I Overview

International Monetary Fund
Published Date:
April 2002
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A fundamental issue in undertaking capital account liberalization is how to reap the benefits from capital market access while coping safely with the risks associated with international capital flows. Increased attention has been focused recently on the growing frequency of financial crises and the possible role that capital account liberalization might play in contributing to such phenomena. A variety of factors and forces can lead to the emergence of a financial crisis in a specific country. In a world of growing financial globalization and more open capital accounts, events in other countries may have an impact on a country’s financial stability. Nevertheless, country experiences indicate that the ability to avoid financial crisis in the context of more open capital accounts often depends upon the ability of financial and nonfinancial institutions as well as the government to manage financial risks in general. At the same time, legal, institutional, and prudential arrangements must be adequate to deal with complex risks associated with increasingly diverse types of capital flows.

In general, the range of factors bearing on financial stability and its linkages with capital flows is very broad. However, as discussed in Chapter II, three basic sources of financial sector instability may be distinguished: disturbances arising from the linkages between the financial sector and the macro-economy; structural weaknesses in the financial sector; and certain types of government involvement in the financial sector. These three sources of instability can interact in a variety of ways to increase risk. Thus, financial sector stability requires both macroeconomic stability and structural policies and conditions consistent with a sound and efficient domestic financial sector. These structural policies, which are discussed in Chapter V, involve the development of financial markets and institutions; prudential regulation and supervision; risk management and good practices in accounting, auditing, and disclosure; and financial safety nets. Closely associated policies that are not discussed in this paper include policies dealing with insolvency, corporate governance, creditor rights, systemic restructuring of financial and nonfinancial institutions, public debt and foreign exchange reserve management, transparency of public policies, and improved statistics.

Country experiences presented in Part III point to some general principles that are helpful in sequencing and coordinating capital account liberalization with other policies, particularly structural policies to strengthen domestic financial systems. These principles, which are elaborated in Chapter III, emphasize the importance of macroeconomic stability and the choice of an appropriate exchange rate regime while giving priority to financial sector reforms that support macroeconomic stability. They also underscore the need to: coordinate capital account liberalization with different Financial sector policies, taking into account the initial condition of financial and nonfinancial entities and their capacity to manage the risks associated with international capital flows; assess the effectiveness of existing capital controls; identify and implement urgent measures in connection with reforms that require a long lead time; and ensure the sustainability of the reforms and the transparency of the liberalization process. The principles point to the desirability, in most cases, of liberalizing long-term flows—especially foreign direct investment (FDD flows—ahead of short-term flows. At a minimum, any partial early liberalization of short-term flows needs to be accompanied by adequate prudential measures.

Even so, there is no simple method for devising an operational plan for sequencing and coordinating capital account liberalization with other policies. This reflects the reality that capital account liberalization and financial sector development are often mutually reinforcing; therefore, removing controls on one type of flows affects other types of transactions, and hence the financial sector and the economy as a whole. In particular, the effectiveness of any remaining capital controls could be eroded by a partial liberalization. Steps toward capital account liberalization and other policies thus cannot be analyzed in isolation, as the interactions between them are complex and subject to considerable uncertainty. Thus, sequencing will only become tractable once the specifics of a particular case are analyzed.

The design of an operational plan for sequencing will therefore need to be based on a careful assessment of individual countries’ circumstances and will require judgment, discretion, and flexibility. When macroeconomic and financial sector conditions are sufficiently good, capital controls could be removed quickly without undue risk. In many cases, however, a gradual approach to capital account liberalization may be required; but a gradual approach would not by itself guarantee an orderly liberalization. Moreover, countries would need to be prepared to change their sequencing plans in the face of changing macroeconomic conditions or emerging signs of vulnerabilities, and in some cases it could be appropriate to adopt a contingency plan that may delay further capital account liberalization until conditions become more favorable. Therefore, care must also be taken in applying approaches that were successful in one country to other countries.

Based on the general principles, a methodology for sequencing capital account liberalization is presented in this paper. This methodology, which is illustrated by an example, involves an assessment of capital controls and macroeconomic and financial sector vulnerabilities, and the design of a plan for sequencing capital account liberalization with financial sector reforms and other policies. The methodology is intended to support a better integration of the domestic and international dimensions of financial sector development and stability in the IMF’s policy advice, surveillance activities, and technical assistance involving countries wishing to undertake an orderly liberalization of their capital accounts.

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