During the recent decades, many countries decided to get access to international financial markets by liberalizing their capital accounts. As we will see in this paper, the issues of liberalization are very complex. Many different areas like, for example, growth, inflation or the labor market are affected by it. For some areas, empirical research supports theory and delivers sustainable and significant results. For others, theory is inconsistent or not supported by evidence from the real world. Some special ones, like for instance welfare or productivity, even show that it is important to split up the results to see whose welfare is increased or which’s branch productivity is affected. Another interesting point is the connection between crises and capital account liberalization. Due to the financial crises that occurred in the aftermath of liberalization the concept has been controversially debated by academics for a long time. The real connection between these two issues is not yet clear.
The structure of this paper is as follows. Section 2 will give short case studies of countries that liberalized their capital account. Section 3 is meant to endow the reader with some basic tools that will be important for the understanding of the concepts that will be presented later on in this paper. This includes definitions and conceptual ideas about measuring capital account liberalization. Section 4 focuses on the theory and empirical findings. In that section, the effects of liberalization on various macroeconomic variables will be presented. Section 5 follows the thoughts of the prior one by having a look at the implications that can be concluded from the theoretical and empirical findings that have been presented in the prior chapter. Section 6 discusses capital account liberalization with respect to the role the IMF played concerning its promotion. This section will also discuss the development of the Fund’s stance towards liberalization. Section 7 will conclude.
Table of Contents
Abbreviations
1. Introduction
2. History
3. Some Fundamental Tools
3.1 Definition
3.2 Measuring
3.2.1 Capital Account Liberalization
3.2.1.1 Share
3.2.1.2 Quinn
3.2.1.3 Code of Liberalization of Capital Movements
3.2.1.4 Intensity of Capital Controls
3.2.1.5 Correlation between Indicators
3.2.2 Effectiveness of Capital Controls
3.3 Timing
3.4 Composition of Inward Capital Flows
4. Theory & Evidence: Capital Account Liberalization and
4.1 The post-Keynesian Perspective
4.2 Allocative Efficiency
4.2.1 Revaluation of Stock Prices
4.2.2 The Allocation Puzzle
4.2.3 Credits and Banks
4.3 Macroeconomic Stability
4.4 Growth
4.4.1 Long and Short-Term Growth
4.4.2 Volatility of Growth
4.5 Market Failure
4.6 Inflation
4.7 The Labor Market
4.8 Welfare
4.8.1 Government Spending and Financing
4.8.2 Elusive Gains from Capital Inflows
4.8.3 Welfare Distribution among Different Agents
4.8.4 The Role of Productivity
4.8.5 Rich and Poor Countries
4.8.6 Volatility of Consumption
4.9 Spillover Effects
4.10 Crises & Exchange Rates
5. Implications
5.1 When Should Capital Account Liberalization Take Place?
5.2 Interventions and Capital Controls
6. The IMF & Capital Account Liberalization
6.1 History
6.1.1 1980 -
6.1.2 An Amendment for the Articles of Agreement
6.1.3 The Effects of the Asian Crisis
6.2 Consistency
6.2.1 Different Policy Issues
6.2.1.1 Exchange Rate Policy
6.2.1.2 Capital Controls
6.2.2 Overview
7. Conclusion
Appendix
Figures
Tables
Variables and Formulas for Models
Literature
Abbreviations
illustration not visible in this excerpt
1. Introduction
During the recent decades, many countries decided to get access to international financial markets by liberalizing their capital accounts. As we will see in this paper, the issues of liberalization are very complex. Many different areas like, for example, growth, inflation or the labor market are affected by it. For some areas, empirical research supports theory and delivers sustainable and significant results. For others, theory is inconsistent or not supported by evidence from the real world. Some special ones, like for instance welfare or productivity, even show that it is important to split up the results to see whose welfare is increased or which’s branch productivity is affected. Another interesting point is the connection between crises and capital account liberalization. Due to the financial crises that occurred in the aftermath of liberalization the concept has been controversially debated by academics for a long time. The real connection between these two issues is not yet clear. Each crisis led to discussions why the models were incapable of anticipating it and each crisis produced a new generation of models, which took into account the new insights gained. Of course, they tried to eliminate the deficiencies of the older generations of models, but somehow every following crisis showed that this Sisyphean challenge could not be considered as finished. Rodrik (1998, p59) even believes that this challenge is not solvable at all.
The controversy of this topic is even reflected in the development of the International Monetary Fund’s (IMF) position towards capital account liberalization. Changing policies show its insecurity when it comes to liberalization. Analyzing the history of policy changes in the context of academic research might help to understand the behavior of the IMF.
In a recent paper, Henry (2007) tried to comprehend and criticize the academic research done in the recent years. It was the starting point of my thesis. In the forthcoming pages, I will follow his path by giving insights into the complexity of this problem. However, I will not just stick to the problems he points at, but try to include other aspects and literature.
The focuses of this paper are theory and empirical evidence. Moreover, I will describe historical developments of capital account liberalization in different countries. Due to the broad coverage of the topic, I will analyze different issues of liberalization in a rather superficial manner. I will not study single subjects in-depth but will try to cover the most important issues.
The structure of this paper is as follows. Section 2 will give short case studies of countries that liberalized their capital account. Section 3 is meant to endow the reader with some basic tools that will be important for the understanding of the concepts that will be presented later on in this paper. This includes definitions and conceptual ideas about measuring capital account liberalization. Section 4 focuses on the theory and empirical findings. In that section, the effects of liberalization on various macroeconomic variables will be presented. Section 5 follows the thoughts of the prior one by having a look at the implications that can be concluded from the theoretical and empirical findings that have been presented in the prior chapter. Section 6 discusses capital account liberalization with respect to the role the IMF played concerning its promotion. This section will also discuss the development of the Fund’s stance towards liberalization. Section 7 will conclude.
2. History
Before we will take a deeper look at the theoretical background of the topic, I want to activate the readers’ curiosity by having a look at the history of countries that liberalized their capital accounts. By doing this I want to throw the reader in at the deep end. Many issues that will be touched by this history lesson will be analyzed in the upcoming sections. I will first describe the historical development concerning liberalization in South Korea and then compare the situation with those in Uganda and Malaysia.
In the 1980s, Korea started to liberalize restrictions on capital inflows and tried to prevent outflows in order to finance the current account deficit at that time. From 1986 to 1989, the world economy experienced a recovery from the previous economic distress and Korea was able to generate a current account surplus. Being afraid of foreign influence, the government turned its back on the former policy, decided to impose capital controls on inflows, and relaxed controls on outflows. As time went by, the capital account was liberalized gradually. Having a pegged currency led to problems because appreciation was limited. In the following years, a more flexible exchange rate regime was adopted and restrictions on the capital account were eased gradually during the 1990s, which led to massive inflows of foreign capital. However, many restrictions on flows were still kept in place. In 1995, the government started a three-staged plan to liberalize the capital account. Looking backwards, the timing was not good since the Asian crises punished all those countries that had too much foreign capital in them. This was exacerbated by the fact that the regulatory framework led to a mismatch between short-term and long-term obligations in the sense that the share of short-term debt was much higher. Problems of supervision in the banking sector then put the system over the edge as the Asian crisis reached the country in 1997 and a request for IMF assistance was sent out. Wang even believes that the problems in the banking sector were the main reason why Korea has suffered so much from the Asian crisis (Wang 2002, p12). Within a period of only a few months, short-term transactions of the capital account were fully liberalized in order to get foreign liquidity into the country. Moreover, a free-floating exchange rate regime and other policy measures that were supposed to open the country’s economy were adopted. Looking at the time before the crisis broke out; the Korean government cannot be accused of having opened up the capital account in a premature way. However, the reforms that were done left out to close flaws in the banking system. This was the main reason why Korea suffered so much from the Asian crisis.
In Uganda, the situation was quite different. Officially, the country liberalized its capital account in July 1997 but this event can only be considered as being de jure. Corruption and the disability of the government to control the country’s economy led to a de facto liberalization that was achieved quite earlier in 1987 (Kasekende 2000).
Another path was chosen by Malaysia. It liberalized its stock market as early as in May 1987 (Henry 2000, p534). When the Asian crisis emerged, the Malaysians imposed heavy capital controls and isolated the countries financial markets from other countries. The case of Malaysia is special on two instances. First, when the Asian crisis reached the country, the government chose to impose capital controls. The reason for this was that the government did not believe that the country’s institutions were able to cope with speculative inflows and that it wanted to keep money from leaving. Second, there was no perceivable increase of corruption when the controls where introduced. Therefore, unlike Korea, the country isolated it self from the rest of the world and, unlike Uganda, the de jure situation was equal to the de facto situation. The case of Malaysia was so special that Magud et al. (2005, p2) even judged that “as for controls on outflows there is Malaysia and there is everybody else”. This is because when the long-term effects of the decisions of the Korean and the Malaysian governments are compared it can be seen that both countries developed quite well although they chose very different methods on how to deal with the situation. A detailed analysis even shows that Malaysia recovered faster from the crisis and suffered less in the area of employment and real wages (Kaplan and Rodrik 2001, p7).
I want to stop this short history lesson here in order to turn to the theoretical aspects of liberalization. However, I think that I was able to show the complexity of the topic.
3. Some Fundamental Tools
3.1 Definition
After this excursion, let us approach the issue of capital account liberalization by having a look at the basics. The capital account is part of the balance of payments, which describes a country’s transactions with other countries. Unlike its counterpart, the current account, it does not document the transactions in goods and services but instead the capital flows between a country and the rest of the world. If a country decides to liberalize its capital account, it gives foreigners the opportunity to invest money into the country and national residents the chance to acquire assets abroad. However, this must not be misunderstood as a “yes or no”-decision. There are infinitesimal small steps, which can make a country a little bit more open towards international capital markets in comparison to other countries. To measure the degree of openness in the real world is quite complex. Some methods, which try to do this, will be presented in the upcoming section. Estimations based on a comparison of the laws in different countries, for example, are very difficult to be accomplished. Another problem is that it is critical to distinguish between de jure and de facto liberalization. Concerning de jure liberalization the above-mentioned comparison might be sufficient, but concerning de facto liberalization, many other factors like e.g. corruption or the home bias have to be considered. Moreover, there is also the possibility that some regulations do not fulfill the definition of capital controls but have the same effects (Kose et al. 2006, p13). As we have seen from the case of Uganda, the formal de jure liberalization of the country affected the economy only in such a way that resources used for enforcing capital controls could be rerouted to other areas and not in the way that capital could flow more freely because it already did.
Moreover, it is a difference whether a country enables foreigners to purchase national assets or allows its own citizens to invest abroad. A country could decide to allow its own citizens to participate in the international financial markets but it could on the other hand also prohibit foreigners from investing. Although that country has to be considered as more open than a country, which has decided to live in complete autarky, it would face another development than one, which decided to open its capital market for foreigners. In the sense of this paper, capital account liberalization is primary meant as a country’s decision to ease the restrictions prohibiting foreigners from investing. Nevertheless, the latter will also be addressed.
3.2 Measuring
Liberalization could take place in such a way that all laws that prohibit foreigners from participating in the domestic financial market are dropped from one second to another. This is rarely observable in reality. Instead, a gradual approach is often chosen by countries. One of the common ways to start the journey towards liberalization is the installation of a country fund. Such a fund is allowed to invest into a country, which is closed for foreigners. However, foreigners are able to invest into the fund and therefore, indirectly into the local market. The Korea Fund for instance allowed foreign investors access to the Korean market from 1984 on, although the capital market fully liberalized seven years later (Bekaert and Harvey 2000). Empirical and theoretical research shows that the installation of a country fund should lead to a reallocation in the sense that the cost of capital is reduced and the prices for local companies go up. The point is that if a country’s market is accessible via a country fund it can be regarded more open than a closed country. How can this difference be taken into account when an indicator for measuring liberalization is constructed? Moreover, the liberalization processes in Latin American countries were generally faster than in Asia (Edison and Warnock 2001, p3). Speed of liberalization is an important factor concerning its economic impact. Can it be included into an indicator?
In this section, the problem of measuring will be addressed. First, I will focus on measuring of capital account liberalization. Second, the measuring of the effectiveness of capital controls will be discussed.
3.2.1 Capital Account Liberalization
I will present some representative indicators that melt different characteristics of a country into a number, which is supposed to give information about the openness of the capital account of that country. As one might imagine, it is very tricky to construct such a number. Many different factors have to be included and so, many researchers developed different approaches to solve the problem. Their indicators can and are used to estimate whether there is a significant influence of liberalization on different variables by including them as parameters in models.
3.2.1.1 Share
One of these indicators that are frequently used in that sense is Share. It belongs to the group of de jure indicators, which can be constructed from the information found in the Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) published by the IMF. The summary section of these reports, to be specific: line E2, tells the reader if there were any “restrictions on payments for capital transactions” in a country during a specific year. Share aggregates this binary indicator, which I will call IMF-Indicator (IMFI) from now on, by describing the percentage of years a country had an open capital account during a given period. If for example the period of interest is 1980-1989 and a country had opened its capital accounts from 1987 onwards, then Share would be 0.3. As convenient as this indicator is, as critical is it. The main issue is that it reduces capital account openness to a yes or no decision and only gives quantitative but not qualitative information. If suddenly, a country is considered as having an open account the reader will not be informed about the circumstances that led to the change of classification. And this is, as we know from the introduction, crucial. Moreover, there is the problem that this indicator fails to distinguish between different patterns of capital account policy. Going back to the example, a Share of 0.3 could also have been achieved if the capital account was open in ’82, ’85 and ’89. Such a volatile policy surely will have different impact on a country’s economy than one that is more stable. On the other hand it must be mentioned that such an “on and off”-policy is rarely observable in the real world. Therefore, using Share and assuming a stable policy might not be very accurate but it is normally acceptable. Apart from that, another argument against this type of indicators is that the scope of it is fixed on residents of a country and not on non-residents (Kraay 1998, p5 and Quinn 1997, p535).
3.2.1.2 Quinn
In order to cope with that part, another indicator, which was constructed by Quinn (1997), is used. He developed this indicator by striving through the narrative descriptions of the AREAER and used coding rules to aggregate the information presented in Appendix A of the report. The results were two indicators. One for capital account transactions and one for current account ones. The first one is the one that is of special interest in our case. He calls it Capital, but in my paper, I will refer to it as Quinn. Liberalization is measured on scale from zero to 4 in 0.5 increments. The higher the value of this variable is the higher is the openness of a country’s capital account. The development of the value of Quinn in different groups of countries from 1958 to 1990 is displayed in Figure 1.
Like Share, it also belongs to the category of de jure measure. Compared to it, the information conveyed is more precise but still it is not able to register very small degrees of variation of the openness of the capital account. However, it is more accurate than Share. Another difference is that Share aggregates over a period of time whereas Quinn shows the level of openness at a point of time.
3.2.1.3 Code of Liberalization of Capital Movements
Klein and Olivei (2001) constructed another index (CLMI-Index), which only focuses on OECD countries. It uses the Code of Liberalization of Capital Movements (CLCM) as the source of information. Share and the CLCM-Index are similar to some extent, which is underlined by the fact of their high correlation of 0.86 (Edison et al. 2002, p230). It distinguishes between eleven categories[1], which address different types of international transactions. For each category, it is decided whether it can be considered as open. If open, it receives a value of one, otherwise zero. Klein et al. (2001) then calculate the average over time and aggregate the result into a single index. By this, a value that ranges from zero to one is mapped to each OECD country.
3.2.1.4 Intensity of Capital Controls
All indicators presented so far have one thing in common: They are binary. This makes them incapable to respond to very small changes concerning the openness of capital accounts.
Edison and Warnock (2001) took the bait to fill this lacuna. Their indicator is capable to show the degree of openness and its performance over time (months). It is calculated by subtracting the share of stocks available to foreigners from 1, which then delivers the intensity of capital controls. The source of information is the International Finance Corporation (IFC). To be precise, the IFC calculates two indices. They are the Global index (IFCG) and the Investable index (IFCI). The IFCG describes the total market capitalization of an emerging market country. The IFCI is the amount of market capitalization foreigners are able to hold. It aggregates the amount of shares that can be bought by foreigners and takes into account foreigners’ ability to bring the money they earned back to their home country, national law and company regulations. If dividends cannot be repatriated or high taxes on capital gains keep earnings in the country then the IFCI will shrink. The ratio illustration not visible in this excerptshows the percentage of assets foreigners can posses.
In comparison to other indices, which also (but not primarily) measure the degree of capital controls, it has several advantages. First, it is observed monthly whereas normally indices are adjusted annually. Moreover, it aggregates restrictions and quantitative factors. By doing this, a higher level of precision is at hand because instead of using a “yes-or-no” criterion, the degree and the gradual development of capital account openness is used. However, it is questionable in how far the market capitalization is capable to be representative to work as an indicator for capital controls. This in return undermines its explanatory power.
3.2.1.5 Correlation between Indicators
An interesting question is how these different indicators are correlated with each other. Since they all try to measure capital account liberalization, a positive correlation should be observed. Kraay (1998) analyzed the correlation between Quinn, Share and a measure based on data on actual capital inflows and outflows. His research shows that correlation is not very high, but ranges from 0.32 to 0.73. To be specific, among the three comparisons the correlation between the IMF measure and Quinn are the highest (0.73). The correlation between Quinn and the volume measure is 0.51 and the lowest is the correlation between the IMF measure and volume (0.32).
It is important to note that these indicators differ from each other in some instances so the low correlation is not such a big surprise. Considering this, it can be concluded that all indicators that were discussed are of certain value for regression analysis. None of them is dispensable since it contains different information.
3.2.2 Effectiveness of Capital Controls
How can capital controls be evaded in the real world? Mathieson and Rojas-Suárez (1993, p8ff) state that the most frequent ways are based on playing with the exchange rate of currencies. Examples for this are over- and underinvoicing or the usage of transfer pricing policies. Table 1 shows the development of capital controls from 1975 to 1990.
Magud et al. (2007, p7ff) tried to build an indicator that is capable of measuring this problem. In order to do that a review of more than 30 papers that studied the effectiveness of capital controls in different countries needed to be done. One of these indices is the Capital Controls Effective Index (CCE Index), the other one is the Weighted Capital Effectiveness Index (WCCE Index). In a first step, the authors check if capital controls were able to alter the amount of capital inflows, the dependency of monetary policy, the composition of flows and the real exchange rate pressure. Depending on whether a paper observed a positive change, no change or did not focus on an issue, the values 1;-1 or 0 were assigned for each specification. The four single results are then aggregated by averaging into the CCE Index. The WCCE Index in addition takes into account what methodology was used in the papers. They distinguish between descriptive papers which receive the value 0.1, papers which are based on more formal evaluation but lack formal hypothesis testing (0.5) and papers that use highly developed econometric techniques (1). Multiplication of the according value with the CCE Index delivers the WCEE Index. With these indices at hand, it is then possible to evaluate whether the objectives were achieved or not.
3.3 Timing
Another important question, which is related to measuring, is estimating the starting point of liberalization. If for example a country, which is completely isolated from the outside world, suddenly would change its policy in the blink of an eye determination would be quite easy. However, in reality such a case is rarely given.
Henry suggests three methods to solve this problem by having a look at stock market liberalization. Since enabling foreigners to access, a stock market is maybe the most controversial and important aspect of capital account liberalization, finding out the date of stock market liberalization might help to determine the date of capital account liberalization (Henry 2000, p533):
1. The first is way to look when the value of a predefined indicator of a country exceeds a certain threshold. In such a case, it would be regarded as “liberalized” or “non-liberalized”. The International Financial Statistic’s Investability index, for instance, would be an indicator that fulfils the requirements. If there is an extreme raise of it, it could be interpreted as a sign of liberalization.
2. The second is to take the implementation of a country fund as an indicator. The reason is that this step requires a government’s permission and since such permission is an indispensable constraint for liberalization, it could serve as reasonable evidence.
3. The third is to check if there was a change of policy that directly addresses capital account liberalization. However, it has to be kept in mind that it could also be the case of de jure and not de facto liberalization.
When a country suddenly experiences a change in one of the above-mentioned fields then it is possible to determine the date when liberalization began. Table 2 shows that a country fund and a change of policy are the main indicators for stock market liberalization. Revaluation of stocks was not the reason in the observed cases.
3.4 Composition of Inward Capital Flows
Additionally, it is important to mention that there exist different types of capital inflows. Gilbert et al. (2000) for example distinguish between three:
1. Foreign Direct Investment (FDI)
2. Portfolio Investment
3. Others like loans, aid flows and official funding
Let us have a look at these categories. FDI includes a long-term commitment and even in time of crises, it will normally not reverse, i.e. flows out (ibid. p6). This also explains why FDI usually, with a rate of 0.9, turns into fixed investment whereas, with 0.15, this rate is much lower for portfolio investment (Bosworth and Collins 1999, p162). Therefore, FDI can be regarded as a type of capital flow, which should be supported since, due to its small volatility, the risk that it will be affected by contagion, herd behavior or other market inefficiencies is lower than that of portfolio investment. To support this statement, Aghion et al. (2000) show that FDI does not have destabilizing effects on the economy of countries whereas the liberalization of foreign lending can lead to instability. Their theoretical model will be analyzed in 4.2.3. Moreover, FDI is a key to more advanced technology and can even improve human capital (Stiglitz 2000, p1076). Nevertheless, there are also voices that demand a more critical position towards FDI. Wood (2001, p5) for example states that it has to be distinguished between different types of FDI. Only if the beneficial types of FDI are supported, a stable improvement can be achieved. Those that flow into the primary sector, for instance, have lesser impact on growth than those that flow into the manufacturing sector (Kose et al. 2006, p28).
Portfolio investment is very volatile since it can be withdrawn very quick and easily. The short-term maturity and the connected high volatility of this kind of capital flow is one of the main reasons why the real effects of it are so unclear. Table 3 gives evidence about this. It can be seen that the standard deviation is higher for debt than for FDI.
Apart from that, it has to be distinguished between portfolio equity flows, which are more similar to FDI, and portfolio debt flows, which are the “black-sheep[s]” (ibid., p23) of capital flows. Because they can be reversed more easily, they have a higher volatility. Table 4 and Table 5 give an overview on the development of the composition of capital flows from 1980 - 2004. It can be seen that the share of FDI has increased over time.
4. Theory & Evidence: Capital Account Liberalization and …
In this part, I will discuss theoretical thoughts concerning the motivation of a country to liberalize its capital account. On the other hand, why keeping up or imposing capital controls could lead to benefits, will be analyzed too. Kraay (1998, p9) points out three main reasons why capital account should be beneficial to the economy of a country:
1. improved opportunities for risk diversification through international risk-sharing arrangements
2. more efficient global allocation of investment
3. greater discipline on domestic policymakers
The question now is, in how far capital account liberalization is able to support any of the three arguments. It will be seen that theorists disagree on this issue because capital account is also feared by some researchers and governments. As mentioned above, one of the greatest fears of countries that want to liberalize is becoming a pawn of the arbitrariness of financial markets. The risk of being victimized by a financial crisis is surely existent. However, can capital controls really protect a country from such a situation? Apart from that, it is one of the developing countries’ objectives to attract FDI. If more and more money is invested, the currency of a country will be pressured to appreciate. This in return will decrease the attractiveness of them as a place for investment. Therefore, the industry and the government also fear appreciation.
Another fear governments have is loosing monetary autonomy. When the capital account is open then it is impossible to have fixed exchange rate and monetary policy (Magud et al. 2007, p3ff).
In this chapter, empirical evidence will be presented that led to the invention, corroboration or falsification of models. It will be more specific about the special effects liberalization has on different macroeconomic variables.
There is one issue that the reader must not forget when reading this section: Since capital account liberalization normally is, or at least should be, accompanied by other reforms it is difficult to determine whether the observed effects arose due to liberalization solely or were precipitated by other reforms. Moreover, one might imagine that countries tend to liberalize when global economy is prospering. Therefore, there is an endogeneity problem. Did the economic situation improve due to liberalization, or vice versa?
4.1 The post-Keynesian Perspective
This section will discuss the effects of financial liberalization from the Keynesian point of view. Although capital account liberalization will not be addressed directly, some of the issues connected with financial liberalization can arise too when the capital account is liberalized. Many of the problems that will be addressed here will be found in the specific sub-sections in the upcoming part of this thesis. According to Grabel (1995), post-Keynesians assume that uncertainty between borrowers and lenders of financial markets is distributed equally. In the new-Keynesian theory, borrowers have more information about the projects they want to invest in and lenders know less about them. In such a case it will come to the problem of ‘adverse selection’, similar to the one that exists in Akerlof’s “Market for Lemons”. This problem is even more severe when it comes to capital account liberalization since the lenders are not familiar with the market and must rely on the information that is presented to them from the liberalizing country. Language difficulties and cultural difference make it even more difficult to cope with these problems. As a reaction to this, lenders will set a fixed rate of return. All borrowers with projects that can perform better than this rate of return will be willing and able to pay the lenders. On the other hand, all projects whose performance is not so good will not be financed. By this, the credit is rationed to the good projects. If the rate of return is set too high then the amount of projects that will be executed will be too low and welfare will not reach its optimum. If it is too low, then some maybe welfare decreasing projects will be carried out. By implementing these concepts of adverse selection and credit rationing into a post-Keynesian model, Grabel (1995, p134ff) examines the effects of financial liberalization on the lender’s and borrower’s side under the new scenario. The financial liberalization program consists of:
1. An increase in real deposit and loan interest to their free market level
2. The deregulation of existing financial institutions
3. The dismantling of channels of governmental influence over credit allocation
4. The creation of new types of privately-owned financial institutions, instruments, and markets
As we will see later, some theorists argue that capital account liberalization can have disciplinary effects on the institutions of a country. The just mentioned measures are some of the effects that are considered to have positive impact. Analyzing them can help to balance the arguments of supporters.
Grabel then analyzes the effects. As a first result, the composition of the investments that are carried out will change. Due to the increase of interest rates that will occur after liberalization, projects with low risk and low return will not be considered anymore. Instead, riskier projects with a higher return are needed to pay back the interest fees. Moreover, the introduction of new financial instruments will foster short-term speculation. This will expose the market to risks like herd-behavior or contagion. The important point is that the new opportunity of short-term financing will lead to an increase of risky projects with high return. The lenders will anticipate this change and due to their new expectations, the credit rationing that occurs after financial liberalization will become dynamic and adapt to the new environment. During that time, there is high demand and supply of capital. If the bubble bursts, the supply will decrease sharply and the credit will be rationed. One of the main results is that financial liberalization will lead to an increase of risk and a country will become more vulnerable to macroeconomic shocks. The problem of decrease of more prudent projects, which means low-risk and low-return projects, will be especially severe when the economy busts. This is because the decision not to finance such projects erodes the long-term economic growth of a country. Such a development can also happen when the capital account is liberalized. In such a scenario the situation can get even worse because the lenders are foreigners who are not so familiar with the market.
4.2 Allocative Efficiency
One of the most cited reasons for liberalization of the capital account is the Allocative Efficiency argument (e.g. Fischer 1998, p2). To put it in a nutshell, if money could be invested in every part of the world without restrictions and transaction fees it would go there where the highest return would be generated. Investors could diversify their portfolios in such a way that they receive the highest rate of return for their specific risk preference. However, this must not necessarily lead to greater stability. Due to the instability of capital markets, a country that liberalizes would be exposed to the volatility of financial markets. In autarky, the cost of equity capital depends on the volatility of the local market. If a country liberalizes, then the cost of capital will decrease normally (Henry 2003, p7). The degree of the decrease is higher, the more diversification potential the local market has.
This argument therefore predicts a raise of market value of capital due to liberalization. If true then a revaluation of equity prices and a fall of cost of capital should be observed.
4.2.1 Revaluation of Stock Prices
Let us take a closer look at this revaluation issue. An empirical study by Henry (2000) scrutinizes the impact of stock market liberalization on revaluation of stock prices. It can be seen that there is a significant revaluation of stock prices during the months that precede the date of liberalization and on the month of liberalization itself. The aggregate appreciation rate is about 38% during that timeframe. If the regression is adjusted, in the sense that other policy changes or macroeconomic factors that could also influence the evaluation are left out, then the rate falls to 26% but is still significant (Henry 2000, p545ff). It has to be criticized that there still is an endogeneity problem concerning the question whether stock prices appreciate in anticipation of liberalization, or liberalization takes place due to rising prices. It is hard to imagine that a country would liberalize when the economy is running bad.
Apart from that, the view is focused on the first liberalization a country initiates. Normally, a full liberalization consists of several partial liberalizations.
Another problem with this approach is that it only tells us that there was a reallocation of capital. It does not examine whether it was efficient or not. It would be more efficient if a higher degree of risk sharing were achieved. However, research by Tesar (1995) shows that the gains from international risk sharing are less than two percent of lifetime income.
4.2.2 The Allocation Puzzle
More astounding facts, which concerns the Allocative efficiency of capital flows into emerging market countries that liberalized their capital account, are the relationships between the ratiosillustration not visible in this excerpt, illustration not visible in this excerpt and productivity growth. Gourinchas and Jeanne (2007) were the ones who analyzed the relationships and found a paradox correlation.
The following thoughts refer to the correlation of these indicators in emerging market countries. When a lot of GDP is used for investment then there should be a high amount of capital inflow into a country if that country has an open capital account. If we take a step back, theory predicts that a country, which moves towards the international technological frontier, should experience a capital inflow, and vice versa. What we expect is a positive correlation between inflows and productivity growth as it is predicted in Figure 2. However, the actual relationship can be found in Figure 3. As we can see, theory and reality go different ways. This suggest that an open capital account must not necessarily lead to a more efficient allocation of capital.
The paradoxical behavior they have found so far is also observable for another relationship. In general, a high investment rate normally leads to a high rate of productivity growth. Again, a positive correlation between productivity growth and capital inflow per GDP should be observed. However, as we have seen from the facts stated above, the reader might expect a reaction that contradicts theory. And indeed, there is a negative correlation.
The questions that arise immediately are: Why is the amount of foreign debt (capital inflow) in developing countries that have high investment rates and high growths of productivity relatively lower than in developing countries that disinvest or invest at a very low rate? Does capital account liberalization really lead to a better allocation of capital among emerging market countries?
Before an immediate approach to solve the problem is given, Gourinchas and Jeanne first disaggregate the capital inflows into separate types in order to scrutinize whether all those types contradict theory or not. The observed public and private capital flows relative to GDP for instance show paradoxical behavior whereas FDI inflows follow theory. Moreover, countries that should have a high inflow of capital (prosperous countries) tend to accumulate huge amounts of foreign reserves (ibid,. p20). However, first it is useful to look at the predictions of theory. I will do this by describing the model. The explanation for the variables and formulas of this and all upcoming models can be found in the appendix.
[...]
[1] The categories are: direct investment, liquidation of direct investment, admission of securities to capital markets, buying and selling of securities, buying and selling of collected investment securities, operations in real estate, financial credits and loans, and personal capital movements.
- Quote paper
- Dipl.-Kfm. Christoph Yew (Author), 2008, Capital Account Liberalization, Munich, GRIN Verlag, https://www.grin.com/document/119837
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