Abstract

Financial globalization has increased dramatically over the past three decades, particularly for advanced economies, while emerging market and developing countries experienced more moderate increases. Divergences across countries stem from different capital control regimes, and factors such as institutional quality and domestic financial development. Although, in principle, financial globalization should enhance international risk sharing, reduce macroeconomic volatility, and foster economic growth, in practice its effects are less clear-cut. This paper envisages a gradual and orderly sequencing of external financial liberalization and complementary reforms in macroeconomic policy framework as essential components of a successful liberalization strategy.

Appendix I Country Lists

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Note: Country coverage in the different exercises in the paper depends on data availability.

Appendix II Capital Control Indices

All capital controls indices in this paper, and essentially all existing cross-country indices in the broader literature, are based on information contained in the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). Until 1995, the AREAER summarized a country's openness to capital flows using a simple 0/1 dummy variable, where 1 represents a restricted capital account and 0 represents an open capital account. In 1995, the AREAER started providing information on restrictions on capital transactions in 11 categories: shares or other securities of a participating nature; bonds or other debt securities; money market instruments; collective investment securities; derivatives and other instruments; commercial credits; financial credits; guarantees, sureties, and financial backup facilities; direct investment (including liquidation of direct investment); real estate transactions; and personal transactions. For each of these categories, the AREAER's new methodology distinguishes between restrictions on residents and those on nonresidents.1 For each of these specific types of restrictions, binary indicators were compiled.2 More aggregate indicators for each country were then calculated as simple averages of the respective subcategories. For example, restrictions on equity inflows are the average of the restriction dummies on “purchase locally by nonresidents” and “sale or issue abroad by residents,” and the equity inflows index can thus take three values, 0, 0.5, or 1. The broadest index for an individual country is the average of 18 dummies. The resulting index and its subcomponents are the most comprehensive and detailed indices of capital controls currently available. Compared with broad binary dummies, the new indices provide a more precise measure of controls, and permit analysis of various types of controls. This said, like all AREAER-based measures, the index cannot reflect differences in enforcement or economic relevance of controls across countries.

1

For the purposes of this paper, the focus is on a subset of these categories, namely, equity, money market, bond, collective investment and direct investment. These categories broadly correspond to the standard decomposition of de facto financial flows.

2

Restrictions on capital transactions are coded as a 0 (not restricted) if they consist merely of registration or notification requirements. They are also coded as 0 if a country is generally open but imposes restrictions on investments in a small number of selected industries, for example, for national security purposes, or if it is generally open but excludes a small number of countries, typically for political reasons. Using a binary index at this level facilitates consistency in coding across countries and years, though it requires abstracting from differences in the form of controls (prohibition, limitation, taxation, or registration requirements). Schindler (2008) provides additional detail on the data construction and makes the dataset publicly available.

Appendix III Case Studies on Financial Account Liberalization

Using a variety of case studies on countries' experiences with financial account liberalization, it is possible to illustrate some of the findings reported in Section VI. This appendix summarizes a variety of previously published case studies prepared by IMF staff and the IMF's Independent Evaluation Office.1 Countries covered include eight advanced countries, 22 emerging market economies, and two developing countries (see Appendix Table A3.1). Countries' experiences are grouped along two dimensions: (1) depending on whether a country experienced a currency or debt crisis after it liberalized the financial account; and (2) whether a country is above the median in at least three of the four factors emphasized in Section VI, namely trade openness (imports plus exports, divided by GDP), the soundness of macroeconomic policies (government expenditures divided by revenues), institutional quality (the average index from the International Country Risk Guide, Political Risk Services), and domestic financial development (private credit/GDP).

Table A3.1.

Evidence from Selected Case Studies, 1979–2004

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Notes: Descriptions drawn from previously issued IMF staff or IMF Independent Evaluation Office publications. Selection of the case studies was determined by availability.

As shown below, the overall picture that emerges is that countries with relatively sound macroeconomic policies and well-developed domestic financial systems are less likely to face crisis than countries without these characteristics. While the predicted pattern holds on average, a few countries experienced crises despite faring relatively well with respect to sound policies and domestic financial development, and some countries with policy and institutional shortcomings nevertheless avoided crises.

As shown in the case studies, for the sample of countries covered, whether the pace of liberalization is fast, gradual, or slow does not appear to have a significant impact on the likelihood of crisis. On the whole, crisis propensity seems primarily related to whether financial account liberalization is part of a broader package aimed at the development and appropriate regulation of the domestic financial sector and sound macroeconomic policies (including external imbalances that are not excessive).

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Notes: The cross-country medians for (1) trade openness, (2) the soundness of macroeconomic policies, (3) institutional quality, and (4) domestic financial development were computed using the averages in the period 1975–2004. Then each country was classified according to whether it was above the median (for three out of four variables) for more than half of the period during which its financial liberalization took place.

Countries that liberalized their financial account while suffering from weaknesses in the financial sector, in particular in the banking sector—as was the case for a number of countries affected by the Asian crisis—seem to be more likely to suffer crisis than countries that improved prudential policies before liberalizing the financial account. Countries with increasing current account deficits, rising inflation, and expansionary fiscal policies also seem more likely to suffer a currency or debt crisis when compared with countries with low current account deficits, low inflation, and solid public finances. Countries tied to a credible external anchor appear to be able to liberalize their financial account without suffering currency or debt crisis despite some weaknesses in the financial sector and/or macroeconomic imbalances, as was the case for some of the transition countries in their accession process to the European Union.

1

The country coverage in this appendix differs from that underlying Table 6.2, because the latter covers only de facto integrated countries, and case studies were not available for all countries in Table 6.2. Nevertheless, the broad pattern of results is consistent across the two samples.

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Cited By

  • Abiad, Abdul, Daniel Leigh, and Ashoka Mody, 2007, “International Finance and Income Convergence: Europe Is Different,” IMF Working Paper No. 07/64 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Aghion, Philippe, and Abhijit Banerjee, 2005 Volatility and Growth (Oxford, United Kingdom: Oxford University Press).

  • Alfaro, Laura, and Eliza Hammel, 2006 “Capital Flows and Capital Goods” (unpublished; Cambridge, Massachusetts: Harvard Business School).

    • Search Google Scholar
    • Export Citation
  • Aoki, Kosuke, Gianluca Benigno, and Nobuhiro Kiyotaki, 2006 “Adjusting to Capital Account Liberalization,” Working Paper (London: London School of Economics).

    • Search Google Scholar
    • Export Citation
  • Artis, Michael J., and Mathias Hoffman, 2006a, “Declining Home Bias and the Increase in International Risk Sharing: Lessons from European Integration” (unpublished; Manchester, United Kingdom: University of Manchester).

    • Search Google Scholar
    • Export Citation
  • Artis, Michael J., and Mathias Hoffman, 2006b, “The Home Bias and Capital Income Flows Between Countries and Regions,” CEPR Discussion Paper No. 5691 (London: Centre for Economic Policy Research).

    • Search Google Scholar
    • Export Citation
  • Árvai, Zsófia 2005 “Capital Account Liberalization, Capital Flow Patterns, and Policy Responses in the EU's New Member States,” IMF Working Paper No. 05/213 (Washington: International Monetary Fund).

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  • Bartolini, Leonardo, and Allan Drazen, 1997 “Capital-Account Liberalization as a Signal,” American Economic Review, Vol. 87, No. 1, pp. 138 –54.

    • Search Google Scholar
    • Export Citation
  • Becker, Törbjörn, Olivier Jeanne, Paolo Mauro, Jonathan D. Ostry, and Romain Rancière, 2007 Country Insurance—The Role of Domestic Policies, IMF Occasional Paper No. 254 (Washington: International Monetary Fund).

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