6 Sequencing Capital Account Liberalization: Lessons from Chile, Indonesia, Korea, and Thailand
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International Monetary Fund
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English
Print Publication Date:
15 Mar 1991
Keywords:
BOOK; monetary policy; bank; interest rate; efficiency; spot exchange market; liberalization measure; exchange market arrangement; exchange rate movement; exchange market development; Capital flows; Capital account; Capital account liberalization; Exchange rates; Asia and Pacific; Global
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Abstract

Capital account liberalization can have significant benefits for economic growth and welfare. It can improve a country’s ability to tap global savings (at a lower cost than using only domestic savings); allow domestic economic agents the freedom to choose how and where to borrow, invest, or exchange assets; improve resource allocation through increased competition for financial resources; and increase the availability of resources to support investment, finance trade, and boost other significant economic sectors. At the same time, however, the opening of the capital account entails certain risks, if not accompanied by the necessary structural reforms and macroeconomic policies.

Capital account liberalization can have significant benefits for economic growth and welfare. It can improve a country’s ability to tap global savings (at a lower cost than using only domestic savings); allow domestic economic agents the freedom to choose how and where to borrow, invest, or exchange assets; improve resource allocation through increased competition for financial resources; and increase the availability of resources to support investment, finance trade, and boost other significant economic sectors. At the same time, however, the opening of the capital account entails certain risks, if not accompanied by the necessary structural reforms and macroeconomic policies.

Against this background, one needs to consider sequencing capital account liberalization with structural measures, especially in the monetary and financial sector, and pacing liberalization in conjunction with the development of appropriate macroeconomic policies. This chapter examines some of the general issues involved in the sequencing and pacing of capital account liberalization and draws lessons from emerging market economies that have liberalized their capital accounts and at the same time have received large capital inflows: Chile, Indonesia, Korea, and Thailand. These countries were chosen in order to illustrate the diversity as well as some of the similarities of approaches toward capital account liberalization. The information reviewed is for the period 1985-96, but has been extended to 1997 in the case of Thailand to include the period leading up to the 1997 crisis.

A complete analysis of the role of capital account liberalization would require a comprehensive assessment of structural and macroeconomic policies. This study focuses on key variables and certain interrelationships that are considered critical—specifically, (1) the development of domestic financial markets, instruments, and institutions; (2) reforms to foreign exchange and trade systems; (3) the development in countries’ balance of payments; and (4) the role of monetary and exchange rate policy.

A Conceptual Framework for Orderly Capital Account Liberalization

The conventional view on liberalizing the capital account is that it should follow the opening of the current account and the domestic financial system (see, for example, McKinnon, 1973 and 1982; Frenkel, 1982; and Edwards, 1984). Others have argued for simultaneous liberalization of the current and capital accounts (see, for example, Little, Scitovsky, and Scott, 1970; Michaely, 1986; and Krueger, 1984). Hanson (1994) suggests that a stable macroeconomy and domestic financial liberalization to a significant degree are preconditions to international financial liberalization. Our own assessment suggests that such stylized prescriptions are misleading, because the results of the survey indicate that undertaking the liberalization of the capital account and other aspects of economic and financial sector reform is a good deal more complex and requires attention to linkages among specific components of broader reform areas. In each country, different components and aspects of the capital account were liberalized at various stages, along with specific aspects of the current account and domestic financial sector, in line with each respective country’s overall macroeconomic objectives. In some instances liberalizing, or easing of restrictions, occurred in response to adverse macroeconomic developments. The survey does, however, lead to broad conclusions about the conceptual framework for an orderly liberalization of the capital account.

The Need for an Integrated Approach

The first broad conclusion from this survey is that there is a fundamental need for an integrated approach to capital account liberalization and financial sector reform. It is erroneous to draw sharp distinctions between the public policy approach to the deregulation of the capital account on the one hand, and the approach to the regulation and development of financial markets on the other. Rather, capital account liberalization should be treated as an integral part of economic reform programs.

More specifically, the liberalization of direct investment is often a significant part of real sector reforms, while the liberalization of portfolio investment flows is often coordinated with financial sector reforms and the development of financial markets and instruments.

Liberalizations of direct investment inflows have often gone hand-in-hand with reforms aimed at strengthening the real sector and export potential of the economy, including reforms to the trade and investment regimes, adjustments to the exchange rate to improve competitiveness, and liberalization of exchange controls on current international transactions. Such loosening of capital account controls have aimed, for example, at supporting the development and restructuring of selective industries and sectors, through management and technology transfers, injections of foreign capital, and improved access to trade finance.

Liberalizations of portfolio capital flows have tended to be coordinated with domestic financial sector liberalization and reforms—liberalization of interest rates, development of indirect monetary control procedures, and the strengthening of banks and capital markets.

There are a number of reasons for adopting a coordinated and comprehensive approach to financial sector reforms and capital account liberalization. First, from a macroeconomic and balance of payments perspective, the stage of development and the stability of domestic financial systems are critical to the growth and composition of capital movements. Such factors are often as important, if not more so, in explaining the volume and nature of the capital flows than the particular regulatory framework for such movements. Countries with developed financial markets and institutions have been better able to attract portfolio capital flows than countries where such markets are just emerging. In some circumstances, concerns about banking solvency or inadequate regulatory frameworks have discouraged foreign investment or encouraged capital flight regardless of the capital control framework. Financial sector weakness may also contribute to currency crises to the extent the weaknesses are seen as limiting the scope or the willingness of authorities to use interest rates to defend the currency; or cast doubts on the prospects of the economy in general (e.g., recognition that addressing financial sector weakness may have significant budgetary costs); or cast doubts on the political autonomy and the integrity and governance of financial institutions.

Second, and conversely, the opening of the capital account can have important implications for financial markets and institutions. In many cases, the implications are positive in that the liberalizations help to develop deeper, more competitive, and more diversified financial markets. The sophistication of domestic financial markets can also be improved if foreign financial institutions are allowed to operate directly in the country. The greater volume of intermediation and increased competition that may accompany capital account liberalizations, however, may also increase pressure on previously protected domestic financial institutions and bring weaknesses to the fore in such institutions. Some countries have experienced banking crises when confronted with sudden inflows and subsequent sharp reversals in capital flows. The banking sector problems may be exacerbated by significant open positions of banks, or their borrowers. In such cases, adjustments in interest rates and exchange rates can reduce the net worth of financial institutions that have not developed adequate mechanisms to manage interest and exchange rate risks. Countries with sound banking systems have been better able to handle reversals in capital inflows since in a strong financial system, banking weaknesses do not constrain interest rate and exchange rate policies.

Third, the efficient use of capital flows and, thus, the extent to which such flows contribute to sustained improvements in economic performance depend on the stage of development and efficiency of the domestic financial system. The strength of the domestic system in turn may depend on the existence of a well-regulated and supervised financial system, and on the elimination of various sources of market failures that may be the legacy of previous financial repression. Consequently, there is a need for opening the capital account in step with the reforms of domestic financial markets and institutions.1

Fourth, successful and sustained opening of the capital account requires the existence of a minimum set of instruments, institutions, and markets for the effective management of monetary and exchange rate policy with an open capital account. High capital mobility alters the effectiveness of different monetary instruments in achieving the objectives of monetary policy. On the one hand, instruments that impose a high cost or administrative constraint on the banks—as is the case with credit or interest rate ceilings or high nonremunerated reserve requirements—may be circumvented more easily by disintermediation through the capital account, and therefore become less effective. On the other hand, with an open capital account, monetary instruments that operate on the overall cost of money or credit in financial markets may be transmitted more rapidly to credit and exchange markets and may allow the central bank to influence the decisions of financial institutions and markets that operate in its domestic currency, both locally and internationally. Indirect monetary instruments, such as open-market operations, therefore come to play a core role in steering interest rates, managing the liquidity situation in the market, and signaling the stance of monetary policy.

Fifth, as a practical matter, the distinction between capital controls and financial regulations may not be straightforward. Indeed, many controls on capital movements are often exercised through regulations on the underlying capital transactions rather than the associated payments and receipts. A number of capital controls are in the form of financial regulatory measures, including reserve requirements that discriminate between residents and nonresidents, or may be the consequence of the particular regulatory frameworks for financial markets and financial institutions. An analysis of the regulatory factors influencing capital movements therefore requires a more complete understanding of overall financial regulatory frameworks, and of the extent to which limitations on capital movements are an incidental consequence of the need to protect investors and exercise prudential oversight over financial institutions or a deliberate attempt to influence the volume of capital movements for macroeconomic and balance of payments reasons.

Finally, the dynamics of reforms might also argue for synchronization of domestic financial sector reforms and the liberalization of capital movements. Financial sector reforms often involve a rapid monetization of the economy and a period during which the growth of credit exceeds that of money as agents adjust to the elimination of financial repression (see Chapter 3). Capital account liberalizations are often associated with initial surpluses in the capital account of the balance of payments—a factor reflecting the improved environment for investors and the return of flight capital (see Johnston and Ryan, 1994). If confronted separately, each of these factors can create problems for monetary and macroeconomic management. If confronted together, however, the adjustments in the monetary and external sectors can be offsetting to some extent (see Johnston, 1997). Thus, the more rapid growth of credit than money following domestic financial sector liberalization would, other things being equal, tend to place pressure on the balance of payments. This pressure may be offset through the return of flight capital that may accompany the liberalization of the capital account. Both adjustments of asset portfolios reflect the elimination of financial repression and are in this sense equilibrating, but circumstances could also arise where the capital inflows contribute to a more rapid expansion in bank credits. In such cases, simultaneous financial sector and capital account liberalization could compound the macroeconomic management difficulties. This is likely to be a particular concern when there is limited autonomy in monetary policy.

Capital Account Liberalization and Macroeconomic Policy Design

The second broad conclusion from the survey is that the pace of capital account liberalization needs to be adapted to macroeconomic policy. What is generally important for managing the volume of capital flows is the overall incentive structure that produces such flows. A number of items will tend to influence this incentive structure—including particular regulatory frameworks and the stage of development and soundness of the financial system. Another important consideration is the configuration of interest rates and exchange rates.

As a general proposition, stock-flow portfolio analysis can be applied to analyze the factors influencing capital movements, as well as to distinguish between the short- and longer-run effects of capital controls.2 In the short run, the “grit-in-the-wheels” effect of capital controls might allow a country temporarily to reduce the rate of capital flows, but over time investors will adjust their portfolios to reflect portfolio balance considerations. The longer-run impact of controls on capital flows will thus depend on whether the regulations increase or reduce risk-adjusted rates of return. The observed capital flight in countries maintaining controls, and the observed net strengthening of the capital account when countries eliminate controls, suggests that capital controls are generally treated by investors as an additional risk factor. This leads to the seemingly perverse conclusion that a country restricting capital flows would have to maintain higher interest rates to compensate for the increased risks. Nevertheless, evidence from curb markets in countries with repressed financial systems would generally support this view. Thus, contrary to the usual assumption that capital controls can help reduce local interest rates and limit outflows, one of the major considerations in capital account liberalization is the management of the inflows that are likely to follow such liberalization in view of the decline in investor risk premiums. Similarly, the degree of protection that capital controls provide to individual markets and institutions will depend on the extent to which there would be second-round portfolio adjustments. For example, capital flows into security markets are likely to have an expansionary impact on the balance sheets of domestic banks as well, because of liquidity effects and portfolio adjustments that would follow changes in relative interest rates and asset prices, even if there are controls on inflows to commercial banks.

A portfolio-balance approach is complemented with the covered interest rate parity condition that is the consequence of arbitrage between short-term domestic and foreign interest rates, and the discount on the currency in the forward exchange market. The covered interest rate parity condition can be written as follows:
id=if⁢+Fd;(1)
where
Fd=ef−eses⁢ X⁢ 100,

id is the domestic interest; if, the foreign interest rate of the same maturity, and Fd, the forward discount for that maturity; es is the rate of exchange (units of domestic currency in terms of a foreign currency) in the spot exchange market; and ef, the forward exchange rate on the date of maturity of the interest rate contracts. Thus, where the foreign interest rate and forward exchange rate are predetermined, a country could determine the domestic interest rate or the spot exchange rate, but not both.

With greater freedom of capital movements, short-term interest rates will increasingly be determined by the covered interest rate parity condition. An attempt to set both interest rates and exchange rates, which are inconsistent with this condition, could give rise to incentives for significant short-term capital flows. The potential magnitude of such flows will, among other things, reflect the expectations for the currency and the particular exchange rate.

Thus, with increased capital mobility, the capacity to assign monetary and exchange policies to achieve different macroeconomic targets will be increasingly constrained. If monetary policy is targeted to constraining inflation, the exchange rate would not be free, for example, to be used as an expenditure switching instrument to achieve objectives for the current account. Fiscal policy could be used to influence the savings/investment balance to achieve such objectives but monetary and exchange rate policy could not. Conversely, if the exchange rate is targeted to achieve objectives for the current account, or if the exchange rate is fixed, monetary policy would be left with little autonomy to achieve domestic stabilization objectives.

Assigning monetary policy, and consequently exchange rate policy, the task of domestic stabilization may require that either exchange rates or domestic interest rates, or both, are allowed to become more flexible. Higher capital mobility may also result in greater volatility in interest rates or exchange rates in view of the sensitivity of capital flows to changes in market sentiment and the more rapid transmission of shocks and potential contagion affects. Greater flexibility of the exchange rate or interest rates may help discourage short-term speculative flows that exploit inconsistent interest rate and exchange rate alignments. Where capital is attracted by high domestic interest rates as part of a disinflationary program, temporary appreciation of the exchange rate may help to support the disinflationary strategy and allow for a more rapid lowering of domestic interest rates to international levels, while at the same time meeting the inflation target. Once inflation and interest rates have been brought down, the exchange rate should also adjust to a level consistent with a sustainable balance of payments. The costs would depend on whether export performance would be seriously affected by a temporary appreciation in the exchange rate, as well as whether markets exist to hedge the risks of greater volatility.

One of the risks of assigning exchange rate policy to current account objectives and relying on fiscal consolidation to achieve domestic stabilization with an open capital account is that the authorities’ freedom to deal with speculative short-term flows is likely to be seriously constrained by the limited short-run flexibility of fiscal policy. Many countries have as a consequence resorted to capital controls in these circumstances. The extent to which capital controls can be used to manage the overall volume and structure of capital flows is questionable, however. Thus, the viability of such an assignment of instruments to targets also appears questionable with the increased volumes of capital flows.

Consequences of the Pace and Sequencing of Capital Account Liberalization

The above analysis argues for integrating capital account liberalization with the design of structural and macroeconomic policies. Maximizing the benefits from capital account liberalization while minimizing the risks requires a comprehensive approach to reforms.

A comprehensive approach will generally involve the coordination of the liberalizations of portfolio capital flows with domestic financial sector liberalization and reforms—that is, liberalization of interest rates, development of indirect monetary control procedures, and the strengthening of banks and capital markets through, among other measures, improved regulations. A lack of coordination between the domestic financial sector and capital account reforms can create distortions and regulatory incentives for capital movements that are unrelated to the underlying economic conditions, thus risking greater instability in capital movements. At the same time, there would be good reason to coordinate the liberalization of foreign direct investment with reforms aimed at strengthening the real sector and export potential of the economy, including reforms to the trade and investment regimes, exchange rate adjustments to improve competitiveness, and liberalization of exchange controls on current international transactions.

Where financial systems are weak, policymakers should address the institutional weaknesses in advance of, or concurrent with, the liberalization of the capital account. Countries that have not raised their institutional capacity to implement prudential regulations to the level of international best practice may also need to rely temporarily on selective capital controls as part of their financial regulatory frameworks. In view of the fungibility of capital, however, too much reliance cannot be placed on capital controls in protecting particular institutions and markets.3 Consequently, it is important for countries to make rapid progress in strengthening financial markets and institutions generally.

A comprehensive approach would also require an appropriate and consistent mix of macroeconomic and exchange rate policies. This mix may well require a reorientation of monetary and exchange rate policy to provide appropriate autonomy of monetary policy in dealing with capital inflows.

Such a well-planned and sequenced program of reforms does not necessarily imply a gradualist approach. Rather, an effective program calls for coordinated and concurrent reforms irrespective of the pace of the reforms. In fact, in some cases liberalizing the capital account before implementing other parts of the economic and financial sector reform program may be desirable. More rapid capital account liberalization can provide momentum to the overall reform process by weakening entrenched vested interests and bureaucratic control of private sector activities. It can also help to develop markets by increasing competition and promoting a larger volume of capital flows. In such cases, faster liberalization of the capital account would require similarly rapid progress in the necessary concurrent reforms to domestic financial markets and institutions and in adapting the macroeconomic policy framework. Speeding up these reforms is desirable in any event in view of the limited extent to which countries can insulate themselves from the market.

Selected Country Experiences with Sequencing Capital Account Liberalization

This section discusses the experience of four countries with capital account liberalization from 1985 to 1996. For each country, a detailed country matrix describing the sequence of reforms to domestic and external transactions is provided in the Appendix with a summary of measures in the text. Domestic reforms have been grouped into reforms to the financial supervisory and regulatory framework; the development of money markets and instruments; and the development of capital markets. External reforms are grouped into reforms to the exchange market arrangement and system; direct investment; portfolio investment; the trade regime; and introduction of restrictions on capital flows. Where appropriate a distinction is made between capital inflows and outflows.4 The Appendix tables also present selected macroeconomic and balance of payments indicators. For reference purposes, information on the stock position for the exchange and capital control regimes for the four countries can be found in the IMF’s Annual Report- on Exchange Arrangements and Exchange Restrictions (1997).

Chile

The sequencing of Chile’s reforms of domestic and external transactions during the period 1985-96 is summarized in Table 6.1 and described in detail in Appendix Table 6.6; selected macroeconomic and balance of payment indicators are presented in Figure 6.1 and Appendix Table 6.7.

Table 6.1.

Chile: Sequencing of External and Domestic Financial Liberalization

(M represents major measures and m represents relatively minor measures)

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The peso was devalued twice, the exchange rate band was widened from 0.5 percent to ±2 percent, and the peso was adjusted daily by 1.7 percent per month until August 1985. After August, the peso was adjusted daily based on the previous month’s inflation less external inflation.

The peso continued to be adjusted daily based on the previous month’s inflation less external inflation leading to a 10.5 percent depreciation during the year.

The exchange rate band was widened from ±2 percent to ±3 percent on each side of the center rate.

The exchange rate policy to seek a real depreciation of the peso was abandoned and the exchange rate band was widened from ±3 percent to ±5 percent. In addition, the estimated rate of external inflation used in adjusting the exchange rate was lowered from 0.4 percent to 0.3 percent.

The midpoint exchange rate was devalued three times during the year accumulating a total of 3.4 percent, and the reference rate of the peso was appreciated by 2 percent.

The exchange rate arrangement of the peso changed from a peg to the U.S. dollar to a peg to a basket of currencies, the reference rate of the peso was revalued by 5 percent, and the exchange rate band was widened from ±5 percent to ±10 percent.

The midpoint of the exchange rate band was revalued by 10 percent, and the weights of the reference currency basket were changed.

The weights of the currency basket were changed, and the width of the exchange rate band was increased from ±10 percent to ±12 percent.

The parallel foreign exchange market became an informal legal market in which the exchange rate was freely determined.

After an earlier experience with rapid liberalization and a banking crisis, Chile followed a gradualist approach to reforms. During the period covering 1985-89, the reforms focused on completing the restructuring of the banking system, establishing indirect methods of monetary control, carrying out trade reform, increasing the scope of transactions by banks, establishing the autonomy of the Central Bank of Chile, and selectively liberalizing direct and portfolio capital inflows. Later phases of reforms emphasized the development of financial markets, the adoption of more flexible interest rate and exchange rate policies, and selective relaxation of controls on capital inflows and outflows, accompanied by the introduction of controls on certain capital inflows mainly in 1991 and 1995.

Restoring the soundness of the banking system, which had been damaged in the earlier banking crisis, and reversing the earlier protectionist trade policies were given priority from 1985-87.5 The earlier banking crisis and external shocks had led policymakers to reverse interest rate liberalization. Following the completion of the banking restructuring, the central bank eliminated the practice of announcing indicative interest rates in 1987, and influenced the level of domestic interest rates mainly through open-market operations in its indexed instruments. Capital market activity, which had been moderate, was promoted gradually—pension funds were allowed to invest part of their assets in selected domestic stocks beginning in 1985. In 1989, the law established the legal autonomy of the central bank.

Chile’s liberalization of external transactions focused initially on trade liberalization—providing more liberal access to foreign exchange for current international transactions—exchange rate adjustment, and exchange market development. In 1985, previous tariff increases were rolled back in two steps, and, concurrently, the exchange rate was devalued to offset the impact of the lower tariffs and to bring the exchange rate to a more realistic level.6 Limitations were eased on payments and transfers for current international transactions, and new instruments were introduced in the foreign exchange market.

Figure 6.1.
Figure 6.1.

Chile: Selected Macroeconomic Indicators

Sources: IMF, International Financial Statistics, Direction of Trade Statistics; and IMF staff estimates.

Capital account measures were selective and focused initially on liberalizing capital inflows. In 1985, amendments to Chapter XIX of the central bank’s foreign exchange regulations permitted foreign direct investment inflows through debt/equity swaps.7 Capital from these investments, however, could not be repatriated for 10 years and profits for four years. Such swap operations were further promoted in 1987, with the authorization of External Investment Funds.8 Also under an amendment to Chapter XVIII of the foreign exchange regulations, nonresidents were permitted to purchase selected debt instruments, but the source of foreign exchange and the conversions had to take place outside the official foreign exchange market. Allowable transactions were broadened in 1986, and again in 1987, when nonresidents were permitted to invest in publicly offered instruments with the repatriation of the original capital after five years and no limit on profit remittances. In 1989, the Additional Tax on the repatriation of profits by foreign investors under the Income Tax Law was reduced from 40 percent to 35 percent.

The capital account of the balance of payments showed a marked strengthening and recorded a surplus in 1989 reflecting much stronger foreign direct investment inflows (see Figure 6.1 and Appendix Table 6.7). In 1989, monetary policy was tightened to offset accelerating inflation, and portfolio capital inflows increased substantially, reflecting the large interest differentials. In this context, the authorities abandoned their previous policy of seeking a real depreciation of the exchange rate, and widened the band for the fluctuations in the exchange rate.9

Beginning in 1990, the authorities emphasized the development of domestic financial markets and instruments. Several measures were implemented to broaden and enhance the efficiency and competitiveness of the stock exchange and local security markets: trading in futures contracts was introduced in 1990; pension funds were allowed to invest a greater percentage of their assets in equities; and electronic screen-based trading and settlement systems began functioning in 1993. The following year the stock market introduced trading in options, and during 1995-96, the investment activities of pension funds in the local securities markets were further liberalized. Concurrently, the money and foreign exchange markets were developed. The central bank enhanced its capacity to conduct monetary operations by widening the range of instruments and maturities used in open market operations (see Alexander, Baliño, and Enoch, 1995). Under new foreign exchange regulations, all foreign exchange transactions were permitted unless specifically prohibited by the central bank, and the parallel foreign exchange market became an informal legal market in which the exchange rate was freely determined.

In response to the large capital inflows recorded in 1990, the authorities began to liberalize capital outflows. In 1991, residents were allowed for the first time to use foreign exchange obtained in the unofficial market to invest abroad, and the period of investment after which capital could be repatriated by nonresidents was shortened to three years. In 1992, the pension funds were granted limited freedom to invest overseas, and remittances of profits and capital earned on foreign investments were allowed in advance of pre-existing schedules under certain conditions. Foreign inflows were also liberalized by allowing the issue of American Depository Receipts, and in 1991 the arrangements for trading shares sold through American Depository Receipts were expanded and taxes on dividends were reduced. At the same time, new restrictions were introduced on certain capital flows. In 1991, the central bank introduced a 20 percent reserve requirement on new foreign borrowing—except for trade credits—with the objective of limiting short-term capital inflows. Subsequently, the reserve requirement was extended to most outstanding foreign borrowing and to foreign currency deposits, and increased to 30 percent. The stamp duties imposed on domestic loans were also extended to foreign loans.

Net capital inflows declined briefly in 1991 as interest rates were reduced, but recovered sharply in 1992. In response to continuing large capital inflows and upward pressure on the exchange rate, the reference rate of the peso was revalued, and modified from a peg to the U.S. dollar to a peg to a basket of currencies, and the fluctuation band for the exchange rate around the central rate of crawl was widened from ±5 percent to ±10 percent. Inflation was constrained through continued fiscal consolidation appreciation, in the real exchange rate, and sterilized foreign exchange intervention.10 (See Figure 6.1 and Appendix Table 6.7.)

During the period 1993-96, the pace of capital account liberalization accelerated, with a greater emphasis placed on capital outflows. Certain restrictions on capital inflows were also intensified. In 1993, the minimum period for capital to remain in the country was reduced from three years to one, and the time limit for remittances of profits was eliminated. In 1994, foreign portfolio investment outflows were encouraged by allowing life insurance companies, pension funds, banks, and mutual funds to invest larger percentages of their portfolios abroad through the official market, allowing domestic banks to invest in financial institutions abroad, and granting individuals access to the formal exchange market for a limited set of capital transactions.11 Capital outflows were liberalized further in 1995-96 by broadening the allowable assets and increasing the limits on foreign investments. Portfolio investment inflows were also encouraged by reducing the minimum size of American Depository Receipts issues, lowering the rating requirement for corporations issuing bonds on the international market, and modifying the 30 percent reserve requirement on foreign borrowings. At the same time, due to circumvention of the existing restrictions, the authorities intensified restrictions on certain other inflows. In 1994, reserve requirements on foreign borrowing were required to be held solely in U.S. dollars, and in 1995 the ceiling on credit in Chilean pesos backed by deposits in U.S. dollars was reduced to avoid a circumvention of the reserve requirement on foreign borrowing. The reserve requirement on foreign liabilities was extended to secondary market transactions in American Depository Receipts, and to all investment inflows that did not constitute an increase in the capital stock of the bank.

Chile’s overall capital account strengthened, and there were much larger gross capital movements (Figure 6.1 and Appendix Table 6.7). Direct investments abroad increased to $1.1 billion in 1996, while foreign direct investment inflows increased to $4.1 billion. The net capital account strengthened to $6.3 billion (9 percent of GDP) in 1996. The current account balance fluctuated and showed some tendency to widen on average. The government repaid foreign debt, reducing the surplus in the overall balance of payments, and continued to adapt the exchange rate arrangement by revising the weights of the currency basket and widening the exchange rate band. The real exchange rate continued to appreciate, and the inflation performance continued to improve (see Figure 6.1).

Chile’s capital account liberalization appears to follow a distinct sequencing, with an initial focus on the completion of the restructuring of the banking system, trade reform, liberalization of the exchange system, and selective liberalization of capital inflows. Subsequently, the emphasis shifted to developing domestic money, bond, and equity markets. The capital account liberalization was also combined with the evolution of macroeconomic policies, strengthening of the instruments for indirect monetary control, and modification of the exchange arrangement to allow for greater flexibility of the rate within a crawling band exchange arrangement. Capital outflows were liberalized in response to a strengthening balance of payments. While liberalizing longer-term capital outflows and inflows, Chile introduced selective controls on capital inflows; however, such controls were circumvented and had to be broadened progressively.

Indonesia

The sequencing of Indonesia’s reforms of domestic and external transactions during the period 1985-96 is summarized in Table 6.2 and described in Appendix Table 6.8; selected macroeconomic and balance of payments indicators are presented in Figure 6.2 and Appendix Table 6.9.

Table 6.2.

Indonesia: Sequencing of External and Domestic Financial Liberalization

(M represents major measures and m represents relatively minor measures)

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The rupiah was devalued by 31 percent.

Exchange rate movement allowed more flexibility. Bank Indonesia ceased to announce an indicative exchange rate in the morning and instead began announcing buying and selling rates at 3:00 p.m. computed on the basis of a basket of weighted currencies with a spread of ± Rp 15 (compared to ± Rp 10 previously).

Exchange rate movement allowed more flexibility; the buying and selling rates computed on the basis of a basket of weighted currencies with a spread of ± Rp 22 (compared to ± Rp 15 previously).

Exchange rate movement allowed more flexibility; in June the intervention band was widened to Rp 118 (5 percent) and in September widened to Rp 192 (8 percent).

Indonesia accepted Article VIII of the IMF Articles of Agreement.

The economic reforms in Indonesia focused on reorienting the economy to reduce its dependence on the oil sector, expanding the role of the private sector, and encouraging the creation of a competitive non-oil, export-oriented industrial base that would absorb the rapidly growing labor force. The strategy entailed the pursuit of coordinated financial and exchange rate policies, aimed at providing a stable macroeconomic environment, accompanied by wide-ranging structural reforms to promote sustained growth and economic diversification. Key elements of reform during 1985-96 included the gradual liberalization of direct investment inflows to promote non-oil exports and economic diversification, maintenance of a competitive exchange rate, trade liberalization and tariff reform, and improvements in monetary management. Financial sector reform was also critical during the period and was carried out through the liberalization of external inflows, promotion of competition in the banking sector, strengthening of financial institutions, and encouragement of the growth of the capital market.

In 1985, Indonesia maintained a liberal regime for capital outflows by resident individuals and juridical entities, while prohibiting lending abroad by banks and financial institutions. Limitations on outflows through financial institutions remained in effect throughout the period (see the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions, 1997). Selective controls applied to capital inflows; direct investment inflows were limited by domestic ownerships requirements; the purchase of equity by foreign investors in the local stock market was prohibited; and limits were imposed on foreign borrowings. Trade policy remained substantially protectionist.

Over much of the period, reforms focused on an opening of the real economy through a gradual promotion of direct investment inflows and liberalization of the tariff system as part of a restructuring of the real economy (see Appendix Table 6.8). Direct investment inflows were liberalized by expanding the fields where such investments were permitted. The expansion was accomplished by limiting the equity ownership rules to production of certain goods and investments in certain sectors, and by lengthening the period after which a company had to revert to domestic ownership.

Figure 6.2.
Figure 6.2.

Indonesia: Selected Macroeconomic Indicators

Sources: IMF, International Financial Statistics, Direction of Trade Statistics; and IMF staff estimates.

The exchange rate was depreciated in 1983 and again in 1986 to bring it into line with market conditions as part of the economic restructuring package. Indonesia also liberalized payments and transfers for current international transactions and accepted the obligations of Article VIII of the IMF’s Articles of Agreement in 1988. The foreign exchange market was developed and the selling of swaps in the foreign exchange market was liberalized. These reforms were associated with greater openness of the economy (as measured, for example, by the ratio of exports plus imports to GDP) and faster economic growth (see Appendix Table 6.9).

Reforms were undertaken concurrently in the financial and real sectors. These reforms focused initially on establishing the financial markets, institutions, and instruments for a more market-based system. Beginning in 1983, interest rates were liberalized and direct credit controls on the banking system were partially removed. Money market instruments were introduced in 1984. In 1987, institutional reforms were undertaken to strengthen the operations of the capital market, including reforms to the stock exchange and introduction of new capital market instruments. The authorities modified their monetary control framework by shifting toward targeting international reserves. They introduced daily auctions of money market instruments and allowed the market to play a bigger role in determining interest rates and the exchange rate.

The reforms in 1988 emphasized the functioning of the banking system, enhanced bank supervision, and development of the money market. Financial sector reform was promoted by permitting greater foreign participation in the financial sector through the licensing of new foreign banks and branches, creating a level playing field for foreign and domestic banks, and permitting foreign participation in other types of financial institutions and in the insurance business (see Appendix Table 6.8). Additionally, reforms were undertaken to improve the functioning of the capital market, including extending the role of the market in raising funds for investments, lengthening the maturity of money market instruments, and broadening the range of market makers.

Subsequently, in 1989, the authorities liberalized portfolio capital inflows by eliminating quantitative limits on bank borrowing from nonresidents. For the first time, foreigners were permitted to invest in the stock market, and to acquire up to 49 percent of the ownership of listed stocks. Restrictions on direct investment inflows were also relaxed further and foreign direct investors were allowed to sell foreign exchange directly to commercial banks instead of through the central bank.

In 1990-91, the Indonesian economy began to overheat, the current account deficit widened, inflation accelerated, and interest rates rose substantially. In the context of the maintenance of a stable real exchange rate, however, the increase in interest rates was accompanied by a substantial inflow of foreign capital, and total net private capital flows registered a surplus in 1990 for the first time since 1985 (see Figure 6.2).12 The foreign capital inflow was mainly in the form of commercial bank borrowing, which was converted to domestic currency using the central bank’s swap facility, thus contributing to an increase in the growth of money. Monetary restraint was supported by tightening fiscal policy to curtail domestic demand pressures; however, inflation continued on an upward trend (Figure 6.2).

Concerned that the inflows through the banking sector were excessive and were complicating macroeconomic management, the authorities reimposed in 1991 quantitative controls on offshore borrowing by banks and state enterprises. They also introduced stricter limits on the open foreign exchange positions of banks and reduced their foreign exchange swap positions as a percentage of their capital base. The limitations on public sector borrowing from abroad remained in place from 1992 to 1996. Nevertheless, the authorities continued to broaden the arrangements for foreign borrowing for trade finance by private entities. Sales of securities to nonresidents were permitted and foreign direct and portfolio investment through the stock markets was liberalized as part of the more general economic and financial sector development program. These measures were undertaken concurrently with other measures to strengthen the domestic capital markets and the regulatory framework for banking operations.13 In particular, in 1995-96, regulations were issued to strengthen financial institutions through the upgrading of accounting standards to ensure compliance with prudential guidelines and to safeguard against excessive risk taking through derivative tradings.

Large interest differential in the context of a stable exchange rate and very rapid growth in the domestic stock market continued to promote large net private capital inflows in 1992-96. These inflows took the form of both net direct and portfolio flows. The inflows were partly offset by a reduction in official capital inflows and by a widening in the current account deficit. Inflows were also sterilized through auctions of central bank paper and through swap operations in the foreign exchange market. Additionally, the authorities permitted somewhat greater exchange rate flexibility (1994—96).

In the first half of 1997, Indonesia continued to attract foreign investment flows. In response the central bank took measures to restrict the related credit growth, including partial sterilization from sales of central bank certificates, an increase in reserve requirements, and reduction in subsidized credit to public enterprises. Initially, Indonesia managed the regional currency crises that began in June 1997 better than its neighbors. This performance was attributed to stronger fundamentals, including a relatively smaller external current account deficit. Nevertheless, on July 11, 1997, to protect against speculation, Indonesia widened the trading band for the exchange rate against the U.S. dollar from 8 percent to 12 percent. Subsequently, concerns also emerged about the stability of the banking system, and the Indonesian rupiah came under speculative pressure and was allowed to float. The authorities also took administrative measures to counteract the pressure on the exchange rate. Nonresident transactions in the forward market were restricted to $5 million per customer, and each bank’s net open position in the forward market was limited to $5 million. The authorities also lifted the 49 percent limit on foreign ownership on new initial public offerings in September.14

Korea

The sequencing of Korea’s reforms of the domestic and external transactions from 1985-96 is summarized in Table 6.3 and described in Appendix Table 6.10; selected macroeconomic and balance of payments indicators are presented in Figure 6.3 and Appendix Table 6.11.

Table 6.3.

Korea: Sequencing of External and Domestic Financial Liberalization

(M represents major measures and m represents relatively minor measures)

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Adopted the “market average exchange rate” (MAR) system. The MAR for the Korean won-U.S. dollar would be based on the weighted average of the previous day’s interbank rates for the Korean won-U.S. dollar spot transactions. During each business day, the Korean won-U.S. dollars exchange rate in the interbank market would be allowed to fluctuate within margins of ± 0.4 percent against the MAR.

The margins within which the exchange rate for Korean won-U.S. dollars in the interbank market was allowed to fluctuate daily around the MAR were widened to ±0.8 percent.

The margins mentioned in note number 2 were widened to ±1 percent.

The margins mentioned in note number 2 were widened to ±1.5 percent.

The margins mentioned in note number 2 were widened to ±2.25 percent.

Accepted Article VIII of the Agreements.

Throughout the period, the Korean economy was characterized by significant government intervention and a financial sector that lagged behind the industrialization of the economy. The liberalization of the domestic financial system and the capital account was very gradual and selective, and a comprehensive plan was not adopted until June 1993. Monetary policy was conducted primarily through direct instruments, including ceilings on lending rates and guidance for lending to priority sectors. During the period, interest rate policy played little active role in external management. Developments in the balance of payments position, particularly in the current account, guided the government’s interventions in the foreign exchange market and system and its policies with respect to transactions related to trade and the capital account.

Faced with a significant surplus in the current account balance of payments over the period 1986-89, the authorities progressively liberalized the import regime through a preannounced schedule of measures. Restrictions on payments for current international transactions were relaxed and Korea accepted the obligations of the IMF’s Article VIII in 1988. Capital outflows were also promoted by liberalizing direct investment, purchases of real estate overseas, and certain portfolio investments outflows by institutional investors. At the same time, the central bank undertook various measures aimed at reducing net capital inflows, including encouraging the early repayment of external borrowing, tightening of the regulations on foreign commercial loans and foreign bank borrowing, and imposing restrictions on the volume of foreign exchange that could be brought in and sold to domestic banks (see Appendix Table 6.10). The fiscal position was consolidated to facilitate repayment of official foreign debt. In spite of the exchange measures, the overall balance of payments registered a widening surplus, as the current account surplus increased to reach 8 percent of GDP in 1988. The authorities used sterilization policies extensively—mainly through the issue of large quantities of liquidity control bonds and the reserve requirement on local currency deposits. The fiscal position also improved and the nominal and real exchange rate appreciated (see Figure 6.3).

Figure 6.3
Figure 6.3

Korea: Selected Macroeconomic Indicators

Sources: IMF, International Financial Statistics, Direction of Trade Statistics; and IMF staff estimates.

Beginning in 1989, the current account balance of payments began to weaken, reflecting the background of a weakening fiscal position (in an attempt to stimulate the economy), an appreciation in the real exchange rate, and rising inflation. The authorities responded by encouraging capital inflows. Some of the earlier measures aimed at limiting capital inflows were reversed—foreign exchange banks were allowed to raise funds offshore through certain instruments, and the limits on amounts of foreign exchange that could be imported and sold to local banks were raised. The authorities also accelerated the liberalization of direct investment inflows by lifting the ceilings on these inflows; replacing approvals with notifications; providing tax incentives; and expanding the sectors where foreign direct investment was permissible. However, with increasing labor costs at home, foreign direct investment registered a net outflow in 1990 as enterprises continued to locate manufacturing abroad. Nevertheless, the financial account registered a surplus, reflecting short-term inflows related to trade credits and borrowing for crude oil imports.

During the period 1988-96, Korea adopted a range of reforms aimed at the development of the domestic money, security, and foreign exchange markets. These measures paved the way for a broader opening of the capital account for portfolio capital flows in the 1990s. In 1988 the authorities allowed some initial interest rate liberalization. Two years later, they announced a four-stage plan for interest rate deregulation, and in 1993 the authorities liberalized a wide range of interest rates. Interest rates on deposits of one to two years were liberalized in 1994, followed by the liberalization of short-term deposits in two steps in 1995. The financial system was developed through a number of measures, including the strengthening of bank supervisory procedures, promotion of a bankers’ acceptance and forward exchange markets, development of market makers, and the strengthening of regulations, trading procedures, and transparency of the local security markets. Operational improvements were introduced in the capital market, with the introduction of the “real-name” system for all financial transactions and the computerization of transactions in the stock market. In addition, various steps were taken to improve and strengthen the regulation and supervision of the financial sector, including a thorough revision of the General Banking Act and related prudential measures pertaining to accounting practices to promote transparency. Monetary stabilization bonds were auctioned, as opposed to being sold at administratively determined prices, and repurchase agreements using the liquidity control bonds became a major monetary instrument. Korea also moved from a multi-currency peg to the Market Average Exchange Rate system to allow market forces to play a greater role in exchange rate determination; the margins for the fluctuation of the exchange rate were also gradually widened.

Korea continued its policy of gradually promoting capital outflows by progressively liberalizing the limits on outward investments. The liberalization measures included extending the range of financial institutions eligible to invest abroad and raising the ceilings on their overseas investments; broadening the number of businesses eligible for overseas direct investment; liberalizing purchases of real estate; and allowing residents to retain larger foreign exchange balances abroad and to invest directly in foreign government bonds and equities up to a limit. For capital inflows, in 1992 nonresidents were permitted limited access to the stock market, and the types of securities that could be issued abroad by residents were expanded. The limits on foreign investments in Korea were gradually lifted, and sectors and markets gradually opened to foreign portfolio investment. For example, total foreign direct investment in domestic equities was increased from 10 percent in 1992 to 12 percent in 1994, to 15 percent in 1995, and to 20 percent in 1996. In 1996, nonresidents were permitted to invest in domestic bonds through Country Funds, and the Korean Bond Fund was listed on the London Stock Exchange.

The net private capital account strengthened sharply in 1991, reflecting an increase in foreign bond issues by Korean corporations, and in 1992 net portfolio inflows nearly doubled, reflecting the partial opening of the stock market to foreign investors. Net portfolio investment inflows continued to strengthen in subsequent years, with net private capital inflows reaching $16 billion in 1995. Korea continued to be a net exporter of direct investment, but increasingly became a major net recipient of portfolio investment inflows. These inflows were offset by a weakening in the current account balance of payments and an increasing surplus in the overall balance of payments. The exchange rate was permitted to adjust to some extent, but the degree of adjustment was limited. Nominal interest rates were also reduced, but, with inflation higher than elsewhere, the interest differentials with foreign rates remained positive.

Notwithstanding the significant steps taken during 1985-96 toward a deregulated financial sector, Korea’s financial sector and capital account transactions continued to be subject to many regulations and government intervention. Moreover, the effectiveness of certain reforms—for example, interest rate deregulation—is unclear. Accordingly, further liberalization measures have been scheduled for the period 1997—2000, provided that stable macroeconomic conditions are maintained or the differential between Korean and international interest rates falls below 2 percent.15

Thailand

The sequencing of Thailand’s reforms of domestic and external transactions from 1985 to mid-1997 is summarized in Table 6.4 and described in Appendix Table 6.12; selected macroeconomic and balance of payments indicators are presented in Figure 6.4 and Appendix Table 6.13.

Table 6.4.

Thailand: Sequencing of External and Domestic Financial Liberalization

(M represents major measures and m represents relatively minor measures)

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Data are through August.

The exchange rate arrangement of the Thai baht changes from being pegged to the U.S. dollar to a managed float.

On May 4 the government accepted Article VIM obligations of the IMF Articles of Agreement.

Just before the start of the period under review, Thailand undertook a major adjustment effort: the baht was devalued by 14.8 percent in 1984, significant fiscal consolidation began, and a decisive change was made in the orientation of trade and industrial policies toward exportled growth. Thailand gave priority to promoting capital inflows through tax and institutional reforms while concurrently developing its financial markets. This policy, together with large positive interest differentials and a fixed exchange rate, promoted large net capital inflows. Such inflows contributed to strong economic performance and an increasing opening of the economy. Subsequent concerns about the sustainability of the exchange rate and the solvency of the financial system, however, resulted in a sharp reversal of capital inflows and a currency crisis.

Figure 6.4
Figure 6.4

Thailand: Selected Macroeconomic Indicators

Sources: IMF, International Financial Statistics, Direction of Trade Statistics; and IMF staff estimates.

At the beginning of the period under review, Thailand maintained a relatively open capital account regarding capital inflows. The Alien Business Law of 1972 and the Investment Promotion Act of 1977 expanded the sectors open to foreign investment and liberalized the screening requirement for such investments. Portfolio investment inflows were treated liberally, although initially exchange controls applied to the repatriation of interest, dividends, and principal. Foreign borrowing could be conducted freely but had to be registered with the Bank of Thailand.

During the period, foreign inflows were promoted further through various measures, including eliminating restrictions on foreign investments and foreign ownership of export-orientated industries; granting tax incentives to encourage direct investments in special sectors; granting tax incentives to foreign mutual funds for investments in the stock market; creating new closed-end mutual funds; establishing rules for foreign debenture issues by Thai companies; reducing taxes on dividends remitted abroad; and allowing the free repatriation of investment funds, loan repayments, and interest payments by foreign investors.16 In 1992, the authorities approved the establishment of the Bangkok International Banking Facility, which greatly eased access to foreign financing and expanded short-term inflows (see Figure 6.4); and in 1995 the Provincial International Banking Facility was established, which could extend credit in both baht and foreign currencies with funding from overseas.

Payments and transfers for current international transactions were also progressively liberalized, and in 1990 Thailand accepted the obligations of IMF Article VIII. Further liberalizations followed, with the removal of limits on the amount of foreign exchange that could be purchased, brought in, or taken out of the country; the relaxation of surrender requirements; and the broadening of the uses of nonresident baht accounts and resident foreign currency accounts.

In contrast to the promotion of capital inflows and the rapid liberalization of the exchange system, controls on capital outflows by residents were liberalized only gradually. In 1990, commercial banks were allowed to lend limited amounts to nonresidents in foreign currency and to approve the repatriation of proceeds from sales of securities. The following year, Thai residents were permitted to invest abroad or to lend limited amounts to companies that had at least a 25 percent Thai equity participation. This ceiling was raised in 1994. Purchases abroad of capital and money market securities, foreign direct investments exceeding $10 million, and purchases of real estate remained subject to Bank of Thailand approval. Insurance companies were permitted to invest abroad under certain circumstances, but only up to 5 percent of their total portfolio. Locally issued mutual funds were restricted to investing their total portfolio in the domestic market.

Domestic financial market reforms focused initially on the development of the stock market. The Securities Exchange of Thailand was established in 1975, and the Securities Exchange Act was amended in 1984. Thailand adopted a number of subsequent reforms aimed at developing the stock exchange, including the establishment of the Securities and Exchange Commission in 1989; the creation of an automated trading system to replace manual transactions in 1991; and the passage of the Securities Exchange Act and the Public Company Act B.E. 2535 in 1992. The Acts, designed to support and promote the stock market, allowed public and private companies, listed and unlisted, to issue stocks and bonds. At the same time, the Thai Rating and Information Services was established as a credit rating agency to aid the development of corporate debt markets. Over the period, the number of companies listed on the exchange more than tripled, and the annual average growth in stock market capitalization was a remarkable 57 percent during 1987-94.

Following a crisis among the finance companies in the first half of the 1980s, measures to strengthen the banking system were introduced in 1985, including strengthened prudential standards and improved on- and off-site monitoring. Despite these improvements, the banking system continued to have an oligopolistic structure, which was reflected in large spreads between the deposit and lending rates (see Appendix Table 6.13). Moreover, the 1997 banking crisis indicated that there were a number of financial sector weaknesses that were not fully addressed following the earlier banking crisis.

Interest rates and credit controls were liberalized gradually, and in 1992 the ceilings on savings deposits and lending rates were removed. Nevertheless, indirect monetary instruments were not well developed, and the authorities relied to a considerable extent on foreign exchange swaps to manage the liquidity effects of capital inflows. In the context of the fixed exchange rate regime, such swaps generally involved the central bank setting a forward exchange rate that did not deviate significantly from the spot exchange rate.

Thailand’s promotion of capital inflows, combined with a rapidly growing economy, contributed to substantial net capital inflows in the range of 9-13 percent of GDP between 1989 and 1995 (a much higher percentage than the other countries reviewed in this study). Net capital inflows were offset initially by repayments of official capital and subsequently by substantial deficits in the current account balance of payments, which reached 8 percent of GDP in 1995. Nevertheless the growth of broad money and inflation increased along with the surpluses in the overall balance of payments and in spite of fiscal consolidation (see Figure 6.4).

The composition of capital inflows evolved over the period and appeared responsive to the regulatory reforms and incentives for capital flows. Net direct investment inflows contributed to the initial strengthening of the capital account, but net portfolio inflows became more important with the subsequent reforms to promote investments in the Thai stock markets, the establishment of the Bangkok International Banking Facility, and the large positive interest differential. A growing proportion of the net inflows were short term in nature, reaching 60 percent of the total in 1995. Consequently in 1995, Thailand began to restrict short-term capital inflows by imposing 7 percent reserve requirement on banks’ nonresident baht accounts. These restrictions were extended in 1996, among other reasons, to cover new foreign borrowing of less than one year.

In 1996 growth and investment levels deteriorated in the face of an appreciating real exchange rate and capital inflows and exports declined sharply. The large current account deficit, high interest rates, and increasing inflation left the country vulnerable to external shocks and a shift in market sentiment. Moreover, serious weaknesses appeared in the financial system due to exposures to the property sector and inadequate loan provisioning. High interest rates to counteract outflows aggravated the solvency and liquidity position of many banks and finance companies, and resulted in intervention by the authorities to support the financial system. In July 1997, faced with a banking crisis, a run on the currency, and large foreign exchange losses, the authorities floated the baht and adopted a managed floating exchange rate.

In response to the currency crisis, sales of foreign exchange were restricted for all foreign exchange transactions except those applied to exports and imports of goods and services, and direct and portfolio investment. Banks that had been free to lend to nonresidents subject to open position limits became subject to temporary restrictions on baht lending to nonresidents. Forward outright transactions in baht with nonresidents and the selling of baht against foreign currencies to nonresidents were temporarily restricted (see Appendix Table 6.12). However, such measures did not in general prevent the selling of the currency, which continued to depreciate.

Lessons from the Country Experiences

While the four country experiences reviewed here are diverse, the approach to and the consequences of the capital account liberalizations contain some lessons for managing such reforms.

Sequencing of Reforms

Liberalizations of direct investment inflows were generally undertaken as part of broader strategies aimed at restructuring the real sectors of economies. These strategies included eliminating barriers to trade, adjusting initial exchange rates, removing restrictions on current payments and transfers, and accepting the obligations of Article VIII of the IMF’s Articles of Agreement, as well as liberalizing and promoting foreign direct investment inflows. Liberalizations of portfolio capital flows were generally coordinated with domestic financial sector reforms, especially the liberalization of domestic interest rates and movement toward indirect monetary instruments, strengthening of domestic security markets, and the reform of domestic banking systems and the foreign exchange market. In Chile and Korea, financial sector reforms tended to precede capital account liberalization, while in Indonesia opening the capital account helped to promote the restructuring and to improve the competitiveness of the domestic financial system. The currency crisis in Thailand illustrates the risks when liberalization does not cover all the necessary concurrent reforms. In that case, the strengthening of financial institutions and the development of indirect monetary instruments lagged the liberalization of the capital account.

The approach to the liberalizations of capital inflows and outflows varied depending on the particular priorities adopted by the country. In Korea, management of the current account balance of payments appeared initially to be the overriding consideration, and Korea sought to manage current account surpluses and deficits through regulatory and other changes that influenced capital inflows and outflows. Thailand actively promoted capital inflows while limiting outflows with the objective of supplementing domestic savings and promoting investment and rapid economic growth. Indonesia maintained a relatively liberal regime for capital outflows and gradually liberalized inflows with the aim of attracting foreign capital to assist the restructuring of its economy. Chile also liberalized capital inflows as part of its program of economic restructuring, and liberalized outflows in response to balance of payments considerations.

The pace of reforms varied. Chile and Korea followed a gradual approach to reforms. By contrast, Indonesia liberalized capital outflows early in the reform process; the liberalization of capital inflows occurred much later and more gradually. Thailand opened its economy to capital inflows, especially portfolio investment inflows, much more rapidly than the other countries surveyed but liberalized capital outflows only gradually.

Macroeconomic Management of the Liberalizations

Table 6.5 shows average comparative macroeconomic, financial sector, and balance of payments indicators for the four countries in the periods 1985-90 and 1991-96. In all cases, the capital accounts were more liberal in the second period than in the first. In all cases, net inflows of private capital accompanied the opening of the capital account, and all countries recorded surpluses in their overall balance of payments. In all cases, portfolio investment flows dominated direct investments. Indonesia’s balance of payments was less affected than the other countries by the removal of capital account controls, perhaps because restrictions on capital outflows had been liberalized much earlier in Indonesia. In all countries but Korea, the surpluses were combined with fiscal consolidation.

Table 6.5.

Averages of Selected Economic Indicators

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Sources: IMF, International Financial Statistics, World Economic Outlook, and Direction of Trade Statistics, various issues; and IMF staff estimates. Note: The averages cover the years where there is data available. Parentheses indicate a negative sign.

Excluding official capital.

Interest differential = deposit rate minus London interbank offer rate on three-month U.S. deposits.

The overall balance includes: current account, financial account, capital account, and net errors and omissions. Capital account figures are not shown because they are zero throughout the period.

Total capital = direct investment + portfolio investment + other investment minus official capital + net errors and omissions + misinvoicing.

The impact of the capital inflows on economic performance varied, however. Chile reduced its current account deficit as well as inflation, and also brought down the interest differential with foreign rates and the real deposit rate. The growth of broad money and domestic credit to the private sector was generally constrained in the context of a managed floating exchange rate. In contrast, Korea and Thailand experienced rapid growth of money and domestic credit in the context of stable exchange rates against the U.S. dollar, and in both cases, inflation accelerated and the current account balance of payments weakened. Thailand also faced a currency crisis. In Indonesia, broad money and private credit grew rapidly, inflation accelerated, the current account remained in deficit, and the rupiah came under speculative pressure.

How can the differences in performance be explained? One explanation begins with the observation that the ratios of broad money and private sector credit to GDP fell in Chile at the same time as private capital inflows increased as a percent of GDP, while in the other countries the ratios of broad money and private sector credit to GDP increased significantly (see Figure 6.5). Thus, for a time in Chile, net private capital inflows appear to have substituted for domestic intermediation, while in the other countries the inflows were associated with an increase in such intermediation, and with a rapid expansion in credit to the economy. In turn, this may explain the accelerating inflation and the weakening current account performances in the latter countries. Where the credit expansions were also associated with banking sector problems, this situation can create particular concerns about the efficiency of use of the capital inflows, and thus the sustainability of the balance of payments, and lead to a loss of confidence and capital outflows.

What may determine the different monetary and credit developments? Part of the explanation may reflect the fact that Chile implemented substantial financial sector reforms in the 1980s and adopted strengthened prudential standards earlier than in the other countries. The initial expansion in credit that often accompanies financial sector liberalization may therefore have occurred earlier in Chile than in the other countries surveyed, and the strengthened bank supervision may have led to a better pricing of risks and avoidance of banking problems.

Second, all of the countries sought to manage capital inflows through their regulatory regimes. In Thailand, the regulatory and institutional framework generally favored such inflows, while in other countries limits were applied to certain inflows or controls were liberalized gradually. As a consequence, net private capital inflows were larger as a percent of GDP in Thailand than in the other countries, and a large part of these inflows through the international banking facility were short term in nature, which may have increased Thailand’s vulnerability to a reversal of such flows.

Figure 6.5
Figure 6.5

Capital Flows, Private Sector Credit, and Current Account Deficit, 1985-96

(In percent of GDP)

Sources: IMF, International Financial Statistics, and World Economic Outlook.

There is no strong evidence that the reintroduction of controls was particularly effective in limiting overall capital inflows. The capital controls may have influenced the composition of such flows, and thus had some impact in determining whether the net inflows were directed to the domestic banking system. Chile actively sought to discourage capital inflows to the banking system. Indonesia and Thailand also became concerned by the volume of inflows to their banking systems, although in Thailand this concern came late in the reform process. The introduction in 1991 and subsequent intensification of controls in Chile did not appear to result in a marked growth of bank credit. In fact, private sector credit increased as a percent of GDP after 1991 (see Figure 6.5). Also, at a theoretical level it is not clear that a restriction on certain types of inflows would be particularly effective in limiting bank credit expansion in view of the potential fungibility of capital.

Finally, the countries had different exchange rate regimes. The countries that appeared to better manage the capital inflows followed more flexible exchange rate arrangements. Such flexibility generally created greater autonomy for monetary policy in managing the effects of capital inflows and may itself have helped to discourage short-term speculative capital flows. Part of Chile’s successful management of capital account liberalization may be partly attributed to its more flexible management of the exchange rate within a preannounced crawling band. In contrast, Thailand’s maintenance of a fixed exchange rate limited the flexibility of its monetary policy to constrain the growth of money and credit in the face of significant capital inflows. When combined with Thailand’s policy of promoting capital inflows, the fixed exchange rate arrangement may have initially created unrealistic expectations about the rates of return. When market sentiment changed, the result was a sharp reversal of capital inflows.

Capital Account Liberalization and the Asian Currency Crisis

The currency crises in Asian countries were preceded by a sizable buildup of short-term foreign liabilities. This section investigates one aspect of the events leading up to the Asian crisis—namely, whether the nature of regulation of capital movements, and in particular, the sequencing of the liberalization of the capital account, contributed to the buildup of short-term debt in the three main Asian crisis countries—Indonesia, Korea, and Thailand.

Growth of Short-Term Liabilities

As the description of individual experiences indicate, Indonesia, Korea, and Thailand adopted markedly different approaches to the liberalization of their capital account regimes in the years leading up to the crisis. Generally, the capital account regulations were not directly biased toward short-term external borrowing:

  • In Indonesia, there is no strong indication that regulations favored any particular maturity, especially shorter over longer maturities. In some instances (e.g., Presidential Decree No. 39 in 1991), ceilings were imposed on foreign commercial borrowing, except for purposes of financing long-term projects.

  • Korea followed a very cautious approach to liberalization of capital inflows into its security markets (see Park, 1998). In 1992, nonresidents were permitted limited access to the stock market, and the types of securities that residents could issue abroad were expanded. Foreign exchange banks were authorized to borrow abroad, but direct foreign borrowing by corporations was controlled. Beginning in 1994, the ceiling on banks’ foreign currency loans was lifted, but the Bank of Korea applied window guidance in the form of ceilings on banks’ medium- and long-term borrowings from international financial markets.17 The letter of the law, however, did not entail preferential treatment for short-term inflows, per se.18 The Korean regulations did, however, favor foreign borrowing (and onlending) by banks, over direct access by corporations to international capital markets; and credits from nonresidents to nonbank residents—with the exception of trade credits—were subject to prior approval.

  • In Thailand too, the general thrust of the regulatory framework did not differentiate between the maturity of the capital flows, per se, but it did tend to favor inflows directly intermediated by the domestic banking system. With the establishment of the Bangkok International Banking Facility in 1992, the government tried to improve the access of domestic entities to international capital markets through the banking system, and this helped to channel short-term inflows through the banking system. The authorities subsequently pursued a policy of promoting foreign investments into the country, and security markets were also liberalized. Nevertheless, the inflows of foreign capital through the capital and money markets, controlled by the Security and Exchange Commission, lagged behind those intermediated through the banking sector.

Thus, while there was no strong regulatory bias toward short-term flows except in one respect in Korea, the capital account regulations did bias flows toward the local banking system in Korea and Thailand in particular. This institutional bias seems to have indirectly favored short-term borrowing rather than longer-term flows, since banking institutions normally tend to rely on shorter-term finance. The heavy reliance on short-term flows also reflected inadequacies of risk assessment, management, and control.

The emphasis on bank-intermediated flows was, on the surface at least, consistent with the existing financial structure in these economies. Commercial banks dominated financial intermediation in all three countries, and the development of other financial markets was a more gradual process. For example, the bond market in Indonesia and Thailand barely reaches 10 percent of GDP, while in Korea it is currently equivalent to 50 percent of GDP, but with most corporate bonds guaranteed by financial institutions.19 Moreover, foreign lenders may have generally preferred to channel their loans through the banking sector to the extent that they saw it as less risky, and in view of the difficulties in assessing individual corporations because of more limited information on their balance sheets and prospects. Perhaps even more important in this regard is the possibility that banks were seen to be not just supervised, but backed more directly by the authorities. As a number of economists have stressed, there may well have been a strong element of implicit government guarantee associated with banks in these countries (see, among others, Dooley, 1997; and Krugman, 1998). To the extent such a perception was indeed held, both by the banks themselves and lenders to banks, this may have been an important factor in the lack of adequate currency and liquidity risk management in the banking sector. It is likely that the institutional biases in the capital account regulations interacted with these factors to exacerbate the buildup of inadequately-managed, short-term liabilities.

A second factor behind the buildup of short-term debt is that the underlying riskiness of the investments in these countries may have led to some preference by lenders for shorter maturities. The lack of well-developed bond markets, among other things, probably made pricing of longer-term debt more difficult. Residual uncertainty about the legal and financial infrastructure and relatively costly monitoring of local developments also tend to encourage external creditors to favor shorter-term investment over longer-term ones.20 To some extent, this effect might have declined over time, as apparently robust macroeconomic trends continued to obscure underlying weaknesses. Nevertheless, as the outlook for either the specific borrowing institution or the country more generally became more uncertain, the tendency to prefer shorter-term exposure would have reasserted itself. In such a situation, the interest rates charged by lenders typically increase to reflect the higher risk or uncertainty premium, but the premium itself typically tends to rise more than proportionally with the maturity of the loan. This is particularly so when hedging instruments for foreign exchange risks are limited to very short-term maturities. In these circumstances, the borrower would be squeezed into progressively shorter-term contracts, and could face difficulties in rolling over its obligations should conditions continue to deteriorate. Such a buildup of short-term liabilities can occur regardless of the regulatory environment, in view of the scope to effectively redenominate longer-term contracts into shorter-term ones, through derivative and other transactions.21

Developments in Indonesia seem to confirm a general market preference for shorter-term credit, except perhaps for the strongest and most sizable borrowers. Indonesia’s capital account regulations contained neither an obvious direct bias toward shorter-term rather than longer-term flows, nor a bias toward bank-intermediated inflows (bank borrowing was more restricted than private corporate borrowing, in fact). Nevertheless, to the extent that larger private Indonesian corporations had close links of various sorts with the authorities, moral hazard issues (a perception of official support) may well have played a role in the excessive and inadequately managed external borrowing, similar to that in the buildup of bank debt in Korea and Thailand.

Beyond the underlying reasons for market preferences for shorter-term and/or bank-intermediated external borrowing, and beyond any additional biases that may have been created by capital account regulations, a third important factor in the buildup of shorter-term external debt in the Asian crisis countries has been the incentives created by the macroeconomic environment. The three countries considered here all quite actively pursued either nominal or real exchange rate targets (a de facto peg in Thailand’s case), while orienting interest rates toward internal stability objectives. This resulted in significant periods of relatively high interest differentials, especially at the shorter end, and encouraged capital inflows that were substantially short term in nature, and in particular in the form of foreign currency borrowing. Such borrowing was largely unhedged because of expectations that relatively stable exchange rates would be maintained indefinitely.

Implications of the Crisis for Capital Account Liberalization

There are five main implications of the above analysis. First, the sustainability of inflows depends on the efficiency of the use of the funds, not least as regards the prudent management of the risks involved with external funding. Specifically, the channeling of funds through banking sectors where risk management was relatively weak and unsophisticated and where distorted incentive structures and moral hazard prevailed ultimately brought this efficiency into question. The rapid bank credit expansions strained credit assessment procedures and resulted in banks channeling newly borrowed funds into unprofitable or speculative activities, such as real estate lending, while the prudential supervision framework was not strong enough to curtail these trends effectively. The same issues arise where external borrowing by corporations is guaranteed by financial institutions, as in Korea. A major concern is, therefore, to ensure that commercial banks comply with appropriate prudential standards, including procedures for the management of asset and liability (liquidity) risks, and that banks face appropriate incentive structures (e.g., moral hazard is avoided as much as possible, and there are appropriate controls on lending to interrelated entities).22

Second, appropriate risk management incentives are also fundamental to avoiding excessive direct external borrowing by nonbank corporations. Prudential measures applied to financial institutions may have some indirect effect here (to the extent that corporations borrowing offshore also borrow from local banks). But more central is the need to avoid implicit government guarantees of corporations and associated moral hazard, as with the banks themselves. In addition, exchange rate regimes that avoid excessive rigidity tend to create a much greater awareness, both among banks and nonbanks, of the need to manage exchange rate risk.

Third, increasing recourse to shorter-term debt can be an indicator of growing uncertainty about economic prospects. The monitoring and disclosure of such debt is, therefore, important, both as a guide to domestic macroeconomic management, and as an input into better informed decision making by international financial markets. However, because of the scope to redenominate longer-term debt as short-term debt, statistical measures of short-term liabilities may not always be easy to interpret, particularly in the lead-up to a crisis when private lenders may seek to change quickly the composition of their assets.

Fourth, where restrictions remained on capital market issues abroad by resident corporations and on nonresident purchases of securities on the local market, it might well have been desirable to speed up the development of the longer-term security markets both through domestic capital market reforms (including greater disclosure of information by borrowers), and by removing the capital controls. With an appropriate public sector-private sector relationship that avoids moral hazard, allowing corporations access to the international bond markets could have an important market disciplining effect, since such access would require meeting higher financial disclosure standards. More broadly, policymakers need to be careful when liberalizing capital flows that they do not unduly favor some types of channels or instruments over others—a less than level playing field could skew the incentives for different groups in ways that are unhelpful for prudent competition and sound risk management.

Fifth, it is not clear that the reintroduction of controls helped much, either before the crisis, or especially once the crisis had begun. Thailand and Indonesia resorted to capital controls in an effort to reduce inflows before the crisis, and to restrict outflows during the crisis.23 The more recent controls generally aimed to restrict forward or derivative transactions and their financing, but during the crisis they sent a negative signal to the market discouraging further capital inflows at a critical juncture. It is notable that most of the new controls introduced in Thailand were removed again in early 1998, while in Korea the emphasis was solely on liberalizing measures throughout the crisis. In Indonesia too, liberalization measures were taken in addition to the single restrictive measure.

Conclusion

Opening the capital account can have significant benefits for economic growth and welfare. Achieving the benefits of the liberalization, however, while minimizing the risks requires attention to the sequencing of the reforms and the pacing of capital account liberalization to macroeconomic and exchange rate policies. What is generally important for managing the volume of capital flows is the overall incentive structure that can give rise to such flows. This will be influenced by the regulatory regime for capital movements, the stage of development and soundness of financial systems, and the configuration of interest rates and exchange rates.

Therefore, countries should adopt a coordinated and comprehensive approach to reforms, of which capital account liberalization is an integral part. Such a public policy approach requires attention not only to the sequencing of the regulatory and institutional reforms that impact on capital movements, but also to the design of macroeconomic and exchange rate policies.

The experience of the Asian countries confirms that it is necessary to approach capital account liberalization as an integral part of a more comprehensive program of economic reform, coordinated with appropriate macroeconomic and exchange rate policies, and including policies to strengthen financial markets and institutions. The question concerns not so much speed, since some of the countries in Asia have followed a very gradualist approach. Rather, it concerns the appropriate sequencing of the reforms and, more specifically, what supporting measures need to be taken.

The liberalization of inflows through the banking system clearly needed to be more fully supported with reforms to encourage stronger management and supervision in that sector. There was also clearly a need to avoid moral hazard problems as much as possible for corporations as well as banks; and, in the more liberal market environment, to have adequate transparency and improved information flows so that there could be informed market decision making, which would in turn reduce the risks of sharps shifts in market sentiment in response to uncertainties. There was also a need to develop markets for hedging and managing risks, which are an essential part of efficient market-based financial systems and were notably lacking in many Asian economies.

Finally, policymakers need to recognize that with more open capital accounts a country’s interest rate policy will be constrained by its choice of exchange arrangement and vice versa. Greater attention has to be given to an appropriate, internally consistent mix of macroeconomic policies to avoid creating incentives for excessive short-term capital inflows, and the risk of subsequent sharp reversals.

Appendix

Appendix: Country Tables

This section contains tables that provide a detailed matrix of the sequence of reforms to domestic and external transactions in Chile, Indonesia, Korea, and Thailand. It also features tables containing selected economic indicators for the four countries.

Table 6.6.

Chile: Sequencing of Reforms in the Domestic and Exchange Sectors

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Sources: Annual Report, Central Bank of Chile (various issues); International Tax Summaries: A Guide for Planning and Decisions, Coopers and Lybrand (various issues); Annual Report and Exchange Arrangements and Exchange Restrictions, IMF (various issues); Doing Business in Chile, Price Waterhouse, 1995; The Securities Market in Chile: 1980-1989, Chile, Superintendencia de Valores y Seguros; and Tax Laws of the World: Chile, Foreign Tax Publishers, 1989.
Table 6.7.

Chile: Selected Macroeconomic, Financial Sector, and Balance of Payments Indicators

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Sources: IMF, International Financial Statistics, World Economic Outlook, and Direction of Trade Statistics, various issues; and IMF staff estimates.

Interest differential = Deposit rate minus London interbank offer rate on three-month U.S. deposits.

The overall balance includes: current account, financial account, capital account, and net errors and omissions. Capital account figures are not shown because they are zero throughout the period.

Total capital = direct investment + portfolio investment + other investment minus official capital + net errors and omissions + misinvoicing.

Table 6.8.

Indonesia: Sequencing of Reforms in the Domestic and External Sectors

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Sources: Report for the Financial Year, Bank Indonesia, (various issues); Annual Report on Exchange Arrangements and Exchange Restrictions, IMF, (various issues); Doing Business in Indonesia, (various issues), Price Waterhouse; international Tax Summaries: A Guide for Planning and Decisions, Coopers and Lybrand International Tax Network, (various issues); and IMF staff estimates.
Table 6.9.

Indonesia: Selected Macroeconomic, Financial Sector, and Balance of Payments Indicators

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Sources: IMF, International Financial Statistics, World Economic Outlook, and Direction of Trade Statistics, various issues; and IMF staff estimates.

Interest differential = Deposit rate minus London interbank offer rate on three-month U.S. deposits.

The overall balance includes: current account, financial account, capital account, and net errors and omissions. Capital account figures are not shown because they are zero throughout the period.

Total capital = direct investment + portfolio investment + other investment minus official capital + net errors and omissions + misinvoicing.

Table 6.10.

Korea: Sequencing of Reforms in the Domestic and External Sectors

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Sources: Annual Report, Bank of Korea (various issues); Annual Report on Exchange Arrangements and Exchange Restrictions, IMF, (various issues); Doing Business in Korea, (various issues), Price Waterhouse; International Tax Summaries: A Guide for Planning and Decisions, Coopers and Lybrand International Tax Network, (various issues); and Securities Market in Korea, 1992, Korea Securities Dealers Association; and IMF staff estimates.

As a result, over the year, the refinancing outstanding of the financial institutions decreased by $1.8 billion and bank loans totaling $1 billion were repaid before maturity (Annual Report, Bank of Korea, 1986, p. 28).

Table 6.11.

Korea: Selected Macroeconomic, Financial Sector, and Balance of Payments Indicators

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Sources: IMF, International Financial Statistics, World Economic Outlook, and Direction of Trade Statistics, various issues; and IMF staff estimates.

Interest differential = deposit − Londoninterbank offer rate on one-year U.S. deposits.

The overall balance includes: current account, financial account, capital account, and net errors and omissions.

Total capital = direct investment + portfolio investment + other investment − official capital + net errors and omissions + misinvoicing.

Table 6.12.

Thailand: Sequencing of Reforms in the Domestic and External Sectors

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Sources: Bank of Thailand, Annual Report, various issues; IMF, Annual Report on Exchange Arrangements and Exchange Restrictions, various issues; IMF, Quarterly Report on Exchange Rate Arrangements, various issues; Doing Business in Thailand, Price Waterhouse, 1992; The Thai Stock Market: Leading in Sustained Growth, Association of Members of the Stock Exchange, 1991; Finance Industry in Thailand, Association of Finance Companies, 1991; Foreign Direct Investment in Asia, by E.K.Y. Chin − Asian Productivity Organization, 1990; Tax Laws of the World: Thailand, Foreign Tax Publishers, 1989; Guide to the Investment Regimes on the Fifteen APEC Member Countries, 1993; Thailand’s Laws and Policies on Foreign Investments, S. Sathirathai, and Y. Sudharma in Current Developments in International Investment Law ed. by Ho Peng Lee, 1992; Asian Stockmarket Factbook, SWIFT, 1994/95; and The Emerging Asian Bond Market: Thailand, World Bank, 1995.
Table 6.13.

Thailand: Selected Macroeconomic, Financial Sector, and Balance of Payments Indicators

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Sources: IMF, International Financial Statistics, World Economic Outlook, and Direction of Trade Statistics, various issues; and IMF staff estimates.

Interest differential = deposit rate − London interbank offer rate on three-Month U.S. deposits.

The overall balance includes: current account, financial account, capital account, and net errors and omissions. Capital account figures are not shown because they are zero throughout the period.

Total capital = direct investment + portfolio investment + other investment − official capital + net errors and omissions + misinvoicing.

Note: This chapter was first issued as IMF Working Paper 97/157, “Sequencing Capital Account Liberalization: Lessons from the Experiences in Chile, Indonesia, Korea, and Thailand,” in November 1997. It has been expanded here to include a section examining the relationship between the nature of capital account liberalization and the events leading up to the Asian currency crisis.

1

For a discussion of the sources of such market failures and the need for supporting reforms, see Johnston (1997).

2

For an early discussion of stock-flow portfolio analysis as applied to international capital movements, see Mundell (1963). See also McKinnon and Oates (1966), and Branson (1974).

3

For a discussion of the effectiveness of capital controls, see Johnston and Ryan (1994), Cardoso and Goldfajn (1997), and Dooley (1996).

4

Whether a capital control measure would mainly affect capital inflows or capital outflows may not be evident. For example, a control on the liquidation and repatriation of foreign-held capital, while strictly a control of capital outflows, has often been maintained for the purpose of discouraging capital inflows. Moreover, there is overlap between certain measures classified as exchange system measures and measures classified as changes in the capital control regime.

5

For a discussion of the banking crisis and official responses, see Velasco (1991). In 1986, the General Banking Law and the Organic Law of Superintendence of Bank and Financial Institutions were substantially modified to give banks a broader scope of transactions in recognition of new types of financial services and to reduce the risks of another banking crisis. In October 1989, Congress enacted a constitutional law establishing legal autonomy for the central bank, which gave it the mandate to ensure the stability of the financial system.

6

A 15 percent import surcharge was introduced on July 18, 1984, in addition to the existing 20 percent uniform import duty for products under 248 customs categories, partly replacing existing surcharges. The general tariff level was increased from 20 percent to 35 percent on September 22, 1984.

7

The main legal framework for foreign investment in Chile was the Decree-Law No. 600, or Foreign Investment Statute, of 1974 as amended several times, and the Compendium of Foreign Exchange Regulations of the Central Bank of Chile, in particular Chapters XII, XIV, XVIII, XIX, XXVI, and XXVIII. For legal interpretations of the Regulations, see Mayorga and Montt (1995).

8

Under the new mechanism, small external investors were able to participate in debt/ equity conversions without having to go through the case-by-case conditions normally applied to such operations.

9

Under the crawling exchange rate parity, the peso was devalued daily on the basis of the difference between domestic inflation in the previous month and expected external inflation. The exchange rate had also been widened in 1985 and 1988; see Table 6.1.

10

Sterilization policies were used throughout the entire period but more heavily during 1990-92 (see Lee, 1996). The main instrument used was that of open market operations in central bank paper (one-year promissory notes). Longer-term promissory notes (four- and six-year) were used in 1992. Also in 1992, the central bank raised the real annual interest rate posted by the central bank on auction of its 90-day indexed promissory notes, and in 1993 a more active use of repurchase agreements was introduced.

11

Regulations on the surrender and repatriation of foreign exchange earnings were also relaxed, and authorized exchange houses were permitted to conduct forward and swap operations in the official exchange market.

12

The total net private capital account is defined as net direct portfolio and other investment minus net official capital plus net errors and omissions in the balance of payments plus an estimate of misinvoicing. For a discussion of this measure, see Johnston and Ryan (1994).

13

For example, new banking law was issued in 1992 that provided guidelines consistent with accepted international banking.

14

In July the central bank imposed limits on bank loans to real estate developers who wanted to purchase land, and restrictions were made on banks such that they were not permitted to buy commercial paper from developers raising finance to buy land.

15

In the first half of 1997, several measures were taken to ease investment inflows. For example, a capital increase of about $200 million was authorized for the Korea Fund; the limit on foreign ownership of Korean equities was raised from 20 percent to 23 percent; foreign investors were allowed to purchase nonguaranteed bonds of small- and mediumsized companies with maturities of three years and above and up to 50 percent of the issue; and restrictions on the usage of long-term loans with maturities of over five years brought into the country by foreign manufacturers were abolished.

16

Certain limitations on foreign ownership were retained on non-export orientated industries and on the maximum foreign ownership of companies listed on the stock exchange.

17

one explanation that has been offered for the maintenance of controls on longer term external borrowing by banks is that the Ministry of Finance and Economy was seeking to prevent a loss of control over financial institutions through possible debt/equity swaps.

18

Indeed, on joining the OECD in 1996, the authorities expressed their reluctance to ease capital controls further and explicitly stressed that they wished to maintain controls over short-term capital inflows that may “hamper macroeconomic and financial market stability.” For this reason the authorities resisted the liberalization of access by nonresidents to domestic money market instruments during the accession to the OECD. Frequently the law established detailed quantitative limits on the amount of the transaction or on the size of the firms that were allowed to trade on international markets.

19

By comparison, the bond market accounts for 110 percent of GDP in the United States, 90 percent in Germany, and 75 percent in Japan.

20

The nature of the Basle capital adequacy requirements for OECD creditor banks might also have played some role here. While lending to other OECD banks is given a risk weight of 20 percent for capital adequacy purposes, irrespective of the term of the loan, lending to non-OECD banks carries this weight only for loans of less than one year, while loans longer than that carry the full 100 percent risk weight. Since all lending to corporations also carries the same 100 percent weight, there is also an incentive to favor (short-term) loans to banks, rather than nonbanks in non-OECD countries.

21

Though it is clear that relatively new and innovative instruments such as credit derivatives and options can be used to achieve this effect, it can also be done in much more basic ways. For example, a “synthetic sale” of direct investments can be created relatively quickly and cheaply by obtaining a bank loan in domestic currency.

22

Overall, currency mismatches (open foreign exchange positions) were not a very significant issue in Asian banks, but liquidity mismatches (arising from excessive maturity transformation) and inadequate credit assessment were.

23

Outside the three main crisis countries, the Philippines took a number of successive measures to tighten certain capital controls from mid-1997, while Malaysia took one measure to tighten nonresident access to swap transactions.

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Cover Sequencing Financial Sector Reforms
Sequencing Financial Sector Reforms
ISBN:
9781557757791
Publication Date:
15 Mar 1991
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557757791.071
Pages:
412
Figure 6.1.

Chile: Selected Macroeconomic Indicators
Figure 6.2.

Indonesia: Selected Macroeconomic Indicators
Figure 6.3

Korea: Selected Macroeconomic Indicators
Figure 6.4

Thailand: Selected Macroeconomic Indicators
Figure 6.5

Capital Flows, Private Sector Credit, and Current Account Deficit, 1985-96

(In percent of GDP)