CAPITAL ACCOUNT LIBERALIZATION

1
CAPITAL ACCOUNT LIBERALIZATION

• What is the underlying reasoning for capital
  account liberalization?
• Capital account liberalization can lead to
  significant benefits for economic growth and
  welfare
• But, it can also entail significant risks
• Thus, there is a need for a comprehensive
  approach to capital account liberalization

2
BENEFITS OF CAPITAL ACCOUNT LIBERALIZATION

• Countries can access pool of global savings
  (usually at lower cost than domestic savings)
• Domestic agents can freely choose how and where
  to borrow, invest, and exchange assets
• Resource allocation improves through increased
  competition
• Increased availability of resources to support
  investment, finance trade and boost significant
  economic sectors

3
COSTS OF CAPITAL ACCOUNT LIBERALIZATION

• Wrong timing and steps in the process of capital
  account liberalization may result in
• -- macroeconomic instability
• - balance of payments (volatile flows)
• - monetary policy effectiveness
• - exchange rate instability and crises
• -- financial system instability and crises
• Markets may question sustainability of inflows
  and capacity to service external debt

4
WHICH APPROACH TO CAPITAL ACCOUNT LIBERALIZATION?

• Several economists have argued that capital
  account liberalization should follow
• -- opening of the current account
• -- opening of the domestic financial system
• Many economists agree that macroeconomic
  stability must be a prerequisite
• Others have argued that current and capital
  accounts should be liberalized simultaneously

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THE NEED FOR AN INTEGRATED APPROACH

• Capital account liberalization, macroeconomic
  policy, and financial sector reforms are very
  much interlinked
• Recently, economists have argued for a
  comprehensive approach to the liberalization
  process
• Capital account liberalization must be an
  integral part of an overall package of economic
  reforms

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• Liberalization of FDI inflows must be part of a
  package of real sector reforms
• These reforms aim at strengthening the export
  potential of the economy
• These reforms include
• -- changes in trade and investment regimes
• -- changes in exchange rate to improve
  competitiveness
• -- liberalization of controls on current account
  transactions

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• Liberalization of portfolio capital flows must be
  coordinated with financial sector reforms
• These will include
• -- liberalization of interest rates
• -- development of indirect monetary policy
  procedures
• -- strengthening of domestic banks and capital
  markets

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WHAT IS THE UNDERLYING REASONING FOR AN
INTEGRATED APPROACH?

• First, there is a concern for the macroeconomic
  environment and the balance of payments
• The nature of capital flows after liberalization
  will affect macroeconomic policy and the BOP
• In this regard, the level of development and
  stability of domestic financial markets will
  affect the growth and composition of capital flows

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• Countries with developed financial systems are
  more likely to attract portfolio flows
• Financial sector weaknesses may discourage
  capital inflows and may result in capital
  outflows
• Also, banking sector problems may result in a
  currency crisis after capital account
  liberalization

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• Second, capital account liberalization may have
  significant implications for domestic financial
  markets and institutions
• If there are interest rate or credit
  restrictions, large corporations may borrow
  directly abroad
• Liberalization may result in increased
  competition and improved efficiency
• But, it may also result in a banking crisis

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• This will be more likely if weak institutions are
  faced with rapid inflows and subsequent sudden
  reversals
• In cases where there is concern about rapid
  growth of banks assets, it is better to place
  limits on international borrowing by banks

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• Efficient use of capital flows depends crucially
  on the level of development of domestic financial
  markets
• Third, successful liberalization of capital flows
  requires
• -- existence of minimum sets of instruments
• -- existence of institutions and markets
• for the effective management of monetary and
  exchange rate policies

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• Increased capital mobility changes the
  effectiveness of various instruments of monetary
  policy
• Direct controls (interest rate ceilings or
  reserve requirements) may be circumvented more
  easily
• Capital inflows will occur through
  disintermediation (e.g. borrowing directly from
  abroad)

14

• Open market operations can have a stronger effect
  on the decisions of financial markets and
  institutions
• In this case, open market operations will affect
  the cost of money or credit and influence
  decisions of institutions using domestic currency
  in local and international operations

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• Fourth, some of the dynamics of reforms call for
  synchronization of financial reforms and capital
  account liberalization
• On the one hand, financial reforms lead to a
  rapid growth of credit
• This will put pressure on the BOP through the
  current account

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• On the other hand, capital account liberalization
  usually leads to capital account surplus
• This will offset pressures on the BOP through the
  return of flight capital

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CAPITAL ACCOUNT LIBERALIZATION AND MACROECONOMIC
POLICY

• Capital account liberalization must be adopted to
  macroeconomic policy
• It is important to examine the incentives that
  cause capital flows
• These will include
• -- regulatory environment
• -- development and soundness of financial system
• -- interest rate and exchange rate policies

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• In many countries, the opening of the capital
  account has been followed by a surplus
• This would imply that capital flow restrictions
  are treated as a risk factor
• One incentive for inflows is the reduction of
  risk premiums
• This creates a major policy issue, which is the
  management of increased flows after liberalization

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• Another policy issue is setting interest rates
  and exchange rates after liberalization
• These must be set according to Covered Interest
  Parity
• If interest rates or exchange rates do not
  satisfy this condition, there will be incentives
  for significant short-term flows

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• For example, if monetary policy targets
  inflation, the exchange rate cannot be used to
  affect the current account
• In this case, fiscal policy can help by changing
  the savings-investment balance
• If the exchange rate is targeted to achieve
  current account objectives or it is fixed,
  monetary policy will not be autonomous

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• Thus, increased capital mobility will restrict
  the ability of monetary or exchange rate policies
  to achieve macroeconomic stability
• To do this, it may be necessary to allow more
  flexibility of exchange rates and/or interest
  rates
• This will discourage short-term speculative flows
  that take advantage of inconsistencies

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THE PACE AND SEQUENCE OF LIBERALIZATION

• In a comprehensive view of capital account
  liberalization, a gradual approach is not
  necessarily implied
• The key is to integrate capital account
  liberalization with structural and macroeconomic
  policies
• This involves coordination of liberalization of
  portfolio flows with domestic financial sector
  reforms

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• If the domestic financial system is weak, it may
  be preferable to address the weaknesses before
  proceeding with liberalization
• This may involve adopting some of the
  internationally used regulatory standards
• During this period, a country may need to rely
  temporarily on selective controls

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• A comprehensive approach will also provide more
  autonomy to monetary policy to deal with capital
  inflows
• The speed of reforms may or may not play a role
• In some cases, capital account liberalization has
  provided momentum for overall reforms