- Michael Mussa, Giovanni Dell'Ariccia, Barry Eichengreen, and Enrica Detragiache
- Published Date:
- September 1998
The history of global economic integration is reviewed in the May 1997 World Economic Outlook. There it is shown that the post-World War II phenomenon of globalization may in many ways be viewed as the resumption of a trend observed a century earlier.
Measures of Capital Market Integration
The integration of financial markets before 1914 is evident in the magnitude of current account imbalances. Figure 3 shows five-year moving averages of the mean absolute value of the ratio of the current account to GDP over the last 125 years for 12 countries for which data are continuously available. These data suggest that external capital flows have not yet matched the levels reached before 1914. The net capital outflow from Great Britain reached 9 percent of GNP at its peak, and figures nearly as high can be observed for the other principal creditor countries—France, Germany, and the Netherlands. (By comparison, Japan’s and Germany’s current account surpluses peaked in the mid- to late 1980s at 4–5 percent of GDP.) Similarly, current account deficits persistently exceeded l0 percent of GNP in a number of the principal capital importers, Canada, Argentina, and Australia prominent among them. In recent years, these levels have been approached in developing countries only for short periods, and those periods have often been followed by difficult adjustments when deficits were eliminated or reversed.72 Before 1914, large current account balances were more persistent.73
Figure 3.Selected Countries: External Capital Flows
Note: Five-year moving averages of the mean absolute value of the ratio of the current account balance to GDP for Argentina, Australia, Canada, Denmark, France, Germany, Italy, Japan, Norway, Sweden, United Kingdom, and United States.
Overall, then, the magnitude and persistence of prewar capital flows are impressive by today’s standards. That is, the correlation between domestic savings and investment rates, which should be low if capital mobility is high, was lower during 1870–1914 (Bayoumi, 1990) than after World War II (Feldstein and Horioka, 1980) and even in recent decades.74
Another indicator of market integration is interest parity. Deviations from real interest parity are shown in Figure 4, which plots the standard deviation of annual ex post real long-term bond yields for 12 countries from 1870 to 1994.75Figure 5 shows comparable data for short-term securities (three-month bank bills) for four countries. Both figures provide clear evidence of capital market integration before World War I and in the most recent decade, bracketing a period of massive disintegration. On this basis, it is hard to see the recent period as unprecedented.
Figure 4.Dispersion of Long-Term Ex Post Real (CPI) Interest Rates, Group I
Source: Bordo, Eichengreen, and Kim (1998).
Note: Group I includes Argentina, Australia, Canada, Denmark, Finland, France, Germany, Italy, Japan, Norway, Sweden, United Kingdom, and the United States.
Figure 5.Dispersion of Short-Term Ex Ante Real (CPI) Interest Rates, G-4 Countries
Source: Bordo, Eichengreen, and Kim (1998).
Note: G-4 refers to the four core countries of the gold standard (France, Germany, United Kingdom, and United States).
Explanations for Capital Market Integration
A number of factors help explain the magnitude of international capital flows in the pre-1914 period. One is policymakers’ commitment to stable monetary and fiscal policies, as manifested in the gold standard. The gold standard provided a signal that borrowers followed the same rules as lenders and hence were unlikely to default on their debts. Bordo and Rockoff (1996) evaluate this hypothesis for nine recipients of British capital during 1870–1914 and find strong evidence that countries on the gold standard paid lower interest rates on sovereign debt than those that adhered to gold periodically or not at all. Flandreau, Le Cacheux, and Zumer (1998) find similar results for a different panel of European peripheral countries, as do Sussman and Yafeh (1998) for Japan. Insofar as the gold standard proxied for fiscal rectitude and for adherence to similar norms among the capital recipient as well as the sender countries, the decline in lending after World War I may reflect a shift to less credible and consistent policies. The rise in international financial flows in recent years may be a consequence in part of developing countries’ renewed commitment to macroeconomic stabilization and reform.
A related determinant of the extent and persistence of British capital exports may be the fact that most British investment went to former colonies where the British heritage was strong. These countries (for example, Australia, Canada, and the United States) shared a common language, culture, legal system, and accounting system. British capital also went to countries like Argentina and Uruguay, where Great Britain had a strong commercial presence and considerable political influence, or to colonies directly under British control. The French also directed their lending to countries where they had political influence and cultural ties—for example, Italy, Spain, and Russia (see Fishlow, 1985, and Flandreau, 1998). In contrast, today’s capital recipients tend to be different in the above respects from the capital exporters, which may be less willing to maintain foreign investment in the face of adverse shocks.
A third explanation lies in the nature of the investment itself. Much of the capital flowing to the New World went to finance railroads and other infrastructure, which required a long-term commitment. Because the returns accrued only when the project was completed, it was costly to terminate early, rendering capital flows unusually persistent. Although there is considerable infrastructure investment in today’s emerging markets, it does not dominate to the same extent.
Moreover, insofar as prewar investment, and British investment in particular, was in traded-goods-related sectors—as emphasized by Fishlow (1985), it went into export-related infrastructure and natural-resource-related projects that in the normal course of events generated enough foreign exchange revenues sufficient to pay the money back—it did not give rise to balance of payments problems. And the fact that pre-World War I lending took place in an environment of relatively free multilateral trade allowed countries that engaged in significant amounts of external borrowing to expand their exports as needed to amortize those debts.
A final explanation for the large international capital flows before 1914 may lie in the flexibility of nineteenth century economies. Their markets were less structured and institutionalized, and adjustment was less constrained by policy and powerful interest groups. A shift in capital flows that implied the need to reallocate resources between sectors producing traded and nontraded goods could therefore be accommodated easily. Bayoumi and Eichengreen (1996) and Calomiris and Hubbard (1996) provide econometric evidence consistent with this interpretation.
Differences in the Nature of Capital Market Integration
While integration measured in terms of net capital flows as a percentage of GDP is similar in post-1975 and pre-1914 periods, gross flows (analogously scaled) are larger today. Bank for International Settlements (1997) data on turnover in the foreign exchange market suggest that gross flows amount to about $1.25 trillion a day, or more than $250 trillion a year. Although no comparable estimates of gross short-term capital flows exist for the pre-1914 era, Bloomfield’s (1968) discussion suggests that these were much lower relative to long-term flows than today.
A second important difference between the nineteenth century and today is the sectoral-functional composition of the investment. Although data on the composition of pre-1914 portfolio investment are incomplete, probably the best estimates are those for Great Britain, the leading creditor of the period. (British investors held about 40 percent of the stock of long-term foreign investments outstanding in 1913 according to conventional estimates. In terms of composition, there is no reason to think that Great Britain is grossly unrepresentative.) These data suggest that, circa 1913, fully 30 percent of British overseas investments in quoted securities were in the issues of governments and municipalities, 40 percent in railways, 10 percent in resource-extracting industries (mainly mining), and 5 percent in public utilities.76 Thus, 85 percent of overseas portfolio investment was in the securities of entities with tangible and transparent assets, including the ability to tax or the possession of resource reserves, railway track, and telegraph and telephone lines. Investment in government bonds and infrastructure projects remains disproportionately important today, but the absence of commercial, industrial, and financial concerns from this list of 1913 investments is striking. Portfolio investment in industrial and financial concerns, whose assets are less tangible and whose operations were by implication less transparent, appears to have been less important in the prewar era of globalization than they are now.
Third, the relative importance of debt and equity has changed, reflecting “emerging” stock markets. The most recent issue of the World Bank’s Global Development Finance estimates that stocks and bonds are now of roughly equal importance. Before 1914, the vast majority of portfolio capital flows took the form of bonds, rather than equity.
Fourth, the balance between portfolio investment and foreign direct investment has changed. Direct investment is as important as portfolio investment today, whereas this was not the case before 1914. “Portfolio investment was a far more important component of long term capital movements before 1914 than direct investment…” (Bloomfield, 1968, pp. 3–4), China being the one prominent exception. In contrast, direct investment has consistently exceeded portfolio investment since World War II. While securities markets have grown explosively in recent years, about half of all capital flowing to emerging markets is still in the form of direct investment.
Finally, the nature of that foreign direct investment has changed. Before 1914, it was undertaken by freestanding companies incorporated in Belgium, France, the United Kingdom, and other Western European countries for the purpose of investing and doing business in emerging markets. These enterprises proliferated in mining, agriculture, and transportation—for example, Rio Tinto and the Suez Canal Company. Today, in contrast, foreign direct investment flows through multinational enterprises, whose operations involve extending across borders not only financial capital but also the firms’ preexisting managerial and productive capabilities.
Asymmetric Information as an Explanation for These Patterns
As emphasized in the main body of the text, differences in the scope and structure of international financial integration can be understood as a consequence of the greater extent of information asymmetries before World War I. In particular, the relatively narrow range of assets, mainly railway bonds and public debt, that was traded internationally before 1914 can be understood in terms of the obstacles to the international dissemination of information. Assessing the prospective profitability of a railway was not straightforward, but railroad companies at least had tangible assets (rolling stock, right of way) that could be sold off in the event of failure, effectively collateralizing debt external to the firm and, like bank capital, attenuating principal-agent problems between owner-managers and bondholders. The same was not true, or was less true, of most other commercial, financial, and industrial concerns. Similarly, one should not exaggerate the ease of assessing the creditworthiness of sovereign borrowers, but these too had more tangible and transparent assets (specifically, the power to tax) than most commercial and industrial concerns.
The expansion of the range of financial assets that are actively traded across borders today compared with a century ago reflects the diminution of obstacles to information flows.
Statistical tests for Canada, Argentina, and Australia show that current account balances exhibit significantly more persistence before 1914 than today. Bordo, Eichengreen, and Kim (1998) compute the Phillips-Perron Zt statistic for the two periods as a measure of persistence. The same conclusion is reached for a larger sample of emerging markets in the two periods.
Taylor (1996) uses data for 12 countries from 1850 to 1992 and examines saving-investment correlations over successive decades. His estimated coefficient traces out an inverted “u” shape over time, as if capital markets were well integrated before 1914, ceased being so except in the short period during which the interwar gold exchange standard prevailed, and have again become gradually more integrated since the 1950s, with coefficients in the 1990s reaching the levels of the pre-1914 period.
The data are from Bordo, Eichengreen, and Kim (1998).
These estimates, from Royal Institute of International Affairs (1937), are based on the earlier work of Herbert Feis.
This section summarizes the broad outlines of the industrial and developing countries’ post-World War II experience with capital account liberalization.
Experience of Industrial Countries
The aftermath of World War II was marked by extensive restrictions on trade, other current account transactions, and capital account transactions. Under the European Payments Union (EPU), created in 1950, most quantitative trade restrictions were eliminated, but formal current account convertibility was not achieved until the end of the decade. Most EPU member countries accepted the obligations of the IMF’s Article VIII only in 1961; Japan did so in 1964.
In 1961, the OECD set out its Code of Liberalization of International Capital Movements. Notwithstanding these good intentions, capital mobility was still, in most cases, subject to restrictions.77 Except in Canada, Switzerland, and the United States, which adopted relatively liberal capital account regimes after World War II, liberalization proceeded slowly. The first half of the 1960s saw the gradual relaxation of controls, with the notable exception of the United Kingdom, which tightened restrictions on outflows. Germany, an early starter in liberalizing its capital account, removed its controls on outflows in 1958. (Controls on inflows were kept in place because balance of payments surpluses were applying pressure to the deutsche mark to appreciate.) Japan similarly relaxed its controls on capital account transactions related to exports and imports beginning in 1960 when it abolished its controls on current transactions (Fukao, 1990).
The need to defend nominal exchange rate pegs under the provisions of the Bretton Woods system was a source of pressure to maintain or reinforce controls on international capital flows, especially when strains on the fixed exchange rate system intensified in the second half of the 1960s. After 1964, capital account liberalization ground to a halt as the United States introduced measures to discourage capital outflows (the Interest Equalization Tax of 1964 and restrictions on lending and direct investment abroad the following year). A number of European countries and Japan, for their part, look steps to curtail capital inflows.
With the collapse of the Bretton Woods system in 1971, there was less pressure to maintain controls as a way of defending a fixed exchange rate.78 That said, domestic macroeconomic difficulties associated with balance of payments pressures, oil shocks, labor unrest, and global recession slowed the process of liberalization. As a result, Italy, for example, tightened restrictions in 1972: it imposed a ceiling on foreign borrowing by banks in 1975 and subjected all foreign exchange transactions to severe restrictions the following year (see Micossi and Rossi, 1986, and Goodman and Pauly, 1993).79
At the same time, powerful forces for liberalization were at work in the years following the collapse of the Bretton Woods system. Financial markets were growing rapidly, spurred by technological progress. The increased sophistication of financial instruments made it easier to circumvent restrictions; corporations pressed for the easing of restraints on international capital movements; and multinational firms increasingly used transfer pricing to circumvent controls. Not until the end of the decade, however, did a significant shift toward capital account liberalization take place in major industrial countries. The United Kingdom removed its remaining controls in 1979, and Japan completed its process of liberalization in 1980. Germany lifted its remaining restrictions on capital inflows in 1981 once the effects of the second oil shock moderated the surplus in its external accounts, easing the pressure to restrain inflows. Australia removed capital account restrictions in 1983 and New Zealand in 1984. in connection with their move toward more flexible exchange rate regimes.80
Then, in the 1980s, the members of the European Community (EC; now the European Union (EU)), in accordance with EC directives, took steps toward capital account liberalization. In contrast to trends in many other parts of the world, this action was accompanied by a move toward less flexibility in the exchange rate, an objective achieved through the adoption of the European Monetary System (EMS).81 No realignments took place in the EMS after 1987, the year when the Single European Act, calling for a single market free of restrictions on, among other things, capital movements, was ratified. Having tightened controls in 1981–83, France reversed course and resumed financial liberalization the following year. The Netherlands liberalized capital flows in 1986, Denmark in 1988. France removed its remaining restrictions in 1989, and Belgium, Ireland, Italy, and Luxembourg did so in 1990, consistent with the requirements of the Single European Act. The members of the European Free Trade Area (EFTA) moved in the same direction—Austria, Finland, Norway, and Sweden all liberalizing their capital accounts between 1989 and 1990.
The efforts of the members of the Exchange Rate Mechanism (ERM) of the European Monetary System (as well as EFTA countries shadowing the deutsche mark or a basket of ERM currencies) to maintain fixed exchange rates in the face of free capital mobility suffered a severe setback with the ERM crisis of 1992–93. The Bank of Italy and the Bank of England were forced to float the lira and the pound sterling in the face of large capital outflows, as were the three Scandinavian countries that had been pegging to the European Currency Unit (ECU). As a result of the crisis, Ireland, Portugal, and Spain temporarily reimposed controls. The widening of ERM fluctuation bands at the end of July 1993 in response to another episode of speculative turbulence further increased the degree of exchange rate flexibility. The final steps toward capital account liberalization were then taken by Portugal and Spain at the beginning of 1993, by Greece in 1994, and by Iceland in 1995.
What generalizations can be drawn from this review? In the industrial countries, there has been a strong tendency toward capital account liberalization, although several countries have reimposed or reinforced capital controls during periods of turbulence. Historically, countries with strong balance of payments positions, such as Germany and Japan, have tended to impose controls on capital inflows, while countries with weaker external positions, such as France and Italy, have relied mainly on controls on capital outflows. As Goodman and Pauly (1993) emphasize, countries with restrictions on capital inflows have generally liberalized earlier than countries with restrictions on outflows.
In some countries (including Japan, the United States, and, intermittently, the United Kingdom), this trend toward capital account liberalization has been accompanied by greater exchange rate flexibility, given the difficulty posed by growing capital mobility for the maintenance of pegged but adjustable exchange rates. In other industrial countries (notably, the leading Continental European members of the European Union), the response to the difficulty for pegged but adjustable rates posed by growing capital mobility has been a commitment to economic and monetary union, which is intended to abolish variations in intra-European exchange rates once and for all. For the industrial countries as a whole, the growth of capital mobility has not, therefore, resulted in dramatic changes in the prevalence of fixed versus flexible exchange rate regimes (Figure 6).
Figure 6.Evolution of Exchange Rate Regime
Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions.
Experience of Developing and Transition Economies
There are substantial differences among the developing countries’ experiences with capital account liberalization.82 Before 1980, those that liberalized started from a strong balance of payments position (for example, Indonesia, Malaysia, and Singapore). More recently, developing countries have undertaken capital account liberalization under less favorable external conditions, even in the presence of external arrears. And, as in the (non-EU) industrial countries, the overall tendency toward capital account liberalization has been accompanied by a shift toward increased exchange rate flexibility. Some evidence of this tendency is provided in Figures 7 and 8 although, as discussed in Box 3 of the main text, it is difficult to provide quantitative measures of the degree of capital account restrictiveness.
Figure 7.Evolutions of Exchange Rate and Exchange Restriction: Developing Countries
Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions.
1 In percent of total number of developing countries (left Scale).
2 Cross-country average of an index which includes restrictions on capital account transactions, multiple exchange rates, and surrender of export proceeds. The index ranges from 0 when no restriction is present to 100 when all restrictions are present (right scale).
Figure 8.Summary of Restrictions on the Capital Account: Developing Countries
Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions.
Note: The dummy variable takes value 1 if the specified practice is a feature of the system.
There are substantial regional differences in the pattern of liberalization (Figure 9). According to the indices provided in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (International Monetary Fund, various issues), Latin American countries were relatively open during the 1960s. The 1970s witnessed some increase in the number of Latin American countries maintaining capital account restrictions, with an increase around the time of the collapse of Bretton Woods and the second oil shock.83 The prevalence of controls increased in the early and mid-1980s, as several highly indebted countries imposed restrictions on capital outflows in the wake of the debt crisis. Capital account liberalization then resumed in the late 1980s and early 1990s.
Figure 9.Summary of Restrictions on the Capital Account: Developing and Transition Countries
Source; IMF, Annual Report on Exchange Arrangements and Exchange Restrictions.
Note: The dummy variable take a value of 1 if the specified practice is a feature of the system.
In Asia, the pattern has been different, with a steady decline in the number of countries imposing capital account restrictions since the late 1970s, and no increase around the time of the debt crisis, reflecting the fact that (with the exception of the Philippines) the debt crisis affected East Asia much less than Latin America. There was a clear acceleration in the process of capital account liberalization in the 1990s, a pattern that is common across regions. For Middle Eastern and European developing countries, no clear liberalization trend is visible until the early 1990s, and the same goes for African countries, where restrictions on capital account transactions and surrender of export proceeds were applied in virtually every country during the 1970s and 1980s. In transition economies, capital account liberalization has proceeded speedily since 1990, with a rapid removal of requirements to surrender export proceeds and the abandonment of multiple currency practices. Capital account liberalization has proceeded especially rapidly in the Czech Republic, Estonia, and Hungary, but is also well advanced in Armenia, Georgia, Latvia, and Poland.
As highlighted by Quirk and Evans (1995), capital account liberalization in developing countries has typically occurred gradually. It has been part of an overall approach to economic and structural reform and has occurred after the establishment of current account convertibility. The opening of the capital account has typically been accompanied by financial sector reforms. In recent years, however, a number of countries have liberalized the capital account abruptly, including Argentina, Costa Rica, El Salvador, Jamaica, Trinidad and Tobago, and Venezuela in the Western Hemisphere; Hong Kong S.A.R. and Singapore in Asia; Mauritius in Africa; and the Baltic countries and the Kyrgyz Republic among transition economies.
Opening the capital account exposes the domestic financial system to foreign competition. Hence, most developing countries have attempted to implement financial sector reforms before fully liberalizing the capital account. These reforms typically include freeing interest rates on loans and deposits, developing indirect monetary instruments such as treasury bills, and abolishing credit ceilings. Many countries strengthened prudential supervision before opening the capital account, while others undertook these measures concurrently. Nevertheless, preexisting weaknesses in banks’ balance sheets and insufficient implementation or enforcement of prudential regulations led to the emergence of severe banking problems in a number of countries that rapidly liberalized their capital account, such as Costa Rica, Jamaica, Latvia, and Venezuela.84
In the developing world, capital account liberalization has been accompanied by a “polarization” in the choice of exchange rate regime, with countries responding to the environment of increased capital mobility by either adopting hard currency pegs or moving toward greater nominal exchange rate flexibility. Argentina, Estonia, and Lithuania freed capital account transactions in the context of establishing a currency board.85 Some developing countries instead opted for a more flexible exchange rate (for example, El Salvador, Peru, and Venezuela), whereas others (such as Mauritius and Trinidad and Tobago) abandoned their formal pegs altogether.
One reason it is so difficult to isolate the effects of capital account liberalization on exchange rates and capital flows is that liberalization typically takes place concurrently with other reforms or policy changes. It is often accompanied by a tightening of macroeconomic policy, sometimes in the context of an IMF-supported program. In Central and Eastern Europe, for example, almost all IMF-supported programs entailed measures to facilitate inflows of foreign capital, foreign direct investment in particular. In general, the elimination of controls led to an increase in capital inflows, with an accumulation of foreign exchange reserves and some worsening of the current account position. This was the case in both the liberalization experiments in the Southern Cone in the late 1970s and the more recent episodes.
Both internal and external factors have played an important role in developing countries’ decisions to tighten restrictions on outflows and inflows. Controls on outflows have tended to be imposed or strengthened during periods of economic distress, in particular in countries facing severe capital flight. This was the case for a number of Latin American countries in the run-up to, and aftermath of, the 1982 debt crisis, for example, and in Venezuela in 1994. Numerous studies have found that, notwithstanding the imposition of controls, substantial capital flight ensued (see, for example, Cuddington, 1987, and Dooley, 1988). In addition, the imposition of foreign exchange restrictions led to the emergence of parallel markets and sizable black market premiums.
In contrast to controls on capital outflows, controls on inflows in developing countries have been associated with periods of economic boom, typically when confidence rises following macroeconomic stabilization and reform. Foreign capital has been attracted by high real interest rates, reflecting not only high rates of return on capital (and expected capital gains on financial assets) in emerging markets but also inefficiencies remaining in developing countries’ financial systems; in addition, capital has sometimes been “pushed” out of the mature markets by a relatively low level of interest rates there.86 While large capital inflows alleviate liquidity constraints for the recipient country, and foreign direct investment can contribute to increasing productivity through direct and spillover effects, these inflows can pose problems for macroeconomic management. If sterilized, they impose large quasi-fiscal costs on the central bank. Lack of sterilization, in contrast, can mean loss of monetary control, while a policy of allowing the exchange rate to appreciate can crowd out net exports. A number of developing countries have adopted controls on inflows in response to these problems, some of which have been geared toward altering the maturity structure of inflows. Such controls have taken the form of quantitative restrictions as well as differential reserve requirements on nonresidents’ deposits, and unremunerated reserve requirements on foreign borrowing, etc., as in Chile. (See Appendix IV for a discussion of the Chilean experience.)87
The severe restrictions on capital outflows were part of an overall policy of “financial repression,” with real interest rates on government debt averaging -7 percent during 1973–79.
The opening of the capital account in New Zealand was part of a general process of financial liberalization, which was followed by large capital inflows and a sharp appreciation of the real exchange rate.
See Figure 6. Johnston and others (1998, pp. 71–2) have previously observed that external liberalization tends to be associated with the adoption of more flexible exchange rates. Indeed, the share of IMF members with Article VIII status increased from 35 percent in 1978 to 78 percent in 1997, while the share of members with flexible (free or managed floating) exchange rates more than doubled over the same period. There is a correlation coefficient of 0.87 between the share of IMF members with Article VIII status and with flexible exchange rate regimes.
The discussion in this section follows Quirk and Evans (1995).
The late 1970s saw rapid financial and capital account liberalization in the Southern Cone, in conjunction with the adoption of preannounced or fixed exchange rates. This was followed by a severe banking crisis in conjunction with the overall debt crisis. See Diaz-Alejandro (1985) for an analysis of this process.
The financial crises in the Southern Cone in the early 1980s are another telling example. Demirgüç-Kunt and Detragiache (1997, 1998) and Eichengreen and Rose (1998) discuss banking crises in emerging markets. This topic is taken up in more detail in Appendix III below.
Another such example is Latvia, which has pegged to the SDR since 1995 while taking steps to significantly liberalize its external financial transactions.
Calvo, Leiderman, and Reinhart (1993) and Fernandez-Arias and Montiel (1996) have documented the role of external factors in stimulating capital account liberalization in emerging markets. Bartolini and Drazen (1997b) show a strong positive correlation between the tightness of controls in developing countries and the level of real interest rates in industrial countries in the 1970s and the 1980s. The relationship seems to break down, however, in the 1990s, with an acceleration of the trend toward capital account liberalization but no steady decline in industrial countries’ real interest rates.
A crucial issue is the degree to which these controls can reduce the size or alter the effective composition of inflows, given the variety of financial instruments available to circumvent them (see Appendix IV).
The most extensively studied recent crisis episodes are the Southern Cone currency and banking crises of the early 1980s, the 1992 ERM currency crisis in Western Europe, the Mexican crisis and its spillover effects in 1995, and the East Asian currency and financial crisis. In a number of cases, these crises occurred in the context of newly liberalized capital accounts.88 To be sure, crises can also occur when capital accounts are restricted, but the record of the last 20 years points at least to the possibility that the liberalization of capital accounts heightens countries’ susceptibility to crises.89 It does not follow that restrictions on international capital movements are necessarily desirable; depending on the mechanisms through which financial integration leads to crises, it may be possible to reduce their incidence by constructing appropriate institutional defenses or adopting appropriate domestic policies.
Unfortunately, no systematic empirical investigation exists of the link between capital account liberalization and financial crises. This section therefore reviews theory and evidence on this relationship.90
Capital Account Liberalization and Currency Crises
Since Mundell and Fleming, it has been well understood that a small country with a fixed exchange rate and freely mobile capital cannot pursue an independent monetary policy. Any attempt to set domestic interest rates above or below international levels will be offset by an inflow or outflow of funds. It follows that it is not possible to use monetary policy to stabilize the business cycle.91 Thus, the decision of whether to liberalize the capital account and, if so, at what speed should be predicated on an assessment of the prospective need to use monetary policy for domestic policy purposes. For instance, if fiscal policy can be effectively used to stabilize cyclical output fluctuations, or if prices and wages are flexible in the short run, then capital account liberalization can be pursued more aggressively. It may be argued that “tying the hands” of domestic policymakers is a desirable effect rather than a drawback of international capital mobility.92 For this argument to be fully convincing, however, international investors must be trusted to be good judges of domestic policy.93
Currency Crises Caused by Inconsistent Policies
A corollary to the Mundell-Fleming proposition is that a country with a fixed exchange rate and free capital mobility that follows an overly expansionary monetary policy will be vulnerable to a speculative attack.94 Inconsistent policies would eventually lead to a crisis even in the absence of international capital mobility, but the crisis would be delayed, because agents would have to reduce their holdings of domestic currency through current account transactions (Auernheimer, 1987).
In many countries, domestic financial markets remain at least partially segmented from international markets even after administrative restrictions on capital movements are removed, reflecting transactions costs, informational asymmetries, and other frictions. Monetary policy will then retain some of its effectiveness, so that both industrial and developing countries with managed exchange rates have been able to undertake sterilized intervention. But as financial integration proceeds, sterilization will become increasingly difficult. Attempts to keep domestic interest rates above world rates will provoke persistent capital inflows, while attempts to keep domestic rates below world rates will lead to continued outflows.95
Currency Crises in the Presence of Consistent Policies
Do all currency crises reflect inconsistent policies? Theory suggests otherwise. In second-generation models of balance of payments crises, there exist two equilibria: a “good” equilibrium in which market participants expect the peg to last, policymakers to follow consistent policies, and crises never to occur; and a “bad” equilibrium in which market participants expect a devaluation, in which they launch a speculative attack, and in which policymakers alter policies to validate the devaluation once it has occurred. (See Obstfeld, 1986.) Accommodation, which validates the initial beliefs and makes the crisis self-fulfilling, may in fact be the optimal policy response (Obstfeld, 1994b), especially if defending the parity is costly. In a country with an open capital account, fending off a speculative attack is likely to be especially painful, because speculators can use a wide range of financial instruments to bet on devaluation and leverage their positions substantially. Large amounts of reserves can be lost in a matter of hours, and short-term interest rates may have to be raised to high levels. Thus, in the presence of an open capital account, speculators may expect policymakers to be more willing to yield to an attack, and self-fulfilling crises become more likely.
Interest in second-generation models intensified in the wake of the ERM crises of 1992 and 1993 when it was not obvious that all the countries targeted by speculators had been following inconsistent policies. Eichengreen, Rose, and Wyplosz (1996a) studied the behavior of macroeconomic variables in the period leading up to attacks in 22 countries from 1967 to 1992. For non-ERM countries, they found evidence that inconsistent fundamentals preceded the attack (namely, larger than normal budget deficits, inflation, and credit expansion), although this was not the case for ERM countries. The fact that the latter attempted to peg their exchange rates, especially from the second half of the 1980s, without the support of restrictions on international capital flows suggests that their susceptibility to self-fulfilling attacks could have been heightened by their having liberalized their capital accounts.96
Another type of self-fulfilling crisis is the “debt and currency crisis” to which countries with substantial short-term external debts are vulnerable. If investors suddenly lose confidence in the creditworthiness of a country, they may refuse to roll over its stock of short-term debt, and the country will be forced to finance its debt service out of reserves or current account proceeds.97 If reserves prove inadequate, a sharp current account reversal must then take place. Inasmuch as domestic banks and corporations are rendered illiquid, the reversal can take place only through a severe and costly contraction of output.98 In turn, these developments can validate the belief that the country has lost its creditworthiness and render investors’ pessimistic expectations self-fulfilling.99
These models of self-fulfilling crises assume that all agents are rational and fully informed. If, however, investors are irrational or imperfectly informed, herd behavior and bandwagon effects may lead to large swings in capital flows unrelated to fundamentals.100 In this context, capital controls, even if only temporarily effective, may give policymakers the time they need to restore confidence, perhaps by credibly revealing relevant information to market participants or by coordinating the actions of large investors.
Moreover, allowing the exchange rate to float may not restore macroeconomic and financial stability if the foreign exchange market is dominated by imperfectly informed traders. While runs on official reserves may be averted, large fluctuations in nominal exchange rates unrelated to fundamentals could still occur (as explained by DeGrauwe and Dewachter, 1990). Insofar as movements in the real exchange rate tend to follow movements in the nominal rate, distortions of resource allocation and uncertainty about relative prices could result.
Another mechanism that can trigger crises is contagion from other countries.101 Contagion may occur, for example, if investors are imperfectly informed about the viability of a particular group of currency pegs. If one country is forced to devalue, investors may then revise upward their assessment of the probability of a devaluation in other countries, especially in other countries with at least superficially similar characteristics. Inasmuch as well-diversified international investors may have relatively little incentive to acquire information about all the countries in which they invest, the hypothesis of imperfectly informed investors may be realistic (Calvo and Mendoza, 1997).
A crisis may also spread through trade and financial links.102Gerlach and Smets (1995) develop a model in which devaluation by one country leads its trading partners to devalue as well to preserve their competitiveness. In a world in which economies become more integrated owing to increased capital mobility, the potential for spillovers is likely to be increased.103
Capital Account Liberalization and Banking Crises
As world capital markets have become increasingly integrated in the last two decades, numerous banking sectors have experienced episodes of instability, culminating sometimes in full-fledged banking crises. Banking crises have plagued a wide variety of countries, from industrial countries to emerging economies, from economies in transition to the poorest developing countries (Caprio and Klingebiel, 1996, and Lindgren, Garcia, and Saal, 1996). Is increased international capital mobility responsible for the proliferation of banking crises? This is certainly a complex question, and no empirical study is available to shed light on it. An important consideration in forming a judgment is that, as shown in the previous section, in many countries capital account liberalization went hand in hand with the gradual liberalization of domestic financial markets, and of the banking sector in particular. Thus, since the early 1970s, a growing number of countries have progressively eliminated ceilings on bank interest rates and directed credit allocation programs, privatized banks, lowered barriers to entry in banking and insurance, and introduced indirect instruments of monetary control. This newfound freedom of action meant that banks were increasingly able to invest in highly risky ventures. In the presence of an appropriate incentive structure, it is reasonable to expect bank managers to control risk by screening and monitoring borrowers and by diversifying loan portfolios; in any case, increased risk would be offset by higher returns. However, when explicit or implicit deposit insurance is present, and the government is expected to intervene to rescue the banking system in case of systemic problems, bankers’ appetite for risk is likely to exceed what is socially optimal. Moreover, financial liberalization, unless it is accompanied by enhanced prudential regulation and supervision, is likely to result in increased banking sector fragility. Demirgüç-Kunt and Detragiache (1998) find that financial liberalization increases the probability of a banking crisis in a large sample of countries.104
Perhaps the best-known example of banking crisis following financial liberalization is the U.S. Savings and Loan crisis of 1980–92. At the end of the 1970s, the industry was experiencing serious financial difficulties, compounded by the sharp increase in interest rates in 1979. In the early 1980s, the U.S. Congress and state authorities substantially deregulated the savings and loan industry, allowing thrifts to enter more risky activities. Prudential regulation and supervision were weakened rather than strengthened, and generous federal deposit insurance gave depositors no incentives to monitor the riskiness of the institutions (Kane, 1985). The liberalization of deposit interest rates allowed insolvent thrifts to continue attracting deposits by offering high rates of return. The deposits were then gambled in risky ventures, mostly in the commercial real estate sector, while thrift owners and managers continued to receive dividends and generous salaries (Akerlof and Romer, 1993). A total of 1,142 thrifts failed between 1980 and 1992, and the cost of the deposit guarantee to the federal government is estimated at $127 billion, or 2.3 percent of 1990 GDP (Lindgren, Garcia, and Saal, 1996). While the U.S. Savings and Loan crisis is a clear example of a crisis originating from domestic financial liberalization and in which international financial linkages play virtually no role, other episodes suggest that capital account liberalization can sometimes affect the risk of banking sector problems, as well as the modalities in which they manifest themselves and their effects on the economy. What follows illustrates this point, with reference both to the theory of banking crises and to case studies of such crises.
Banks raise funds by borrowing from depositors through short-term, noncontingent loans (demand and time deposits). They lend to consumers and firms using long-term loan commitments that usually carry a nonnegligible risk of default (credit risk). While this enhances the efficiency of economic activity insofar as banks can pool liquidity and credit risk more efficiently than individuals (Bhattacharya and Thakor, 1994), to the extent that pooling cannot eliminate these risks, banks can become illiquid or insolvent. When a significant portion of the banking system experiences illiquidity or insolvency, a systemic banking crisis occurs.
Banking Crises Originating in Runs by Depositors
Diamond and Dybvig (1983) have shown that the banking sector can become illiquid as a result of depositor runs driven entirely by self-fulfilling beliefs. If depositors believe that a bank will become insolvent, they will rush to be “first in line” to withdraw their deposits and the bank will indeed become illiquid. Runs can also take place if depositors are imperfectly informed about bank solvency and interpret a random increase in withdrawals as a signal that the bank is indeed insolvent. A run on one bank may lead depositors to withdraw from other banks if it is viewed as a signal that the banking system is in trouble; a run can thereby precipitate a panic (Chari and Jagannathan, 1988).
How are these dangers affected by capital mobility? Theoretical and empirical analysis of this question is not well developed, but some tentative answers can be offered on the basis of closed-economy bank-run models.105 In a closed-economy bank run, bank customers withdrawing their deposits must increase their consumption or invest in domestic nonbank assets. Both options have welfare costs. With international capital mobility, in contrast, depositors can invest in offshore deposits. If the latter are better substitutes for domestic deposits than are domestic nonbank assets, the opportunity cost of running on the bank is lower, and bank runs become more likely. International capital mobility may, however, enhance the ability of a bank confronted by a run to continue funding its loan portfolio by borrowing abroad.106 If the run reflects self-fulfilling beliefs of domestic depositors, foreign investors may still be willing to lend.107 Conversely, if the loss of depositor confidence reflects a genuine deterioration in bank balance sheets, foreign creditors may be unwilling to step in.108
Even if banks are unable (or unwilling) to replace deposits with foreign funding, a decline in domestic credit following a run may be offset by an increase in foreign borrowing by domestic consumers and corporations. In the limit, if foreign bank credit is a perfect substitute for domestic credit, a domestic run need not affect the amount of credit available to the economy. In this case, capital mobility would moderate the adverse effects of the bank run on the real economy and, therefore, the negative feedback effects on the financial system. In practice, however, information barriers and transactions costs are likely to make direct foreign borrowing accessible only to large, well-known corporations even in the absence of capital controls.
In the scenario just described, a bank run would manifest itself in a flight of deposits toward foreign banks that may or may not be matched by increased external borrowing by the domestic corporate sector and/or by the domestic banking sector. If the decline in deposits is not matched by an increase in foreign loans, perhaps because effective capital controls on inflows are in place, then the run will result in a net capital outflow that will put pressure on the currency. If the exchange rate is pegged, a banking panic can thus lead to a currency crisis (Miller, V., 1998). Through contagion or spillovers in foreign exchange markets, the banking panic in one country may then spread to other countries as well. In the absence of controls on inflows, however, banks and corporates are likely to respond to the run by tapping foreign capital markets. In this case, pressure on the exchange rate will be averted. Nevertheless, the deterioration in the net foreign asset position of the corporate and/or banking sector may lead to problems down the road, specifically when the debt needs to be serviced. Unless hedging instruments exist and are employed, this deterioration would imply increased exposure to the risk of an exchange rate depreciation. If the exchange rate is fixed, domestic private debt is short term, and foreign exchange reserves are insufficient to cover it, then an increase in corporate or bank external debt may trigger a self-fulfilling “debt and currency crisis” of the type described in the preceding section. Debt defaults and restructurings may then lead to a deterioration in the balance sheet of banks in the lending countries, potentially spreading the crisis internationally.
Banking Crises Triggered by Currency Crises
The discussion so far has dealt with runs originating in a loss of confidence in the banks. In a country with an open capital account and a pegged exchange rate, a banking crisis can also result from loss of confidence in the currency. If depositors believe that the exchange rate will be devalued, they will seek to convert assets denominated in domestic currency into assets denominated in foreign currency. Unless banks can issue foreign currency deposits, deposits will leave the domestic banking system. (Miller, 1996). Confirming the empirical relevance of this channel, Demirgüç-Kunt and Detragiache (1997) find that countries with a high ratio of broad money to foreign exchange reserves are more prone to banking crises. Interestingly, the effect of this variable is negligible in countries with capital account restrictions.109
A speculative attack against a currency can undermine confidence in the banks even in the absence of a run if interest rates are allowed to rise in response to the attack. An increase in short-term rates that increases the cost of funds cannot be matched by an increase in the rate of return on assets because banks lend long term at fixed interest rates. And even if banks were able to increase lending rates commensurately, borrowers might become insolvent at those rates. Eichengreen and Wyplosz (1993) and Obstfeld (1994b) argue that a speculative attack may be triggered by a belief on the part of speculators that the authorities will not raise domestic interest rates to defend the parity for fear of damaging the banking system. A weak banking system may thereby undermine the credibility of a fixed exchange rate regime. But with capital controls in place, the increase in interest rates needed to defend the parity is likely to be smaller and may therefore be compatible with the objective of preserving a weak banking system.
Bank Crises Stemming from Moral Hazard
Many governments have sought to prevent bank runs by introducing deposit insurance. Even where deposit insurance does not exist, they have reacted to bank runs by providing ad hoc deposit guarantees in an attempt to restore confidence, as in the recent crisis in Indonesia. The adoption of implicit or explicit deposit insurance renders less plausible the attribution of recent banking crises to self-fulfilling runs as described by Diamond and Dybvig (1983).110 Rather, increased banking sector fragility may be the result of excessive risk taking induced by deposit insurance itself, as illustrated by the savings and loan crisis in the United States. Banks then get in trouble because increased rates of borrower default lead to an expansion of nonperforming loans, eroding bank profitability and capital.111 Insofar as the perverse incentives created by explicit or implicit deposit insurance are well understood, mandatory minimum capital and liquidity requirements can be used to keep the stake of equity holders high enough and limit moral hazard. Limits on risky activities, on exposures to individual borrowers, and on connected lending can also be imposed to further limit risk. Off-site and on-site inspections can be used to monitor compliance.112 This analysis points to the need to strengthen prudential regulation when liberalizing the capital account.
On the Southern Cone crises, see, Diaz-Alejandro (1985) and Hanson (1995). The ERM crises are analyzed in Eichengreen and Wyplosz (1993). On the Mexican crisis and its spillover effects, see Sachs, Tornell, and Velasco (1996) and Folkerts-Landau and Ito (1995). Recent accounts and interpretations of the Asian crises are in International Monetary Fund (1997), Radelet and Sachs (forthcoming), and Goldstein and Hawkins (1998). For comprehensive reviews of recent banking crises, see Lindgren, Garcia, and Saal (1996) and Caprio and Kliengebiel (1996).
For a recent survey of the extensive empirical literature on currency crises, see Kaminsky, Lizondo, and Reinhart (1998). An important issue that will not be specifically addressed in this section is the risk posed by the transition from a regime of restricted capital mobility to one of free capital mobility. This issue has been debated in the large literature on the optimal order of economic liberalization (see, for instance, McKinnon, 1993). Some of the financial crises observed in the last 20 years may have been due to the transition to capital account convertibility rather than to the effects of a fully liberalized regime.
A generalization of this proposition is that when domestic and foreign assets become highly substitutable because of capital account liberalization, “the greater the attention given to the exchange rate, the more constrained monetary policy is in pursuing other objectives,” (Obstfeld, 1998, p. 8). Small, open economies are also likely to be more vulnerable to speculative attacks than large open ones.
The experiences of Hong Kong, S.A.R. and Singapore may lend support to this view.
As noted by Cooper (1998), the conclusion is questionable, given that many currency crises are preceded by periods of rapid capital inflows, suggesting full endorsement of domestic policies by capital markets.
For a discussion of the drawbacks of sterilized intervention, see Calvo (1991). For an opposing view, see Frankel (1993). It can be conjectured that the widespread use of increasingly ineffective sterilized intervention has been one of the factors contributing to the large size of capital inflows and outflows to emerging economies. It can be further conjectured that attempts to use sterilization to insulate the economy from the effects of outflows contributed to currency crises such as Mexico in 1994 (Folkerts-Landau and Ito, 1995).
However, the authors do not find that policies in the ERM crisis countries shifted after the devaluation took place, as predicted by second-generation models. Thus, while their findings lend some support to the possibility that crises may not be preceded by a policy deterioration, they do not provide evidence in favor of second-generation models. In a more recent study, Jeanne and Masson (1996) estimate an empirical model of the expected probability of devaluation of the French franc in 1992–93, using a technique that allows them to test whether the economy was in a multiple equilibrium region. They find evidence consistent with this hypothesis.
If doubts emerge about the solvency of domestic banks or corporations, domestic residents and other holders of domestic assets (such as foreigners who hold domestic equity) may also flee domestic assets in favor of foreign assets, thereby exacerbating the crisis.
Sachs (1995) and Radelet and Sachs (forthcoming) use this framework to interpret the 1994 Mexican devaluation and the 1997 Asian crisis.
These swings may lead to currency crises despite the authorities’ pursuit of consistent domestic policies. Chari and Kehoe (1997) provide a formal analysis of these phenomena based on the model of herd behavior of Banerjee (1992) and Bikhchandani, Hirschleifer, and Welch (1992). A shortcoming of Chari and Kehoe’s model is that the microstructure of the foreign exchange market assumed in the model is quite different from that of realworld markets.
A phenomenon often mentioned in relation to the recent crises in Asia—see for instance Cooper (1998).
Masson (1998) calls these effects “spillovers” to distinguish them from contagion.
Thus, the Asian crisis has contributed to the weakness of the Japanese economy not only through trade linkages but also because Japanese banks have large exposures to borrowers in the area. Glick and Rose (1998) provide some evidence consistent with the importance of this mechanism.
This study also finds that the effect of financial liberalization on crisis probabilities is weaker in countries with highly developed institutions for law and contract enforcement.
In principle, without capital mobility banks may be able to replace deposits with other domestic liabilities, such as bonds. In most countries, however, domestic bond markets are not well-developed. Furthermore, if the run is sudden there may be no time to arrange a bond issue, while credit lines with offshore banks can be hastily arranged. Following the Mexican devaluation of December 1994, Argentine banks lost 16 percent of deposits ($7.5 billion), but obtained additional credit lines from foreign banks of $2 billion (Ito and Folkerts-Landau, 1996).
Coordination problems among foreign creditors may be an obstacle, however, especially if the run is on a large bank.
Unless they expect to be bailed out by the authorities, as explained below.
If domestic banks do issue foreign currency deposits, then the currency crisis may just lead to a shift into foreign currency deposits within the domestic banking system (Rojas-Suarez and Weisbrod, 1995). In this case, however, the domestic banking system would become vulnerable to the risk of a devaluation. Realizing this, depositors may soon decide that the only safe haven is abroad, and they will run domestic banks after all. This sequence of events closely resembles events in Argentina in 1995: when confidence in the currency board was rocked by the Mexican devaluation, there was a large shift of deposits from pesos to dollars, soon followed by a flight of deposits out of the country (Ito and Folkerts-Landau, 1996).
Deposit insurance would not prevent bank runs resulting from a loss of confidence in the currency, however, since such insurance does not guarantee the foreign currency value of deposits.
Financial liberalization, by removing constraints to bank risk-taking activities (such as ceilings on lending interest rates), may have contributed to banking system fragility in some countries (Demirgüç-Kunt and Detragiache, 1998).
For a discussion of bank prudential regulation and supervision, see Folkerts-Landau and Lindgren (1998).
This appendix surveys the extensive literature on the effectiveness of capital controls. It first reviews the literature in broad brush, distinguishing industrial and developing countries, and then considers the Chilean case in some detail. Chile is singled out because its experience with nonremunerated deposits on capital inflows features so prominently in policy discussions.
Most of the relevant literature focuses on the capacity of controls to limit interest arbitrage in debt and money markets, generally concluding that controls can have a significant impact on interest rate differentials, at least in the short run. It suggests that governments are able to drive a wedge between domestic interest rates and comparable foreign rates, although the effectiveness of such restrictions diminishes over time as the private sector develops new techniques for avoiding controls.
There are several reasons to think that this literature provides a “lower-bound estimate” of the effects of capital controls. It neglects the experience of wholly closed economies, such as the Democratic People’s Republic of Korea, for which there is little question about the effectiveness of controls. It focuses mainly on interest rate arbitrage, a function that is relatively highly developed, while paying less attention to other, potentially more subtle effects of controls, such as those on the composition of international capital movements. Finally, it focuses on controls affecting international trade in bonds and short-term credit instruments, as opposed to controls on equity investment and foreign direct investment. In part, this focus on debt markets may reflect the abundance of data on their operation. But it may also reflect the fact that there is little question about the effectiveness of controls on equity investment by foreigners and on foreign direct investment. Ownership of equity claims (especially large equity claims) on domestic firms often has to be registered with the authorities, in contrast to the anonymity associated with bearer bonds, and equities tend to be traded on a centralized exchange. Similarly, foreign direct investment is easy to monitor and detect. While the literature on the effectiveness and evasion of capital controls is mostly about debt and money markets, it also provides a lower-bound estimate on the effectiveness of controls.
Countries with Well-Developed Financial Markets
Most studies of the effectiveness of capital controls in industrial countries use tests based on covered interest parity or offshore-onshore interest differentials. For currencies where well-developed offshore or forward markets exist, arbitrage should ensure that the covered interest rate parity holds in the absence of controls. At time t, an investor can either buy a dollar-denominated bond, or else convert dollars into, say, yen at the current exchange rate, buy a yen-denominated bond of the same maturity, and sell the receipts on the forward market at the prevailing forward rate. If both bonds have the same default risk, these two operations are exactly equivalent, and, by the law of one price, should have the same return. Hence, any deviation from covered interest parity implies the presence of frictions that are generally adduced to be capital controls. A similar argument can be made for offshore-onshore interest rates on deposits in the same currency. Thus, for currencies with well-developed offshore markets for bank deposits, an alternative test of the effectiveness of controls is based on the differential between the return on domestic bank deposits and the return on similar deposits offered by an offshore branch of the same bank or of a bank with similar characteristics.
A representative study is Dooley and Isard (1980), who examine the effectiveness of the capital controls in Germany between 1970 and 1974, examining the offshore-onshore interest differential. Capital controls are introduced in the regression as a step function constructed using dummy variables, corresponding to the five major doses in which controls were imposed. The results suggest that controls generated a 5 percentage point interest rate differential in the period when they were most rigorously applied. This evidence is consistent with Gros (1987), who finds that capital controls can provide only temporary autonomy for national monetary policy and are ineffective in the long run. He reports interest rate differentials between domestic and Eurocurrency deposits for France and Italy from 1979 to 1986 and observes that spreads are very small in periods of “tranquility,” but tend to rise in periods of turbulence (immediately before realignments). His interpretation is that controls can be temporarily effective in that they can restrain large changes in investors’ positions, making it costly for speculators to adjust open positions. Over longer horizons, spreads tend to return to low levels.113
Browne and McNelis (1990) reach similar conclusions for Ireland. They examine the impact of domestic and foreign money market conditions on Irish interest rates in 1979–86. Their results suggest that domestic factors became more important following the imposition of controls. However, interest parity conditions were restored within six months of the introduction of controls for most assets and liabilities. This theme is developed further by Bacchetta (1992), who explicitly treats the issue of evasion. He uses past arbitrage opportunities as a proxy for the incentives to evade controls and examines Madrid-London interest differentials for the peseta in the late 1980s.114 He argues that the variability of offshore-onshore differentials is too high to be attributable to changes in the regulatory framework, suggesting that it is better explained by the development of activities aimed at avoiding the controls. In support of this view, he estimates an error-correction model specification of the interest rate differential. The results are consistent with the idea that the benefits of evading controls are an increasing function of existing interest differentials. The data confirm that the interest rate differential tended to disappear quickly and that monetary policy was afforded little permanent independence.
Obstfeld (1995) analyzes interbank Eurocurrency interest rate differentials for France, Germany, Italy, and Japan during 1982–93. For 1982–87, he finds that the data are consistent with the view that France and Italy restricted capital outflows and held domestic interest rates artificially low. For the remainder of the sample, however, he finds no evidence of significant barriers to capital mobility inasmuch as the offshore-onshore differential is close to zero, as are arbitrage profits. However, there is evidence that government intervention was effective in driving a small temporary wedge between offshore and onshore interest rates following the ERM crisis.
Jansen and Schulze (1996) use the Dooley-Isard approach to analyze the effectiveness of the Norwegian controls in the 1980s. During this period, Norway had in place a set of restrictions on international capital flows, which it phased out only in 1990. The results suggest that, even in the presence of controls, the Norwegian money market was relatively well integrated. Capital account restrictions did not prevent interest rate equalization, presumably reflecting scope for evasion.
One analysis of the ERM experience is offered by Fieleke (1994), who examines the behavior of differentials between interest rates in the Eurocurrency markets and comparable rates in the domestic money markets of Ireland, Portugal, and Spain. In all three countries, controls were used to defend the currency during the 1992 ERM crisis. The usual interest rate methodology rejects the effectiveness of the controls, because spreads remained close to zero for all three countries. However, given that Finland, Norway, and Sweden, three countries that did not impose capital controls, experienced much sharper increases in the level of interest rates, the question remains as to whether capital controls sheltered Ireland, Portugal, and Spain from the systemwide crisis.115
Tests based on covered interest rate differentials are available only for countries with well-developed financial markets. Most emerging markets and developing countries do not have either a well-developed forward exchange market or an offshore market for their currency. Hence, empirical work on these countries has relied on alternative procedures to test for effectiveness. The results of some of these papers should be interpreted with caution because of both methodological and data problems. In particular, some of these studies are characterized by problems of endogeneity that may infect the parameters with simultaneity bias. Moreover, the possibility of misreporting of information, reflecting incentives to avoid the capital account restrictions, raises doubts about the accuracy of some of the data. Thus, studies of emerging markets must be interpreted even more cautiously than those for industrial countries.
Edwards and Khan (1985) introduced a methodology applied subsequently in many studies of countries lacking well-developed financial markets. They started from the assumption that the domestic interest rate can be expressed as a weighted average of the uncovered interest rate parity and the domestic interest rate that would prevail if the capital account were completely closed. Hence, in countries with effective controls, the coefficient (weight) of the foreign rate should be relatively low. Edwards and Khan apply this approach to Singapore (1976–83), which they regard as a relatively financially open economy, and Colombia (1968–82), which they consider only a semiopen economy. Their results support the hypothesis that capital account restrictions have some impact on equilibrium interest rates. In Colombia, both the foreign interest rate and domestic financial conditions appear to have been important in the period of pervasive controls, while in Singapore the foreign interest rate played the dominant role in the determination of the domestic rate. Haque and Montiel (1991), using instrumental variables techniques, extend the Edwards-Khan (1985) approach to developing countries in which financial repression prevents the use of official interest rate data. They estimate the degree of capital mobility for 15 developing countries. Their findings are consistent with the view that capital controls are ineffective in the sense that the degree of capital mobility in the sample appears to be quite high.
One attempt to examine changes in the effectiveness of controls over time is Reisen and Yèches (1993), who apply a modified version of the methodology in Haque and Montiel (1991) to Korea and Taiwan Province of China. They use time-varying parameter estimates based on the Kalman filter technique to obtain information on how financial openness evolved between 1980 and 1990. They find a low, and possibly decreasing, degree of capital mobility consistent with the presence of effective capital controls. Evidence conflicting with these results is in Dooley and Mathieson (1994), who examine capital mobility in the Pacific Basin from the mid-1960s to 1990. They propose a modified version of the Haque and Montiel (1991) approach to allow for the effects of anticipated inflation and estimate changes in the degree of capital mobility. They find that, despite the presence of capital control programs, capital was almost perfectly mobile, and in most cases the degree of mobility was increasing over time, suggesting that the restrictions were increasingly ineffective.
Similar results are reported in Haque, Kumar, and Leigh (1994), who again extend the basic Edwards-Khan (1985) model, adopting an error-correction formulation of the money demand equation for 27 developing countries. Their results indicate that the degree of capital mobility was much higher than often assumed. Moreover, they find that the financial deregulation of the 1980s had a significant, positive impact on the degree of financial market integration. Maloney (1997) uses a methodology similar to that of Edwards and Khan to analyze the effects of opening the Chilean capital account during 1979–82. In contrast with other studies, the evidence in this paper shows that in spite of the financial reforms, Chilean interest rates behaved as if the capital account were closed for much of the period following liberalization. To test the accuracy of the Edwards-Khan approach, he applies the same methodology to the Japanese liberalization of 1979 for which covered interest parity data are available. In that context, he shows that the two different approaches lead to the same conclusions about the effects of capital account opening.
Phylaktis (1988) follows a different approach. Analyzing Argentina during 1971–84, she uses realized spot rate changes as a proxy for the expected exchange rate changes (or the forward discount). Although she confirms that capital controls affected the uncovered interest rate differential, her methodology is open to the objection that it requires restrictive assumptions about agents’ expectations of future exchange rate changes (see Obstfeld, 1995). In particular, it requires that the uncovered interest rate differential be an unbiased predictor of future exchange rate changes.116 Moreover, even if this restrictive assumption is valid, there are other serious problems. If agents perceive a finite probability of a discrete change in the exchange rate, which does not actually occur in the sample period, the interest rate differential will systematically exceed the spot rate change, in the phenomenon known as “peso problem.” The uncovered differential test will then tend to overestimate the effectiveness of capital controls. In a similar paper, Wong (1997), uses a sophisticated version of uncovered interest rate parity to test for the openness of various Asian countries’ financial markets. He finds that the presence of black markets in foreign exchange significantly eroded the effectiveness of capital controls. A different approach is in Garcia and Barcinski (1996), who examine Brazil in the 1990s. They construct three measures of the covered interest rate differential, using the U.S. dollar futures in Brazil, Brazilian bonds indexed to the U.S. dollar, and Brazilian bonds issued in U.S. dollars. All these approaches lead to the conclusion that the controls imposed in the second half of 1993 were ineffective.
It is possible, of course, that governments respond to international and financial conditions changing capital account regulations, rendering capital controls endogenous. Some evidence on their endogeneity is provided in Edwards (1989), who analyzes the relationship between currency devaluation episodes and changes in capital account regulations. He examines the evolution of controls for 39 countries in the years that preceded currency devaluations. In the great majority of the cases analyzed, devaluation was preceded by a significant increase in the prevalence of exchange rate controls and restrictions. This evidence confirms the hypothesis that capital controls are, at least in part, an endogenous variable and that governments react to capital flows with regulatory reforms.117
Cardoso and Goldfajn (1998) develop this idea for the case of Brazil. They argue that capital controls are not exogenous and show, consistent with Edwards (1989), that the government reacts strongly to capital flows by adjusting the intensity of control measures. Using a vector autoregression approach, they show that capital controls are effective in reducing flows and changing their composition in the short run, although there is little evidence that they have lasting effects. The reaction of the private sector is also examined in Dooley, Mathieson, and Rojas-Suarez (1997), who construct a measure of the cost of undertaking private capital flows in countries with capital controls, based on the past history of uncovered interest rate differentials and the current account. If the cost associated with disguised flows has tended to fall over time, then financial integration should have increased even in those countries that have maintained capital account restrictions. The authors’ estimates for Mexico, Korea, and the Philippines suggest that between the 1970s and the 1990s the cost of undertaking private capital flows fell by some 70 percent.
Few papers have attempted to examine the effectiveness of capital controls using direct measures of international capital flows. An exception is Johnston and Ryan (1994), who analyze the impact of controls on the capital account with data for 52 industrial and developing countries. They use different measures of private capital flows than those reported in the official balance of payments statistics, including errors and omissions and estimates of unrecorded flows and trade misinvoicing. The impact of controls on capital flows is estimated by F-tests for structural differences between regimes with and without controls and by estimating the coefficients on dummy variables intended to capture the nature of the restrictions.118 The results suggest that capital controls were largely ineffective in insulating developing countries’ balance of payments, while they significantly affected the composition of capital flows in industrial countries.
Chile’s Experience with Nonremunerated Deposits
In the early 1990s, Chile experienced a surge in capital inflows that created a conflict between the authorities’ internal and external objectives. The problem was how to maintain a tight monetary policy without hindering Chilean export competitiveness. In 1991, the central bank attempted to resolve this dilemma by imposing a one-year unremunerated reserve requirement on foreign loans, which was designed to discourage short-term borrowing without affecting long-term foreign investments. The fixed holding period of the reserve requirement implied that the financial burden diminished with the maturity of the investment. Between 1991 and 1997, the rate of the unremunerated reserve requirement was increased and its coverage extended in several steps to cover most forms of foreign financing except foreign direct investment. Currently, there is a one-year minimum holding period on capital inflows (applying to all inflows above $10,000 except for short-term borrowing and holding of American Depository Receipts). Bonds issued abroad by local companies must have an average maturity of at least four years. In addition, there is a 10 percent unremunerated reserve requirement, also with a one-year holding period, for all external liabilities that do not increase the stock of capital, regardless of their maturity.119 This measure applies to all inflows that do not increase the stock of capital. In practice, this means that not only loans, but also fixed income securities, and equity investments (American Depository Receipts) are subject to the unremunerated reserve requirement. Hence, only primary issuances of American Depository Receipts and foreign direct investments (over $1 million) are exempted from the reserve requirement. However, American Depository Receipts primary issues are subject to two minimum rating requirements (BB), granted by internationally recognized credit rating agencies.
The Chilean experience has also been viewed as a means of controlling the composition of foreign borrowing without hindering the volume of capital inflows to the country (see Le Fort and Budnevich, 1996). However, the evidence on the effectiveness of the Chilean controls in reducing the short-term external debt is somewhat ambiguous.
Table 2 and Figure 10 describe the evolution of Chile’s external debt. They suggest that the introduction of capital controls affected the maturity composition of net capital inflows only after 1995 when the controls were strengthened. When the controls were initially introduced, the short-term component of the external debt dropped 5 percentage points in 1991, but climbed back to about 25 percent in 1992. It was only in 1996 that short-term debt fell below 20 percent of total external debt. In 1997, the short-term component declined to 11 percent.
|Percentage of Short-|
Term External Debt
|1997||3,078||27,639||11.1||35|Figure 10.Chile’s Short-term External Debt
Source: IMF, World Economic Outlook.
Data from the Bank for International Settlements (BIS) on the maturity structure of Chile’s external debt also lend support to the view that capital controls have had some effect in limiting the short-term component of Chilean external debt. At the end of June 1997, loans with less than one year to maturity represented 43 percent of Chile’s total exposure to banks in the BIS area—one of the lowest ratios among the major emerging market economies (see Table 3).120 That Colombia has followed similar policies and also has a relatively small share of short-term loans reinforces the point.121
|Country||Total||Up to One Year||One to Two Years||Over Two Years||Unallocated||Percent Short (<=1)|
|Hong Kong S.A.R.||222,289||183,115||4,417||24,974||9,783||82.4|
|Taiwan Province of China||25,163||21,966||236||2,598||363||87.3|
Literature on the Effectiveness of Chile’s Controls
Many studies test for the effectiveness of capital controls by examining either the evolution of offshore-onshore interest rate differentials or whether covered interest rate parity is violated. Since Chile did not have either a well-developed forward exchange market or an offshore deposit market for Chilean pesos, studies of Chile have relied on alternative procedures to test effectiveness. As will be discussed, the evidence regarding the ability of the Chilean controls to drive a sustained “wedge” between domestic and external monetary conditions is mixed. However, there is another dimension to the effectiveness of Chilean-type capital controls—namely, their ability to limit the accumulation of short-term external debt by financial and nonfinancial entities. In particular, there is the issue of whether controls can be used to limit the growth of potential claims on the official safety net underpinning the financial system. Such limits could be particularly important in countries with banking system weaknesses and poorly developed supervisory systems.
Quirk and Evans (1995) observe that net short-term private capital inflows recorded in the balance of payments fell in 1991 with the introduction of capital controls. However, they also observe that net errors and omissions and estimated trade misinvoicing also increased sharply that year. One possible interpretation is that the change in errors and omissions represents an increase in unrecorded short-term flows reflecting an attempt by the private sector to circumvent capital account restrictions.
Le Fort and Budnevich (1996) provide an empirical study that suggests that Chilean capital controls have been effective, because, in the absence of effective capital restrictions, it would have been impossible to keep domestic interest rates above comparable international rates. Their argument implicitly assumes that the mix of sound macroeconomic policies and sustained growth ruled out a peso problem explanation for the interest rate differential. However, they do not provide an econometric analysis of the degree of effectiveness.
Valdés-Prieto and Soto (1997) analyze the effects of the Chilean reserve requirement on the short-term external debt as a share of GDP. They use the tax revenues generated by the unremunerated reserve requirement as a proxy for the effectiveness of the restrictions and include errors and omissions from the balance of payments in their definition of short-term capital inflows. Their estimates suggest that the unremunerated reserve requirement did not have a significant effect on short-term borrowing before 1995, when the implicit tax increased from 3.6 percent to 6.7 percent, after the central bank changed the regulations and required investors to hold their reserves in U.S. dollars.122 However, the paper does provide evidence that the unremunerated reserve requirement was effective in 1995–96. Nevertheless, the authors suggest that other forms of short-term borrowing increased over that period as the private sector substituted exempt short-term flows—not always classified as short-term credit in the Chilean statistics—for taxed short-term flows, as the authorities gradually changed the tax design over time to counteract new methods of evasion.l23 A shortcoming of the methodology applied in this paper is the possibility of a simultaneity bias of the estimated parameters, because some of the variables used as regressors may in fact be endogenous.
To overcome this endogeneity problem, Soto (1997) runs a vector autoregression analysis on capital flows, interest rates, and level and volatility of the real exchange rate for Chile. He finds that capital controls have the desired effect of reducing capital inflows, maintaining higher interest rates and a lower real exchange rate, and reducing the share of short-term capital inflows. However, the magnitude of these effects turns out to be very small.
Edwards (1998a) tests the effectiveness of Chile’s capital controls’ indirectly. To compensate for the lack of offshore interest rate and forward exchange rate data, he focuses on the evolution of the real exchange rate and interest rate differential. His hypothesis is that effective controls will alter the relationship between domestic and foreign interest rates and the time series behavior of the real exchange rate. His results suggest that the impact of capital restrictions on the behavior of the real exchange rate has been limited and short-lived. He also provides some evidence suggesting that the persistence of interest rate differentials increased after the introduction of capital controls.
Cardoso and Laurens (1998) find that the introduction of capital controls had some temporary effect on the composition of external financing. This is consistent with the view that the private sector will attempt over time to circumvent restrictions on capital movements. They regress a direct measure of net private capital inflows on an index of capital account restrictions and a vector of control variables, including real interest rate differentials, domestic GDP, and seasonal dummies. Their results suggest that capital controls were effective in the six months following their introduction, but ceased to be effective afterward. However, their analysis does not control for the possibility of simultaneous bias. As in Valdés-Prieto and Soto (1997), a number of the regressors could in fact be endogenous variables. In particular, it would seem difficult to establish the direction of causality between the interest rate differential and capital inflows.
Controls on Foreign Investment
A number of countries still maintain controls on foreign investments, either by restricting foreign direct investment or by limiting the position of foreigners in domestic equities. Unfortunately, there is very little empirical evidence on the effectiveness of these kinds of controls. However, Korea’s experience may shed some light on the impact of such controls on the composition of foreign capital flows and total external debt.
In 1990, Korea started a series of reforms designed to liberalize the capital account. The sequencing of the reforms led to an early liberalization of commercial credit and short-term flows, while it left in place significant restrictions on foreign direct investments and portfolio investments in domestic equities (see Park and Song, 1996, and Johnston, Darbar, and Echeverria, 1997). In 1997, Korea allowed foreign exchange banks to borrow abroad and permitted most forms of short-term financing and commercial credit, while maintaining restrictions on long-term flows. Foreign direct investment through merger and acquisition was not permitted, and approval of the authorities was required for the establishment and extension of a domestic branch of a foreign enterprise. Portfolio investments in domestic equities were also restricted, through a 20 percent limit on the percentage of any listed firm that nonresident investors as a group could hold (5 percent for individuals).124
To some extent, the Korean capital controls program should have had the opposite effect of the Chilean program. In Chile, controls focused on short-term flows and were designed to reduce short-term foreign borrowing without hindering long-term portfolio investment and foreign direct investment. In Korea, controls focused on long-term investments and should have increased short-term liabilities as a percentage of total foreign inflows and external debt. Data from the BIS confirm this intuition. Chile’s short-term borrowing from banks in the BIS area represents 43 percent of total borrowing, while the corresponding figure for Korea is 68 percent. Furthermore, ranking emerging markets by the relative weight of short-term bank borrowing, Chile and Korea appear at opposite ends of the spectrum (see Table 3). However, more pervasive empirical evidence should be collected before any strong conclusions are drawn.
This view that capital controls are only temporarily effective is reinforced by Spiegel (1990). who examines the case of Mexico. He applies the Dooley-Isard methodology to estimate the effect of the controls of August 1982. His conclusion is that the Mexican program was successful, but only for a limited time, as the impact of controls died out after six months.
At that time, Spain introduced temporary controls on short-term capital inflows to limit the appreciation of the peseta.
Fieleke (1994) also offers another perspective from which to evaluate capital controls in the context of a currency crisis. Theoretically, traded and nontraded goods prices react differently to a devaluation. If controls are expected to succeed, the relative market value of the stocks of nontraded goods industries should rise. However, if controls are expected to fail in preventing a devaluation, the relative market value of the stocks of traded goods industries should rise after the imposition of the program. The application of this technique in Portugal in 1992 obtained mixed results.
In other words, the exchange rate expectational error has to be zero on average.
Evidence to the same effect is provided by Eichengreen and Masson (1998).
One difficulty is controlling for other factors that may also affect the behavior of the capital account. In particular, capital controls become an endogenous variable to the extent that governments react to capital flows by changing the nature and the extent of the restrictions. Hence, a positive spurious correlation might emerge between the extent of the restriction and capital flows.
The rate of the unremunerated reserve requirement, which had been 30 percent since May 1992, was reduced to 10 percent in June 1998.
The BIS data include all cross-border bank claims plus claims in nonlocal currency of local affiliates of banks in the BIS area. The total stock of short-term external borrowing according to this source in 1997 was roughly double that reported by Chilean sources. Among the possible explanations for this discrepancy are that the BIS data include foreign currency loans issued by Chilean affiliates of foreign banks and outstanding import credits (both types of loans are not included in official short-term data), as well as that BIS data classify loans by their actual maturity, while Chilean data consider the maturity at the date of issuance. The BIS data on the structure of external debt by maturity also include both public and private sector debt (a maturity breakdown for the private sector alone is not available).
For the evidence to be definitive, it would be necessary to quantify the intensity of controls and prudential regulations intended to influence the term structure of the debt in all the countries in Table 3 and to control also for other policies and conditions with a potential impact on the dependent variable. This, clearly, is a project for future research.
Previously, reserve requirements could also be constituted in other currencies, including yen. Because interest rates in yen were lower than in U.S. dollars, investors preferred to constitute their reserve requirements in yen, which carried a lower implicit tax.
This argument, albeit weak, seems consistent with the behavior of the central bank, which, at the end of 1995, strengthened the regulation extending the reserve requirement to fixed-income securities and to equities.
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171. Monetary Policy in Dollarized Economies, by Tomás Baliño, Adam Bennett, and Eduardo Borensztein. 1998 (forthcoming).
170. The West African Economic and Monetary Union: Recent Developments and Policy Issues, by a Staff Team led by Ernesto Hernández-Catá and comprising Christian A. François, Paul Masson, Pascal Bouvier, Patrick Peroz, Dominique Desruelle, and Athanasios Vamvakidis. 1998.
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167. Exchange Rate Assessment: Extensions of the Macroeconomic Balance Approach, edited by Peter Isard and Hamid Faruqee. 1998
166. Hedge Funds and Financial Market Dynamics, by a staff team led by Barry Eichengreen and Donald Mathieson with Bankim Chadha, Anne Jansen, Laura Kodres, and Sunil Sharma. 1998.
165. Algeria: Stabilization and Transition to the Market, by Karim Nashashibi, Patricia Alonso-Gamo, Stefania Bazzoni, Alain Féler, Nicole Laframboise, and Sebastian Paris Horvitz. 1998.
164. MULTIMOD Mark III: The Core Dynamic and Steady-State Model, by Douglas Laxton, Peter Isard, Hamid Faruqee, Eswar Prasad, and Bart Turtelboom. 1998.
163. Egypt: Beyond Stabilization, Toward a Dynamic Market Economy, by a staff team led by Howard Handy. 1998.
162, Fiscal Policy Rules, by George Kopits and Steven Symansky. 1998.
161. The Nordic Banking Crises: Pitfalls in Financial Liberalization? by Burkhard Dress and Ceyla Pazarbaşioğlu. 1998.
160. Fiscal Reform in Low-Income Countries: Experience Under IMF-Supported Programs, by a staff team led by George T. Abed and comprising Liam Ebrill, Sanjeev Gupta, Benedict Clements, Ronald McMorran, Anthony Pellechio. Jerald Schiff, and Marijn Verhoeven. 1998.
159. Hungary: Economic Policies for Sustainable Growth, Carlo Cottarelli, Thomas Krueger, Reza Moghadam, Perry Perone, Edgardo Ruggiero, and Rachel van Elkan. 1998.
158. Transparency in Government Operations, by George Kopits and Jon Craig. 1998.
157. Central Bank Reforms in the Baltics, Russia, and the Other Countries of the Former Soviet Union, by a staff team led by Malcolm Knight and comprising Susana Almuiña, John Dalton, Inci Otker, Ceyla Pazarbaşioğlu, Arne B. Petersen, Peter Quirk, Nicholas M. Roberts, Gabriel Sensenbrenner, and Jan Willem van der Vossen. 1997.
156. The ESAF at Ten Years: Economic Adjustment and Reform in Low-Income Countries, by the staff of the International Monetary Fund. 1997.
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154. Credibility Without Rules? Monetary Frameworks in the Post-Bretton Woods Era, by Carlo Cottarelli and Curzio Giannini. 1997.
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152. Hong Kong, China: Growth, Structural Change, and Economic Stability During the Transition, by John Dodsworth and Dubravko Mihaljek. 1997.
151. Currency Board Arrangements: Issues and Experiences, by a staff team led by Tomás J.T. Baliño and Charles Enoch. 1997.
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144. National Bank of Poland: The Road to Indirect Instruments, by Piero Ugolini. 1996.
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140. Government Reform in New Zealand, by Graham C. Scott. 1996.
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137. The Lao People’s Democratic Republic: Systemic Transformation and Adjustment, edited by Ichiro Otani and Chi Do Pham. 1996.
136. Jordan: Strategy for Adjustment and Growth, edited by Edouard Maciejewski and Ahsan Mansur. 1996.
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133. Policy Experiences and Issues in the Baltics, Russia, and Other Countries of the Former Soviet Union, edited by Daniel A. Citrin and Ashok K. Lahiri. 1995.
132. Financial Fragilities in Latin America: The 1980s and 1990s, by Liliana Rojas-Suárez and Steven R. Weisbrod. 1995.
131. Capital Account Convertibility: Review of Experience and Implications for IMF Policies, by staff teams headed by Peter J. Quirk and Owen Evans. 1995.
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129. IMF Conditionality: Experience Under Stand-By and Extended Arrangements. Part II: Background Papers. Susan Schadler, Editor, with Adam Bennett, Maria Carkovic, Louis Dicks-Mireaux, Mauro Mecagni, James H.J. Morsink, and Miguel A. Savastano. 1995.
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Note: For information on the title and availability of Occasional Papers not listed, please consult the IMF Publications Catalog or contact IMF Publication Services.