The explosive growth of international financial transactions and international capital flows is one of the single most profound and far-reaching economic developments of the late twentieth and early twenty-first centuries. This growth has several origins. Prominent among them are the removal of statutory restrictions on capital account transactions, itself a concomitant of economic liberalization and deregulation in both industrial and developing countries; macroeconomic stabilization and policy reform in the developing world, which have created a proliferation of attractive destinations for foreign capital; enterprise privatization, which has created a growing pool of commercial issuers of debt instruments; the multilateralization of trade, which has encouraged international financial transactions designed to hedge exposure to currency and commercial risk; and the growth of derivative financial instruments, which has permitted international investors to assume some risks while limiting their exposure to others.
Along with these forces (indeed, underlying some of them) is the powerful role of technology. This takes the form of the revolution in information and communications technologies, which has transformed the financial services industry worldwide. Globalization has many dimensions, all of which have been stimulated by the decline in the costs of transportation, communication, data processing, and transactions.1 But nowhere does the revolution in information and communications technologies have such far-reaching ramifications as in the financial sphere.2
The financial innovation and liberalization that result are domestic as well as international phenomena. Not only have restrictions on international financial transactions been relaxed, resulting in the explosive growth of international capital movements, but also regulations constraining the operation of domestic financial markets have been relaxed or removed as countries have moved away from repressive financial policies. Domestic and international financial liberalization have generally gone hand in hand. They are responses to many of the same incentives and pressures.
However, in a significant number of cases, financial liberalization, both domestic and international, appears to have been associated with costly financial crises. This apparent association is somewhat deceptive, because financial crises are complex events that usually have multiple causes and that have occurred in less liberalized as well as more liberalized financial systems. Nevertheless, there have also been several cases in which financial liberalization, including capital account liberalization, is reasonably assessed to have played a meaningful role in crises. This raises a serious question about whether and under what conditions financial liberalization—and particularly capital account liberalization—will be beneficial rather than harmful. The answer advanced in this paper is the following. Capital account liberalization, and financial liberalization more generally, is essentially inevitable for all countries wishing to take advantage of the substantial benefits of broad participation in the open world economic system in this modern age of technology and communications. Financial liberalization also has its dangers, as liberalized systems generally afford opportunities for individuals, enterprises, and financial institutions to undertake greater and sometimes imprudent risks, thereby raising the potential for systemic disturbances. There is no way to completely suppress these dangers, other than through draconian financial repression, which creates worse problems. The dangers, however, can be limited quite considerably through a combination of sound macroeconomic policies to contain aggregate Financial imbalances and ameliorate the effects of financial disturbances and sound prudential policies to ensure proper private incentives for risk management. These must be backed up by adequate supervision and regulation, especially of the financial sector. With these important safeguards, capital account liberalization and broader financial liberalization are not only inevitable, but will clearly be beneficial.
At the theoretical level, the controversy over the benefits of financial liberalization reflects diverging views: are liberal financial markets predominantly efficient or, instead, are they so distorted by information asymmetries and other problems that financial transactions perceived to be beneficial to their direct participants too often yield outcomes detrimental to the general welfare? A large “efficient markets” literature argues the first hypothesis. At the same time, some observers insist that asymmetric information—a situation where one party to a transaction has less information than the other—is a key feature of capital markets and that it shapes the outcome of financial transactions so as to limit the efficiency of resource allocation. This is not to deny that information asymmetries exist also in other markets or that such problems, even when relatively mild or adequately controlled, can be a barrier to privately and socially beneficial transactions.3 However, they are not in general so serious as to preclude trade in goods and services altogether. Monitoring and verifying the quality of a tangible good or labor service are usually relatively straightforward and are often not a central issue, whereas for many financial transactions, acquiring accurate and reliable information to establish value is the essence of the issue.
Problems of asymmetric information are particularly prevalent in the international domain, where geographical and cultural distance complicates the task of acquiring and analyzing information.4 The revolution in information and communications technologies, by reducing data acquisition and processing costs, has had a particularly powerful effect in stimulating international financial transactions.5 And if the information and communications revolutions are irreversible, so is the growth of international capital flows.
The growth of international financial transactions concomitant with the information revolution thus poses a dilemma for policymakers. To the extent that information asymmetries are only attenuated but not eliminated, financial markets will continue to be affected to some degree by adverse selection, moral hazard, principal-agent problems, and herding behavior (see Box 1).6 In this setting, sharp investor reactions can give rise to unpredictable market movements and, in the extreme, financial crises. If these problems are serious enough, as they sometimes appear to be, then it may be necessary to temper the general presumption that market liberalization enhances the efficiency of resource allocation. A more accurate statement is that international financial liberalization, like domestic liberalization, unambiguously improves efficiency only when accompanied by the appropriate policies to limit moral hazard, adverse selection, excess volatility, and related problems and to contain their potentially damaging consequences.
Also, as has long been recognized, sound macroeconomic policies are essential (although not sufficient) for maintaining reasonable financial stability. Indeed, a liberalized financial system is probably more demanding in this respect than a repressed system, in which significant financial imbalances can sometimes be suppressed for extended periods, at great cost in terms of economic efficiency and often also of good governance. However, the ability to substitute financial controls for sound macroeconomic policies is being eroded by the economic and technological forces that are fundamentally driving financial liberalization. Even controls that may serve better purposes are generally subject to these forces, and policymakers will need to search for new ways, compatible with more liberal financial systems, of maintaining financial stability.
These observations provide the context for a discussion of the liberalization of capital account transactions and policy toward international capital flows. Capital account liberalization is defined as freedom from prohibitions on transactions in the capital and financial accounts of the balance of payments. Note the distinction between controls on the one hand and taxes on the other. While current account convertibility is defined under Article VIII of the IMF’s Articles of Agreement as freedom from restrictions on the making of payments and transfers for current international transactions (defined in Article XXX(d) to include certain transactions that are defined as capital transactions for purposes of balance of payments statistics), Article VIII does not proscribe the imposition of restrictions, such as import tariffs and taxes, on the underlying transactions. Correspondingly, capital account convertibility is taken here to mean the removal of exchange and other controls but not necessarily all taxlike instruments imposed on the underlying transaction, which agents retain the option of undertaking.
Asymmetric Information
Information is “asymmetric” when one party to an economic relationship or transaction has less information about it than the other party or parties. While asymmetric information is present in many markets, some economists believe that it is particularly pervasive in financial markets. Asymmetric information gives rise to adverse selection when the party does not know a relevant characteristic of the product that is being transacted or of the preferences or technology of the other party. For instance, the buyer of a used car may not know if the car is a “lemon,” or a lender may not know the riskiness of the borrower applying for a loan. Adverse selection typically results in inefficient pricing and, in extreme cases, may prevent efficient transactions from taking place. In credit markets, adverse selection may lead to credit rationing.
When one party cannot observe a relevant action to be undertaken by the other party, moral hazard may result. For instance, an insurer may not be able to observe whether the insured takes precautions to curb risk. Thus, a contract obliging the insured to take such precautions is not enforceable, and too much risk will result. In financial markets, a creditor may not be able to observe whether the borrower will invest in a risky project or a safe project, and, if the borrower is protected by limited liability or guarantees of some sort, too much investment in risky projects will result. An extreme case of moral hazard occurs when companies or banks with negative net worth borrow to gamble for redemption; namely they invest in ventures that can yield a high return (enough to stave off bankruptcy) but have a low probability. Gambling for redemption can result in large losses for the lenders. Moral hazard can also arise in the context of principal-agent situations, in which a principal asks an agent to perform certain tasks on her behalf (in exchange for compensation), but cannot perfectly monitor the execution of the tasks. To the extent that the agent’s preferences differ from those of the principal, the outcome will be suboptimal. For example, principal-agent situations arise when a small investor invests in a mutual fund and cannot perfectly monitor the investment strategy of the fund manager, or when equity holders entrust managers with running the business they own.
The importance of asymmetric information in financial markets is underscored by the fact that the very existence of financial institutions can be explained on asymmetric-information grounds. For instance, it has been argued that banks and other financial intermediaries specialize in assembling and analyzing information about borrowers and their investment projects, thereby attenuating informational asymmetries. From this perspective, banks and other financial intermediaries act as “delegated monitors” on behalf of their customers.
The next section describes recent trends in capital flows, focusing on the experience of developing countries, and elaborates on the role of technology in stimulating the growth of international financial transactions. It documents the far-reaching consequences of these developments, including the pressure they impart for the removal of capital controls and for changes in the exchange rate regime. It concludes with the observation that, despite experiences with serious financial crises in a number of cases, the decisions of many countries to proceed with financial liberalization are important evidence that such liberalization, including capital account liberalization, is generally beneficial when carried out under appropriate safeguards.
The paper then examines what economic theory has to say about the benefits and costs of capital mobility. It lays out the classical case for international capital mobility as intertemporal trade, as a mechanism for risk sharing, and as a means for enhancing the efficiency of financial services. It examines the counterarguments arising from problems of asymmetric information and other distortions that, if serious enough, could make financial liberalization harmful. It notes that, as some of these problems are the direct consequence of misguided government policies that should be reversed or can be removed by countervailing policies, they provide an argument for policy adjustment in connection with, rather than as a true barrier to, successful financial liberalization and the benefits that such liberalization can bring. Other problems, especially some of those associated with asymmetric information, are intrinsic to financial markets, both domestic and international, and cannot be entirely overcome. Noteworthy in this regard are problems of herding that may contribute to excessive volatility in financial markets and the nexus of problems relating to the banking system, which may be subject to runs and is influenced by moral hazard arising from expectations of government support to contain such runs. Here the answer is to structure appropriate prudential policies (especially for the banking system and to contain short-term debt), and supporting macroeconomic policies, to limit these problems to the point where the risks potentially arising from a liberalized financial system are at an acceptably low level—a level at which the benefits of liberalization clearly outweigh the costs. This is the approach taken by countries with respect to domestic financial liberalization, and the same approach is relevant for international financial liberalization.
The fourth and fifth sections assess countries’ practical experience with capital account liberalization by reviewing studies of the effects of capital account convertibility on economic growth, cyclical stability, and susceptibility to crises. This review highlights the difficulty of making unconditional statements like “capital account convertibility is beneficial” or “capital account convertibility is harmful.” Rather, what emerges is the need to marry capital account liberalization with domestic policy reform to ensure that the favorable effects dominate.
This leads to a discussion of the prudential regulation of financial institutions and markets, the role that can be played by limits on international capital flows, and the issue of sequencing. For purposes of this discussion, the range of prudential measures toward capital account transactions is conceived broadly, so as to encompass capital controls in the form of statutory prohibitions on certain transactions, open position limits, and taxes and tax equivalents that provide a pecuniary disincentive for such flows. The core question is what prudential measures are necessary to limit systemic risks that may arise more easily in liberalized financial markets and thereby ensure successful liberalization of the capital account.
The May 1997 edition of World Economic Outlook (International Monetary Fund, 1997) takes globalization as its theme and traces the implications not just for financial markets but also for the rest of the world economy.
For an overview of these developments see Werthamer and Raymond (1997).
For example, a firm producing and exporting a computer chip or a pharmaceutical product will know more than a potential importer about the quality-control methods under which it is produced and hence about the uniformity and reliability of the good, which will limit the volume of trade.
In addition, contracts are more difficult to enforce when they span national borders and legal jurisdictions. In principle, one way of neutralizing some of the adverse effects of information asymmetries is to write contracts whose payoffs are contingent on observed outcomes. But where enforcement is less effective (i.e., in the international domain), such relatively complex contingent contracts will be more difficult to write.
Historical experience is consistent with this view: even in the last era of financial globalization, prior to 1914, markets were significantly integrated only in securities issued by governments and railways, entities with tangible assets (the power to tax in the first instance, the road bed, railway, and rolling stock in the second) that were therefore largely exempt from the most severe information problems. The historical evidence on these questions is summarized in the next section and described in more detail in Appendix I.
Adverse selection arises in financial markets characterized by asymmetric information when the average quality of agents active in the pool of potential borrowers deteriorates with increases in the interest rate. Moral hazard arises in several areas, including when borrowers alter the characteristics of their investment projects after contracting a loan. Herding is defined as a situation where investors have an incentive to emulate the actions of other investors. For further discussion of some of these terms, see Box 1.