liquidity in its conduct of monetary policy. Construction projects should be phased over a longer time period and the private sector must be encouraged to see a plan for long-term infrastructural development in which they can invest. From the standpoint of best practice, long-term assets should ideally be matched with long-term liabilities not short-term funding. Additionally, a more flexible approach to exchange rate management is long overdue. Any action that raises questions of credibility will not work. Further, a modern set of rules and regulations for the entire financial sector is also important. The supervisory authorities must ensure that all foreign exchange flows are adequately monitored for

compliance with the law.

But it would seem that there is yet another important factor that is serving as a “push factor” in the promotion of outflows. This has to do with crime and the crying need by the citizenry for a greater sense of personal security. The less secure the domestic environment the greener will foreign pastures appear. Definite and prompt attention to these factors will go a long way in alleviating the pressures on what is by no means an unmanageable situation.

We will do well to remind ourselves that in a much more open global financial and economic system there is little room for complacency. What this means is that if countries cannot provide the “correct” environment for investors and citizens in general, then capital – financial and human, will be willing to look to other pastures which are greener or which are so perceived. Politicians and policy makers must consider that in a liberalized environment, they too must be willing and able to match, if not better, the performance of other countries in all areas of life that matter to people. Specifically, we in Trinidad and Tobago must get it right on all fronts or face the dire consequences of our incompetence!


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