Saturday, December 5, 2009

Financial market liberalization

The aftermath of the sub-prime mortgage bubble has pitchforked cross-border capital controls into the centerstage of global economic debates.

For long, capital account convertibility (CAC) has been one of the most scared prescriptions of the Washington Consensus, despite many real world setbacks, the most famous being the East Asian currency devaluation crisis of 1997. Both the IMF and the World Bank have seen capital account convertibility as an important requirement for proper macro-economic management.

It is argued that in an increasingly integrated world, as economies get integrated by trade and cross-border Foreign Direct Investment (FDI), it becomes virtually impossible to control capital flows beyond a point. In this view, capital flows are a form of tax imposed on domestic private businesses who are prevented from accessing private capital at cheaper rates.

However, in the wake of the current crisis, Dani Rodrik had made the point that the four Asian countries with the least open financial markets - China, India, South Korea and Thailand - are the least affected by the ongoing financial turmoil. Asian-style resistance to financial globalization has taken the form of limiting the role of foreign banks in the domestic banking system and of restricting cross-border arbitrage in foreign currency, money, bond and equity markets. Evidence from prices and quantities shows the most limited globalization in China, followed at a distance by India, followed in turn by Thailand and then Korea.

Menzie Chinn and Hiro Ito, using the KAOPEN index which measures the degree of a country's capital account openness, has the following graphic.

The graphic shows that the East European and Latin American economies, which have been the worst affected by the current crisis among the emerging economies, are also the most open. Further, their financial market liberalization has been dramatic over the last decade. In contrast, the East Asian economies pulled back after the bitter experience of the late nineties and were saved off much of the troubles. Interestingly, South Asia has been amongst the most consistent of reformers, with a gradual and phased liberalization over the last three decades. The LDCs are also among the most liberalized of all developing economies, laying to rest some of the claims that attribute their backwardness to their failure to pursue open market policies.

The idea that greater exchange rate flexibility leads to more rapid current account adjustment has been a central tenet of the Washington Consensus and the policies of IMF. However, Menzie D Chinn and Shang-Jin Wei find that contrary to conventional wisdom, the benefits of exchange rate flexibility for current account adjustment are greatly exaggerated and by some measures, a fixed exchange rate facilitates faster adjustment.

They studied the performance of the financial markets of countries having freely floating currency, a dirty float, a crawling peg, or a fixed rate with respect to their current account balances for 170 countries over the 1971-2005 period. They find some evidence that for non-oil developing countries, the most rigid fixed regimes have the fastest current account adjustment, followed by pure floaters, whereas countries with a dirty-float exchange rate regime exhibit the slowest current account adjustment.

In a recent NBER working paper, Maurice Obstfeld writes that "there is strikingly little convincing documentation of direct positive impacts of financial opening on the economic welfare levels or growth rates of developing countries" and also "that there is little systematic evidence that financial opening raises welfare indirectly by promoting collateral reforms of economic institutions or policies". He also agrees that opening the financial account does appear to raise the frequency and severity of economic crises.

Despite all this, developing countries have moved over time in the direction of further financial openness, because "financial development is a concomitant of economic growth, and a growing financial sector in an economy open to trade cannot long be insulated from cross-border financial flows". He also finds that domestic financial market development - which promotes growth, can enhance welfare more generally, allows easier government borrowing, and eases the conduct of a domestically oriented monetary policy - also makes capital controls costlier to enforce.

The development of the domestic financial markets, which also helps correct the domestic financial market imperfections and institutional weaknesses, makes external financial liberalization easier to live with. He is in favour with the standard World Bank prescription for external financial policy making which has "three core components – membership in a credible currency union (like euro zone), or an exchange rate that reflects market forces; gradual opening of the capital account; and a monetary policy framework that favors price stability". The benefits of financial market liberalization are most likely to be realized when implemented in a phased manner, when external balances and reserve positions are strong, and when complementing a range of domestic policies and reforms to enhance stability and growth.

In another NBER working paper, Raghuram Rajan and Easwar Prasad, too argue in favour of a gradual movement towards capital account liberalization by emerging economies. They claim that the main benefits of capital account liberalization for these economies are indirect, more related to their role in building other institutions than to the increased financing provided by capital inflows. This line of thought places more emphasis on the efficiency improvement function of CAC.

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