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Capital Account Liberalisation and Financial Crises



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Capital Account Liberalisation and Financial Crises

The drawbacks of commercial capital flows discussed above have important implications for the prescription of universal capital account liberalisation by developing countries, and for any attempt by the IMF to enforce it. The significance of capital account liberalisation is not only that it reduces the ability of governments to control the overall level of commercial capital flows, but also (and perhaps more importantly) that governments lose the ability to influence their composition and the level and terms of the individual components, except through broader economic policies. This may lead to an excessive build-up of liabilities which are more expensive or more volatile than is appropriate for the country concerned; and it is likely to have a significant effect on governments’ ability to make economic policy in the future.


Capital account liberalisation entails the removal of controls, not only on capital inflows, but also - and equally importantly - on outflows. The case for this is that potential investors will be seriously discouraged from investing if they face the risk of restrictions on taking their capital out of the country. The removal of such restrictions thus encourages greater inflows. However, greater inflows also imply a faster build-up of liabilities; and, coupled with the removal of restrictions on the repatriation of capital, this entails a larger risk of much greater outflows.
Thus capital account liberalisation implies a much greater volatility of capital flows: more will flow in during good times, and more will flow out during bad times, giving rise to the potential for massive swings in net flows from year to year. This is compounded by the speculative nature of many such flows (eg., equity investments), and the herd-like behaviour of speculative investors. Assuming that investors pull out before the price falls so low that the returns fall to zero or below, the outflow will be greater than the inflow19.
In general, developing countries have tended to design economic policies specifically to attract capital inflows - in particular, maintaining fixed exchange rates coupled with relatively high interest rates. Mexico and Thailand have been notable examples. The subsequent financial crises in these countries demonstrate the serious risks inherent in this process, and may discourage others from pursuing this path in the future.

Once a country has embarked on such a path, it becomes bound into it by the need to avoid the outflow of the capital which has been attracted. This entails the continuation of the interest rate and exchange rate regimes, possibly long after they have ceased to be viable. Again, Mexico and Thailand are clear examples: in both cases it was clear a long time before the crisis that a major devaluation would be needed sooner or later, but this appears to have been largely ignored by the market. (The Thai crisis suggests that speculators may be learning from experience, accelerating the transition from initial doubts to full-scale crisis.)
Apart from the resulting explosive increase in foreign exchange liabilities, this has potentially important effects for the domestic economy. In particular, the increasingly over-valued exchange rate makes domestic producers of tradeable goods increasingly uncompetitive, in both export and domestic markets; and the resulting loss of profitability, coupled with the high cost of capital due to high interest rates, discourages productive domestic investment. Together with the potentially high rates of return from speculative bubbles, this may divert domestic savings into unproductive speculative investments, inflating the bubble still further. When the bubble bursts - which is inevitable - the economic and social impact can be catastrophic.
Governments have little incentive to avoid the development of speculative bubbles (unless they are confident of still being in office when the bubble bursts), and still less to burst them. Rising property and share values can be expected to increase the popularity of the government among those who own these assets, ie., the richer, more influential sections of the population.
The Mexican and East Asian financial crises are illustrations of the problems which may arise from capital account liberalisation. There has been much dispute in the East Asian case as to whether the cause of the crisis was the liberalisation of the capital account, or weaknesses in financial and banking systems. However, this is a false dichotomy, as the crisis was caused by the interaction of the two. Capital account liberalisation compounded the initial shortcomings of the financial system, by intensifying the pressures which led to speculative bubbles in stock markets and real estate. It thus made the scale of the potential crisis worse, as well as making it more difficult to manage or control. The crisis might well not have happened if the financial markets and banking systems had not been so weak in the first place; but, given their weakness, capital account liberalisation made the potential crisis inevitable and worse than it might otherwise have been.
The proponents of capital account liberalisation argue that the associated market discipline reduces the domestic causes of such potential crises. However, as the East Asian crisis demonstrates, this is potentially an immensely destructive mechanism. The greatest "economic miracle" of the post-war period has been brought to an end by an economic crisis which, for the countries concerned, is "of the same sort of order as the slump in America during the Great Depression"20. The capital inflows associated with capital account liberalisation may have contributed to the initial very rapid growth; but, given the very high domestic savings rates in the region, it is far from clear that the benefits of additional capital inflows significantly outweighed the negative effects of diverting local capital from productive to speculative uses, let alone the devastating effect of the bubble bursting.


As in the Mexican crisis (see above), the relationship between the impact of the East Asian crisis and the openness of capital account regimes, at least among the less developed countries of the region, is telling (Table 4). The slowest projected growth rates for 1997-9 are in Thailand and Indonesia which have gone furthest in liberalising their capital accounts; the fastest is for China, which has throughout maintained the least open regime. Malaysia (which reversed its initial liberalisation more substantially, to regain control of monetary policy) and the Philippines (which opened its capital account more recently than Indonesia and Thailand) fall between the two.
Among the high-income East Asian economies, the picture is less clear. The country with the greatest foreign exchange restrictions (Taiwan) is set to out-perform Hong Kong and Singapore, which have much more open regimes; but the margin is relatively small; part of the shortfall in Hong Kong is also likely to be affected by its reunification with China; and Korea, which also has a relatively restrictive regime, performs worst in this group.
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