Liberalizing Capital Movements: Some Analytical Issues
Barry Eichengreen
The explosive growth of international financial transactions and capital flows is one
of the most far-reaching economic developments of the late twentieth century. Net private
capital flows to developing countries tripled—to more than $150 billion a year during
1995–97 from roughly $50 billion a year during 1987–89. At the same time, the
ratio of private capital flows to domestic investment in developing countries increased to
20 percent in 1996 from only 3 percent in 1990.
Powerful forces have driven the rapid growth of international capital flows, including
the trend in both industrial and developing countries toward economic liberalization and
the globalization of trade. Revolutionary changes in information and communications
technologies have transformed the financial services industry worldwide. Computer links
enable investors to access information on asset prices at minimal cost on a real-time
basis, while increased computing power enables them to rapidly calculate correlations
among asset prices and between asset prices and other variables. At the same time, new
technologies make it increasingly difficult for governments to control either inward or
outward international capital flows when they wish to do so.
All this means that the liberalization of capital markets—and, with it, likely
increases in the volume and the volatility of international capital flows—is an
ongoing and, to some extent, irreversible process. It has contributed to higher
investment, faster growth, and rising living standards in many countries. But financial
liberalization—both domestic and international—has also been associated with
costly financial crises in several cases. This underscores that liberalization carries
risks as well as benefits and has major implications for the policies that governments
will find it feasible and desirable to follow.
This paper addresses the potential gains and risks of open capital markets by first
looking at what classical economic theory suggests about the benefits of capital mobility
and then examining the counterarguments arising from problems of incomplete information
and other distortions. It shows that the risks of removing controls on flows of capital
across national borders are similar to those associated with removing controls on domestic
financial institutions. The paper then explores how to manage liberalization to minimize
the risks and maximize the benefits.
What Theory Says
The Classic Case for Capital Mobility
The flows of capital—debt, portfolio equity, and direct and real estate
investment—between one country and others are recorded in the capital account of its
balance of payments. Outflows include residents’ purchases of foreign assets and
repayment of foreign loans; inflows include foreigners’ investments in home-country
financial markets and property and loans to home-country residents. Freeing transactions
like these from restrictions—that is, allowing capital to flow freely in or out of a
country without controls or restrictions—is known as capital account liberalization.
Classic economic theory argues that international capital mobility allows countries
with limited savings to attract financing for productive domestic investment projects,
that it enables investors to diversify their portfolios, that it spreads investment risk
more broadly, and that it promotes intertemporal trade—the trading of goods today for
goods in the future. More specifically:
 | Capital mobility means that households, firms, or even countries can smooth consumption
by borrowing money from abroad when incomes are low in the home country and repaying when
incomes are high. The ability to borrow abroad can thus dampen business cycles by allowing
households and firms to continue buying and investing when domestic production and incomes
have fallen. |
| By lending money abroad, households and firms can reduce their vulnerability to domestic
economic disturbances. Companies can protect themselves against sudden cost increases in
the home country, for example, by investing in branch plants in several countries. Capital
mobility thus enables investors to achieve higher risk-adjusted rates of return. In turn,
higher rates of return can encourage saving and investment that deliver faster economic
growth. |
Information Problems and Their Implications
At the theoretical level, the controversy over the benefits of financial liberalization
reflects diverging views on whether free capital movements can deliver an efficient
allocation of resources. Critics of the "efficient markets" view argue that
liberalized financial markets are so distorted by incomplete information and other
problems that transactions often yield outcomes harmful to the general welfare. They point
out that information in financial markets is pervasively "asymmetric"—that
is, one party to the financial transaction (such as a loan officer) has less information
about it than the other party (perhaps a borrower with a high tolerance for risk-taking).
Such information gaps give rise to several problems—known in the academic literature
as adverse selection, moral hazard, and herding (see Box)—that plague financial
markets in particular. At a minimum, they say, such asymmetries can lead to
inefficiencies; in the extreme, they can lead to costly financial crises.
A chief concern here is moral hazard—the risk that investors will expect
governments to bail them out—created by government guarantees for financial
institutions in the absence of adequate safeguards or sufficient incentives for market
discipline to police excessive risk-taking. Important, too, are concerns about herding
behavior that can lead to sharp investor reactions, unpredictable market movements, and
even financial crises.
Is, then, the theoretical presumption that market liberalization enhances the
efficiency of resource allocation correct? A more accurate statement is that international
financial liberalization, like domestic liberalization, unambiguously improves efficiency
only when accompanied by policies to limit moral hazard, adverse selection, herding
behavior, and related problems, and to contain their potentially damaging consequences. As
discussed later, these policies include prudential supervision and regulation combined
with careful design of a lender-of-last-resort facility to limit the scope for financial
market participants to take on too much risk and to contain potentially systemic
disturbances. In addition, every effort must be made to encourage world-class standards
for accounting, auditing, and information disclosure, which facilitate sound rules of
corporate governance and protect investors and lenders from fraud and unfair practices.
| Lemons, Herds, and Other Problems of Asymmetric
Information Information is "asymmetric" when one party to an economic
relationship or transaction has less information about it than the other party or parties.
While asymmetric information characterizes many markets (such as that for used cars, where
sellers know which cars are "lemons"), some economists believe it particularly
pervades financial markets. Three problems in particular—called adverse selection,
moral hazard, and herding behavior—have been associated with asymmetric information.
Each has the potential to lead to inefficient and unstable financial markets.
Adverse selection. In financial markets, lenders frequently have
incomplete knowledge of the creditworthiness—or quality—of borrowers. Given that
lenders cannot fully evaluate the creditworthiness of each borrower, they will be willing
to pay a price for a security (that is, lend money at an interest rate) that reflects only
the average quality of firms (or borrowers) issuing securities. That price is likely to be
less than the fair market value for high-quality firms but more than fair market value for
low-quality firms. Because the managers of high-quality firms know that their securities
are undervalued (or, their borrowing costs are excessive), they will avoid borrowing on
the market. Only low-quality firms will wish to sell securities. Since high-quality firms
will issue few securities, many projects that would have generated profits will not be
undertaken. At the same time, the less successful or even loss-making projects of
low-quality firms will be financed—an inefficient outcome.
Moral hazard. This occurs when one party to a transaction has both the
incentive and the ability to shift costs onto the other party. For example, homeowners
with fire insurance may be less careful than the uninsured about smoking in their homes,
knowing the cost of their carelessness is shifted to the fire department, the insurance
company, and, indirectly, other purchasers of fire insurance. In financial markets, when
information is asymmetric, a creditor may not be able to observe whether a borrower will
invest in a risky project or a safe project, and, if the borrower is protected by limited
liability or guarantees of some sort, too much investment in risky projects will result.
An extreme case of moral hazard occurs when companies or banks with negative net worth
borrow to gamble for redemption—that is, invest in ventures with a high
potential payoff (and thus potential rescue from bankruptcy) but a low probability of
success. Over time, lenders will become more reluctant to make loans, and the quantity of
money being invested will be less than the amount that makes sense from an economic
standpoint.
Herding behavior. Lenders may try to follow the lead of someone they
believe to be better informed about, say, the probability a certain bank will fail.
Herding behavior can also occur when investors lack information about the quality of those
who manage their funds. Low-quality money managers will find it rational to emulate the
investment decisions of other managers in order not to be found out. And herding can make
sense when the payoff to an agent adopting an action increases because many other agents
adopt the same action. For example, individual currency traders may be too small to
exhaust a central bank’s reserves and force a currency devaluation, but simultaneous
sales by several traders can bring about such a devaluation, thus rewarding the first
agent’s decision to sell the currency. It is easy to see that in the presence of
asymmetric or incomplete information, investors will quite rationally take actions that
can amplify price movements and precipitate sudden crises. |
Capital Account Liberalization and Crises
Economic theory aside, experience has demonstrated that liberalizing the capital
account before the home-country financial system has been strengthened can contribute to
serious economic problems. In particular, domestic and international financial
liberalization heighten the risk of crises if not supported by robust prudential
supervision and regulation (and appropriate macroeconomic policies). Domestic
liberalization, by intensifying competition in the financial sector, removes a cushion
protecting intermediaries from the consequences of bad loan and management practices. It
can allow home banks to expand risky activities at rates that far exceed their capacity to
manage them and permit home banks with negative net worth to use expensive funding to
"gamble for redemption" (see Box). By granting home banks access to complex
derivative financial instruments, it can make evaluating bank balance sheets more
difficult and stretch the capacity of regulators to monitor risks.
External financial liberalization can magnify the effects of inadequate policies. By
allowing the entry of foreign banks, external liberalization, like its domestic
counterpart, can squeeze margins and remove home banks’ cushion against loan losses.
Like domestic financial liberalization, it can facilitate gambling for redemption, in this
case by offering access to an abundant supply of offshore funding and risky foreign
investments. A currency crisis or unexpected devaluation can undermine the solvency of
banks and bank customers who, under lax regulation, have built up large liabilities
denominated in foreign currency and are unprotected against foreign exchange rate changes.
Moreover, capital account liberalization, which increases the potential for sudden
reversals of capital inflows, can force the national authorities to hike interest rates
even more dramatically to defend a currency peg under attack, something they may be loath
to do when the banking system is already fragile. Thus, external financial liberalization
increases the scope for lack of confidence in the banking system and in the currency peg
to feed on one another in a vicious spiral.
Recognizing these possibilities, the IMF’s policy-setting committee—the
Interim Committee—and subsequently the finance ministers and central bank governors
of the Group of Seven industrial nations, in the fall of 1998, stressed that a country
opening its capital account must do so in an orderly, gradual, and well-sequenced manner.
These are ongoing issues, but two points about these dangers require emphasis:
The mechanisms through which internal and external financial liberalization can
expose threats to financial stability are largely the same.
As an inevitable—and desirable—consequence of improving financial and
economic efficiency, both internal and external liberalization tend to squeeze margins and
leave less leeway for poor loan and management practices. Both give banks and other
intermediaries opportunities to profit by carefully assessing and prudently managing risky
investments. But both also widen the opening for imprudent or improper exploitation of
those expanded opportunities. There is nothing unique or different about external
financial liberalization in this regard.
It is not financial liberalization that is at the root of the problem but
rather weak management in the financial sector and inadequate prudential supervision and
regulation, whose consequences are magnified by liberalization.
Systemic Policy Issues
In an ideal world, those who invest would bear the risk associated with that
investment. Banks and other financial market participants would be prudent in their
investment choices and forced by their shareholders and clients to adopt best-practice
accounting, auditing, and disclosure standards. In the real world, where techniques of
risk management are not always well developed, auditing and accounting practices leave
much to be desired, and other distortions interfere with banks’ ability to manage
risk, prudential regulation has an especially important role.
Prudential regulation seeks to (1) reinforce private incentives for banks (and other
participants in financial markets) to recognize the risks they are taking, and (2) enable
the authorities to monitor potential threats to systemic stability so they can take
corrective measures if needed. Prudential regulation falls short when it allows financial
institutions to expand risky activities faster than their capacity to manage them, allows
banks and bank customers to build up dangerous unhedged exposures, or allows distressed
banks to gamble for redemption. (In some cases, measures to address financial and
organizational restructuring of major banks may also be needed to remove the incentive to
gamble for redemption.) Appropriate prudential regulation, by contrast, encourages banks
to put aside reserves that many be needed when events suddenly interrupt their access to
foreign funding (including external events such as a change in world interest rates, for
example, or a crisis in a neighboring country).
A century or more of historical experience points to the need, in most countries, for
central banks to provide lender-of-last-resort services to prevent illiquid financial
markets from seizing up in periods of general distress. This backstopping function, though
essential, is also a source of some moral hazard. The appropriate response for national
authorities is rigorous prudential supervision and regulation combined with careful design
of the lender-of-last-resort facility.
At the international level, policymakers must also address what should be done on the
side of the suppliers of capital flows. Recent efforts to improve data on flows of
international credit from (and through) major capital markets to emerging market countries
should help alert both lenders and borrowers to excessive concentrations of debt,
especially short-term debt. In addition, if banks were more accurate in assessing the
riskiness of their interbank lending, in particular their loans in emerging markets, they
might be more conservative in setting limits to such lending, thus reducing the potential
contagion effects of a financial crisis in one of those countries.
Research and experience confirm that sound macroeconomic policies are also key to
successful liberalization. They help prevent the buildup of destabilizing imbalances in
financial markets, as well as offset the damaging effects of financial crises as the herd
stampedes to the downside. Prudent fiscal policy that prevents the ballooning of large
deficits will avoid the temptation to rely on foreign loans that might create
debt-management problems, reduce creditworthiness, or weaken an economy’s ability to
manage external shocks. Monetary policy can be used to counteract disorderly markets
(e.g., by raising interest rates temporarily, capital flight can be reversed), and fiscal
and monetary policy can be used to ameliorate economic contraction in a downturn (monetary
and fiscal expansion can raise output and employment and can be used to counteract the
effects of temporary disturbances).
Sequencing Matters
The sequencing of capital account liberalization is an important but complicated issue.
Countries vary greatly: in their levels of economic and financial development, in their
institutional structures, in their legal systems and business practices, and in their
capacity to manage change in a host of areas relevant for financial liberalization.
Accordingly, there is no cookbook recipe for the sequence of steps to follow and no
general guideline for how long the process should take.
Presumably, a country with a fully liberalized domestic financial system that had
firmly put in place the safeguards necessary to ensure its successful operation could
proceed almost immediately and with confidence to full capital account liberalization.
This advice, however, generally applies to countries (mainly the industrial countries)
that already have quite liberal policies toward international capital.
Alternatively, maintaining tight restrictions on virtually all forms of international
financial flows until the domestic financial system is fully and successfully liberalized
is generally not advisable. International and domestic liberalization can reinforce one
another and can benefit from parallel development. In countries where entrenched interests
and policy inertia inhibit reform, external pressures created by the opening of capital
markets can provide the needed impetus.
Where domestic preparations are well advanced, essentially full international
liberalization should be able to proceed relatively rapidly, perhaps within a decade or so
for the more advanced emerging markets. Where the essential infrastructure for a liberal
and stable financial system is not well developed, full liberalization, both domestic and
international, will generally require more time.
On sequencing, a few general principles are worth noting:
| Although direct foreign investment sometimes raises concerns about foreign ownership and
control, such investment can bring considerable benefits, including technology transfers
and more efficient business practices. Also, because foreign direct investment flows are
less prone to sudden reversals in a panic than bank loans and debt financing, they do not
generate the same acute problems of financial crises as do sharp reversals of debt flows.
Thus, liberalizing inward direct investment should generally be an attractive component of
a broader program of liberalization. |
| It is usually a mistake to liberalize the domestic banking system or to open it fully to
inflows if important parts of the system are insolvent or likely to be pushed into
insolvency by liberalization. As a general rule, nonviable institutions should be weeded
out and remaining banks put on a sound footing before liberalizing or opening the domestic
banking system. |
| Because banking systems play a central role in the financial affairs of most emerging
market countries, capital flows to and through the domestic banking system are already
significantly liberalized in many of these countries. Reversing this situation by going
back to detailed restrictions on capital flows through domestic banks hardly seems
sensible. But the fact that capital inflows are already a reality only highlights the
danger of removing most restrictions on capital account transactions too quickly, before
major problems in the domestic financial system have been addressed. Inadequate
accounting, auditing, and disclosure practices weaken market discipline; implicit
government guarantees encourage excessive, unsustainable capital inflows; and inadequate
prudential supervision and regulation of domestic financial institutions and markets can
breed corruption, connected lending, and gambling for redemption. Countries in which these
problems are severe should liberalize the capital account gradually, in conjunction with
steps to eliminate these distortions. |
| The domestic markets and financial infrastructure for portfolio investments in equities
and debt instruments are not well developed in many emerging market countries. Creating
the domestic infrastructure is necessary before these markets can be opened
internationally. The economy can also benefit from the development of domestic financial
markets that allow financial flows to be less heavily dependent on the banking system. |
| Given the particular problems associated with short-term foreign debt, there may also be
a case for liberalizing longer-term flows, particularly foreign direct investment, ahead
of short-term capital inflows. |
| Much of the above discussion has focused on the liberalization of capital inflows.
Regarding the liberalization of capital outflows, the main concern arises when the
restrictions to be removed are supporting either a significant macroeconomic imbalance or
a distorted financial system. If an overvalued exchange rate has been maintained with the
help of restrictions on capital outflows, then the government must be prepared to adjust
the exchange rate when the restrictions are removed. Similarly, if policies have kept
interest rates for savers artificially low, market participants must be prepared for a
rise in rates. To avoid such costly accidents, countries should liberalize outflows after
they have reduced macroeconomic imbalances and financial distortions to manageable
proportions. |
Summary and Conclusions
Financial liberalization is inevitable for countries that wish to take advantage of the
substantial benefits—higher investment, faster growth, and rising living
standards—of participating in the open world economic system in today’s age of
modern information and communications technologies. As recent events in Asia, in Russia,
and in Latin America have again demonstrated, however, financial liberalization also has
its dangers.
The classic case in favor of open, or liberalized, capital markets includes the more
efficient allocation of savings, increased possibilities for diversification of investment
risk, faster growth, and the dampening of business cycles. Critics of open capital
markets, on the other hand, point to the inefficiencies resulting from adverse selection,
moral hazard, and herding behavior, all of which are byproducts of asymmetric
information—a situation in which not all parties to a transaction have equal
information. Government policies, however, can lessen or mitigate the potential damage
from asymmetric information problems.
If domestic financial markets are being distorted by inappropriate tax policy,
shortcomings in bank supervision and regulation, or government guarantees of private
sector liabilities, the solution is to properly sequence and supplement capital account
liberalization by removing the distortion at the same time, or before, the capital account
is liberalized. But to the extent that the problem lies in information asymmetries
intrinsic to financial markets that cannot realistically be eliminated and give rise to
systemic risks, there may be an argument for instituting policies to influence the volume
of certain types of financial transactions.
For example, governments might wish to intervene to inhibit or counteract the excesses
of herd behavior. Likewise, governments may wish to introduce taxes and policies that have
tax-like effects (e.g., differential capital requirements or non-interest-earning deposit
requirements) to discourage a particular category of capital account transaction, such as
excessive dependence on short-term foreign debt. The use of such instruments, which modify
behavior by altering relative prices, is not incompatible with the ultimate goal of
capital account liberalization.
Has capital account liberalization been responsible for an increase in costly financial
crises? Liberalizing the capital account before strengthening the domestic financial
system certainly creates an environment conducive to serious economic problems and,
potentially, financial crises. At the same time, reducing the barriers to the movement of
savings has been a boon to economic development worldwide. And powerful and irreversible
changes in information and communication technology have made highly mobile capital a fact
of life. The solution to reconciling these considerations is not to revert to restrictions
on capital flows, but to liberalize controls in an orderly, well-sequenced way,
accompanied by sound macroeconomic policies, strengthened domestic financial systems, and
improved transparency through disclosure of timely financial and economic information.
With these safeguards, liberalization becomes not only inevitable but clearly beneficial.
|
