VI Summary and General Lessons
- Age Bakker, and Bryan Chapple
- Published Date:
- September 2002
The previous chapters illustrate that advanced countries have followed considerably diverging patterns in undertaking capital account liberalization, reflecting both international circumstances at the time of liberalization as well as their own economic and political situations. The main motives for maintaining capital controls were to limit exchange rate movements and to preserve a degree of independent monetary policy (and thereby to increase economic policy autonomy more generally). In some cases, these motives were linked to a desire to protect and stimulate domestic industry or to taxation considerations. This chapter briefly summarizes the variety of liberalization processes undertaken in advanced countries, discusses the relationship of liberalization to other policy areas, and concludes with a brief assessment.
Although governments tended to see capital controls as an integral part of economic policy until recent decades, the effectiveness of these controls varied considerably and tended to erode over time as markets adjusted to them. At times, capital controls were able to have some stabilizing effect, depending on the economic circumstances and the financial structure of the country concerned. Controls were more effective when the domestic Financial sector was heavily regulated and/or largely owned by the government. The circumstances of their introduction also influenced their effectiveness. Controls introduced as part of a more wide-ranging package of measures designed to restore confidence were likely to be more effective than controls introduced without supporting policies. During periods of relatively stable foreign exchange markets, capital controls may well have helped stabilize the exchange rate and provided greater monetary policy autonomy. But any success was. at best, temporary. The recurrence of exchange crises in some countries (for example, France, the United Kingdom, and New Zealand) illustrates that sizable capital flows remained possible when macroeconomic trends or policies were seen as unsustainable, regardless of the presence of capital controls. It was also found that capital controls provided only a temporary respite when they were imposed to offset speculative attacks and were usually not able to prevent an eventual exchange rate adjustment. Moreover, controls tended to remain in place for longer than originally intended (or announced), since the authorities failed to undertake the structural reforms that were needed to underpin sustainable macroeconomic policies. As controls lost their effectiveness in response to market innovation, the authorities often sought to close emerging loopholes rather than reform the entire system.
Eventually, advanced countries came to the view that capital controls involved more costs than benefits, while the increasing size of international financial markets and the growing sophistication of financial products made it increasingly difficult to maintain effective controls. Over time, the growing importance of financial markets in the economy meant that the real economic costs of controls tended to become more evident. For example, controls can hinder financial sector development and restrict the ability of companies to fully diversify in search of profitable opportunities. They may also disrupt the financing of trade and investment and impede the transfer of technology. In many countries, controls were removed as part of wide-ranging reforms aimed at increasing economic efficiency and growth. Capital controls were no longer used to shield the domestic economy from adverse shocks and postpone difficult policy adjustments. In general, countries recognized that liberalization was in their own interests.
The time taken for capital account liberalization varied considerably between countries, ranging from a considerable number of years for France and Japan to a matter of months for the United Kingdom and New Zealand. Experiences indicate that a successful liberalization under either approach critically depends on the accompanying macroeconomic policies and domestic reforms. On the one hand, the gradual approach generally allows changes to be made in an orderly manner, providing time for economic stabilization to become entrenched and for market participants to adjust, but this approach also runs the risk of being delayed by interest group lobbying, backtracking on previous reforms, or loss of (political) momentum. On the other hand, a rapid approach requires a strong institutional framework and, in particular, sound financial sector supervision in order to avoid excessive risk taking by financial market participants as economic rents (owing to controls and regulations) are eliminated. While a gradual approach allows time for other required policy changes to take place, this is not always taken advantage of, as the Japanese experience indicates. In practice, political feasibility may well determine the approach taken.61 In the EU, this political dimension was evident, since capital account liberalization was part of the process of achieving economic and monetary integration.
In most cases, direct investment flows have been formally liberalized ahead of portfolio flows. In practice, however, informal barriers or controls in other areas have often restricted inward investment flows for a considerable period. Japan is perhaps the most prominent example here, since it retained administrative procedures that slowed or dissuaded direct capital inflows for a number of years after the forma) abolition of controls. In most cases, restrictions on cross-border bank lending and foreign currency accounts opened by residents are among the last to be lifted. Besides the order in which cross-border financial transactions are liberalized, their proper sequencing in relation to reforms in other areas is critical if stabilization is not to be undermined. In particular, it is important to develop adequate prudential supervision standards before these flows are liberalized. (This is discussed further later in this section.)
Relationship of Liberalization to Other Policy Objectives
In order to avoid potentially destabilizing capital flows, credible macroeconomic policies are required prior to capital account liberalization. The sustainability (and flexibility) of fiscal policy is particularly important when monetary policy is geared toward the maintenance of an exchange rate objective and is therefore unable to respond to imbalances in the economy. Some European countries that were part of the EMS experienced sizable capital inflows following liberalization in the early 1990s. Monetary policy was unable to offset the impact of the expansionary inflows, and other policies were not sufficiently tightened, underlining the risk that capital inflows following liberalization can full the authorities into a false sense of security and delay macroeconomic reforms (as may be seen in Italy’s experience in the 1990s). Some currencies again came under downward pressure as sentiment turned around, and exchange rates had to be adjusted in the EMS crises of 1992 and 1993. The currencies of low-inflation countries came under considerable downward pressure at the same time, emphasizing the point that although macroeconomic stability is a necessary condition for successful capital account liberalization, it is not always a sufficient condition. Regardless of the macroeconomic fundamentals, markets will at times test the willingness of authorities to defend the exchange rate at a particular level.
When the exchange rate is floating, sizable capital flows can also have significant impacts on the exchange rate and therefore on the economy. Flexible product and labor markets are likely to be helpful in ensuring that the economy is able to adjust to changes in capital flows. Following capital account liberalization, investors are more easily able to move funds in response to policy decisions made by governments. In that sense, capital account liberalization can act as a useful disciplinary mechanism to promote the pursuit of stable and sustainable macroeconomic policies.
In addition to limiting the scope for monetary policy to respond to domestic developments following liberalization, the exchange rate regime may influence the behavior of borrowers. A perceived commitment to a fixed exchange rate may encourage borrowers to accumulate foreign currency debt (depending on relative interest rates) without hedging. If domestic imbalances are such that an exchange rate adjustment will eventually be required, the value of foreign debt increases in domestic currency terms and can add to financial (and corporate) sector stress. In contrast, a floating exchange rate increases the incentives to hedge foreign currency exposures, although the greater exchange rate volatility may lead to other economic costs. A floating exchange rate may be particularly important when liberalization is rapid and maintaining macroeconomic stability is more challenging. On the one hand, countries (such as the United Kingdom, New Zealand, and Australia) that moved to a floating exchange rate around the time of their rapid capital account liberalization experienced relatively minor financial sector difficulties compared with some Nordic countries where an exchange rate peg was maintained longer. On the other hand, the French experience in the 1980s indicates that a gradual process of capital account liberalization can actually enhance exchange rate stability within a multilateral system when it is combined with supporting macroeconomic policies.
Financial Market Reform and Monetary Policy Issues
Because credit controls are no longer effective when they can be offset by capital flows, advanced economies have all moved to indirect monetary control mechanisms at the time of, or prior to, the liberalization of capital account transactions. Deregulation of the domestic financial market is required to allow monetary policy to be implemented via indirect means and has normally preceded capital account liberalization (although in some cases, such as Japan, complete deregulation of the financial system did not occur until capital account liberalization was close to completion). Delaying domestic financial market reform runs the risk of financial sector activity transferring abroad following capital account liberalization. In both Japan and the United States, controls on the domestic financial system contributed to the development of offshore financial markets. Deregulated domestic financial markets are also likely to be more able to cope with the increased capital flows following rapid capital account liberalization.
When domestic financial systems are heavily regulated (that is, when they are characterized by segmentation between different types of financial institutions and limits to entry), rents accrue to various parts of the financial system and the incentives for innovation can be weak. In such an environment, premature capital liberalization can place financial institutions under pressure and increase the risk of financial crises. In several Nordic countries, property price boom-and-bust cycles, enhanced by bank-lending cycles, affected the value of collateral held by banks and resulted in financial crises. Other countries (such as Australia and New Zealand) also experienced periods of financial stress following similar asset price cycles. Although these episodes followed capital liberalization, they were primarily the result of domestic financial market deregulation that was insufficiently supported by monetary and prudential policies.
At the same time, capital liberalization can provide incentives to deregulate domestic financial markets. Moreover, competition from international markets and foreign entrants to the domestic market may be required to enhance competition and innovation. Achieving the appropriate balance between domestic financial market reform and capital liberalization is, therefore, not straightforward.
In those countries that moved to a floating exchange rate (for example, the United Kingdom, Sweden, Australia, and New Zealand), monetary policy strategies have moved toward direct inflation targeting in order to provide monetary policy and financial markets with a new anchor. Increased short-term exchange rate volatility has been accepted as a fact of life, although corporations are better able to hedge against exchange risks in a liberalized and deregulated financial environment. Given that exchange rate realignments frequently occur under fixed exchange rate regimes, currency movements measured over longer periods are not necessarily substantially different (or less predictable) under a floating exchange rate regime.
The formulation of monetary policy is complicated by the change in implementation procedures and the impact of financial sector reform and capital account liberalization on the transmission mechanism. Traditional relationships can alter, making it difficult for the authorities to distinguish between cyclical developments (which may require a monetary policy response) and portfolio adjustments (which may not). Arguably, a delayed monetary policy response exacerbated the economic cycle in some countries following liberalization, contributing to financial crisis. In some cases, this was because monetary policy was focused on exchange rate objectives.
Prudential Policy Settings and Financial Crises
Liberalization creates opportunities for risk diversification but, at the same time, can create significant new risks for banks, particularly when combined with the deregulation of domestic financial markets. Competition between financial institutions increases, creating incentives for institutions to lend more aggressively to maintain or increase their market shares. The increased ability of large corporations to borrow directly from capital markets adds to the pressures on banks. The traditionally close links between banks and their customers may be diminished, requiring banks to develop new methods of risk analysis. Combined with the tendency of economic reforms to generate increased confidence in the economy, these changes can encourage borrowing and sometime result in asset price booms. At the time, it is tempting to portray the expansion of capital inflows as reflecting portfolio adjustments. As the experiences of a number of countries illustrate, however, asset prices can rise to unsustainable levels and the subsequent price falls may precipitate a financial crisis.
Concerns regarding financial crises have increased over the past two decades—the possibility of financial crises was not viewed as a significant risk during earlier liberalization and deregulation episodes. There are a number of possible reasons for this change. Economies (and financial markets in particular) are now more integrated than was the case in earlier years. This is partly because more countries have now liberalized capital flows. However, the increasing size and sophistication of financial markets, and the development of new financial products have also played a role in increasing economic integration and are likely to increase the risk of financial crises. This increases the importance of institutional strengthening (particularly of prudential policies) prior to liberalizing capital flows.62
Harmonization of Regulations
Substantial differences exist between countries in such areas as taxation, prudential standards, corporate governance, and accounting standards. During European negotiations on capital account liberalization, some countries sought to make harmonization in these areas a precondition for freeing up capital flows. This effort was generally not successful, however. In practice, there is little indication that capital account liberalization as such has resulted in a significant movement of funds offshore in search of more fiscally attractive or less regulated locations. Nevertheless, the increasing integration of European financial markets has also increased pressures to achieve a degree of harmonization on some taxation issues and increased authorities’ willingness to undertake closer cooperation in such areas as prudential supervision. This has been partly driven by their desire to facilitate the further integration of financial markets.
Overall, the usefulness of capital controls, as well as their effectiveness, for advanced economies, has diminished over time. Because partial control systems are ineffective in a deregulated environment, full capital account liberalization has eventually been achieved in all industrial countries. Capital account liberalization has been successful in the majority of advanced countries and has usually been perceived by financial markets as a sign of strength. Once capital controls have been removed, advanced countries have not reintroduced them, with the exception of some backtracking during early liberalization episodes. In addition, liberalization has proved to be a catalyst for further economic reform in a number of countries. Nevertheless, liberalization has not been without its difficulties and costs. Some countries probably took too long to liberalize, and in recent years insufficient attention has sometimes been paid to the need to strengthen the prudential environment to avoid the risk of a financial crisis. In general, it is not so much capital liberalization as such that has caused financial sector instability but rather domestic financial market liberalization undertaken without accompanying supervisory and prudential strengthening. Such considerations appear to have become more important in recent decades as financial markets have become more internationally integrated. The fact that advanced countries have not sought to reintroduce controls in recent years suggests, however, that the advantages of capital account liberalization in stimulating economic growth and efficiency have more than outweighed these transition costs for advanced economies.
Experiences of advanced countries indicate that it is possible for small, open economies to liberalize capital markets without suffering financial crises, provided that their macroeconomic policies are sound and their financial sectors are healthy and subject to appropriate prudential standards. A number of European countries (Austria, Belgium, Denmark, and the Netherlands) were also able to maintain exchange rate stability following liberalization, although this required accepting the loss of monetary policy autonomy by pegging to the deutsche mark. In contrast, some countries (France, Italy, and some Nordic countries) found it more difficult to achieve macroeconomic stability following liberalization particularly where they had histories of inflation and depreciation. Large capital inflows at times complicated monetary policy while other areas of policy were not tightened sufficiently to offset the impact of capital inflows. An important lesson in this respect is that well-developed capital and money markets and a sound financial sector improve a country’s capacity to absorb large inflows without destabilizing the economy.
The general consensus now among advanced countries is that capital account liberalization is beneficial. It took some time for all of them to reach that conclusion and to then actually liberalize capital flows. A range of factors influenced the changing consensus regarding capital controls. In the 1970s, there were large disagreements between countries over the macroeconomic policy prescriptions that should be followed in response to the breakdown of the Bretton Woods system and to external influences such as oil price shocks. There were associated inflation differentials between countries and concerns on the part of some countries that capital account liberalization would undermine domestic policy objectives (that were then seen as appropriate). During the course of the 1980s, there was growing agreement regarding the limits of fiscal and monetary policy in stimulating economic activity. As domestic policies changed to focus more on long-term objectives, there was less need for capital controls to shield unsustainable macroeconomic policy objectives. At the same time, the economic environment was changing. Increasing integration (particularly of financial markets) reduced the effectiveness of controls and tended to hamper Financial sector development. These factors combined to change attitudes toward controls. Once liberalization was started in each country, the process was generally rather rapid and in most countries—even those choosing a gradual approach—took only a few years.
Key Lessons from Experiences in Advanced Countries
On the basis of the assessment provided in preceding sections, this section draws some key lessons from the experiences of advanced countries that might continue to apply in the current economic environment. Of course, significant caveats do apply, in that advanced countries liberalized in earlier decades when international financial markets were smaller and less sophisticated. Government intervention in the economy was also more widespread. Nevertheless, there are some lessons from the previous analysis that are likely to continue to apply. These are grouped under the headings of effectiveness, relationship to policy goals, and links to financial stability.
Capital controls have been more effective in relatively calm periods than in times of market pressures or speculative flows.
Controls have been more effective when they formed part of a more comprehensive set of regulations, including controls on domestic financial markets.
The effectiveness of capital controls erodes over time and is thus inversely linked to their duration,
The effectiveness of capital controls is enhanced through strict enforcement procedures and cooperation by the banking system.
Partial systems of capital control that seek to discriminate between types of flows or destinations provide incentives for circumvention and are vulnerable to diversion of capital flows to unregulated financial markets.
Where capital controls can be switched on and off, there is a risk that long-term capital flows will be adversely affected.
Relationship to Policy Goals
Capital controls have not been particularly helpful in supporting exchange rate or monetary policy objectives over prolonged periods.
Capital controls have been helpful in avoiding short-term fluctuations of the exchange rate and providing some room for maneuver for monetary policy, provided the exchange rate has moved broadly in line with fundamentals.
Capital controls cannot act as a substitute for macroeconomic policy, and, more generally, controls have tended to delay macroeconomic adjustment.
When there have been clear misalignments, the maintenance of capital controls has resulted in distorting exchange rate corrections once controls have become ineffective.
Capital account liberalization (particularly when combined with deregulation of domestic financial markets) may alter the monetary policy transmission mechanism.
Links to Financial Stability
Domestic financial market deregulation renders capital controls less effective.
A liberalized financial system helps mitigate the adverse impact of volatility on the real economy by offering hedging opportunities to industry.
Controls on inflows have generally been regarded more favorably than controls on outflows.
It is important to improve risk management and prudential supervision prior to reforms.
Achieving macroeconomic stability prior to reforms may reduce the risk of financial crises, particularly when the exchange rate is fixed.