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Tuesday, April 1, 2003
U.S. House of Representatives,
Subcommittee on Domestic and International
Monetary Policy, Trade and Technology
Committee on Financial Services,
Washington, D.C.

    The subcommittee met, pursuant to call, at 10:01 a.m., in Room 2128, Rayburn House Office Building, Hon. Peter T. King [chairman of the subcommittee] presiding.

    Present: Representatives King, Biggert, Manzullo, Ose, Feeney, Hensarling, Murphy, Barrett, Harris, Maloney, Sanders, Sherman, Hooley, Velazquez and Frank (ex-officio).
    Chairman KING. [Presiding.] The hearing will come to order. I welcome all of you here today.
    Today, the Domestic and International Monetary Policy, Trade and Technology Subcommittee meets to discuss the financial services-related aspects of the recently announced free trade agreements. While the issue of trade is generally the ambit of other committees, this subcommittee is specifically responsible for international investment policies, both as they relate to U.S. investments for trade purposes by citizens of the U.S., and investments made by all foreign entities in the United States. This also includes trade as it relates to the U.S. financial sector as a key service industry.
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    Today, the subcommittee examines the recently concluded free trade agreements with Chile and Singapore. The United States reached agreement with these allies on December 10, 2002 and January 15, 2003 respectively. Many have suggested these agreements will help provide a framework going forward from which the United States can negotiate with other countries and regions. Specific to financial services, these agreements will provide much-needed certainty and transparency to allow U.S. investment to operate with confidence in these expanding global markets. National treatment, capital controls, transparency of financial regulation and efficient administrative review are just some of the many complex issues that U.S. negotiators have addressed in coming to resolution on these specific FTAs. I commend Ambassador Zoellick and his team at USTR and the Treasury for the work they have done on behalf of the working men and women of this country. As a supporter of U.S. free trade, I look forward to working with the administration to ensure implementation of these agreements.
    I recognize that with any negotiated agreement that there will be some who disagree with its provisions. While we can agree to disagree, I hope that if there is discussion on these disagreements, it will be based on facts and conclusive evidence. Today, we have a strong two-panel group of witnesses ranging from administration officials to academia to the private sector. I look forward to a lively debate on the merits of these trade agreements and would remind members that as the Financial Services Committee, we would greatly appreciate that the topic of discussion remain focused on financial service trade issues.
    I now recognize my New York colleague and ranking member, Mrs. Maloney, for opening statements.
    Mrs. MALONEY. Thank you, Mr. Chairman, for granting this hearing, and thank you especially, Ranking Member Frank, for working to include this topic in the subcommittee's agenda. I know it is an area that you have great expertise and have done a great deal of work.
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    As the lone world superpower and with U.S. forces engaged militarily around the world, the importance of using U.S. economic strength to spread American values gains heightened importance. Through promotion of rules-based fair trade policies, the U.S. has had an opportunity to lead the international community for the benefit of both rich and poor countries, while at the same time increasing opportunities for U.S. businesses and workers. By and large, the bilateral trade agreements between the U.S. and Chile and the U.S. and Singapore advance this effort. Both agreements knock down restrictions on domestic markets that serve to increase in efficiency and punish consumers who often pay the cost of protectionist policies. In financial services, these bilateral agreements offer U.S. companies exciting new opportunities in areas as diverse as excess to ATM networks, to increased opportunities to compete in new insurance markets.
    Given the many positives in these agreements, it is disappointing that our trade negotiators held out for a controversial position on capital controls that seeks special protection for U.S. investors. The trade agreements contain investor-state dispute settlement procedures that determine how U.S. investors can win damages if Chile or Singapore violate the free transfer provisions in each agreement. Reports indicate that these protections for U.S. investors were included at the urging of the Treasury Department, and that these negotiations over these provisions were some of the most contentious areas in the negotiations. Effectively, these provisions allow U.S. investors to seek damages in the event that Chile or Singapore take measures to limit capital flight in the event of a reoccurrence of an Asian financial crisis-like emergency. While Chile and Singapore are unlikely to need to impose capital controls, many economists have expressed the concern that the administration will insist on these provisions as a template in future trade negotiations with less stable countries.
    Such a policy could lead to a situation where wealthy U.S. bondholders have legal claims against a country that has imposed capital controls, while all other investors face losses and where the country's own people are suffering through an economic collapse. This special status for U.S. investors sends the wrong message about promoting free trade and could increase anti-American feelings. Critics of this policy have said its effects are to protect a special class of capitalist, rather than to promote stable capital markets.
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    In addition to the fairness argument, many economists including some at the IMF increasingly believe that the imposition of limited capital controls can be an effective means of stemming the flight of hot money. In the short term, capital controls can increase stability and reassure investors that economies are not prone to sudden collapse. I note that the witnesses who will express concern about capital controls in their testimony today are otherwise staunch free traders. I think this lends credence to the argument that at the very least, the effectiveness of capital controls is open to debate and the rigidity of the administration's position is a concern of many mainstream trade supporters and economists.
    I yield back my time.
    Chairman KING. Mrs. Biggert, any opening statements on this side? I recognize the ranking member of the full committee, Mr. Frank.
    Mr. FRANK. Thank you, Mr. Chairman.
    Let me pick up from where the ranking member of the subcommittee left off with her excellent statement. What is striking to me is the number of leading advocates of increased trade who are critical of this inclusion of capital restrictions. We will have a very distinguished economist, Professor Bhagwati; we will have Mr. Tarullo, who helped in the Clinton administration push forward with trade agreements, some of which I did not agree with.
    I want now at this point to enter into the record a statement, first from Nancy Birdsall, who is president of the Center for Global Development, a strong supporter of free trade.

    [The following information can be found on page 208 in the appendix.]

    Chairman KING. Without objection.
    Mr. FRANK. I appreciate that.
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    Secondly, I want to read excerpts from it. I will include statements from Joseph Stiglitz. I must say Professor Stiglitz and Professor Bhatwati are two of the acknowledged experts internationally in support of sensible liberalized trade and a globalization that will take us where we ought to go. It is impressive to me that both of them are quite critical of this particular inclusion of restrictions on capital controls. I will now read Mr. Stiglitz's statement. ''The importance of the subject of these hearings cannot be overestimated.''
    Let me say that he was not able to come because of scheduling problems.
    ''The provisions of the recent trade agreements with Chile and Singapore limiting government interventions in short-term capital flows are a major source of concern. Everything should be done to eliminate them from the agreements and to make sure that such provisions are not inserted into future trade agreements. Reducing trade barriers can be of benefit to all parties. Problems are encountered, however, when trade agreements go beyond trade issues, as in this case, forcing countries to undertake measures which should be a matter of national sovereignty. Such provisions have earned trade agreements a reputation for undermining democracy, and I believe that sometimes these accusations are deserved.
    ''It is of salient concern with a particular provision that risks imposing considerable harm on the country. Much of the instability in global financial markets in recent years, especially in the emerging markets, has been related to short-term capital flows. Capital rushes into a country and just as quickly rushes out, leaving havoc in its wake. The crises in East Asia were largely caused by premature capital market liberalization. The volatility is particularly hard on the poor and serves to create poverty. It is the low-skilled workers who bear the brunt of recessions and depressions. Chile, in its period of rapid economic growth in the early 1990s, imposed restrictions on the in-flow of capital. I believe such restrictions played an important role in its growth and stability.
    ''By the same token, developing countries in Asia that have grown the fastest, done the most to eliminate poverty and exhibit the greatest stability, have all intervened actively in capital markets at critical stages in their development, and many continue to do so today.
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    ''Let me be clear, while there were financial interests in the United States that might benefit from forcing countries to open up to the short-term capital flows, and there are even some who have benefited from the resulting economic chaos by buying assets at fire-sale prices only to re-sell them at great profit when economic calm has been restored, forcing countries to open up their markets to these short-term capital flows is not in the interests of the United States. It is in our interest to have a more stable global economy. It is in the interest of businesses that are investing abroad that there be greater economic stability.
    ''Yet economic research has identified short-term capital market liberalization as the single most important factor contributing to the instability in Asia and Latin America. Today, there is a growing consensus among economists against liberalizing capital markets for short-term capital flows for most emerging countries. Even the IMF has recognized this. The extent and form of capital market liberalization is a matter which should be left for each country to decide through democratic processes.
    ''We can encourage a full democratic debate on these issues with a public discussion of experts in developed and developing countries, debating the advantages and disadvantages. But we should not be using our economic power and the promise of increased investment and exports to impose the viewpoint of a particular set of interests or a particular ideology on our trading partners.
    ''The arguments for trade liberalization are totally distinct from those for capital market liberalization. They share in common but one word—liberalization. There is an emerging consensus among economists that emerging markets should be particularly wary about full capital account liberalization. It makes little sense for our trade agreements to be pushing on our trading partners restrictions which fly in the face of sound economics.''
    Let me just reiterate, it is clear we in this case imposed on both Chile and Singapore over their initial objections and their continuing objections this particular addition to free trade. I think that it is very important to understand, I would hope that we would move toward a consensus on freer trade, globalization, taking into account other values. This inclusion of a very rigid particular ideological view using America's power to impose these in individual free trade agreements goes exactly in the opposite direction.
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    Chairman KING. Thank you, Mr. Frank. I would ask if any other members have an opening statements, that they submit them in writing so we can get to the statements of our witnesses.
    Mr. Sanders?
    Mr. SANDERS. Thank you very much, Mr. Chairman.
    This is an important hearing. It is an important hearing because it raises discussion about our trade policy. It is important to begin to talk truth about our trade policy and recognize that from beginning to end our trade policy has been an outrageous failure. And it is incomprehensible to me that people keep coming forward—we had Alan Greenspan in front of the full committee a couple of months ago talking about the ongoing success of our trade policy. I wonder. I scratch my head and I say, what world are these people living in?
    If our trade policy is such a success, Mr. Chairman, why do we have a $400 billion trade deficit? Why in the last two years, and let me reiterate this, because it is not talked about too often by all the editorial writers who support free trade, how come in the last two years on our ongoing success of free trade, we have lost close to two million manufacturing jobs—10 percent of our manufacturing workforce? How come 20 or 30 years ago, General Motors used to be the largest employer in America where workers earned a decent wage?
    And Mr. Chairman, you know who the largest employer in America today is? It is Wal-Mart, where large numbers of people are on food stamps. How come any concrete examination of NAFTA will tell us that it has been a disaster for the people of Mexico, for the middle class, the poor people of Mexico, as it has been a disaster for working people in this country?
    I returned from China a month ago. It is not just that we have a $100 billion trade deficit with China. If anybody thinks that all the Chinese are going to be doing is stuffing teddy bears and making sneakers, you are absolutely mistaken. All of the evidence is there. It is not just blue collar jobs that are going to be replaced. It is white collar jobs and that is taking place right now. All of the evidence is there.
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    Mr. Chairman, I have a long statement which I would like to submit for the record. But I think that extending our trade policy should be laughed out of the Congress. We should be saying, are you serious? Obviously, you are joking, aren't you, coming here asking us to extend a disastrous trade policy. You are not really serious? We all have a good sense of humor. But to tell us to extend a disastrous trade policy which is causing havoc not only for the middle class, the working class of this country, but for poor people all over the world. Tell us about what is going on in Latin America—Venezuela, Argentina, the huge uprisings, mass demonstrations against the IMF, against these trade policies.
    Now, obviously we understand what goes on in American politics. Large corporations flood this building with huge contributions. Yes, I admit it. Trade policy works well for those companies that want to throw American workers out on the street and hire poor people for pennies an hour. Yes, I grant you. It works well for those CEOs that make a few hundred million dollars when they retire. But for the poor people of the developing world and for the middle class of this country, it is a failure, and the idea that we are thinking of extending our trade policies should be laughed out of this office.
    I would ask unanimous consent to allow my statement to be submitted for the record.
    Chairman KING. The gentleman's time has expired. Without objection, his full statement will be made part of the record.

    [The prepared statement of Hon. Bernard Sanders can be found on page 49 in the appendix.]

    With that, we will go to our first panel today—the Honorable John B. Taylor, Under Secretary of Treasury for International Affairs, and Mr. James Mendenhall, Assistant U.S. Trade Representative for Services for Investment and Intellectual Property. We will begin with Mr. Taylor.
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    Mr. TAYLOR. Thank you very much, Mr. Chairman, and Ranking Member Maloney for calling this hearing and inviting us to testify. I would like my oral remarks to just summarize briefly the written testimony and submit the written testimony to the record.
    Chairman KING. Without objection, your full statement will be made part of the record.
    Mr. TAYLOR. I would like to focus in my oral remarks on provisions related to trade in financial services and to investment in capital transfers in the free trade agreements with Chile and Singapore. Let me focus first on trade in financial services.
    We believe that reducing barriers to trade in financial services is an essential part of a good trade policy which aims to reduce barriers of all kinds to trade. Open financial sectors lead to more growth. They lead to a better allocation of savings. They lead to better services for people who take advantage of the better financial services. There is a reduction in the barriers to trade in financial services that is part of the two free trade agreements that we are discussing today. For example with respect to Singapore, Singapore has agreed as a matter of opening its market to financial services, to lift the ban it has had on new licenses for banks to operate in Singapore. It has also allowed for banks to get access to additional ATMs that are run by local banks. And it has reduced the limits to the number of ATMs that banks can have. So you can just see by these examples that these are the kind of things that improve the financial services that are available to people in Singapore, and at the same time bring business opportunities to U.S. firms.
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    With respect to Chile, Chile has agreed that it would make prior notice to any regulatory changes that might have bearing and implications for financial service firms. It is also providing more access to financial advisers and financial management firms who want to take a role in the management of the Social Security accounts in Chile. These are just some examples of the specific things that U.S. firms and consumers in Singapore and Chile can benefit from from reducing the barriers in financial services. On top of all those, as a chapeau, is an agreement that there would be a lock-in, a commitment not to remove these commitments, not to increase the barriers their current levels, so that there is no going back from the position where the countries are with respect to financial services.
    Let me now briefly talk about the investment in capital transfers part of the agreements. Reducing barriers to the flow of foreign investment is also an essential for raising economic growth and reducing poverty in countries around the world. More capital means there is more capital for workers to use to produce, to raise their productivity. Access to capital is an essential way to reduce poverty by raising productivity. One of our major objectives in this administration is to reduce barriers to the flow of capital to emerging markets in developing countries in general, and thereby having greater productivity and lower interest rates as well. I just might mentioned as an aside that the president's proposal for Millennium Challenge Accounts, which is aimed at the very poorest countries in the world, has as a feature a way that their policies will be ones that attract foreign investment and attract capital so that again productivity can increase and poverty can be reduced.
    Another example of how our policy is aimed to improve foreign investment around the world is our long-term BIT policies, the bilateral investment treaties, which have been underway for the last 20 years. These bilateral investment treaties are an effort to make the policies in the countries more welcoming to foreign investment so that the countries themselves can benefit from it, as well as the foreign investors.
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    Now, our FTAs with Singapore and with Chile have endeavored to stick with this policy of free transfers that exists in our bilateral investment treaties. I would say that all sides to these agreements with respect to the Chile, the Chileans and the Americans, with respect to Singapore, the Singaporeans and the Americans—they have agreed that there is an importance to have this free transfer of capital. They agree that restrictions on transfers would clearly not be consistent with the goal of encouraging investment to raise productivity and reduce poverty.
    As with the rest of the free trade agreement, there is a dispute settlement mechanism that we put in place. It comes into play when there is a restriction placed on goods trade, service trade, or on capital transfers. The dispute settlement mechanism that we negotiated with respect to capital transfers we think makes a lot of sense and it is one that both the Chileans and the Singaporeans are happy with, as we are. In the case of restrictions on capital, there is a cooling off period before a dispute settlement mechanism comes into place. For foreign direct investment type of investment, the cooling off period is for six months before action can be taken. For other types of restrictions, the cooling off period is for 12 months—other types of restrictions on shorter-term capital movements—direct loans. So there is a longer cooling off period for the types of capital transactions and capital flows, capital transfers that several of you have already raised in your opening remarks.
    We think this dispute settlement mechanism builds on current practice, but allows for a compromise for different views about how capital markets work. We think it is a good place to have the subject of transfers dealt with in agreements. It is a novel approach and we think it works quite well.
    Let me just summarize after giving these specifics. We think that the approach undertaken in these FTAs is consistent with a shared economic philosophy and policy perspective of all three countries that we are talking about—the United States, Chile and Singapore. The inclusion of these free transfer provisions, as I have just described it, in the Chilean and Singaporean FTAs with the United States we think sends a strong signal to the markets that all these countries support the free flow of capital and they recognize its importance to the development and growth of economies. Without a doubt, these agreements represent a win-win situation for all the countries involved.
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    I would like to thank you very much, Mr. Chairman, and to your colleagues, for the opportunity to testify here and look forward to a discussion of these issues.
    Thank you.

    [The prepared statement of Hon. John B. Taylor can be found on page 193 in the appendix.]

    Chairman KING. Thank you, Secretary Taylor.
    Mr. Mendenhall?


    Mr. MENDENHALL. Good morning, Mr. Chairman, Ranking Member Maloney and Mr. Frank and other members of the committee. I appreciate this opportunity to come before you today to testify on the financial services chapters in the Chile and Singapore free trade agreements. I particularly look forward to this discussion because I am newly appointed in my current position as assistant U.S. Trade Representative and this is my first opportunity to discuss these issues with you.
    Since the passage of the Trade Act of 2002, we have pursued an aggressive trade agenda. As stated by Ambassador Zoellick, we are proceeding with trade initiatives globally, regionally and with individual nations. This strategy creates a competition in liberalization, with the United States at the center of a network of initiatives. The recently completed agreements with Singapore and Chile represent the first of the next generation of trade agreements. We have also launched FTA negotiations with five other countries or regions, and at the same time the free trade are of the Americas negotiations are ongoing and are set for completion by January of 2005. On the multilateral front, just yesterday the United States submitted its initial offer in the current round of services negotiations in the WTO.
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    For several reasons, Chile and Singapore provided a good point of departure. First, the United States has a growing and significant economic interest in trade with these countries. Second, specifically with respect to financial services, Singapore and Chile have taken steps to open their financial sectors. Both countries respect the concept of the rule of law and were in a good position to explore market access-enhancing concepts relating to transparency of regulatory structures. They have already committed to moving in the right direction for many sectors and our FTAs will reinforce these trends.
    Finally, the Chile and Singapore FTAs provide good toe-holds for expanding liberalization in South America and Asia respectively. The liberalization of financial services was one of our main objectives in negotiating the Chile and Singapore FTAs. In the final texts, we achieved the objective set forth in TPA to eliminate discriminatory and other types of restrictive measures on the supply of services. The United States already enjoys a significant competitive advantage in financial services in international markets, and the market-opening initiatives in the Chile and Singapore FTA and in other for a should create additional opportunities for our financial services suppliers. Opening foreign markets for exports of U.S. financial services has two added advantages. First, it creates jobs and expands economic opportunities. For example, states like New York, California, Florida, Illinois, Massachusetts and Pennsylvania depend on financial service activity to contribute to their economic growth and tax base. Also by expanding access to financial services, it enhances prospects for economic growth at home and abroad.
    Second, the opening of foreign markets for financial services creates export opportunities for other sectors. For example, financial services companies rely heavily on specialized software and data processing, thereby creating increased demand for computer-related services which is another strong point of the U.S. export picture. And as countries develop their economies with the help of foreign financial services, those countries consume a wider range of goods and services, which benefits U.S. exporters more generally.
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    The financial services chapters in the Chile and Singapore FTAs cover all means of supply that are relevant for financial services trade, and include a set of important core protections. The agreements require national and most-favored-nation treatment, which ensures that U.S. financial service suppliers are treated on equal terms with their foreign competitors. They also include a market access obligation to ensure that measures such as quantitative restrictions and requirements regarding forms of legal entities do not undermine general market access rights. Lack of transparency is also a major problem facing our financial service suppliers, and we have included provisions that directly address this more subtle, but equally insidious market access barrier. In addition, we have provided rights for foreign-owned institutions to introduce new financial services when certain conditions are met.
    Finally, I would like to say a word on the issue of capital controls. The issue of capital controls is clearly complex, yet we have to recognize the potentially serious negative impact capital controls could have on U.S. investors. Our FTAs contain safeguards to allow American investors to have access to their funds, while at the same time they grant Chile and Singapore the flexibility to manage capital flows.
    The Chile and Singapore FTAs mark a significant advance over commitments in other fora. For example, unlike in some other agreements, our Chile and Singapore FTAs adopt a presumption that national treatment will apply unless a specific sector is carved out. Chile and Singapore have agreed to commitments across a wide array of financial services that exceed the level of the current GATT's commitments. In some cases, they have undertaken commitments to preserve existing levels of openness that go beyond their GATT commitments, while in other cases they have agreed to commitments that go beyond the current practice. We would be pleased to discuss specific commitments with you here today or to meet separately with you and your staff to discuss in further detail.
    While we have moved aggressively to open foreign markets, we are sensitive to the careful balance struck through our own political and legal processes between regulatory and commercial interests. In fact, while the United States agreed to a high level of access under the Singapore and Chile FTAs, implementation of the financial services chapters in the FTAs will not require any changes to U.S. law or practice.
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    We can expect real benefits to accrue to the U.S. economy as a result of the Chile and Singapore agreements. As we advance a strong trade promotion agenda, we remain ever-mindful of the objectives Congress asked us to achieve when it granted trade promotion authority. I look forward to working with you and your staffs in the future as we strive to continue opening markets around the world. I thank you for the opportunity to testify here today.

    [The prepared statement of James E. Mendenhall can be found on page 172 in the appendix.]

    Chairman KING. Thank you, Mr. Mendenhall.
    As you can determine from some of the opening statements, there is a concern, I believe, by certain members of the committee and certain members in the Congress that in certain elements of the negotiations the United States may have used coercion or improper pressure to cause Singapore and Chile to agree to, or to make certain concessions they would not have made otherwise, specifically in the area of capital controls. If you could address that to the extent you can, how the give and take went, and why you feel that this is essential as far as capital controls.
    Mr. TAYLOR. I would say the give and take was healthy and candid, like any other negotiation that I have been involved with. The issues are very complex, as Mr. Mendenhall indicated. There are different points of views. But I think what was most often emphasized to us is that the free transfers of capital is important by Singapore and by Chile. They have those policies in place right now. Neither country has capital controls in place. We were working with them. In fact, many of the ideas that are in this were mutually reached in the discussions. So I would say that they were good. They were healthy. Some of them took place in Singapore. Some of them took place in the United States. They were part of a larger trade agreement, to be sure, in which there were many issues being discussed. Financial services and some of the others we discussed here, but there is trade in goods as well.
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    Chairman KING. Mr. Mendenhall, do you have anything to add to that?
    Mr. MENDENHALL. I agree with everything that Under Secretary Taylor just said. I think in the give and take of these negotiations, it is just that—a give and take. However much we may like to lay down the law on a particular point and force our trading partners to accept it, it is a negotiation. In fact, I believe where we ended up with on capital controls was the result of a negotiation. It was not the result of the United States imposing its will in any way, although Under Secretary Taylor would know this more than I would on that particular issue. I believe that was the case here.
    Chairman KING. Secretary Taylor, in your testimony you discuss the president's MCA initiative. Can you go into more detail on that as to how you believe the requirements of the MCA will make this country more attractive to investors?
    Mr. TAYLOR. Mr. Chairman, the Millennium Challenge Account is a program which is designed for which funds will go to countries that are following policies that are conducive to economic growth. Many of those same policies are conducive to foreign investment. So for example, there are the three categories of policies—ruling justly, investing in people, and encouraging economic freedom. In the ruling justly part of the policies, there is an emphasis on the rule of law so for example, foreign investors know the rules of the game before coming into a country. It is a very important part of the Millennium Challenge Account—the rule of law. In the encouraging economic freedom section, there is a commitment to have a low inflation rate, a stable macroeconomic environment, which is also conducive to foreign investment. It creates greater certainty. In the investing in people part of the Millennium Challenge Account, it is a commitment for countries to invest in their people, in education and health. So obviously, a good well-educated workforce is one of the best ways that foreign investment can be productive in a country.
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    So just for example, as you know, some foreign investment in Africa has taken advantage of countries where the skill level is rising. In Ghana for example, education is improving and we see U.S. firms and other firms going in to take advantage of that for computer work, for call centers. Those are the kind of foreign investments that can actually improve well-being in the country directly. The Millennium Challenge Account encourages that through the policies that I indicated.
    Chairman KING. Mr. Mendenhall, do you have anything to add to that?
    Mr. MENDENHALL. No, I agree.
    Chairman KING. Mrs. Maloney?
    Mrs. MALONEY. Thank you for your testimony. Secretary Taylor and Mr. Mendenhall, in future trade agreements and negotiations, what will be the position on capital controls? Is the language in the Chile and Singapore agreements an example for future negotiations? Is this something we are going to continue or is this just for these two very strong economies, Chile and Singapore?
    Mr. TAYLOR. I think the strategy of focusing on dispute resolution is one that we have found attractive in dealing with these negotiations, and we would like to see how that works with respect to other countries.
    Mrs. MALONEY. So do you plan to use this in other trade agreements? That is what I want to know.
    Mr. TAYLOR. Yes, I think the dispute resolution mechanism is a good way to handle this. It is very attractive to both Chile and Singapore, but the specifics will differ by country. I gave the example of the six-month and twelve-month—maybe those numbers would change. I gave examples of what kind of foreign direct investment type of investments at the six-month. Maybe that would change. But I would say it would depend on what the country wants to do. The country is negotiating with us. They have their own interests and their own desires. We think this general approach works well, and would like to try it out as we go, but it is flexible. It is one of the good advantages of it, it is flexible. And it does have this constant ability for us to emphasize the importance of foreign investment and free transfers and not putting restrictions on capital, at least trying to stay away from that as much as possible. That is a philosophy that is embedded in the approach.
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    Mrs. MALONEY. Secretary Taylor, your testimony reads, and I quote, ''our position is to seek greater protection for U.S. investors than the IMF articles of agreement and the GATTs afford,'' end quote. If this language is included in trade agreements with countries that are more prone to economic collapse than Chile and Singapore, are you concerned about the international fall-out in a situation where U.S. investors win compensation, while all other foreign investors face losses and while a suffering country's own people are experiencing an economic collapse?
    Mr. TAYLOR. The comparison with the GATTs is important. The way I think about it, an FTA, a free trade agreement, is an effort to get a reduction in barriers compared to what you would have if you did not have a free trade agreement. It is an opportunity for both countries to reduce barriers compared to what would exist out there under the GATTs or under other multilateral trade agreements. So it is natural that the barriers are less in a free trade agreement and that is what you are seeing here. With respect to other countries, as we go forward, I just go back to my previous answer that it will depend on the country's situations and what they really would like. We have noted in just going over our BITs and reviewing all the BITs we have had, that there are many very poor countries who welcome the opportunity to pledge to make it clear in an agreement that they were very welcome to foreign investment and very open. My best guess is other countries are going to do that as we do more BITs and as we do more FTAs, but it very much depends on the countries and the negotiations.
    Mrs. MALONEY. I want to follow up on if we go into these trade agreements and U.S. investors are able to recover for losses caused by imposing the capital controls, won't foreign investors learn to channel their own investments through U.S. investment banks, so that they would get the protection of the U.S. trade agreements? It is not going to be long that they are going to see if I put my money in, I cannot get it out; if I go through the U.S., I will be able to get my money out. Does that increase efficiency? What would the impact of that be? If I were a foreign investor, I would immediately start going through U.S. banks to make sure I could have the same treatment that U.S. investors have.
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    Mr. TAYLOR. I think that is an observation which is important. I think that if you recognize the dispute settlement mechanism that we are using here in the free transfers is similar to dispute resolutions that occur in other places. For example, it is called investor state, and investor-state gives the opportunity for individuals to take action in an agreement like this.
    Mrs. MALONEY. I was not aware other countries had the same language. I thought we were unique in that respect.
    Mr. TAYLOR. What I was going to say is it occurs in other trade agreements. I have not observed any particular phenomenon that you are mentioning in our other agreements. In a way what we have done in the capital area here is lengthen the cooling off period from what it was otherwise, because the six-month cooling off period in other agreements I do not know exactly the time in the BITs, but there is always a cooling off period of some kind; there is always and investor-state dispute resolution mechanism in all of our bilateral investment treaties, and in NAFTA.
    Mrs. MALONEY. But Mr. Secretary, even after a year couldn't they face the same problems with the economic collapse of their own people, other investors not being able to get their money out? Even after a year, you would still have the same elements that could be problematic, wouldn't you?
    Mr. TAYLOR. The year gives it more time to sort things out, and it is a substantial period with respect to any of the desires or any of the requests that I have ever seen that the countries would like to put on controls like this. So that leeway seemed very acceptable to both Chile and Singapore, and I believe to other countries as well. Remember, neither Singapore nor Chile are using these controls right now.
    Mrs. MALONEY. My time is up. Thank you for your testimony.
    Chairman KING. Mrs. Biggert, the vice-chair of the subcommittee.
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    Mrs. BIGGERT. Thank you, Mr. Chairman.
    The Asian financial crisis has been cited here and it is often cited by proponents of capital restrictions as a reason why developing countries should be able to limit the movement of capital within their borders. But wasn't the Asian crisis the result of a weak banking system and cronyism and ineffectual regulation? With increased trade in financial services and greater regulatory transparency, will countries that were once vulnerable to currency crises be stronger and be able to withstand economic downturns?
    Mr. TAYLOR. Yes, I agree with that very much. What we have seen when investment is open to foreign companies or financial services firms, it frequently brings in better prudential regulations. With respect to the first part of your question, yes I very much agree that a lot of the crisis had to do with currency mismatches, where liabilities and assets did not match by currency, and that was because of defective regulations in many cases. So that can be improved and I think the foreign investment and the experience of financial service firms in the United States and other developed economies can be very helpful.
    Mrs. BIGGERT. And then going back to the short-term restriction on the transfer of capital which was put in for Chile and Singapore, can you give the committee any examples of where capital restrictions were responsible for preventing a crisis or promoting growth?
    Mr. TAYLOR. No, I cannot personally give you examples, but looking at the many examples where capital controls have been applied, sometimes they change the maturity structure of debt, maybe more longer term, less short term. There is evidence for that in Chile. That has not, in my view, had an impact on crises. But it has also had disadvantages. There are some recent studies that show that those same controls made it more difficult for small firms to get credit, to get access to markets. So it had a bias against small firms in the country. So often these kinds of controls have impacts that you do not even know about when you are putting them on. There are always disadvantages, even studies that try to find and look for the benefits of a capital control, that it really was effective in stemming a crisis or in remedying a crisis. As I read the data, I do not see them used effectively that way. But even when they are used, you see the other harmful effects that come from them.
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    Mrs. BIGGERT. Our U.S. financial service products are some of the most effective and most sophisticated in the world. How will increases in trade in financial services result in greater economic stability in these countries and what impact will greater access to capital have on Chile and Singapore? Maybe Mr. Mendenhall can answer that.
    Mr. MENDENHALL. I will have to leave it to Under Secretary Taylor to talk about the specific economics of it. But I think there are several studies out there available, the most recent on coming out of the University of Michigan talking generally about the liberalization of trade in goods and the benefits for developing and developed countries alike. I apologize I do not have specifics for Chile and Singapore, but this particular study for example said that just for the United States that for services alone, a one-third cut in services restrictions would result in a gain for the United States of $150 billion. I think there are studies out there supporting, maybe not of the same magnitude, but supporting benefits for the average Chilean and Singaporean citizens as well.
    Mr. TAYLOR. If I could just add briefly, I think the Chilean economy is a real success story in Latin America. They have withstood lots of crises. A lot of that is because of the openness of the economy. In the financial services area, they are relatively open already, so the examples of the increased openness are smaller than in the case of Singapore. But the economic stability is improved when banks run more efficiently, when there is more prudential investments and better regulations. What we have found in Mexico and other countries, that the foreign investment, again whether it comes from the U.S. or other countries, improves the efficiency and the regulatory oversight in ways that are beneficial for economic stability.
    Mrs. BIGGERT. It has been about the last 10 years that Chile has had much more stability, isn't it? It seems to me that before that there was pretty wild fluctuation in their currency and the financial markets. Why is that?
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    Mr. TAYLOR. The Chileans have chosen a number of good policies—the openness which is now even better with the FTA that is coming, but the also the policy with respect to keeping inflation down. They basically, it used to be they had hyper-inflation for many, many years, big ups and downs, triple-digit inflation numbers. In the early 1990s, they went to a policy that focused on getting inflation down. It has been very successful, but it is just one example of the improvement in policies that they have had.
    Chairman KING. The gentlelady's time has expired. The gentleman from Massachusetts, Mr. Frank.
    Mr. FRANK. Thank you, Mr. Chairman. I want to reemphasize we are not talking here—no one is arguing, I believe, that capital controls are always a good thing or they ought to be mandatory. We are talking about a very extreme argument on the other side that says they are never a good thing and they ought to be prohibited, and that no government democratically elected might be even allowed to experiment with them.
    Mr. Taylor, you keep talking about the cooling off period, but I am afraid the ice is in the eyes of the beholder here. It is not as cooling off as you say, because while you have to wait six months in the case of foreign direct investment and 12 months in the case of foreign direct investment and 12 months in the case of portfolio investment to bring a complaint if you are an aggrieved private investor, in either case if you decide to bring it, in the first place that is the decision of the private investor—no government intervention can dissuade you; and secondly, your damages go back from the day it happened. In other words, the six and twelve month cooling off periods are cooling off periods when you can file your claim, but you do not delay the effective of this. So that a country that decides to impose controls on short-term capital, yes, someone might have to wait 12 months, has to wait 12 months before claiming damages, but if that private individual decides to claim damages, it is the absolute right of that private individual to go to the arbitration panel—there is no government role in this on either side—and the damages accrue from the first day. Isn't that accurate?
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    Mr. TAYLOR. That is accurate if the controls on these particular types of capital last for longer than year and if they substantially impeded transfers, yes.
    Mr. FRANK. Right. And of course, the definition of ''substantially impede'' is nowhere in the agreement. We have not been able to get anybody to tell us what that means, and it will be left to them. We ought to be very clear about this, because these are very important policy issues, as all the questions are made clear. But the ultimate determination is left to these private arbitration panels which can be triggered by private aggrieved individuals. So what is a substantial impediment would be left to that group.
    Now, you make a distinction here, which I am struck by, because I do not think you carried through, frankly, with it in policy terms, between foreign direct investment and portfolio investment. I think if we were talking about foreign direct investment, there would be much less objection here. You talked about providing funds for workers. Short-term capital flows—does our government really think that there are never times when a country, particularly one that might not have a well developed banking system—the gentleman from Illinois said, well, the problem was not liberalized capital flows; it was a poor banking system. But our problem is enforcing these capital flows when people have weak banking system, and it seems to me that is what—I see no indication you do not plan to do that in any case. But are there no cases where controls on the short-term capital flow in countries that do not have fully developed regulatory systems would be a good idea?
    Mr. TAYLOR. I think the important thing is they get the prudential regulations in place so that the chances of financial——
    Mr. FRANK. Okay. Let me ask you this question. I accept that answer, but then the question is, does that mean that you will not be including these provisions in any free trade agreement with a country that does not have a well developed regulatory system financially?
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    Mr. TAYLOR. I was indicating to Ranking Member Maloney, as we go through and consider future free trade agreements, we are going to have to consider what the countries want. As you say, these are democracies.
    Mr. FRANK. Oh, let us leave aside what they want, because the question is whether you will be pressing, the United States will be pressing—is it a prerequisite for your insisting on these kind of provisions that the trading partner in this case have a well developed regulatory system? That would be particularly a problem, say, with the free trade area of the Americas. Let me ask you this specifically, does every country that would be encompassed in the FTAA have a well developed financial regulatory system, in your judgment?
    Mr. TAYLOR. I think, as you know, the FTA agreements that we are considering are with countries that we want to be doing all the things with respect to their policies.
    Mr. FRANK. So there is no country that would be included in the FTAA that does not have a good financial——
    Mr. TAYLOR. Well, I hope that they can all improve and get better. But your question about whether we insist on this imposition, it is really not the way to think about it. We negotiate with a point of view which we think is a good point of view, a good philosophy. We have listened. We negotiated.
    Mr. FRANK. Mr. Taylor, I am sorry to have to say this, but that is not true, and I know that first-hand. I have been in conversations with the Ambassador of Singapore. The United States market is the eighth wonder of the world. We have developed fortunately for us an economy that is extraordinary. Access to the American market, access to American capital is obviously enormously important, particularly when you were talking about bilateral agreements. The ability of an individual country to refuse to deal with America is quite minimal. I know as a fact that the Singaporeans would have much preferred not to have had this. They were for free trade. They did not want to give in to this, and I know this from the ambassador from Singapore, who sought me out when my colleagues and I objected in a letter that we sent to the Treasury, saying do not push for this.
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    So I have to say I am disappointed by what I think is an inaccurate characterization you give of these negotiations. I think it is clearly a case where the enormous economic power of the United States was put in the service of an ideology and some economic interests, but I believe it was primarily the ideology, and that the Singaporeans assented. I will tell you this, and my time is up, but I think that probably also accounts for the fact that your testifying partner has been significantly less enthusiastic in this testimony than you have been. I think it is clear that in fact this is the Treasury Department imposing not just on Singapore, but on the U.S. Trade Representative.
    Thank you, Mr. Chairman.
    Mr. TAYLOR. If I could just answer briefly, these are negotiations. They are give and take. Different parties have different interests. That must be clear in every single negotiation that takes place, whether it is on a reduction for trade in a particular good or a particular commodity or whether it is trade in financial services or whether it is these issues. We had a lot of discussion in our government on these, and this agreement represents a compromise which was negotiated.
    Mr. FRANK. I agree, but you have just acknowledged, I think, the United States and Singapore saw themselves as having different interests. I understand why the Singapore government felt they had to give in to you on this important point, although very reluctantly.
    Chairman KING. Mr. Mendenhall, do you want to comment on the gentleman's observation on your level of enthusiasm?
    Mr. FRANK. I would note, Mr. Chairman, that was not a volunteered intervention. I appreciate that.
    Mr. MENDENHALL. I generally have a penchant for understatement. I am quite enthusiastic about these particular agreements.
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    Mr. FRANK. I would hate to see you when you were bored, Mr. Mendenhall.
    Mr. MENDENHALL. Part of my silence on this issue is because I was not at the table for most of this. I am newly appointed to this position, and I observed much of it from afar. But I think the points that Under Secretary Taylor has made are correct. In fact, I know we fully endorse them. In our view, the particular provisions that we negotiated on, or that my colleagues have negotiated on capital controls strike an appropriate balance between the regulatory interests and the commercial interests. I think the points that Under Secretary Taylor has made on those points are quite powerful. Again, just a general comment on whether or not the United States was unilaterally dictating the terms of these agreements, I think that is—in fact, I know that is not the case. This was the result of a compromise, as were many other provisions in the FTAs. There were many things that we wanted to get at the end of the day.
    Mr. FRANK. A compromise between our wanting it and their not wanting it on this one issue. That is all I would agree.
    Mr. MENDENHALL. Again, to the extent that we wanted it and they did not want it, I defer to Under Secretary Taylor. But again, there are points of convergence and that is what the compromise is about. That is what the negotiation was about and that is where we ended up at the end of the day. Did both sides get everything they wanted in every aspect of these FTAs? No, probably not. This was a negotiated compromise. That is the nature of what a negotiation is for a free trade agreement and any other area.
    Chairman KING. I would advise the gentleman from Massachusetts that is really an unfair standard to apply to witnesses to expect them to match your level of exuberance.
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    That is a very unique level, and witnesses can have other talents besides being as exuberant at the gentleman from Massachusetts.
    Mr. FRANK. Well, if the majority would let me pick more of the witnesses, we might have a little more energy here.
    Chairman KING. The gentleman from Florida, Mr. Feeney.
    Mr. FEENEY. Thank you, Mr. Chairman, and thank you, gentlemen.
    Earlier, one of my colleagues suggested that the restriction on capital controls might tend to favor U.S. banks and that investors would seek the protection provided by these agreements. Granted that that is certainly a possibility, isn't there also a corollary benefit that it will discourage countries that otherwise might be in a haste to exercise those capital controls on their own banks? And isn't there also the possibility that those countries will focus increasingly on sound monetary policy, good regulatory practices with respect to their own financial institutions? And isn't there a potential net positive effect on their internal mechanisms coming from doing the right thing with respect to U.S. investors and banks?
    Mr. TAYLOR. Yes, I agree with that very much. The controls and restrictions have benefits that sometimes go to particular individuals, but they have harms that are broad. You are pointing out some of the harms that can actually occur in the country themselves. We are focusing on rights for foreign investors, but the harms actually I think are more pervasive in the country itself. Just for example, short-term capital flows sometimes are bank loans, short-term bank loans. A lot of businesses need bank loans for various purposes. So if there are restrictions on those of any kind, it is harmful to the businesses that are trying to get the loans. That is just an example. So every time one of these restrictions is put in place, it has harmful effects. In fact, I think people would prefer not to use the restrictions and that is what we have found in the case of Singapore and Chile. They would prefer not to use them, and we gave them in this agreement an opportunity for flexibility in case they really had to in the future, but they were very reluctant to do it.
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    Mr. FEENEY. Mr. Mendenhall, I do not know how enthusiastic you can get about helping countries reform their banking regulation and fiscal policy and monetary policy, but maybe you can add to that.
    Mr. MENDENHALL. I think in large part, it would be our policy that the countries should reform independently, even if what we do in the free trade agreements. The free trade agreements are a useful tool to prod them along, to lock in the commitments that they have already made.
    Mr. FEENEY. And just so competition helps improve goods and services in countries, so it may improve regulatory practices with respect to financial institutions.
    Mr. MENDENHALL. I think that is correct, and I think that has been our approach on our whole trade agenda. That is one of the reasons we are being so aggressive on our free trade agreements is we expect this competition for liberalization, which is why we are pursuing liberalization of financial services, both in the WTO and on the free trade agreement side. We might be able to get more or less in some areas, and make up for it or complement it in other areas. So I think that is right.
    Mr. FEENEY. If I can, several of my colleagues here, and I think at least one of the professors is going to address this, has suggested that there is some huge difference between free trade practices and free capital flow regulatory issues. They have actually suggested that some of us free traders are not so free when it comes to letting countries regulate their own capital flow. But indeed, isn't there another way to look through the prism at this, and that is that to protect a country's ability to essentially confiscate or freeze the flow of capital actually encourages protectionism in those countries. What you are protecting is faulty monetary policy and bank regulations. Can't you look at it through the free trade prism?
    And finally, because I see my time is almost up, you will not get to respond if we wait to the suggestion that bilateral agreements somehow will ultimately interfere with the ability to deal with multinational approaches to free trade, so if I could have the gentleman weigh in on the first question with respect to aren't we really suggesting, some of my colleagues, that what we want to do is to protect bad regulatory behavior, (A); and (B) is it true that promoting bilateral agreements with friends is somehow going to undermine the ability to deal with multinational free trade throughout the globe?
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    Mr. MENDENHALL. Sure, I will address those comments in turn. I think the dichotomy between free trade and free movement of capital is a bit false. What we are really talking about is free markets, opening free markets. So that principle I think would apply equally to both free movement of trade and free movement of capital. The nature of those problems may differ. The free movement of capital and the regulatory issues related to financial services are complicated, in many cases more complicated that dealing with reductions of tariff barriers and that type of thing. But I do not think that changes the underlying fact that the free market principles is what we are trying to enshrine and promote in these trade agreements.
    On the point about whether, if I understood the question, is whether bilateral agreements, the pursuing of a bilateral trade agreement agenda undermines or undercuts the multilateral initiative—did I understand that question correctly? Okay. We do not believe that. In fact, we believe that they complement each other. One of the points I wanted to raise in my testimony was that this is certainly Ambassador Zoellick's philosophy and it is the philosophy that we are pursuing, that we are pursuing bilateral, regional and multilateral initiatives at the same time, precisely to encourage competition and liberalization. In fact, we are even doing it within the same region. We are pursuing free trade agreements with Central American countries. We just concluded the trade agreement with Chile. At the same time, we are pursuing the FTAA. We are engaging in these bilateral discussions because you can frequently make much more progress in a bilateral context than when you are negotiating in a multilateral context. But they all have value and they all complement each other in many ways. The advantage of the bilateral context is, one, you can make progress; two, you can tailor the specific provisions if you need to to specific problems that are in a country. You do not always get reduced to the lowest common denominator.
    Chairman KING. The gentleman's time has expired. The gentleman from Vermont.
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    Mr. SANDERS. Thank you very much, Mr. Chairman.
    What I would like our guests to do, and thank you very much for being with us today, is, I am going to make some what I believe to be statements of fact. When you disagree with me with exuberance or not, just tell me where I am wrong.
    The United States believes, this administration, previous administrations believe very strongly in pushing free trade and globalized liberalization. This country today has a $400 billion trade deficit, the largest in our history. We have $100 billion trade deficit with China. In the last two years, we have lost 1.7 million manufacturing jobs, and at 16.5 million jobs, we now have the lowest number of manufacturing jobs in the United States in the last 40 years. Anything I have said that you disagree with? I do not see any disagreement, Mr. Chairman.
    Mr. TAYLOR. Just on the facts, of course.
    Mr. SANDERS. Yes.
    Mr. TAYLOR. There is a causality that is implicit, but we can come back.
    Mr. SANDERS. If you disagree with the facts, please, but you are not disagreeing with what I have said.
    You will not disagree with the fact that over the last number of years there has been a transition in our economy from manufacturing to service industry jobs, and that most service industry jobs pay workers less than manufacturing jobs. That is what is happening in the United States, which indicates to me a failure of so-called free trade. Let me quote from the New York Times of September 4, 2002. I think we can all agree that the flagship of free trade, the model that we looked at, is NAFTA. The New York Times, by the way, strongly supported NAFTA when it was passed; article, September 4, 2002—you will forgive me. I am, needless to say, excerpting. ''It has been two decades since Mexico committed itself to free trade reforms aimed at propelling this country into the developed world. But government statistics show that economic liberalization has done little to close the huge divide between the privileged few and the poor and left the middle class worse off than before. According to a recent government report, in the year 2000 half the Mexican population lived on about $4 a day, with scarcity shifting along with the population from rural regions to cities. Some 10 percent of Mexicans at the top of the economic period controlled close to 40 percent of the nation's wealth. Meanwhile, the 35 percent of Mexico's population that lives in the middle, with average earnings of about $1,000 a month, spirals slowly downward. The economist Rogelio Ramirez de la Oze, said that in the 1970s, when Mexico's population was 50 million and the country had begun to enjoy the benefits of an oil boom, some 60 percent of Mexicans were middle and working class. Their numbers and buying power have declined dramatically since then,'' Mr. Ramirez said.
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    In other words, free trade and NAFTA has failed for Mexico. It has failed for the United States' workers in the United States. I believe that if you look at what is going on in Argentina, what is going on in Venezuela, what is going on in Brazil and other countries throughout Latin America, you will find the same story.
    So my first question, starting off, and there are two questions I would like to ask, Mr. Mendenhall, is why are you here telling us that we should defend a policy which has failed American workers and failed the poor people and the middle class of developing countries? My second questions—of course, we are here dealing with financial services—let me quote from Business Week, February 3, 2003, quote, ''In the past year, Bank of America has slashed 3,700 of its 25,000 tech and back-office jobs, an additional 1,000 will go by March. Ex-Bank of America managers and contractors say one-third of those jobs are headed to India, where work that cost $100 an hour in the U.S. gets done for $20. Bank of America acknowledges it will outsource up to 1,100 jobs to Indian companies this year. My second question is, in terms of free trade in financial services, how many decent-paying, middle class jobs do you expect will be lost?
    Two questions, why are you telling us to expand free trade when it has been by and large a disaster for working people in this country and for poor people abroad? Number two, in terms of financial services, how many jobs will American workers lose? Mr. Mendenhall, could you start it please?
    Mr. MENDENHALL. Sure. I do not know all the numbers that you cited in the beginning. I cannot take issue as to whether they are right or wrong. I will assume they are. I do not know the sources. I think there is, as Under Secretary Taylor started to explain earlier, there is a tendency, I think, to load too much onto trade, perhaps for the bad and for the good. Trade is often blamed for the world's evils and on the other hand, trade is often viewed by some as the panacea for all the world's ills. The true answer is probably somewhere in the middle. So when you talk about loss of manufacturing jobs or the other factors that you cited, Under Secretary Taylor is entirely correct that we have to look at the cause of those particular losses. So I do not know for sure what the causative factors are for those losses.
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    Mr. SANDERS. If I may, sir, thank you—but when the evidence is overwhelming that companies are laying off American workers and going to China and to Mexico, can you doubt that trade and this policy plays a significant role in limiting manufacturing jobs, cutting back on manufacturing jobs in America?
    Mr. MENDENHALL. I can tell you that the United States——
    Mr. FEENEY. [Presiding.] The gentleman's time has expired. Without objection, he is yielded another 30 seconds.
    Mr. SANDERS. I thank the gentleman, but I would ask for roughly the same amount of time as some of my colleagues had. I am not going to go on indefinitely. Do we have a vote, by the way? Did I hear bells go off? Did anyone hear that? No.
    Mr. FEENEY. We will try to let you know, but if we can, to answer that question, we will try to go on and stick to the five-minute rule. We do have another panel of witnesses.
    Mr. SANDERS. Okay. Yes, I understand.
    I understand your point that trade is not the end all. There are other factors, but I find it very difficult to hear people keep coming forward when the evidence is overwhelming that for the middle class, working class in this country, and for poor people abroad, this policy has largely failed. Mr. Taylor, did you want to comment on that?
    Mr. TAYLOR. I do not think it has failed at all. I think you are pointing to some trends about manufacturing and services that have been going on for many, many years. Our productivity in manufacturing is increasing at leaps and bounds, so to provide the same number of products, workers are going into services, which the United States has a great comparative advantage; and some very sophisticated services, some very high-paying services. So I think that is something that is going on, and as long as it is being done in a way that is beneficial to workers and firms, it is fine.
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    Mr. SANDERS. It does not concern you that millions of American jobs are now in China, where people do jobs at 30 cents an hour.
    Mr. TAYLOR. I do not think millions of American jobs are in China.
    Mr. SANDERS. You do not believe that?
    Mr. FEENEY. The gentleman's time has expired. The gentleman from Texas is recognized for five minutes.
    Mr. HENSARLING. Thank you, Mr. Chairman.
    Mr. Secretary, when the Administration sits down to negotiate a trade agreement with Singapore, is the Administration there to advocate, negotiate on behalf of Singapore's interests or the U.S.'s interests?
    Mr. TAYLOR. No, it is on behalf of the U.S. interest.
    Mr. HENSARLING. For those who wish to invest in Singapore, for those who wish to trade in Singapore, have you heard, have you seen any evidence, have you heard any evidence, or testimony that they prefer capital controls, or that they want to increase the risk of the loss of their capital?
    Mr. FEENEY. Mr. Taylor and Mr. Mendenhall, if you would pull those mikes a little closer to you we could hear better and the recording secretary could hear you better.
    Mr. TAYLOR. No, I have not heard requests for capital controls from U.S. financial representatives.
    Mr. HENSARLING. Mr. Mendenhall, in your testimony, you indicate that the U.S. provides a substantial portion of the world's financial services, which I think many members of this panel are aware of. You point to several statistics that show we run a trade surplus in certain aspects of financial services. I must admit I am not one who is concerned about trade deficits. For example, I run a trade deficit with my barber every month. I run a trade deficit with my grocer every month. I am more concerned about whether or not my income is increasing and whether I have enough income to pay my bills. For those who are concerned about the trade deficit figure, if we are running a surplus in many aspects of financial services, a trade surplus, can you speak to the impact of capital controls on the further export of U.S. financial services?
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    Mr. MENDENHALL. I can speak to it briefly. On the surplus issue, I think on the services side, not just financial services, but services as a whole, the United States is essentially running a trade surplus overall, as opposed to the trading goods sector. On the impact of capital controls, I can speculate what that would be. I would imagine the riskier that the investment would be in foreign markets, whether they be Singapore, Chile or elsewhere, if there is a high risk of capital controls being imposed that it would lessen the degree of investment and lessen the degree of cross-border transactions, and therefore reduce the surplus, would be my speculation.
    Mr. HENSARLING. Mr. Secretary, can you speak, give us a little bit more detail about the regulatory transparency that has been negotiated in these two trade agreements?
    Mr. TAYLOR. The regulatory transparency in the case of Chile is one in which they have agreed to, for example, make formal notification if there is a change in regulation, so that becomes very clear and is not a surprise. In the case of Singapore, there is just more information put out about the regulations, more transparent in the sense of more public notice in general.
    Mr. HENSARLING. Thank you.
    Mr. MENDENHALL. If I could just say a word about that as well, the transparency provisions I think are fairly central to the financial services chapter. I know it is of critical importance to our own financial services industries. In many ways, it parrots what we do in the United States. We have a publication and comment period. We have time frames for issuing or responding to applications for permits for financial services and so on. The reason I wanted to come back to the point is because I got an earlier question dealing with how these agreements might promote stability in some of these countries. I think the transparency provisions by making the markets more open, promoting information sharing, promoting the formulation of good regulations—all of that I think contributes to the rule of law and the stability of these financial regimes. Thank you.
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    Mr. HENSARLING. Thank you, Mr. Mendenhall. In the few seconds I have left, Mr. Chairman, if I could simply state for the record, coming from Texas, which is a lot closer to the nation of Mexico than the state of Vermont, I can tell you that NAFTA has been an incredible success on both sides of the border. Approximately one out of six jobs in Texas results from export and trade, principally with Mexico. If you have traveled south of the border, you see how many people have been liberated from poverty because of the American investment along the border, particularly in the maquiladors.
    Thank you, and I yield the balance of my time.
    Mr. FRANK. Would the gentleman yield for one second?
    Mr. FEENEY. This is not the geography committee.
    The gentleman from New York, you are recognized for five minutes.
    Mr. MANZULLO. Illinois is a long way from New York.
    Mr. FEENEY. I am sorry. Mr. Manzullo, you are recognized.
    Mr. MANZULLO. I appreciate it. Thank you very much.
    What was that, Barney?
    It is good to see you here. I would like to see everybody here on one panel, because I would—it would be delicious if Professor Bhagwati were there and able to point for point meet with Ambassador Zoellick on the efficacy of these regional free trade agreements, as opposed to world free trade agreements as a whole. I do not know if I agree with his calling it a Leninist approach, but that certainly would make things pretty interesting.
    I have this question. I am the Chairman of the U.S.-China Interparliamentary Exchange. We have met with the members of the National People's Congress on five different exchanges now. We just came back from China in January. Mrs. Biggert and Mr. Saunders were with us. One of the problems in the U.S.-China WTO accords is the fact that even with the liberalization or the ability of the United States' financial institutions to establish a presence in China, there has been this incredible standard that the Chinese have been setting. I do not want to call it deposit reserves, but in terms of almost a separate licensing requirement. It is obviously a non-tariff barrier, but it is just not working to get our people in there.
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    I know it is not related to the issue of capital flight or anything like that, but what have we learned from the fact that there perhaps is a lack of specific language in the U.S.-China WTO accord, and to take that lesson and put it in future agreements so that we do not have the continuous problem of fighting with the foreign government as to exactly what the reserve requirement is.
    Mr. MENDENHALL. I think I am going to have to defer on that question myself. I would be happy to meet with you afterwards to talk about the specifics. I do not know the specifics of that.
    Mr. TAYLOR. Just briefly, the WTO agreements are of course much different than these FTAs we are talking about, which are regional.
    Mr. MANZULLO. Regional.
    Mr. TAYLOR. Yes, but not only that, they get better agreements in some sense; more substantial tariff reductions. Perhaps that is the issue that Professor Bhagwati is concerned about. But the nature of the FTAs is they do get more specific about these kinds of things. In fact, these capital control issues we were talking about are just exactly the kind of deposit regulations you are referring to. In this free trade agreement with Chile, we have endeavored to reduce the likelihood that those would take place. It was very specific. That is one of the advantages of free trade agreements, or more general trade agreements. The WTO is not as substantial as these free trade agreements.
    Mr. MANZULLO. But it could have been. I know, Mr. Mendenhall, you are the new guy on the block. I would love you to stop by the office and discuss this in depth, obviously at a later time. But there is considerable frustration going on. Why, when we entered into the China-WTO accession accord, and I know that is before you came on board, why can't you have just in the matter of—Mr. Taylor, if you want to answer this—why can't you have strict provisions with regard to that problem in banking reserves, as you would in a regional agreement?
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    Mr. MENDENHALL. I can answer the question at a certain level of generality.
    Mr. MANZULLO. That is Okay. Could you pull the mike closer, Mr. Mendenhall?
    Mr. MENDENHALL. Sure.
    Mr. MANZULLO. Thank you.
    Mr. MENDENHALL. I can answer the question at a certain level of generality because I do not know the specifics of the issue you are referring to. But I think the tendency in a multilateral setting is that everything tends to get sort of reduced, if you will, to the least common denominator. In a bilateral or regional setting, the trade-offs are a lot clearer. The wants on both sides are a lot clearer, and it is easier to just trade one for the other as a single undertaking, if you will. The WTO has a great advantage, of course, that the global trading community is there, but it has the disadvantage of making the trade-offs and the gamin of the system, if you will, must be more complicated, and it is just easier to get higher standards agreements, if you will, in a bilateral or regional setting.
    Mr. MANZULLO. Okay. I appreciate that. That really goes to the guts of Professor Bhagwati's statement in there. Thank you very much. I look forward to meeting with you sometime later.
    Mr. FEENEY. And thank you, Mr. Taylor and Mr. Mendenhall. I assume that if members of the committee have additional questions and would submit them in writing, that you will do your best to reply.
    Mr. MENDENHALL. Thank you. I appreciate the opportunity of testifying today.
    Mr. FEENEY. Thank you very much.
    We have another distinguished panel. While you are on your way up, I will try to introduce you briefly so we can get straight into your testimony and introductions: Dr. Bhagwati, Andre Meyer Senior Fellow in International Economics, Council on Foreign Relations; Dr. DeRosa, President of DeRosa Research and Trading, Incorporated; Dr. Henry, Associate Professor of Economics at Stanford University Graduate School of Business; Dr. Lackritz, President, Securities Industry Association; Mr. Tarullo, Professor of Law at Georgetown University Law School; and Mr. Vastine, President of the Coalition of Services Industries.
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    Welcome. I think we have got your name tags set up in order. As soon as you get seated, we will invite Dr. Bhagwati to start his testimony.


    Mr. BHAGWATI. Thank you, Mr. Chairman.
    I think a lot of what I am going to say has been partly covered by the morning's discussion, but I will still indicate some principal points to recap and bring my own emphasis to bear. I think there are three questions before this committee. One is should we seek to impose serious restraints on the developing countries' ability to use capital controls, just a general question. Two, should we do this as part of our trade agreements. And three, what can we even say about the wisdom of the specific provisions which we have in the two agreements before us? I will take up these issues in that order.
    First, on the general wisdom of putting restraints on the use of capital controls, I am not encouraging people——
    Mr. FRANK. Professor Bhagwati, could you pull the mike a little closer to you please? Thank you.
    Mr. BHAGWATI. On whether we should impose constraints, as against encouraging people to use these, we have to be very clear whether we want to restrain countries from using these kinds of capital controls. I think after the Asian financial crisis of 1997 and 1998, nearly all economists in my judgment and information, and the International Monetary Fund, publicly now, have become much more cautious about the freedom of capital flows unregulated, you know, total freedom like total free trade. I would distinguish between three different contexts to understand this. First, should we pressure countries that are not on capital convertibility at all, to hasten their progress to doing so? IMF and U.S. Treasury were in fact doing this prior to the Asian crisis.
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    But both the crisis and the fact that India and China escaped it, I think as Under Secretary Taylor was somehow forgetful when one of you asked as to whether there were examples of people who did well by not going in for capital convertibility, and these are two gigantic countries, which have been outward-oriented on trade, on foreign investment coming into them—China more so than India, but India has caught up. They escaped the crisis, the contagion altogether and they survived. So we do have examples where countries were prudent, maybe excessively prudent, probably too closed—one can discuss that—but they really escaped it. So I think IMF certainly, and economists have become much more cautious and prudential compared to the pre-Asian crisis situation. Second, when you are more or less open—this is a different problem—when you are more or less open financially anyway, should you also not be prudent at the same time? The Chilean example with the Chilean tax, which might be looked upon as a token tax at a country level, was designed to moderate in-flows. So flows coming in, when they seemed too large relative to the reserves and to the fundamentals at hand—your export capabilities and so on—and there I would say, again, people concede everywhere that such a tax, as against a permanent capital control, is actually a good weapon to have. Not that you want to rush and in use it all the time, but it is something you want to be able to have as a weapon under your command.
    The third is a more difficult one, namely that when you actually have panicky out-flows happening, as part of crisis management, do you then resort to capital controls? That is a different problem, again. Now, the Malaysians, of course, used them during the Asian crisis, and there was more controversy on this one. Again, my own judgment from whatever I have studied on this problem, is I am inclined to agree with those who have actually argued that Malaysians did rather well out of it, compared to the countries which took the then-prescription of the IMF.
    In conclusion, I would say on the first question, we are far more conscious today about the wisdom of not taking an ideological or a financial lobby-driven position against the use of capital controls. I think today we certainly would be emphasizing in the classroom and in every course we will teach that, look, this is not on a par with free trade. I think one of the Congressman asked me, you know, why is this different? The reason it is different is that with trade, which I am a great proponent of, as the Congressman from Illinois pointed out, that is a very different kind of proposition. I say that if I exchange my surplus toothbrush with some of your surplus tooth paste, and we remember to brush our teeth before we go to bed, we are both going to get white teeth. And the possibility of our teeth being knocked out in the process is very negligible. But when it comes to the analogy on capital flows, it is obvious that really the analogy is like fire. You can use, as I have pointed out in my written testimony, Tarzan can roast his kill, but if he goes back as the Earl of Greystoke and he plays around with fire, he can bring his ancestral home down. So you have to be prudent. It is a very elementary point, and only ideologically one could be against it today. So I think that is number one.
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    Now, two, putting any such restrictions——
    Mr. FEENEY. Doctor, if I can, we have your written testimony, and unfortunately as have a number of distinguished witnesses.
    Mr. BHAGWATI. Okay. Let me just make one point quickly.
    Mr. FEENEY. Yes, sir. Wrap up.
    Mr. BHAGWATI. On putting any such restrictions down in a trade agreement, I think the Under Secretary was right, that trade liberalization should include services. We have a general agreement on trade in services. But that is not the issue we are discussing. We are discussing whether we should have capital controls ruled out, and there it seems to me that there is a real problem about bringing this into trade agreements. It is not just Congressman Frank or me and others who are worried about this. Today, we have had problems, as you know, with Chapter 11 and NAFTA, if this is where overly liberal ideological views seem to have been taken on takings. And that got us into a lot of trouble.
    Today, all the NGOs are anti-globalizers. They are very concerned about post-financial crisis about what we are doing on the financial issue. If we put something like this into a trade agreement, no matter which trade agreement, that is immediately going to attract flack. So I think it is politically imprudent to mix up trade treaties with capital account controls. If you want to shove it into an investment agreement, fine, then more of the objections will go there, but trade is bad enough—Congressman Sanders was exaggeratedly pointing to its perils, in fact erroneously so in my view—but you have positions like that. You do not want to mix it up and make and over-burden your case.

    [The prepared statement of Jagdish Bhagwati can be found on page 51 in the appendix.]

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    Mr. FEENEY. Thank you, Dr. Bhagwati.
    Mr. DeRosa?


    Mr. DEROSA. Good afternoon, Mr. Chairman and members of the subcommittee. I am David DeRosa. I am president of DeRosa Research and Trading, and I am an Adjunct Professor of Finance at the Yale School of Management, where I have taught international finance for the last six years.
    My testimony is going to be on my position on capital controls. In the middle 1990s and continuing up to the present time, a great many emerging market nations experienced cataclysmic financial crises. Many of these same nations had previously been identified as growth miracle economies. Examples are Mexico in 1994; Thailand, Indonesia, Malaysia in 1997; South Korea, 1997, 1998; Russia, 1998; Brazil, 1998; Turkey, 2001; Argentina, 2002. These were devastating crises, much economic suffering ensued; inflation, unemployment, bankruptcies were widespread.
    Now, stock and bond markets plunged and in all of these cases, the national currencies depreciated greatly and the foreign exchange regime that governed those currencies were abandoned. The reaction to the crisis has been largely to blame—the international capital markets and in particular the foreign exchange market. Some say the afflicted countries were victims of capricious international capital flows. Hence, we are here today to discuss capital controls in the context of some trade legislation.
    I studied economics at the University of Chicago for 10 years. I have a bachelor's and a Ph.D from the school in economics and finance. I have been a currency trader at a major bank. I have been an investment manager and I have been a hedge fund manager. At present, I am a member of the board of directors of two of the most successful hedge funds. That does not affect my opinion on capital controls. It just explains my experience.
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    Now, I want to call your attention to this, because it is my sincere belief that much of what happened in the 1990s and the last three years has been totally misunderstood. Take this, for example: All of the above-mentioned crises that seems to have shaped our thinking, all except one, Malaysia, which I will come to, took place in economies that had some form of fixed exchange rate regimes. In fact, the climax of all of these crises were when the fixed exchange rate regime exploded or was terminated. Each crisis was marked by a sharp out-flow of capital prior to the moment when the fixed exchange rate regime was scrapped. Once it was scrapped, there was sharp depreciation in the currencies, sometimes as much as 70 percent.
    In each case, the government replaced the fixed exchange rate regime with a floating exchange rate regime. And you know what? No more crises. No more crises. Once a floating exchange rate, no more currency crises. All of these countries had accumulated massive amounts of private and public debt denominated in U.S. dollars. So when the exchange rate depreciated, the local value of those debts magnified up, sometimes two or three times. Preceding the crises, an enormous amount of foreign capital flooded into these countries, sometimes buying local securities, sometimes as direct investment, sometimes as leveraged transactions. But most important, all of these trades, which are called carry trades, were really not investments per se in the country, they were investments in the fixed exchange rate regime. Under the umbrella of safety that they thought they had, people invested in these countries to get superior interest rates, hoping that the fixed exchange rates would preserve the value of their capital.
    History has shown that fixed exchange rate regimes are crisis-prone. Almost all of them have blown up. It is an endemic problem, and it is not just emerging markets, it is major countries as well—witness Bretton Woods and the exchange rate mechanism. The reason why currencies depreciate so violently when fixed exchange rate regimes are abandoned is that domestic dollar borrowers and foreign investors all rush to hedge their positions. So it is the case of a crowded theater, 200 fat men, somebody yelled ''fire,'' and it is a narrow doorway. Governments in crises almost always make these crises worse, if not considerably worse, by enacting bad responses that exacerbate the situation. Thailand, Indonesia, Russia, Brazil and Argentina stand out as especially poor examples of how to respond to financial crises.
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    Now, we have this myth that Malaysia found a kinder and gentler way by imposing capital controls. The fact is, Malaysia imposed them 14 months after the crisis started. This was a spectacular case of locking the barn door after the horse was out. In fact, Malaysia also simultaneously pegged the ringgit at 3.8 to the dollar and that is where it is today. And subsequently, all of the other Asian currencies have rebounded substantially. What relief Malaysia got was——
    Mr. FEENEY. Dr. DeRosa, if you can wrap up. Thank you.
    Mr. DEROSA. Right. It was simply because it pulled a fast one. It devalued the ringgit relative to its neighbors.
    So the point is that you do not really have to worry about these crises or capital flows. They are a function of fixed exchange rate regimes. You do not need the capital controls. They are a bad idea.
    Thank you very much.

    [The prepared statement of David F. DeRosa can be found on page 64 in the appendix.]

    Mr. FEENEY. Thank you.
    Mr. Lackritz? I am sorry. Dr. Henry?


    Mr. HENRY. Mr. Chairman, members of the committee, my name is Peter Henry. I am Associate Professor of Economics at the Stanford University Graduate School of Business. I am also Faculty Research Fellow at the National Bureau of Economic Research. My research is funded by the National Science Foundation's Early Career Development Program. I have written extensively on the economic effects of capital account liberalization.
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    Thank you for the opportunity to discuss the implications of my research for the financial services component of the recent U.S. trade agreements with Chile and Singapore. My testimony consists of three brief general points. Point number one, what is my position on the importance of free trade? Free trade in goods, also known as trade liberalization, is the linchpin of globalization. All countries can benefit from free trade because free trade allows countries to export those goods for which they are low-cost producers, and import those goods for which they are high-cost producers. This kind of specialization brings two specific benefits. First, countries get to consume goods at a lower price than would be possible if instead of importing the goods, the countries produced them at home. Second, specializing in the production of goods at which they are more efficient raises countries' gross domestic product.
    Trade liberalization is not costless, however. Liberalizing trade may cause unemployment by driving inefficient producers out of business. In principle, however, the overall gain in gross domestic product that result from free trade are sufficiently large to pay for the cost of retraining workers in redundant industries. In other words, all members of society can be made better off from trade liberalization when it is judiciously applied. Therefore, we should take the lead in promoting worldwide free trade by continuing to open our borders to foreign goods and encouraging other countries to follow suit. The recent trade agreements with Chile and Singapore provide a small step in the right direction.
    Point number two, what is my position on the importance of capital controls? A heated debate over capital account liberalization has followed in the wake of financial crises in Asia, Russia and Latin America. Opponents of the process argue that capital account liberalization invites speculative hot money flows, increases the likelihood of financial crises, and brings no discernible economic benefits. Some economists have gone so far as to assert that open capital markets may actually be detrimental to economic development. I believe that there is a serious flaw with such reasoning. This flaw stems from the fact that those who oppose capital account liberalization have failed to define exactly what they mean. Why is it important to define precisely what one means by the term capital account liberalization? The reason is that there are many different types of capital account liberalization. At a minimum, we need to distinguish between two categories: those that involve equity and those that involve debt.
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    Consider first equity market liberalization—opening the stock market to foreign investors. My research demonstrates that three things happen when economies open their stock markets to foreign investors. First, the cost of capital falls for companies that are listed on the stock market. Second, in response to the reduction in their cost of capital, the companies that are listed on the stock market increase their investment in physical assets. And third, as a result of the increase in investment, productivity rises and the country's growth rate increases by more than 1 percentage point per annum. Since the cost of capital falls, investment booms and economic growth increases when countries liberalize the stock market. The view that capital account liberalization brings no real benefits seems untenable.
    Liberalization of debt markets, on the other hand, has often led to great difficulty. For example, excessive short-term borrowing in dollars by banks, companies and governments have played a central role in the onset of almost every emerging market financial crisis during the 1990s. In essence, the mismatch between the term structure of borrowers' assets, which were typically long-term and denominated in local currency, and their liabilities, which were short-term and denominated in dollars, placed these countries in an extremely vulnerable position. Any bad news that made the lenders reluctant to extend new loans was bound to create an immediate liquidity problem. So we have to distinguish between debt and equity. Equity market liberalizations bring about good results; debt market liberalizations are much more problematic.
    Point number three, and last point—the lessons for this and future agreements on capital controls. The evidence I have outlined in this report can be distilled in a few key lessons for the capital controls portion of the Chile and Singapore free trade agreements. First, the liberalization of dollar-denominated debt flows should proceed slowly and cautiously. This agreement, as well as all future agreements, should refrain from any language that inadvertently pushes countries into prematurely liberalizing dollar-denominated foreign borrowing. The second lesson is that all the evidence we have indicates that countries derive substantial economic benefits from opening their stock markets to foreign investors. There is no reason to think that Chile and Singapore will be any different in this regard.
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    Thank you.

    [The prepared statement of Peter Blair Henry can be found on page 151 in the appendix.]

    Mr. FEENEY. Thank you, Dr. Henry.
    Mr. Lackritz, welcome and thanks for being here.


    Mr. LACKRITZ. Thank you, Mr. Chairman. It is a pleasure to be here. Thank you for the opportunity to testify. I am Mark Lackritz, president of the Securities Industry Association. I want to testify in very strong support of these bilateral free trade agreements with both Chile and Singapore.
    These agreements will result in increased commerce between our respective countries, and in both cases the already close economic relationships will be further strengthened, providing new opportunities for U.S. securities firms and additional jobs in the United States. Importantly, we believe these agreements are excellent precedents upon which to build and negotiate ongoing and future bilateral and regional trade discussions. Both agreements successfully achieve many of the securities industry's specific objectives, including, first, permitting 100 percent ownership and market access. Both of these countries are open market and provide U.S. securities firms with full market access by the establishment of a subsidiary or the acquisition of a local firm. Since the conclusion of the 1997 WTO financial services agreement, both countries have undertaken extensive liberalization of their financial services markets. These agreements not only lock in current levels of access, but also produce commitments by both countries to eliminate and reduce some of the remaining establishment barriers.
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    In terms of specific commitments, the FTA would for the first time afford legal certainty to U.S. firms to establish a wholly owned affiliate in Chile to provide asset management services on a national treatment basis. Singapore also made commitment guaranteeing U.S. membership on the Singapore stock exchange, as well as for the acquisition of equity interests in local securities firms.
    Increasingly, services must be delivered through a business presence in the host country. As a result, the ability to operate competitively through a wholly owned commercial presence or other form of business ownership must be a fundamental element of any agreement. These agreements guarantee the ability of U.S. securities firms to enter into these markets through the establishment of a subsidiary or the acquisition of a local firm. Once established, U.S. securities firms will receive the same treatment as domestic companies. For example, the free trade agreement with Chile provides national treatment to U.S. asset management firms in managing the voluntary portion of Chile's national pension system, and the ability to manage the mandatory portion of the pension system without arbitrary differences between the treatment of providers. In Singapore, U.S. firms will now be able to compete for asset management mandates from the government of Singapore investment corporation.
    In addition, obtaining commitments on regulatory transparency was our industry's major goal in the agreements with Chile and Singapore. We view the provisions contained in these agreements as excellent, and view the FTAs as important precedents for transparency of future efforts. The specific financial service transparency commitments in the FTAs will require that rules cannot be adopted without appropriate public notice and opportunity to comment; that requirements and documentation for applications be clear; and that decisions on applications be made in a specified or reasonable time. The ability to freely transfer and process information is essential to the business of modern financial services firms. Indeed, many products such as instruments built around market indices that are vital to smoothing out risk, could not function without timely data flows. Nevertheless, too few countries have committed to this key link in the financial services infrastructure. In this regard, commitments by both Chile and Singapore mark a major step forward. Chile made no commitments in financial information in the 1997 GATT agreement, while Singapore made a limited commitment. The FTAs will now give U.S. firms the legal certainty to process and disseminate financial information both domestically and cross-border.
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    As a general matter with respect to capital transfers, our members believe that restrictions on capital flows deprive both parties of the benefit of cross-border investment. This is of particular concern to financial services companies and others engaged in portfolio investment. We welcome the general commitment in both agreements to permit the free and immediate transfer of capital related to an investment. However, we regret that both agreements contain exceptions to this general commitment. Our members fervently hope that these exceptions to free capital movements will not form a template for future agreements.
    In conclusion, Mr. Chairman, we believe these agreements offer Congress another opportunity to secure open and fair access to foreign markets for U.S. firms and our clients. This pact will result in benefits to consumers and businesses in both countries, as well as globally. We look forward to continue to work with both this committee and the Administration in developing a fair, rules-based trading system that enhances U.S. economic competitiveness.
    Thank you very much.

    [The prepared statement of Marc E. Lackritz can be found on page 161 in the appendix.]

    Mr. FEENEY. Thank you.
    Mr. Tarullo, please pull that mike close to you so we can hear you.


    Mr. TARULLO. Thank you, Mr. Chairman.
    Mr. Chairman, I am struck by the fact that it is Chile and Singapore we are talking about here. Chile and Singapore have been among the most exemplary developing countries in terms of their economic policies, their financial policies, and the orthodoxy of those policies. The fact that both of those countries, neither of which have imposed capital controls on out-flows in recent decades, asked that they be allowed to retain some capacity to impose capital controls in exigent circumstances seems to me a reason why this committee and the Congress ought to take a moment and reflect upon the import of these capital control provisions as a template for future agreements.
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    Now, why would Chile and Singapore, as I say, two orthodox exemplary sets of macroeconomic policymakers ask for an exception? I think it is because of the cumulative effect of not just the Asia crisis, but the Mexico crisis, and what they have observed over the last decade in an increasingly globalized and sometimes turbulent financial system. They want to retain the capacity, in an emergency, to do something that they otherwise have no intention of doing. The International Monetary Fund, which was certainly a proponent of full capital account liberalization as recently as seven or eight years ago, has just released a very careful study which shows how nuanced one has to be in determining when and how capital flows are going to be efficient and effective in developing economies.
    Why is it that capital flows do not have the effect in a developing economy that they do in the United States, where more or less untrammeled capital flows are indeed productive? I think it is because we are in that murky realm which economists call the world of second-best. Developing countries do not have deep and liquid capital markets, by and large. They do not have well regulated securities markets. They do not, by and large, have sophisticated supervision for their banking systems. For all of these reasons, the countries are not able to absorb capital flows, particularly shorter term debt flows, in the way that the United States or the United Kingdom could. That is the reason why Chile and Singapore want this insurance policy, and that is the reason why I think we need to pay heed to their policymakers, speaking for themselves and on behalf of other developing countries.
    What troubles me about the present template is that it is really quite absolutist. It really does not distinguish, as Dr. Henry is trying to do, among different kinds of capital flows. Indeed, I note that the investment chapter of the Singapore agreement mentions and includes as an ''investment'' bonds, debentures, other debt instruments and loans. Unlike the NAFTA, for example, it does not say such bonds, debentures, debt instruments and loans of longer than three years duration. It is any such bond, debenture, debt instrument or loan. That kind of painting with a broad brush seems to me not to incorporate the appropriate modesty that we all must have in assessing the operation of global financial systems in developing countries in the wake of all we have seen in the last decade.
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    I am concerned that what we are witnessing here is a bit of a triumph of economic creed over economic evidence. What I would like to see is more of what Dr. Henry and others are doing, of trying to draw distinctions, to see how much we can learn, and then through appropriate channels such as the IMF and discussions in the G-7, to see if we can come up with a set of sensible nuanced standards—standards that are not just based upon the textbook finance that apply in the United States, but that are based on the real operation of capital markets in the murky second-best world of developing countries.
    I do absolutely believe that when the United States enters into trade agreements, it ought to be doing so with its self-interest in mind. But that self-interest needs to be an enlightened self-interest. By ''enlightened'' I mean that we promote rules which are going to redound to the benefit of all of our trading partners, which will produce a more growth-oriented, stable international economy in which the exports of the members of the coalitions represented by the gentlemen on my flanks today will be able to prosper. I do not think we have an interest in some sort of short-term asset grab, if it is at the cost of our ability to promote such sensible rules.
    Thank you very much, Mr. Chairman.

    [The prepared statement of Daniel K. Tarullo can be found on page 177 in the appendix.]

    Mr. FEENEY. Thank you.
    Mr. Vastine?

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    Mr. VASTINE. Thank you very much, Mr. Chairman. I am here to testify on the commercial advantages of the Singapore and Chile agreements, and explain why they should be approved by the Congress.
    U.S. financial services companies are committed to trade negotiations to remove barriers to trade and investment. In any form, these barriers are very extensive. We would be glad to supply lists by countries of the kinds of barriers our companies face. The industry's $6.3 billion trade balance in cross-border trade in financial services last year would grow if we could remove these barriers. Indeed, reducing barriers to U.S. services trade is our best hope to reduce the chronic goods trade deficit that Congressman Sanders has referred to.
    Indeed, in order to try to add some light to the statistics raised earlier by Mr. Saunders, there were 20 million new services jobs created in our economy between 1992 and 2002. That more than offset the loss of manufacturing jobs. It is not correct to think that those jobs are low-paid, poor jobs. In fact, there are some, of course, as there are in manufacturing, low-paid jobs in services. But the average annual earnings in services in 1999, which is the last year for which we have data, were $32,800 compared to $32,400 in manufacturing. So it is not true that services jobs in general on the whole are low-paying jobs. Just to add one more statistic, between 1990 and 2001, U.S. total employment increased from 92 million to 115 million in the private sector. That is not the evidence of a country that is being laid waste by its foreign trade policies.
    Singapore and the Chile agreements, to go back to the subject, deal with the trade agenda of financial services companies more thoroughly than any other trade agreement to date. The Singapore and Chile markets are small, but the agreements are important precedents. They should be approved by Congress because, first, they fulfill the negotiating objectives of the TPA Act. Secondly, they bind liberalization already adopted by the two countries. Thirdly, they make commitments to new liberalization. For example, the provisions in the Singapore agreement on banking give U.S. banks significant new rights to operate as qualified full banks in Singapore, and to create and join ATM networks. They include commitments to cross-border services trade in insurance. Both agreements allow U.S. companies to offer many more products such as reinsurance auxiliary services, including actuarial and other consulting services, marine aviation and transport cross-border, and brokerage services.
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    They provide for freedom of financial information flows for firms like Reuters. They contain important commitments to freedom of establishment, that is to say direct investment. You cannot sell a life insurance policy to a Singaporean from an office in New York. You have to establish. As Mr. Lackritz said earlier, services trade is characterized by this need to establish, to enter a market, to set up your business, and to sell a product. This creates, as in the case of New York Life in India, a lot of new jobs in New York and elsewhere in our country. It supports the home offices of our companies.
    Next, the agreements contain extensive commitments to transparency, which are very, very helpful—indeed, a breakthrough. They contain new provisions for improved regulatory quality. They provide modest provisions, but important ones, for the movement of people for temporary foreign assignments, which is a very important way in which financial services are traded. Finally, the agreements have sound investment chapters, which include of course commitments to freedom of capital transfers. We join the Securities Industry Association in noting that the agreements have measures to compensate private investors in case a country controls capital movements. I would just like to point out that these measures can backfire against the country that wants them. Countries that reserve the right to use controls may risk chilling the investment climate to their own disadvantage. It is like putting up a sign on the highway into town, ''investors are welcome, but we reserve the right to keep your cash.''
    Finally, Mr. Chairman, we believe these agreements are in our national interest and the Congress should approve them. They fulfill the TPA negotiating objectives. They are the result of substantial industry consultation. They contain some real breakthroughs, like in transparency. They are good precedents for FTAs with larger economies. They can seriously increase our financial services trade, especially if broadened among other countries, and increase U.S. jobs and prosperity. Finally, they can help reduce the goods trade deficit.
    Thank you very much.
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    [The prepared statement of J. Robert Vastine can be found on page 198 in the appendix.]

    Mr. FEENEY. And thank you.
    Congressman Frank, if it is all right with you, why don't you take about 10 minutes and then I will defer to you, and then I will conclude if we still have some time and interest.
    Mr. FRANK. Thank you, Mr. Chairman. I appreciate this.
    Let me say, I was pleased to hear Mr. Vastine say that this goes much further in terms of accommodating the prudential interests than any previous treaty. I think that is a far more accurate description than Mr. Taylor saying, oh, it is just what we have always been doing. I think Mr. Taylor significantly understates the difference.
    I was particularly interested in Professor Henry's distinction. I welcomed it, with regard to debt versus equity. To some extent, I think that they are overlapping categories. There are short-term, long-term. There is foreign direct investment in portfolio and there is debt and equity. They have substantial overlap. What strikes me, Professor Henry, is that the interesting thing about these provisions is they do not make that distinction that you so carefully made. I wonder if you would care to comment on whether or not when we do this, we ought to take those fundamental differences into account.
    Mr. HENRY. One of the reasons that I wanted to point that out was actually when I read through the agreement myself, the chapter on investment, it struck me that there were two separate issues. One issue is to what extent do you actually require a country to open up to various kinds of investment, and that issue does not seem to be addressed at all in the current investment agreement. What the current investment agreement addresses is really the second issue, which is given the decision to open up to certain kinds of investment, how do you treat foreign versus domestic holders of a given asset? The point that I just wanted to make, just so it would be on the record and people can think about it, is that I think the first point, the extent to which we actually require or possibly inadvertently push countries to open up to certain kinds of investment prematurely, is something that we should move away from.
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    Mr. FRANK. And again, the problem I think many of us have with these sets of treaties is that they do not make those distinctions. There were things—nondiscrimination, national treatment—a number of these things—access to ATMS—which are very good things. The point that Professor Bhagwati made, who has been a very strong support of free trade, is that the danger here is that this will undercut precisely the kind of support for trade that we wanted.
    Mr. Tarullo, one other point you noted, because again Mr. Taylor keeps saying this is just more of the same, you noted that with regard to NAFTA I think it was, there was a three-year requirement that is not here in this treaty. Is that correct, with regard to bonds, et cetera?
    Mr. TARULLO. Congressman Frank, there are a number of differences between the NAFTA provisions covering investments and those in the Singapore agreement. I am not able to get a copy of the Chile agreement. Apparently the Administration has not formally released it, but I gather it is pretty much the same. The one difference I mentioned in my testimony, which is that the definition of investment in NAFTA covers debentures, bonds, other debt instruments which are of longer than three years duration. Obviously, that was distinguishing between shorter and longer term. Another point of difference is——
    Mr. FRANK. And here there is no such distinction.
    Mr. TARULLO. Not that I am able to find, sir. No.
    Mr. FRANK. I was told there is not, that there is no short term, long term, or any other kind of distinction.
    Mr. TARULLO. The second point—there are a number of distinctions; we do not want to go through all of them here—but a second distinction is that the NAFTA explicitly incorporates IMF standards. Whereas, this agreement, at least with respect to the investor-state dispute settlement, seems——
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    Mr. FRANK. And the IMF does allow for certain kinds of exceptions.
    Professor Bhagwati, I want to go back again to the experiences that we have had, because again I know no one is arguing for a regular reliance on capital controls. But would you talk some more? We have had some dispute about the East Asia experience in particular. Would you just talk a little bit more about what we learned from East Asia about particularly short term, hot money, portfolio investment, and how it is covered in this treaty?
    Mr. BHAGWATI. Just to keep matters short, I think there is a diversity of experience there. South Korea was sort of caught up by the flu that came from Indonesia and Thailand. Thailand was a little weaker than Indonesia was, but essentially I think what happened was that despite relatively strong fundamentals compared to, say, Mexico or South American countries, these countries suddenly experienced massive out-flows. So it was in fact panic. Now, in economic theory, we do recognize that even when you are strong, you can have panic withdrawals simply because of things like what we economists call in jargon asymmetric information and so on. There are lots and lots of reasons why one could have this. DeRosa would have probably learned this as destabilizing speculation at Chicago, but it does occur. This is certainly did occur.
    So it had nothing to do with mismanagement or something like you had, you know, tremendous excess spending, the kind of thing which broke out in Mexico in 1994. So in that sense, it was really I think a classic case where you really learned that systems could in fact collapse under this kind of regime. So I think that is one lesson that we have learned. So we should no be too complacent, Congressman.
    Mr. FRANK. Thank you. I would just note, I understand there are legitimate differences here. But to impose one particular view of what is at best a very hotly disputed thing, and to tell other governments that the price of dealing with the American market on these terms is to acquiesce to it seems to me a mistake.
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    I have one final question for Mr. Lackritz and Mr. Vastine. We tend to get involved in two ways here. One, we negotiate treaties as to what kind of investments go, but when countries get into trouble and are not able to pay off either through sovereign debt or through other kinds of debt, our government also gets involved. Does this preference for a complete laissez faire, free trade, pure let the market work approach apply to when the trouble starts? Should we be equally saying, okay, the United States will run interference for you, and we will create for you absolutely open areas to invest in any of these countries. However, if having done that, you get into any kind of trouble and there are not payments et cetera, you are on your own. Should that be part of the deal, Mr. Lackritz?
    Mr. LACKRITZ. Well, I think you are referring to sort of sovereign debt restructuring.
    Mr. FRANK. No, I am referring to—no, there are other things. There is sovereign debt restructuring. There is the United States lending money. There is pressure on the IMF. You know, there are a whole range of things, not sovereign debt restructuring only. I am talking about whether or not the United States Treasury, whether it is Argentina or Mexico or any other country, ought to get involved and say, alright, let's get involved and let's try and increase the flow of funds, partly so that the American investors can get their money back out.
    Mr. LACKRITZ. First of all, I think that what you are talking about, first of all, we favor having private contractual mechanisms to work out these kinds of situations.
    Mr. FRANK. So you do not want any United States government involvement?
    Mr. LACKRITZ. And the involvement of the government obviously is helpful in those circumstances, but——
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    Mr. FRANK. But you would be opposed to it as an interference with the free market?
    Mr. LACKRITZ. I was not saying——
    Mr. FRANK. You want the right to go in unimpeded. If you want to go in on your own, shouldn't you stay on your own once you are in there?
    Mr. LACKRITZ. Well, conditions change, as you know.
    Mr. FRANK. Oh, yes, once you have your money in there, they change.
    Mr. LACKRITZ. I think you have to look at this from a longer-term perspective, from the standpoint of, how do we improve the flows of capital.
    Mr. FRANK. No, that is a separate issue. I understand that. But I really will be honest, you know, Mr. Tarullo said there is a question of a creed intervening here. Let's put it on the table, there is also a question of whether greed is intervening. Obviously, people have a right to pursue their own interest, but I do not think it is in America's interest, by the way, to gain every short-term advantage for every commercial interest. We have an interest in stability. We have an interest in democracy. And the question is, frankly, are you not being inconsistent in being free-marketers when it comes to put the money in, but somewhat more mercantilist when it comes to you getting it out? Mr. Vastine?
    Mr. VASTINE. I do want to respond to something you said earlier, characterizing my statement that these agreements gave more attention to financial services and other services, all other tradable services than previous agreements. Listen, the capital transfers provision of these agreements is a very small element.
    Mr. FRANK. Could you get back to the question? I was just trying to say that you and I agreed that this is more different than previous ones than Mr. Taylor says. But what about the differential standards on the money going in and the money coming out?
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    Mr. VASTINE. Well, the market should be encouraged to work. Countries should be encouraged to take fundamental steps, not surface, not arbitrary, not administrative steps, to try to cure their international payments problems. Those are the real cures.
    Mr. FRANK. I understand that, and that is a good answer if somebody asked you that question. But the question I had was, when you have taken advantage of these treaties and freely invested short-term, long-term, and trouble comes up, should I not just say, well, I will be interested to watch that because, you know, you took advantage of the market and the market has its bumps and its ups and its downs.
    Mr. VASTINE. And some Treasuries take that point of view.
    Mr. FRANK. What do you want them to take? I understand that, but what would your position be? Would you say to the Treasury, please, let's not be inconsistent here; the free market should work and we went in eyes open and we knew what we were getting into; let's not hear any talk of bailouts or federal government pressures for restructuring.
    Mr. VASTINE. That is why this agreement provides a mechanism. If flows are stopped, the agreement does indeed provide a mechanism, a rather complex one and somewhat delayed one, to make investors whole. So in theory, there would not be any need for the government to involve itself.
    Mr. FRANK. Unfortunately, the way to make investors whole would be, and I think this is a point that others have made—Mr. Tarullo and others—it would make investors whole by taking from a fairly poor country money that would otherwise be available for some basic services.
    Mr. LACKRITZ. Could I just respond to that?
    Mr. FEENEY. Why don't we let Mr. Lackritz and Mr. Vastine, and then we are going to go the gentleman from Illinois.
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    Mr. LACKRITZ. Thank you, Mr. Chairman.
    Mr. FEENEY. Mr. Lackritz?
    Mr. LACKRITZ. I think the point that you are raising, Congressman, is an excellent point, but I would only refer you back to Emerson's notion that a foolish consistency is the hobgoblin of small minds. That is why we are trying to be pragmatic and practical here as well.
    Mr. VASTINE. I guess my last point, Congressman, is that I cannot quote Emerson. I could give you a little Mark Twain on ''lies, damned lives, and statistics,'' but I will not do that. I would just like to caution that we should not be cavalier or presumptuous in thinking that the Chileans and the Singaporeans have weak regulation, and are not sophisticated negotiators. They are very sophisticated.
    Mr. FRANK. I agree. One second here, I just want to say to Mr. Lackritz, to modify another quote, reference to Emerson in that sort of a situation is the last refuge of people who do not have a logical answer for an inconsistency.
    Mr. FEENEY. Well, I thought we were talking to economists. We expect some inconsistencies, don't we?
    The gentleman from Illinois.
    Mr. MANZULLO. I have a son studying English and poetry and Grove City, and he fell in with the libertarians and now he wants to double major in economics, so he can quote Emerson along with the economists.
    First of all, I am sorry I could not listen to the testimony of everybody, but it really ties into the constituents I have back there. There is a very skeptical mood in Congress with regard to any new free trade agreements, based upon the fact that there are not empirical studies that can justify economic theories. Members of Congress are elected by real constituencies, and not theorists.
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    Let me give you an example. We have got a huge war going on with massive waivers of the Berry amendment by the Secretary of the Air Force, that is allowing Russian titanium to go into engines on our military aircraft. The waivers are granted ex parte. There is no notice. These are strategic metals, and therefore in the area of procurement. As a person who calls himself a free trader, we have looked upon the $300 billion in procurement in this country as a way of leveling the playing field. In other words, if the local manufacturers can get contracts for U.S. consumption, paid for by U.S. taxpayers' dollars, then that is the way to get a good share and to maintain a base, especially in the area of strategic metals.
    In examining these free trade agreements of America, the new FTAA, the Singapore and the Chilean agreements, our U.S. procurement is opened to these countries, and they can manufacture goods obviously a lot cheaper than our people, by providing nondiscriminatory treatment. In other words, if somebody from Chile wants to make a tank tread or tank turret, they can come in, bypass the Berry amendment, and again add to the hollowing out of manufacturing that is going on. I asked one of the assistant USTRs, and I have tremendous respect for Bob Zoellick. I do not think he is a Leninist, Dr. Bhagwati, even though the theory may have been Leninist. I am just teasing you, you know that.
    But I said, do you have any quantitative evidence as to who wins and who loses when we open U.S. procurement to foreign countries? In other words, are there any documents out there that show how much U.S. companies are buying of procurement from other countries, and how much other countries are buying of procurement from the United States. I was told the statistics do not exist. If the statistics do not exist, then why do we proceed with going ahead with these new agreements that leave the procurement open and further hollow away at our manufacturing base in the United States? I know this is on services and services are extremely important because the more liberalization of services you have, the merchandise follows after that. That is after the Vastinian theory put forth in a Cato article that Mr. Vastine published about three years ago, and that is when we first got involved in this. Does anybody want to tackle that question, take a look at it? Professor, I know you would like to.
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    Mr. BHAGWATI. I do not know of any empirical studies because procurement has usually been for one's own people, so that you would have to have an anticipatory study—you know, what would happen if, which would be very problematic. But I think I would just sort of make one response to this. This is a matter of opening up your system to more trade, just like the rest of the system. Procurement has been usually, even in the Uruguay Round agreement, I mean, that was kind of optional for most countries, I think, who signed onto it. But it is not in the regular agreement. It is on the annex.
    I would simply say that as more countries do that—I mean, obviously we are not going to get much out of these two partner countries in an FTA, but as we open it up and make procurement open to everybody around the world, and in the major countries, we will gain as much as we give, even looking at it on the terms in which you specify.
    Mr. MANZULLO. But that is theoretical. You do not have any——
    Mr. BHAGWATI. Well, we are pretty competitive, Congressman, so I would say we would expect to win a fair amount.
    Mr. MANZULLO. But if that is the case, then the Chinese could come in and make all of our aircraft. They could make everything for us at a cheaper cost. Currently, if a document is shipped from the United States, with the exception of something that is bonded going to Mexico, because we know it is coming back, and with the exception of the 62.5 percent, NAFTA content in automobiles, we have no way of knowing how much foreign content exists is in an item that is shipped as a U.S. export. We have to study that because, you know, I lost 10,000 manufacturing jobs in the congressional district that I represent in the past two years. So has the Speaker. His district is the mirror image of mine. Rockford, Illinois, which is in the center of the congressional district I represent, led the nation in unemployment in 1981 at 24.9 percent. And now, it is pushing 11 percent and we are losing more and more manufacturing jobs. These jobs are not coming back. So we are taking a look again at free trade being fair trade, and we are trying to make sure that what is touted as something that is made in America actually has American parts.
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    If I may indulge the chair for a minute or so.
    Mr. FEENEY. How about you take another two minutes?
    Mr. MANZULLO. Okay. Thank you very much.
    In October of 2002, the Congress passed a bill that would authorize Boeing aircraft to lease to the United States 100 767s, retrofitted as KC-135s, which are the fuelers that haul the fuel. Included in that legislative language, was a Berry waiver. I have scheduled an April 30th hearing on this before the Small Business Committee. I have held a meeting with the principals of this hearing this past week, along with Duncan Hunter from the Armed Services Committee. The question became, this is a noncompetitive contract; it is done by the grace of the U.S. Congress to help out Boeing aircraft. At the same time, with all the Berry waivers in there, we do not even know how much of that aircraft would be U.S.-content. In fact, Pratt and Whitney were at that meeting, and on the military aircraft they are selling, not only is there Russian titanium, but the drive shafts are made of nickel coming from Japan. Nickel is also a strategic metal that is covered under the Berry amendment.
    The reason I bring this up is the fact that, and I know you are testifying on services, and services are critical, and those who are not free traders in service do not understand that unless the service industry gets way out front, it is the service industry that pulls the manufacturing component behind it—so I know that you all have different views on this, but I accept that basic theory. Bob Vastine, you have been a real mentor to me on that, and Professor, I have read your stuff. I will read the testimony of each of you. But if anybody has anything they want to send me with regard to that, please do not send it through the mail. Call our office, and we will give you the fax number.
    Mr. BHAGWATI. I would be glad to do that.
    Mr. MANZULLO. And thank you very much for giving me the additional time.
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    Mr. FEENEY. Thank you. Obviously, this is a very important issue to Mr. Manzullo and his constituents. If any of our distinguished panel has anything that they can assist him with, I am sure he would be grateful and so would the committee.
    I just have one or two questions before we wrap up and let everybody go for lunch. First of all, I want to make sure that there are six other people that are engaged in the same premise I am, and that is that in general, with some exceptions, Adam Smith was right and free trade is best for both parties involved. Does anybody want to raise their hand?
    Mr. DEROSA. Absolutely.
    Mr. FEENEY. Mr. DeRosa, maybe you can start, then, if we all start with the same basic premise, it seems to me that the history of both undeveloped, developing and highly developed countries is based on a couple of things—certainly being at peace is helpful—but in terms of things that you can help internally with respect to domestic policy. They are prudent monetary policy; respect for the rule of law; respect for property rights, both real and intellectual; relatively low marginal tax rates; and transparency in terms of the way the country does business. These help generate prosperity within a country, but is it also true to say that those policies attract capital? That is part one.
    And then number two, and then I will open it up for some other folks to respond, with respect to this question about basically restricting or freezing capital. This is part two of the question. Surely, regardless of whether you come down as an absolutist, that it should never be done or allowed in these particular trade permits, or whether we should always allow countries free rein, surely most of the panel will agree that there is going to be a risk associated with investment in nations that can essentially restrict, or at least temporarily nationalize capital.
    And so going to Dr. Henry's distinction, which is sort of the moderate position as I review the testimony, can you attack the problem based on Dr. Henry's testimony? If I want to create a widget manufacturing plant and invest $100 million, am I more or less likely to invest in a country that is prone or able under a trade agreement to nationalize the $100 million investment in my manufacturing plant? And if I am less likely, and I assume we all agree that I am less likely to make that investment, why would we in terms of incentives for investors, because after all capital is the most liquid and the most morally neutral thing I know of, why would we be more likely to disincentivize investors on the debt area, as opposed to the equity area? Maybe Dr. DeRosa, you can start.
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    Mr. DEROSA. Thank you. The reason that these countries that we speak of got in trouble was not necessarily a distinction between debt and equity, but the denomination of the financing. But they did get in further trouble by using excessive amounts of short-term debt, so when the crunch hit, they could not find investors to roll the debt. The reason why this enthusiasm for short-term debt—it is an interesting question, because I indicated earlier that in every one of these cases, you can trace back almost signature errors that governments did in responding. In the case of at least Thailand and South Korea, and I think other ones as well, but I know in those cases, there were government policies before the crisis to force or greatly encourage local companies to borrow short term and never long term. The title for this, the name for this is called window guidance. Thailand had effectively had a government institution set up to encourage companies that borrow internationally only to borrow short term. The same was for Korea.
    So it is a combination of a squeeze on the currency and also a squeeze on the denomination. But your characterization of what it takes for growth is something that I have great sympathy for. These are things that actually are in Adam Smith's Wealth of Nations, about what is the proper role of the government in terms of the rule of law, property rights, things like that. Essentially, that is what went wrong in the early stages after the Soviet Union disintegrated. Why didn't growth come earlier? But I come back to this basic premise that capital really is not as fickle——
    Mr. FEENEY. Well, and in Latin America, agrarian reforms do not help if every new regime every three years nationalizes property and institutes a new set of reforms.
    Mr. DEROSA. Absolutely. And this is what is going on wholesale in Venezuela right now. This is why a country that ought to be prosperous is in a tailspin thanks to the leader of Venezuela. But you know, it all comes back to this. There is this central thing that I keep saying to people. Capital really is not as flighty as people think. The hot money that people describe, thinking that it is going to rush in and rush out, every case that I know of, and I have studied all of these crises in detail; I wrote a book on this; I write columns about this. It is all associated with the nature of the foreign exchange regime. It is always traceable back to a fixed or a creeping fixed exchange rate regime. People are trying to game the system. The locals are borrowing in dollars because dollar interest rates are lower by definition because of country risk. Foreigners are investing in the local currency, and sometimes on a leverage basis.
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    When the situation becomes untenable, then when the exchange rate regime goes to break, that is when you get this massive outflow of capital. Once the exchange rate starts to float again, this phenomenon does not—I do not know of a single case; I have studied a lot of economic history, have written a lot about economic history—all of these things are coming out of the exchange rate regime. That is why the crises occur. No country that I know of has gone from a fixed exchange rate regime to a floating regime in the last 20 years and suffered a second crisis. So all this talk about putting in capital controls is irrelevant and damaging, because it is unnecessary. It is unnecessary. Countries do not just fall over dead in their tracks. They do not just roll over and collapse. That is not the nature of modern economics as we know it. You can always dissect it. You can always do a post-mortem and in all of these cases that we are talking about, where capital flight is a problem, go back and look at it carefully and you will see it is coming out of the disintegration of a pegged or fixed exchange rate regime.
    Mr. FEENEY. Thank you, because it would be a waste of some superior intellect and talent to speak at length to a freshman Congressman from Florida, if each of you will take two minutes—Dr. Bhagwati, and then maybe we will skip Dr. DeRosa—thank you for your lengthy—and maybe we will just conclude and thank you for your participation.
    Dr. Bhagwati?
    Mr. BHAGWATI. Thank you, Congressman. Just to respond to your last question very briefly, what we are dealing with is the ability to use capital controls in a crisis and what the consequences would be. I think to treat that as something like confiscation. I do not think that is what the gentlemen who are going to invest are going to look at it that way. I think the probabilities are on the low side. What we are saying is you have to allow for it and let these countries really be able to exercise this option. I do not think anybody is going to be affected by that in terms of investing in one country rather than another. So I think it is, my answer to you is, well, the threat of nationalization, et cetera, of course it is something we would all react to. We would not want to put money there. That is not what we are dealing with. So I would say relax on that one and take this out if you can.
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    Mr. FEENEY. Thank you.
    Dr. Henry?
    Mr. HENRY. Let me start by saying that free trade is one of the best means we have for actually increasing global welfare, so we should almost always in all circumstances continue to push for free trade on a fair basis. With respect to free trade in capital, by and large free trade in capital also has the potential for the same kinds of effects. Where we need to be careful is when we are dealing with systems in which there are other distortions, for example a fixed exchange rate regime, as Dr. DeRosa mentioned. In those circumstances, we want to be careful about inadvertently pushing countries into undertaking policies which, given those other distortions in the system, could prove very damaging in certain kinds of situations.
    So for example, if you have a fixed exchange rate system and people are tempted to borrow in dollars because interest rates are low, what we have seen time and time again is that the people who actually borrow in dollars are people who are not actually earning dollar revenues, and that creates a real, very explosive situation when in fact the exchange rate regime comes to an end. So what we should do in those situations is really force people to internalize those risks and recognize that in certain situations where there are obviously other distortions, the first best policy—complete free trade in capital—might not be the best answer. In particular, since history has shown us empirically that these debt market liberalizations seem to get countries in trouble, we should just be very wary of that.
    In general, I agree with your point. Anything which creates a disincentive to capital to go into a country is going to lead to less investment. But we should remember that what we want is efficient investment, not just investment.
    Mr. FEENEY. Or higher interest rates or expectations of return on capital.
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    Mr. HENRY. That is right, but sometimes higher interest rates or implicit interest rates are in fact warranted because there are risks involved. We should in general move to a situation that is efficient, to use an economist's term, ex ante—before things happen—where we get people to actually internalize those risks and generate efficient investment.
    Mr. FEENEY. Thank you, doctor.
    Dr. Lackritz?
    Mr. LACKRITZ. Thank you. I appreciate the upgrade in my degree.
    I think going to your point, Congressman, that obviously capital flows to countries which have institutions where there is the rule of law, where there is an openness and a transparency, and where there is a culture and a tradition of where there is an expectation of returns. At the same time, the market is fairly efficient, and where these institutions do not exist, obviously the rate of return has to be higher to attract the capital to reflect the added risk that is involved. I think one of the benefits of these kinds of free trade agreements is that they open up markets more to promote more capital flows back and forth from country to country, and more flows of goods and services, which of course the financing is accompanying. That is why the capital flows are going back and forth as well.
    So these agreements actually are a good start, which help other countries to see what they need to do to attract capital. They see the results from the standpoint of the marketplace and the rate of their own development, which is a very powerful incentive for them to open up and to create these institutions.
    Mr. FEENEY. Thank you.
    Mr. Tarullo?
    Mr. TARULLO. Thank you, Mr. Chairman.
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    Mr. Chairman, I will end where I began, which is urging some sense of modesty in this area. We are all experts in retrospect. We look back at the Asia financial crisis, and we say, aha, that is what happened. But if we are honest with ourselves and go back eight or ten years, so far as I am aware the people at this table and the people elsewhere were not identifying some of the problems which we now in retrospect see were very important. I have no doubt but that the next financial crisis, when it comes, will contain elements of traditional financial vulnerabilities and will contain something new, that will be a surprise, and that will give more fodder for scholarly and policy work thereafter.
    I think the reason why some of us are concerned with the capital controls provisions is not because we want to go proselytizing for capital controls. I think Dr. Bhagwati and I have tried to make that clear in our own approaches to this issue. We believe we need to understand this more, we need to understand where and how problems may arise, and we need to have a system prepared that will allow countries to respond if the worst happens. My own sense is that if Singapore and Chile are concerned about not having this fallback position, then other countries with even less well-developed capital markets and regulatory systems are even less well developed, will be more concerned. I do not think we want to push them down that road. I think what we want to help them to do is to build the institutions that will make for strong securities markets and strong bank regulatory systems, and then see what benefits the free flows of capital can bring.
    Thank you very much.
    Mr. FEENEY. Thank you.
    And finally, Mr. Vastine, you can sum up.
    Mr. VASTINE. Thank you very much, Mr. Chairman.
    First of all, these are good agreements. They contain a great deal more than the capital issues. Congress should adopt these agreements. Chile and Singapore freely agreed to these provisions. I was familiar with these negotiations. No one held a gun to their heads. They are very sophisticated negotiators. They are very good regulators.
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    Finally, I do not think the objections raised today give grounds to the committee or to other members of Congress not to vote for these agreements.
    Thank you.
    Mr. FEENEY. I want to thank all of you. We will get you out for a late lunch. The chair would like to thank all of you for traveling and being here with us today. Without objection, the record of today's hearing will remain open for 30 days to receive additional material from members and supplementary written responses from witnesses to any question posed by a member on the panel.
    The hearing of the Domestic and International Monetary Policy Subcommittee is hereby adjourned.
    [Whereupon, at 12:35 p.m., the subcommittee was adjourned.]