V Rapid Liberalization
- Age Bakker, and Bryan Chapple
- Published Date:
- September 2002
As discussed in Section IV, most countries have followed a gradual approach in liberalizing capital controls. Nevertheless, some countries proceeded more rapidly, particularly where economic performance in the 1970s was poor. Rapid liberalization has often followed a change of government and has been part of a radical change in policy direction. In all cases, the swift removal of capital controls has been accompanied by marked changes in macroeconomic policy strategies and wide-ranging deregulation in the financial sector. Unlike the experiences of France and Japan, rapid liberalization generally reflects a deliberate policy choice by the country concerned and is therefore perhaps less likely to be a result of external pressure.
A striking example is provided by the experience of the United Kingdom, which in the postwar period operated one of the most extensive systems of capital controls alongside tight domestic financial regulation. Despite extensive controls, the external constraints were felt repeatedly and the United Kingdom suffered frequent exchange rate crises and poor economic performance. In 1979, capital controls were abolished in one step, and the United Kingdom embarked on a major reorientation of economic policies. Other countries, attracted by its apparent success, also reduced capital controls over a short period of time. The need to deal with rapidly deteriorating economic circumstances can provide an alternative source of pressure, as the subsequent account of New Zealand’s experience illustrates. This section focuses on the experience of rapid liberalization in the United Kingdom and New Zealand and also briefly discusses the Nordic liberalization experiences.
Rapid Liberalization in the United Kingdom
Since World War II and until 1979, the United Kingdom had operated a tight capital control system, codified in the 1947 Exchange Control Act. The main motive was to protect the exchange rate and preserve official foreign exchange reserves by restricting residents’ cross-border capital movements. Because nonresidents could freely move in or out of sterling once external convertibility had been restored in 1958, capital controls imposed on residents could not prevent large net flows at times and so could not avert periodic sterling crises. A further key concern in the postwar years was the continuous overhang of sterling reserves held by the former sterling area countries and Commonwealth countries as the pound sterling became less important as a reserve currency. Sales of these countries’ sterling reserves led to downward pressure on the exchange rate, and the United Kingdom experienced a severe exchange crisis in 1967 when official sterling balances were unloaded.
The United Kingdom became a member of the European Community in 1973 and, under transitional arrangements, was permitted to postpone the liberalization of all capital transactions that had previously been liberalized by the founding member states under the European directives.42 A further sterling crisis in November 1976 prompted an additional tightening of capital controls to their postwar peak. Outward portfolio and direct investment flows, lending to nonresidents, and resident holdings of foreign currency deposits were tightly limited. For direct investment abroad, British industry needed to seek foreign financing or acquire foreign currency at a premium through the so-called investment currency market, which had been in operation since 1947.43 In this closed-circuit market, foreign exchange needed for procuring foreign securities could be purchased with the proceeds from the sale of previously held foreign securities. Actually, the regulatory regime was not intended to, and in fact did not. significantly influence direct investment flows themselves but was instead intended to control the financing of these flows.44
The stop-and-go economic policies of national administrations through the 1970s adversely affected investment flows and resulted in a less favorable economic performance compared with continental European economies. The incoming Conservative administration, which took office in 1979, placed a high priority on the restoration of market forces through deregulation.
The exchange rate came under considerable upward pressure from early 1979, influenced by the second oil price shock, which boosted sterling owing to the extent of oil production in the United Kingdom. Initially this upward pressure was countered by interventions, but when these resulted in overshooting of domestic monetary aggregate targets, the exchange rate was allowed to float freely. A substantial appreciation of sterling followed (with the nominal effective exchange rate appreciating by approximately 12 percent over a six-month period), causing concerns about competitiveness and a serious deterioration of the non-oil current account. These developments, combined with a comfortable level of official exchange reserves, reduced the arguments for maintaining capital controls (which, in any event, had been gradually eased since 1976).45 Soundings taken among institutional investors, whose foreign asset holdings had been restricted through the operation of the investment currency market, indicated that they wished to diversify their portfolios by increasing the share of foreign assets by 10 percentage points. This could, it was thought, exert a welcome downward pressure on the exchange rate. A further factor explaining the relaxation of controls was the desire to maintain the position of London as a major financial center.
The circumstances for dismantling capital controls in 1979 were therefore favorable. At the same time, there were considerable risks. In particular, the very high level of domestic cost increases (wages increased by around 15 percent in 1979) was a cause for concern. It was hoped that the decrease of inflation brought about by the earlier exchange rate appreciation would lead to lower wage demands. There were concerns, however, that labor unrest, which had contributed to serious exchange crises in the past, could prevent wage demands from falling. At the same time, nominal interest rates were at high levels (Figure 5.1) and the fiscal situation was about to improve. In weighing these risks, the new government was well aware that the abolition of capital controls needed to be accompanied by domestic deregulation and macroeconomic policies oriented toward stabilization. In addition, it was necessary to break the wage-price spiral to ensure that the benefits were not lost through a loss of competitiveness and eventually another severe exchange rate crisis.
Figure 5.1.United Kingdom: Interest Rates, 1970–80
Source: Thomson Financial.
Following a partial relaxation from June 1979 onward, remaining restrictions were abolished in one step in October 1979.46 Capital account liberalization marked the start of further domestic deregulation and the enhancement of market forces. It was followed by the removal of direct credit controls, which, in the absence of capital controls, were no longer effective. Informal encouragement by the Bank of England for banks to not encourage borrowing abroad proved to be ineffective. The marginal reserve requirements on increments of interest-bearing deposits, which were intended to curtail funding for credit and were popularly known as the “corset,” were eliminated in June 1980. This was followed by a general overhaul of monetary policy in 1981, when indirect control mechanisms were introduced.
It is difficult to separate the effects of capital account liberalization from the strong upward pressure on the exchange rate emanating from market-oriented government policies and the influence of the North Sea oil discovery. In general, there is no strong evidence of a major net effect on direct foreign investment flows arising from the abolition of capital controls. In contrast, there was a sizable effect on portfolio investment flows. Outward portfolio investment flows, which were very small until the abolition of the investment currency market, subsequently increased sharply, whereas the increase in inward flows was smaller, resulting in a net outward flow estimated at £30 billion over a five-year period.47 The currency substitution with respect to the financing of outward portfolio and direct investment flows, which took place after the abolition of capital controls, shows that these controls must have been substantially effective, although the periodic crises suggest that significant capital flows could still occur at times. All in all, the increase in overseas demand for sterling assets was probably smaller than the pent-up demand of U.K. residents for overseas assets at the time of the liberalization.
The liberalization of capital controls was part of a more encompassing policy package aimed at increasing efficiency; improving the functioning of the labor market; and, more generally, injecting new dynamism into the U.K. economy. Economic growth did improve during the 1980s and inflation fell. Nevertheless, there were transitional costs, including a period of industrial unrest, and an asset price bubble developed toward the end of the 1980s. Exchange rate volatility was also problematic at times, although this was viewed as less costly than attempting to use capital controls to limit that volatility.
Rapid and Extensive Reforms in New Zealand
The New Zealand experience is of interest because of the extremely rapid pace of economic reforms and their comprehensive range.48 Prior to the reforms (which began in mid-1984), regulation of the economy was pervasive. Capital controls formed part of the regulatory environment and were intended to limit the outflow of funds (particularly portfolio flows). In addition, controls helped support the exchange rate peg.49 The capital controls were combined with import controls on a wide range of products and requirements for exporters to repatriate foreign currency receipts through the banking system. Inward direct investment was allowed (although prior approval was required), as was the repatriation of funds by foreigners. The controls sought to offset the impact of adverse external developments on national income. However, the failure to adapt structural policies in response to a long-term decline in New Zealand’s terms of trade resulted in persistent current account deficits, an ongoing exchange rate depreciation, and relatively high inflation.
Capital controls also allowed the government to operate a monetary policy that was to some extent independent of exchange rate considerations. By mid-1984, most interest rates were controlled, since the government sought to maintain cheap access to credit (reversing the significant deregulation of the financial system in the late 1970s). Monetary policy was operated by adjusting the proportion of assets that financial institutions were required to hold in the form of government securities. Limits on credit expansion were also used to try to offset inflation pressures, resulting in credit rationing. These controls were not fully effective, however, and regulations were introduced in mid-1982 that froze interest rates and prohibited most increases in prices and wages.50
Some tentative liberalization in the foreign exchange market occurred in 1983 with the licensing of additional foreign exchange dealers and a decision to allow intraday fluctuations in the exchange rate within a specified band. The Reserve Bank of New Zealand, the country’s central bank, also withdrew from the forward market for foreign exchange, allowing private sector participants a greater role in the market. More significant reforms began following a change of government in July 1984 and were hastened by a foreign exchange crisis immediately prior to the election.51 Subsequent to the election, the exchange rate was devalued by 20 percent and the new government embarked on a program of economic reform.
The 1984 foreign exchange crisis encouraged the authorities to deregulate financial markets by illustrating the limited ability of capital controls to support the currency in the face of increasing indications that adjustment was necessary. Capital controls were progressively eased over the following months; and in December 1984, most remaining controls were abolished, allowing free portfolio flows.52 Although some forms of direct inward investment required approval, this became largely automatic for investment in most sectors of the economy. The final step in the process was taken in March 1985, as New Zealand moved from an exchange rate pegged against a basket of currencies to a freely floating exchange rate, allowing the operation of an independent monetary policy.53 Contrary to some expectations, the exchange rate appreciated significantly as higher interest rates (associated with the move to a firmer monetary policy stance) and the broad economic reform program encouraged significant capital inflows.54
Deregulation of the domestic Financial system also proceeded rapidly. Controls on interest rates and credit growth were abolished in July and August 1984, allowing the implementation of monetary policy to move from direct controls to indirect means (via open market operations). Interest rates rose sharply as a result of the decision to focus monetary policy on reducing inflation (Figure 5.2).
Figure 5.2.New Zealand: Inflation, Credit Growth, and Interest Rate, 1980–95
Sources: IMF, International Financial Statistics (Washington), various issues; and Reserve Bank of New Zealand.
1 CPI denotes the consumer price index.
The reforms occurred at a time of relatively healthy economic growth. Reflecting pent-up pressure for wage and price adjustments following the freeze, as well as an asset price boom, inflation rose rapidly from artificially low rates in 1984.55 At the same time, rising interest rates and the exchange rate appreciation indicated a tightening of monetary policy. Increased competition between financial institutions helped feed the boom in equity and urban property prices, despite the very high interest rates, with equity prices rising by 160 percent during 1985–86. Despite the signs of inflationary pressure in some sectors of the economy (and private sector credit growth averaging more than 30 percent in 1985–86), the weakness of the tradable sector limited the scope for additional monetary policy tightening.56
Inflation and domestic demand showed signs of easing toward the end of 1987 as the effects of the tight monetary policy took hold and the worldwide stock market crash contributed to the end of the asset price boom. The rapid appreciation in the exchange rate also contributed to the difficulties by placing the traded goods sector under pressure. The financial sector also came under considerable pressure as a result of a fall in asset prices, with banks suffering sizable loan losses (particularly against lending on property and to entrepreneurial companies). One mid-sized bank failed and the country’s largest bank required an injection of capital from the government (its majority shareholder). Despite the pressure on banking sector capital, however, there was no financial crisis.
Although data on overseas debt levels show that the private sector took advantage of the ending of capital controls to increase offshore borrowing, the increase was relatively modest.57 Moreover, the problems in the banking sector were the result of poor credit controls in the newly liberalized financial sector and reflected the poor risk-management culture and inadequate corporate governance. To that extent, the problems were not directly linked to foreign exchange exposure. The floating exchange rate seems to have reduced the incentives to take unhedged foreign exchange positions. The degree of exchange rate volatility in the years immediately following the reforms presumably increased awareness of exchange rate risks.
The transition costs of liberalization and deregulation (including higher unemployment) were greater than expected and at least partly reflect the fact that fiscal consolidation, along with reform of the labor and some product markets, lagged behind reforms in other sectors of the economy. The exchange rate appreciation added to these costs, as did the asset price boom (which was probably influenced by financial market deregulation) and the subsequent asset price slump. If risk-management capacity within the financial sector had been stronger, and if supervisory standards had been tightened prior to financial sector reform, the asset price cycle might have been less pronounced. Nevertheless, it is difficult to disentangle the extent to which macroeconomic developments were influenced by reforms per se (including capital account liberalization), by macroeconomic policies aimed at stabilization, or by external shocks. Overall, however, the reforms were characterized by a move toward a coherent and consistent approach to economic management. The early floating of the exchange rate was also beneficial because it allowed monetary policy to focus on domestic price stability. The initial changes triggered a dynamic process that encouraged further reform in subsequent years—including in banking supervision (where there is now an increased emphasis on the risk-management capacity of financial institutions, as well as on fuller disclosure and stronger market discipline).
Other Rapid Liberalization Experiences During the 1980s
Australia, Denmark, Finland, Norway, and Sweden also undertook fairly rapid capital account liberalization and deregulation of domestic financial markets during the 1980s. Their reforms followed the growing ineffectiveness of controls, given the increase in international integration and growing disintermediation of financial activity from banks toward less regulated parts of the financial sector. In addition, reforms reflected a desire to increase economic efficiency and were in line with multilateral obligations (for example, to the OECD or the EU).
As in New Zealand, the reforms resulted in an increase in private sector credit, because of both strong economic growth and portfolio adjustments, as the private sector adapted to the new environment. To varying degrees, there was also an asset price boom. When growth eventually slowed, loan losses mounted rapidly in Norway, Finland, and Sweden, leading to banking crises.58 The combination of domestic financial market reform and inappropriate macroeconomic policy settings, coupled with insufficient strengthening of the prudential environment, appear to have led to these crises. Although capital liberalization resulted in increased overseas borrowing in some countries, the roots of the crises lay in the response of the banking system to the changed environment. Denmark escaped any significant financial sector difficulties despite experiencing significant loan losses. The tightening in prudential supervision prior to the reforms is likely to have assisted in preventing any crisis.59 Australia also escaped a generalized crisis, although some of its banks experienced difficulties and required capital injections.
Exchange rate regimes also differed between countries. Australia moved to a floating exchange rate during the reform process while the other countries maintained pegs. Eventually, Finland, Norway, and Sweden were forced to devalue their currencies during the economic downturns. The value of foreign currency debt increased accordingly, adding to the burden of domestic loan losses.
As is the case with gradual liberalization, experiences of rapid liberalization vary widely. However, rapid capital account liberalization has generally occurred around the same time as, or immediately following, deregulation of the domestic financial system. Reforms often coincided with a period of strong economic growth, boosted by the increased availability of credit. In a number of countries, the associated boom in asset prices and bank lending led to a financial sector crisis when the economic boom ended.
Determining why some countries experienced a financial sector crisis following reforms is not straightforward. However, two key points emerge from the experiences discussed. First, given the increased risks that are present in a deregulated environment and the loss of economic rents that financial institutions may previously have enjoyed, it is important to ensure that prudential practices and standards are strengthened to meet the challenges of the new environment and that banking system capitalization is sufficiently strong prior to undertaking reforms. Both supervisory authorities and financial institutions need to enhance their risk-management capabilities.60
Second, macroeconomic policy must be credible and sustainable. Undertaking liberalization as part of a broader package of reforms (as was done in the United Kingdom and New Zealand) appears to increase the credibility of the changes. A supportive program may be particularly important when monetary policy is directed at maintaining an exchange rate peg. An exchange rate peg prevents monetary policy from reacting to any macroeconomic imbalances, thus increasing the need for sound fiscal policies. At the same time, a perceived commitment to a fixed exchange rate reduces the incentives to hedge foreign currency borrowing. The eventual exchange rate realignments in Sweden, Finland, and Norway (owing in part to unbalanced macroeconomic policies) increased the burden of foreign debt and intensified the crises. In contrast, the floating exchange rates in New Zealand and Australia reduced the incentive to accumulate foreign currency exposure. Exchange rate flexibility is likely to be particularly important where liberalization is rapid and occurring alongside other reforms. In such circumstances, monetary policy flexibility can be useful to help maintain macroeconomic stability.
Even where financial sector crises have followed reforms, countries have not reintroduced capital controls. Instead, prudential controls have been strengthened and economic reforms have continued. Rapid capital account liberalization and deregulation of financial markets expose policymakers to the disciplines of international capital markets and can help ensure that the momentum of the reform process is maintained.