a pragmatic approach to a pragmatic approach to capital ... · capital account...

A Pragmatic Approach to A Pragmatic Approach to Capital Account LiberalizationCapital Account Liberalization

Eswar PrasadCornell University

Presentation partly based on my joint work with:

• Ayhan Kose, Kenneth Rogoff, Shang-Jin Wei (2003, 2006)

• Raghuram Rajan (2005, 2008)

• Raghuram Rajan and Arvind Subramanian (2007)

Benefits of Financial Integration: Theory

Efficient international allocation of capital

Consumption smoothing via international risk sharing

Large welfare effects for developing economies

Figure 4. GDP (per capita, PPP weighted): 1970-2004

100

150

200

250

300

350

1970 1975 1980 1985 1990 1995 2000

Advanced Economies

Emerging Markets

Emerging (excluding China and India)

Other Developing Economies

Figure 5B. Change in Financial Openness and GDP Growth, 1985-2004Unconditional Relationship

FJIZMB

TUN

TGO

TZA

SEN

ZWE

NER

MUS

MWIKEN

GHA

CMR

DZA

THA

PHL

PAK NPL

MYS

KOR

IDNIND

LKA

BGDEGYISRIRN TTO

JAM

VEN

URY

PER

PRY

MEXHND

GTMSLV

ECU

DOMCRI

COL

CHL

BRABOL ARG

ZAF

NZL

AUSTURESP PRT

GRC FINJPNCAN SWE

NOR

ITA DEU FRADNKAUTUSA

-0.02

-0.01

0

0.01

0.02

0.03

0.04

0.05

0.06

-150 -50 50 150 250 350 450

Change in financial openness

Gro

wth

rate

of p

er c

apita

GD

P

Figure 5B. Change in Financial Openness and GDP Growth, 1985-2004Conditional Relationship

USA

AUTDNK FRADEUITA NOR SWECAN

JPN

FINGRCPRTESP

TUR AUS

NZL

ZAFARG

BOLBRA

CHL

COL

CRI DOM

ECU

SLVGTM

HNDMEXPRY

PER

URY

VEN

JAM

TTO

IRN

ISR

EGY

BGDLKA

IND

IDN

KORMYS

NPL

PAK

PHL

THA

DZACMR

GHA

KEN

MWI

MUS

NER

ZWE

SENTZA

TGO

TUN

ZMB

FJI

-0.03

-0.02

-0.01

0

0.01

0.02

0.03

0.04

0.05

0.06

-150 -50 50 150 250 350 450

Change in financial openness

Gro

wth

rate

of p

er c

apita

GD

P

Growth Benefits of Financial Integration: Evidence

About 25 studies of growth effects

No effect: 4Mixed: 18Positive: 3

No robust macroeconomic evidence of growth benefits

Correlation between Growth and Current Account BalancesNon-industrial Countries, 1970-2004

DZA

ARG

BGD

BOL

BRA

CMR

CHL

CHN

COLCRI

CYP

CIV

DOM

ECU

EGY

SLV

ETH

GHA

GTM HTIHND

IND

IDN

IRN

ISR

JAM

JORKEN

KOR

MDG

MWI

MYS

MLI

MUS

MEXMAR

NGA

PAKPAN

PRY

PER

PHLRWA

SEN

SLE

ZAF

LKA

TZA

THA

TTO

TUN

TUR

UGA

URY

VENZMBZWE

-20

24

68

Per

cap

ita G

DP

grow

th

-10 -5 0 5Average current account balance to gdp

Why Doesn’t Foreign Capital Boost Growth?

1. Domestic financial system cannot effectively intermediate foreign capital

Above Median

Below Median

Below Median

Above Median

0.00

1.00

2.00

3.00

Ave

rage

Per

Cap

ita G

DP

Gro

wth

Investment/GDP

Current Account/GDP

Figure 6. Current Accounts, Investment and Growth in Developing Countries

Why Doesn’t Foreign Capital Boost Growth?

2. Foreign capital leads to exchange rate appreciation (overvaluation)

=> Lower exports, returns to investment, and overall growth

Foreign Capital and Overvaluation, 1970-2004

KOR

IRN

BGD

IND

ETHDZAZAF

MUS

GUY

TUR

URY

LKAZWE

ISR

MDG

HTI

MWIKEN

PAKIDN

CMR

SLVRWA

PRY

COL

VEN

SEN

ARG

MAR

BRA

JOR

GHA

PHL

CIV

MLI

GTMECU

UGA

THA

CHLHNDDOMPEREGY

CHN

TZA

JAM

TUN

CRI

MEX

CYP

NGA

SLE

ZMB

TTO

BOLMYS

PAN

-50

050

100

Res

idua

ls o

f ave

rage

ove

rval

uatio

n

-.02 -.01 0 .01 .02 .03Residuals of average net fdi flows to GDP

coef = 837.49992, (robust) se = 363.32526, t = 2.31

Financial Integration and Volatility: Evidence

Capital mobility does not increase probability of crises

Banking crises are most disruptive and occur frequently in closed economies

No evidence that financial integration by itself is proximate determinant of financial crises

But Two Issues on Volatility

Relative volatility of consumption growth increases at low and intermediate levels of integration

Developing economies, including emerging markets, have not attained better risk sharing

Other Ways of Looking at the Data

Effects of different types of private capital flows:

> Equity flows> FDI> Debt

Macroeconomic vs. microeconomic evidence

Summary of New Evidence

Equity market liberalization seems to work

FDI benefits becoming more apparent

Benefits more evident in micro data

More risk-sharing benefits from FDI, portfolio equity flows; debt not good for risk-sharing

The Traditional View

Financial Globalization

More efficient international allocation of capital

Capital deepening

International risk-sharing

GDP growth

Consumption volatility

A Different Perspective

Traditional Channels

Potential Collateral Benefits

Financial market developmentInstitutional development

Better governanceMacroeconomic discipline


GDP / TFP Growth

Consumption volatility

FG and Financial Development

Foreign ownership of banks improves efficiency of domestic banking system

Inflows add to depth of equity markets

Financial sector FDI has benefits

Figure 6A. Financial Openness and Financial Development: 1985-2004Private Credit/ GDP

PNG

FJI

ZMB

TUN

TGO

TZA

SENZWE

NER

MUS

MWI

KEN

GHA

CMRDZA

THA

PHLPAK

NPL

MYS

KOR

IDNIND

LKABGD

EGY

ISR

IRN

TTO

JAMVEN

URY

PERPRYMEXHND

GTM

SLV

ECUDOM CRICOL

CHL

BRABOL

ARG

ZAF

NZL

AUS

TUR

ESPPRT

GRC

FIN

JPN

CANSWE

NORITA

DEU

FRA

DNK

AUT

USA

0

0.2

0.4

0.6

0.8

1

1.2

0 50 100 150 200 250 300Mean financial openness

Priv

ate

Cre

dit/

GD

P

Figure 6A. Financial Openness and Financial Development: 1985-2004Stock Market Capitalization/ GDP

USA

AUT

DNKFRA

DEUITA NOR

SWECANJPN

FIN

GRCPRT

ESP

TUR

AUS

NZL

ZAF

ARG

BOL

BRA

CHL

COL CRI ECUSLV

GTMHND

MEX

PRY

PER

URYVEN

JAMTTO

IRN

ISR

EGY

BGDLKA

INDIDN

KOR

MYS

NPLPAK

PHLTHA

GHAKENMWI

MUSZWE

TZATUN ZMBFJI

CHN

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6


Stoc

k M

arke

t Cap

italiz

atio

n/ G

DP

.

FG and Quality of Institutions, Governance

Openness to foreign capital provides incentives for improving corporate governance

Corruption, lack of transparency discourage FDI, portfolio flows =>incentives for improving public governance

Figure 6B. Financial Openness and Quality of Institutions: 1985-2004Institutional Quality

CHNPNG

FJI

ZMB

TUN

TGO

TZASEN

ZWE

NER

MUS

MWI

KEN

GHA

CMRDZA

THA

PHL

PAKNPL

MYSKOR

IDN

INDLKA

BGD

EGY

ISR

IRN

TTO

JAM

VEN

URY

PER

PRY

MEX

HNDGTM

SLV

ECU

DOM

CRI

COL

CHL

BRABOL

ARG

ZAF

NZLAUS

TUR

ESP PRT

GRC

FIN

JPN

CAN SWENOR

ITA

DEU

FRA

DNKAUT

USA

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

0 50 100 150 200 250 300

Mean financial openness

Inst

itutio

nal Q

ualit

y .

Figure 6B. Financial Openness and Quality of Institutions: 1985-2004Control of Corruption

CHN

PNG

FJI

ZMB

TUN

TGOTZA

SEN

ZWE NER

MUS

MWI

KEN

GHA

CMR

DZATHA

PHL

PAK

NPL

MYSKOR

IDN

IND LKA

BGD

EGY

ISR

IRN

TTO

JAM

VEN

URY

PER

PRY

MEX

HNDGTM

SLV

ECU

DOM

CRI

COL

CHL

BRA

BOL

ARG

ZAF

NZL

AUS

TUR

ESP PRT

GRC

FIN

JPN

CANSWE

NOR

ITA

DEU

FRA

DNK

AUTUSA

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

3


Con

trol o

f Cor

rupt

ion

FG and Macroeconomic Policy Discipline

Capital account liberalization as commitment device

Even Stiglitz is on board!

Sadly, limited evidence

Complication: Threshold Effects

Threshold ConditionsFinancial market development

Institutional Quality, GovernanceMacroeconomic policies

Trade integration


GDP / TFP growth

Risks of Crises

GDP / TFP growth

Risks of Crises

Above Thresholds

Below Thresholds

X?

Why Do Thresholds Matter?

Financial Market Development- Allocates financial flows efficiently- Enhances macroeconomic stability

Institutional Quality- Affects the volume and stability of financial flows- Shifts the composition of flows towards FDI and equity

Trade Openness - Makes less vulnerable to sudden stops- Mitigates the adverse effects of financial crises

TENSION !!

Financial integration can catalyze financial development, improve governance, impose discipline on macro policies...

But, in the absence of a basic pre-existing level of these supporting conditions, financial integration can wreak havoc

Collateral Benefits Framework May Help Make Progress

Unified conceptual framework

Country-specific requirements, initial conditions can be taken into account

Selective approach to liberalization based on prioritization of collateral benefits

Can manage risks during transition to thresholds, but can not eliminate them

Has the Benefit-Cost Tradeoff Improved?

Composition of inflows and stocks of external liabilities has become more favorable

International Financial Integration:Distribution of Gross Inflows(% of Total)

Emerging Markets

0

20

40

60

80

100

FDI Equity Debt

80-84 90-94 00-04



High levels of foreign exchange reserves

Foreign Exchange Reserves Held by Non-industrial Economies(in trillions of US dollars)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1980 1985 1990 1995 2000 2005

All Non-industrial Economies

All Non-industrial Economiesexcluding China

Foreign Exchange Reserves Held by Non-industrial Economies(as percent of nominal GDP)

0

5

10

15

20

25

30

1980 1985 1990 1995 2000 2005

All Non-industrial Economies

All Non-industrial Economiesexcluding China




Greater exchange rate flexibility, with inflation targeting

Rising trade openness

Trade Openness(the sum of imports and exports as a ratio to GDP, in 2000 constant prices)

Emerging Markets

20

30

40

50

60

70

80

90

100

1980 1985 1990 1995 2000

25th PercentileMedian75th Percentile




Greater exchange rate flexibility, with inflation targeting

Rising trade openness

New players, new instruments have made international financial markets deeper and more efficient

But …

Many developing economies still below threshold levels of financial, institutional development

Still de facto fixed or tightly-managed exchange rates

Real exchange rate appreciations hurts poor and undeveloped economies

Herding behavior of unregulated investors such as hedge funds + risks in system harder to trace

CAL: The Reality on the Ground

• Capital account becoming de facto more open

• De jure controls increasingly ineffective as channels for capital to flow in and out expand

Rising trade flows

Increasing sophistication of international and domestic investors

Other aspects of financial globalization

Implications of Rising Financial Openness

• Controls not very effective, especially beyond short horizons

• Controls on inflows have large distortionary costs

• Government constantly playing catch-up, which makes policy environment unpredictable

• Maintaining de jure controls despite rising de facto openness => economy has to deal with complications of open capital account but doesn’t get full indirect benefits

Dealing with the Reality of CAL• Key problem is mismatch between level of de facto openness and other policy settings

• Synchronize other policies to deal with open capital account:

monetary policy that can respond nimbly to shocks and focus on domestic objectives

well regulated and supervised financial marketsbroadening of financial markets to reduce effects

of capital flow and exchange rate volatilityfiscal disciplinetrade openness

Pragmatic Approach to CAL

• Manage rather than resist CAL (latter futile in any case)

• Opportunistically liberalizing outflows makes sense in present circumstances

• But need to remove fetters on financial markets to promote vehicles for international portfolio diversification

• Increasing de jure openness can generate positive spillovers for financial market development--e.g., removing restrictions on participation of foreign investors in domestic bond markets

• Level of reserves makes CAL safer (but not riskless)

Complications from an Open Capital Account

• Monetary policy has to cope with domestic liquidity consequences of capital inflows

• Exchange rate management harder, both in terms of level and volatility

• Risks to financial system (if underdeveloped and/or weakly supervised) -- inflows could feed into asset price bubbles

• Regulatory and supervisory capacity may not be sufficient to keep up with foreign firms and financial innovations that they introduce (transitional risks)

Implications for Macro Policies

• Policy objective of tightly managed exchange rate could be counterproductive if capital account is de facto open

• Rising sterilization costs make exchange rate objective untenable

• Monetary stability essential to deal with volatile inflows

• Need a new nominal anchor to take place of exchange rate objective and to manage inflation expectations

• Reducing fiscal deficits and level of government debt is key medium-term objective, esp. to support monetary policy

Implications for Financial Market Regulation

• Financial market regulation must adapt to allow broad range of markets (e.g., currency derivatives) to develop and deepen

• This would provide a buffer against external shocks, and take some of the pressure off monetary policy as a short-term stabilization tool

Broader Policy MessagesFinancial integration can support and catalyze other reforms, especially financial development

Best to actively manage the process of capital account liberalization rather than fight the inevitable

Seize windows of opportunity when benefit-risk tradeoff improves; but coast is never completely clear.

Capital account liberalization not an end in itself; needs to be put in the context of a more completepolicy/reform agenda

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