Introduction
In the course of the 1980s, a general trend toward the liberalization of capital movements emerged in the face of growing disillusionment regarding the effectiveness of capital controls. In eliminating restrictions, most advanced economies followed a cautious approach. Typically, authorities moved gradually to avoid jeopardizing exchange rate and monetary stability. Countries that had liberalized capital movements substantially in the 1960s but were forced to reintroduce controls were reluctant to prematurely liberalize again. It was considered that if liberalization were once again reversed, the economic and political costs would be high. Gradual liberalization was linked to reform in other policy areas, both domestically (such as the deregulation of the domestic financial sector and changes to the monetary policy strategy) and externally (with respect to the exchange rate regime).
In this section, the gradual approach to capital liberalization is exemplified by the experiences of Japan and France. Japan dismantled capital controls and deregulated the domestic financial sector over several decades and has only very recently established a fully liberalized environment. The Japanese experience is one of the most interesting and complicated examples of capital account liberalization. In Europe, the Federal Republic of Germany and the Netherlands were the only advanced countries to gradually dismantle capital controls in the 1970s. Other countries followed in the 1980s, encouraged by a general improvement in the economic climate. Among those countries, France’s experience is discussed at some length, because the clear linkages to other policy areas were explicitly addressed and also because it provided an example for other countries, such as Italy, Spain, and some smaller European economies. In contrast, the United Kingdom, Australia, New Zealand, and some of the Nordic countries liberalized their capital controls more rapidly. Their experiences are discussed in Section V.
Experience with Gradual Liberalization in Japan
Japan’s motives for capital controls were a mixture of exchange rate and industrial policy considerations. Controls on inward direct investment formed part of domestic industrial policy and restricted the overall share of foreign ownership in companies in various industries.23 Although formal controls were eased in 1967, 1973, and 1979, investment inflows remained low (Figure 4.1). A prior-approval system was in place, and a decisive answer on a request for permission to invest was given only after a significant (and varying) waiting period. This approval process could be used to discourage or retard investment. The high domestic saving rate (and associated current account surplus) reduced the extent to which direct investment inflows were required to finance industrial development, in contrast to the situation in many other countries.
Japan: Foreign Direct Investment, 1970–98
(Percent of GDP)
Sources: IMF, International Financial Statistics (Washington), various issues; Thomson Financial; and Bank of Japan.Japan: Foreign Direct Investment, 1970–98
(Percent of GDP)
Sources: IMF, International Financial Statistics (Washington), various issues; Thomson Financial; and Bank of Japan.Japan: Foreign Direct Investment, 1970–98
(Percent of GDP)
Sources: IMF, International Financial Statistics (Washington), various issues; Thomson Financial; and Bank of Japan.The 1980s saw a number of significant changes in Japanese capital controls, as the domestic financial system developed and international pressure to deregulate and liberalize intensified. Changes in the savings and investment balances between sectors over the 1970s were a key factor leading to reforms. Increasing government budget deficits made banks’ traditional obligation to purchase bonds at below-market rates more burdensome, while corporate borrowing requirements were falling as growth slowed following the oil price shocks that occurred during that time. In addition, there was a growing tendency for corporations to invest liquid funds in instruments in the Gen-saki market, which were not subject to interest rate ceilings, rather than in regulated bank deposits.24 The problems that the banking sector faced owing to these developments led to strong domestic pressure on the government to reform the financial system.
The progress in deregulating the domestic financial system coincided with a changing attitude toward capital controls from 1979 onward. In December 1980, the exchange control system was changed from a negative one in which cross-border capital flows were forbidden unless explicitly permitted to a positive system in which capital flows were allowed unless explicitly prohibited. While the switch to a positive system was certainly a landmark event in the liberalization process, the practical importance of the revision was reduced by several significant exceptions, the most important of which were the preservation of the system of administrative procedures for direct investments (discussed above); restrictions on the operations of banks; and the real demand principle, which required forward foreign exchange transactions to be linked to underlying trade transactions. The limited development and extensive regulation of domestic financial markets also raised transaction costs, thus restricting capital flows (Takeda and Turner, 1992) Finally, limits remained on the share of foreign assets that could be held by institutional investors (although these were gradually lifted in the 1980s).
A key remaining restriction on the operations of Japanese foreign exchange banks was the system of yen-conversion quotas that limited the banks’ ability to borrow foreign currency and make yen investments with the proceeds. Fukao (1990) argues that this restriction was relatively ineffective after 1980 because Japanese nonbank residents were not subject to the quotas. This enabled large corporations, facing low transaction costs, to engage in interest arbitrage. The real demand principle also lost its effectiveness after 1980 because revisions in the December 1980 law liberalized borrowing, lending, and depositing in foreign currency at freely determined interest rates and allowed corporations to take positions that resembled the effect of a forward contract.25
Key changes resulted from the so-called yen/dollar agreement between the Japanese and U.S. authorities that was signed in 1984. Faced with a strong dollar and a rapidly worsening current account deficit in 1983, the U.S. authorities argued that half of the deficit was caused by the bilateral trade deficit with Japan. Furthermore, the United States argued that the Japanese policy restricting capital movements and discouraging the international use of the yen as a transaction currency contributed to the weakness of the yen. In the course of 1983, Japan and the United States agreed to set up a working group to study the misalignment of the yen/dollar exchange rate. The final report of the ad hoc Working Group on Yen/Dollar Exchange Rate Issues, published on May 29, 1984, led to a renewed acceleration in the deregulation of both Japan’s capital controls and domestic financial markets.26
Liberalization directly following the yen/dollar agreement covered several aspects of financial market regulation. Measures stimulating capital outflows included the easing of eligibility requirements and other restrictions on the issuance of yen-denominated bonds in Japan by nonresidents (Samurai bonds). Furthermore, the sale of foreign certificates of deposit and commercial paper in Japan was allowed. With regard to capital inflows, key measures included the abolition of the conversion quotas imposed on Japanese foreign exchange banks and the abolition of the withholding tax on Euroyen bonds issued by Japanese residents. The liberalization of the Euroyen market was a further direct result of the yen/dollar agreement, although it occurred more slowly. Subsequent to the agreement, changes were clearly made part of a transition to a deregulated financial system, in contrast to some earlier ad hoc liberalization measures.
Significant liberalization of both domestic and international financial markets in Japan also took place outside the framework of the yen/dollar agreement. The trend toward more market-determined interest rates, which started in the 1970s, continued. New financial markets and financial instruments were allowed to evolve and to coexist alongside regulated instruments, leading to the development of some parallel markets. To dampen the immediate impact of interest rate deregulation on the financial system, restrictions, such as high minimum amounts or particular maturity standards, were initially imposed on the newly established instruments. These requirements were then gradually eased in subsequent years.
In December 1986, the Japanese Offshore Market was established, providing Japanese foreign exchange banks with a market in which their international activities could be developed. In addition, it enabled foreign banks to access the Japanese market. The market was free of domestic regulations, such as interest rate controls, deposit insurance, reserve requirements, and withholding tax. Funds in offshore accounts, however, could not be transferred to onshore accounts. Japanese banks could circumvent these measures by depositing foreign borrowings with foreign branches and subsequently reborrowing these funds through onshore interoffice accounts. Because of the limited effectiveness of these restrictions, they were abolished in April 1989.
Administrative procedures for inward direct investment were eased and simplified on several occasions, and from 1992 prior approval was required only for investment in the agriculture, forestry and fishing, mining and petroleum, and leather industries. Nevertheless, inward direct investment flows remained low until the late 1990s—much later than in most other industrial countries. The increase in investment inflows in the late 1990s appears, at least in part, to reflect domestic economic reforms. For example, following the Japanese financial market reform, direct investment in the financial and insurance sectors increased significantly.
Outward direct investment increased dramatically between 1987 and 1991, even though the necessary approval process also included a waiting period. In addition to the role played by better-functioning capital markets, the strong yen, in the second half of the 1980s, encouraged Japanese firms to open manufacturing plants in other parts of Asia, Europe, and the United States, Pressure from the United States regarding the size of its bilateral current account deficit with Japan was also a factor in stimulating foreign direct investment outflows.
Responses to the Reforms
The substantial changes during the 1980s largely completed the transition from a system with strong capital controls into a system with virtually free capital movements. Some of the remaining restrictions were removed in the early 1990s, and remaining controls on interest rates were removed in 1994. Developments from the mid-1980s were shaped by the relationship between the progressive internationalization of the Japanese financial system and the more gradual removal of controls on the domestic financial system. Profitable arbitrage opportunities between domestic and international yen markets encouraged banks to use interoffice accounts and interbank borrowing to fund their international activities. Banks engaged in short-term offshore borrowing (in foreign currencies) to fund long-term foreign currency lending to Japanese residents.27. Surprisingly, despite Japan’s large current account surplus, Japanese banks were (on a net basis) capital importers in the late 1980s.28. The use of the offshore markets enabled Japanese banks to expand lending while avoiding the Bank of Japan’s informal guidelines on domestic lending. (Lending from offshore was not covered under the guidelines.) Japanese nonbank residents who wished to invest in foreign currency bonds were also keen to borrow in foreign currency to fund those investments in order to eliminate their exchange rate risk.
Nonfinancial corporations also made increasing use of deregulated financial markets and the associated increased availability of credit. That reduced their dependence on banks and weakened the traditionally close relationships between banks and corporations as large nonfinancial corporations increasingly raised funds directly from securities markets. Capital account liberalization made it easier for corporations to raise funds offshore. Despite the fact that the Japanese savings rate is high by international standards, an increasing proportion of bonds was issued offshore (for example, in Euromarkets).29. Domestic market regulation encouraged offshore bond issues at the expense of domestic issues, although the differences between the two diminished during the late 1980s as eligibility and collateral requirements in the domestic markets were eased.30 Similarly, foreigners preferred to access Japanese savings through the Euroyen market. Portfolio inflows were limited through much of the 1980s but increased strongly during 1989–91 as a monetary policy tightening led to higher interest rates.
After 1984, portfolio outflows show a substantial increase (Figure 4.2). Factors other than those discussed above may also have contributed to this increase. First, an increase in limits on the amount of foreign securities held by Japanese institutional investors in 1986 led to higher foreign security holdings, particularly by insurance companies.31 Second, the strong appreciation of the yen after the Plaza agreement in September 1985 was followed by a relaxation of monetary policy in February 1987, and interventions in the foreign exchange market to support the dollar followed the 1987 Louvre agreement. The expansionary monetary policy contributed to both capital outflows and the asset price inflation that characterized the late 1980s.
Japan: Portfolio Flows, 1975–99
(Percent of GDP)
Sources: IMF, International Financial Statistics (Washington), various issues; Thomson Financial; and Bank of Japan.Japan: Portfolio Flows, 1975–99
(Percent of GDP)
Sources: IMF, International Financial Statistics (Washington), various issues; Thomson Financial; and Bank of Japan.Japan: Portfolio Flows, 1975–99
(Percent of GDP)
Sources: IMF, International Financial Statistics (Washington), various issues; Thomson Financial; and Bank of Japan.The coexistence of free and regulated markets contributed to the gradual transition from a regulated to a free system, although free markets sometimes resulted in a more rapid deregulation of restricted markets than had initially been intended by the authorities.32 While Japanese and world short-term capital markets were integrated from around 1980, 33 arbitrage does not seem to have been so complete in other parts of the Japanese financial sector. Takeda and Turner (1992) attribute this un-evenness in development to the determination of the authorities to limit any disruption to the domestic banking system.
In response to the lower domestic borrowings by nonfinancial corporations, banks were forced to increase their lending to smaller firms and households to maintain their size and earnings, thereby increasing their exposure to real estate. Between 1985 and 1990, the share of bank lending outstanding to the manufacturing sector fell from over 20 percent to 15.5 percent, while the share to households and the real estate sector almost doubled to 25.5 percent. During the 1980s, international expansion by Japanese banks, which allowed them to avoid a number of domestic constraints and meet the needs of Japanese manufacturers who were expanding abroad, was also significant.34 The expansion probably stemmed from a desire to build up market share, which may have induced a willingness to accept lower profit margins than other banks.
Meanwhile, monetary policy in the second half of the 1980s was focused on the exchange rate following the Louvre accord, resulting in lower interest rates that helped sustain growth and finance consumption and housing investment. Debt levels rose rapidly.35 As asset prices boomed, firms borrowed to invest in financial assets, increasing their vulnerability to asset price movements.36 The net portfolio outflow slowed sharply from 1985 to 1989, possibly in response to (and further contributing to) asset price rises. Despite the asset price boom, consumer price inflation remained low, rising above 2 percent only in April 1989. It was, therefore, difficult to ascertain the extent to which the asset price increases represented a stock adjustment following the reforms, or a bubble.
In hindsight, it is clear that asset prices were significantly overvalued and that prudential standards should have been tightened earlier. The bubble eventually burst in 1990, following increases in interest rates and guidelines limiting real estate lending by banks. Lower economic growth, combined with rising interest rates and falling asset prices, reduced the debt-servicing capacity of borrowers, placing banks under pressure. Banks also suffered losses on their equity holdings. Facing new Basel capital-adequacy requirements and experiencing increased difficulty in raising funds on the share market, banks sought to reduce their international role. In addition to banks’ difficulties in raising new equity capital, their funding costs on money markets rose as their credit ratings fell. Banks’ focus, therefore, shifted from gaining market share to increasing their earnings and profitability. Figure 4.3 shows that the stock of Japanese banks’ foreign liabilities peaked during 1989–90.
Japan: External Position of Banks and Nominal Exchange Rate, 1980–2000
Source: IMF, International Financial Statistics (Washington), various issues.Japan: External Position of Banks and Nominal Exchange Rate, 1980–2000
Source: IMF, International Financial Statistics (Washington), various issues.Japan: External Position of Banks and Nominal Exchange Rate, 1980–2000
Source: IMF, International Financial Statistics (Washington), various issues.Evaluation
Given the Japanese industrial and exchange rate policy objectives, the gradual approach taken by the Japanese authorities to capital account liberalization has generally been well advised, although the formal and informal control system for cross-border capital flows should probably have been abolished a decade earlier, in line with die removal of restrictions in most other advanced economies. In addition, completing domestic deregulation prior to capital account liberalization would have reduced some of the pressures on the banking system. The relative effectiveness of controls depended on a well-functioning administration, including the central bank, which was responsible for the execution of capital controls. Domestic deregulation would also have facilitated greater direct investment inflows and therefore stimulated competition and innovation in product markets.
The subsequent problems in the Japanese banking sector do not appear to have been directly related to capital account liberalization as such or to the specific approach taken. Instead, the problems are more likely to be rooted in the gradual and partial approach taken to domestic financial market deregulation (see Hoshi, 2000). The authorities’ initial reluctance to see fundamental changes in the domestic financial system resulted in the existence of parallel markets for a period, with regulations varying between them. Domestic deregulation reduced banks’ access to funds at regulated interest rates, placing pressure on their costs of funding. At the same time, capital account liberalization (and financial sector deregulation) allowed nonbank corporations to increase access to capital markets. Because this took place before line-of-business segmentation within the financial sector was fully removed, banks lost significant lending opportunities and were forced into an increased exposure in the real estate market. This exacerbated the asset price boom and left banks vulnerable to asset price swings. Unlike the situation in some other countries, exposure to international losses were not a prime factor in the banking crisis. International expansion by banks (partly in response to the slow removal of domestic controls), however, may have reduced their ability to adjust to domestic losses.
In addition, the changes in the monetary transmission mechanism following domestic deregulation and external liberalization were recognized only at a relatively late stage, delaying the monetary policy response to the very strong credit expansion that ultimately caused the asset price bubble. At the same time, supervisory policies and risk-management practices by the banks did not keep pace with the increased appetite for risk experienced after financial repression ended. In fact, there are some indications that credit standards fell as banks sought to maintain market share in the face of increasing competition.37 Accounting standards should also have been upgraded at an earlier stage, enhancing transparency and market discipline. This episode shows that the retention of some controls during a gradual liberalization process is no substitute for sound macroeconomic and prudential policies.
Gradual Liberalization in France in the 1980s
In 1979, France joined the EMS while maintaining a relatively tight set of capital controls. In order to lift France out of the recession that followed the second oil price shock later in the year, the government embarked on expansionary policies. Following a change of government in 1981, a program of nationalization (including of the banking sector) was announced, going against the mainstream of developments in other industrial countries and eroding confidence in international financial markets.38 Although the nationalization of the financial sector was in response to domestic concerns and was not aimed at restraining cross-border capital movements, considerable outflows ensued.
A series of repeated speculative attacks on the exchange rate and forced devaluations in France from 1981 until 1983 helped to reshape the French economic strategy. In a period of just 18 months, the French franc was devalued three times by a cumulative 25 percent vis-à-vis the deutsche mark, as investors shied away from reflationary policies and nationalization of financial institutions. Speculation was initially countered by a further tightening of capital controls, which sharply increased differentials between domestic and euro interest rates (Figure 4.4). Measures taken included steps to prevent evasion by using leads and lags in current account transactions and prohibiting all forward transactions by importers and exporters. Although the controls certainly succeeded in dampening certain categories of short-term speculative flows, they did not alleviate the downward pressures on the exchange rate while the substantial balance of payments financing need remained. Even undertaking further tightening until 1983, including severely curtailing foreign travel allowances, proved insufficient.
France: Interest and Exchange Rates, 1980–95
Source: Thomson Financial.France: Interest and Exchange Rates, 1980–95
Source: Thomson Financial.France: Interest and Exchange Rates, 1980–95
Source: Thomson Financial.On the basis of an analysis of capital account items, Davanne and Ewenczyk (1989) conclude that the controls were effective to a certain extent in containing speculative flows, provided there was no buildup of French franc assets by nonresidents (which could then be converted to other currencies without contravening the exchange control regime). Nonetheless, controls did not provide protection when external imbalances were large. Outflows continued both through the current and capital accounts, and were accommodated by double-digit rates of domestic credit growth as a result of expansionary monetary policies aimed at stimulating the French economy. Official interventions to cover the net financing gap and support the exchange rate resulted in a visible depletion of official reserves, which, in turn, further eroded financial market confidence. In the face of continued macroeconomic imbalance, controls were not only ineffective but also began to impose real economic costs.
The economic costs of controls included the burden of the bureaucratic procedures, particularly for commercial banks and enterprises that were active in the international capital markets. Moreover, the system invited evasion, as strategic enterprises obtained derogations from the existing control system, leading to competitive distortions relative to other enterprises.39
Also, commercial and financial activities of French industry and banks tended to be diverted to other centers (for example, financing divisions of French car manufacturers were set up in Switzerland). The ineffectiveness of controls increased rapidly as technological innovation enhanced the possibilities for evasion by lowering the transaction costs of cross-border flows.
A major reorientation of economic policies occurred in France in 1983, as the authorities accepted that it was not possible for economic policies to deviate significantly from those in neighboring countries. A major reformulation of the financial and industrial strategy was supported by a move toward stability-oriented macroeconomic policies. Elements included an opening up of markets, encouraging rationalization of French industry through increased competition, and the gradual deregulation and liberalization of financial markets. The authorities considered preserving exchange rate stability vis-à-vis neighboring European countries, however, to be of paramount importance. Therefore, progress in liberalizing capital movements was made dependent on the simultaneous strengthening of the EMS mechanisms, as well as on improved EC procedures to bring about economic convergence.
The reorientation of France’s economic strategy in 1983 led to major changes in policy implementation. This reorientation encompassed a major deregulation of the financial sector in stages, which eventually needed to be supplemented by the liberalization of capital controls. The disinflation process, accompanied by an increase in real interest rates, influenced the functioning of the French financial markets. The treasury could finance its budget deficit in a nonmonetary way and the commercial banks could issue bonds. A key role was played by a substantive reform of the public debt market, greatly enhancing foreign interest in the French capital market. The financial market reforms, in turn, enabled the Banque de France to abolish the quantitative credit control mechanism (1985), as well as to reform the money market. In France, there was thus a well-thought-out sequencing in which deregulation of the financial sector, restoration of positive real interest rates, and more market-oriented ways of maintaining monetary control were implemented while capital controls were still being used. When the French macroeconomic situation strengthened—the current account moved to equilibrium in 1984—and the financial sector was considered able to withstand foreign competition, capital controls were gradually withdrawn. The authorities’ declaration of their intention to do this was an important political signal.
In 1984–85, controls on direct investment were gradually eased; first, intra-EEC investment flows, and then flows originating from or destined for non-EEC countries, were liberalized. The prior-authorization requirements for direct foreign investment were eliminated in early 1986. By that time, foreign travel allowances had also been eased considerably. In May 1986, after a last major general realignment of EMS currencies in which the French franc was devalued by 6 percent vis-à-vis the deutsche mark, the devises-titres market, reintroduced in 1981, was abolished, and restrictions on forward foreign exchange operations were eased. Very shortly thereafter, the safeguard clause, which France had applied since 1968 with respect to the EEC liberalization obligations, was abolished. The liberalization process then gained considerable momentum: in the same year, bank lending in French francs to nonresidents (largely prohibited since 1974) was partially liberalized; and toward the end of the year, administrative control of import and export settlements (the “domiciliation” regime) was abolished. Under that regime, the French commercial banks had been required to match trade and financial data, thus avoiding evasion of the controls by taking advantage of leads and lags in current account transactions or by channeling flows through uncontrolled capital account items. The regulations became extremely burdensome and put the French banks at a disadvantage compared with banks in other countries.
Although in early January 1987, unrest in the foreign exchange markets led to a relatively limited realignment (the French franc was devalued by 3 percent vis-à-vis the deutsche mark), the liberalization efforts were not interrupted. In 1987, the remaining limits on tourist travel allowances were eliminated, and from June 1988, domestic enterprises were permitted to operate foreign currency accounts and to freely borrow abroad. The considerably strengthened credibility of the hard-currency policy, supported by the Basel/Nyborg operational procedures (described in Section II), ensured that the exchange rate was stabilized in the face of considerably increased capital mobility. The last liberalizing steps were taken in 1989, freeing bank lending in French francs to nonresidents and allowing residents to open foreign exchange accounts (though initially only ECU (European currency unit)-denominated accounts were allowed). On January 1, 1990, six months ahead of schedule, all remaining exchange control regulations were abolished. The overall liberalization process took approximately six years, and this time it was not marred by backtracking, despite realignments during 1986–87 and sizable increases in portfolio flows (Figure 4.5).
France: Portfolio Flows, 1975–95
(Percent of GDP)
Source: IMF, International Financial Statistics (Washington), various issues.France: Portfolio Flows, 1975–95
(Percent of GDP)
Source: IMF, International Financial Statistics (Washington), various issues.France: Portfolio Flows, 1975–95
(Percent of GDP)
Source: IMF, International Financial Statistics (Washington), various issues.Although the French franc came under severe downward pressure in the 1992–93 EMS crises, which led to decisive interest rate hikes, heavy interventions, and a broadening of the EMS fluctuation margins, the central rate of the French franc was not adjusted. Nevertheless, the EMS crises demonstrated that even if the fundamentals were more or less correct and exchange rate targets were supported by stability-oriented policies, the exchange rate could be forcefully tested by the markets. In particular, a willingness to increase interest rates and tighten monetary conditions to support official interventions proved to be crucial. Eventually, the French franc joined the EMU on January 1, 1999 at the parity originally set in January 1987.
Evaluation
The severe exchange crises from 1981 until 1983 and general disillusionment regarding the effectiveness of capital controls provided the political backdrop for a turnaround in French policies. The primary goals of exchange control—maintenance of the external value of the currency and the preservation of official exchange reserves—had not been realized. The tightening of restrictions had only provided short-term relief and had undermined public confidence. In particular, the unpopular carnet de change, which had resulted in a decrease in tourist expenditures abroad by 13 percent in 1983, was regarded as a fairly drastic measure that shook public opinion.40
A large part of the success of the capital account liberalization process undertaken in France over six years must be ascribed to the complementary process of domestic deregulation and macroeconomic stabilization. Great care was taken to strengthen the domestic economy before liberalizing the more volatile items in the capital account. A basic reform of industrial policy was carried out: subsidies to inefficient firms were discontinued; quantitative credit controls were abolished; and financial markets were deregulated. Macroeconomic policies were aimed at decreasing inflation and restoring balance of payments equilibrium. This made it possible to actively pursue a hard-currency policy that restored confidence in the financial markets. In these circumstances, the removal of capital controls may actually have reduced intra-EMS exchange rate tensions by increasing the substitutability of assets denominated in French francs and deutsche mark. Previously, portfolio shifts triggered by expectations of an appreciation of the deutsche mark vis-à-vis the U.S. dollar had invariably triggered intra-EMS tensions, since capital controls hindered flows into French franc assets.41
Liberalization was initially made conditional on stronger monetary cooperation in Europe, particularly through a strengthening of the EMS. But progressively, the French authorities wished to liberalize in France’s own interest and to attune their policies to those of the vast majority of larger industrial countries. Although the exchange rate had to be devalued repeatedly under a tight exchange control system, the period of gradual liberalization saw the eventual restoration of exchange rate stability. When capital flows were fully liberalized, periods of exchange rate tension occurred as financial markets tested the determination of the authorities to maintain exchange rate stability. These episodes were countered by decisive action by the monetary authorities, however. All in all, the French experience shows that full capital mobility can go hand in hand with exchange rate stability, provided the authorities are prepared to adopt supporting policies.
General Lessons
The experiences of Japan and France in gradually liberalizing capital controls show that deregulation in one area can create momentum for further change. They also illustrate that a gradual process does not necessarily eliminate the risk of financial crises or transition costs (including pressures in foreign exchange markets as participants test the determination of the authorities). These risks appear to be minimized, however, when an integrated approach to reform is taken involving macroeconomic stabilization and institutional strengthening. The Italian experience also illustrates the importance of ongoing structural reform during the liberalization process (Box 4.1). In all three countries, external pressure (multilateral on France and Italy and bilateral, from the United States, on Japan) played an important role in stimulating liberalization.
Although a variety of sequencing approaches have been adopted by advanced countries making slow transitions, allowing changes to be seen as part of a coherent, clear plan and reducing the incentives to delay progress appear to be helpful. The Japanese experience indicates that attempts to shield the domestic financial sector from the impact of liberalization are unlikely to be successful and may actually increase the risk of ensuing problems. For France, the prospect of further European economic and monetary integration was a major factor in maintaining confidence in the liberalization process. Nevertheless, when there were doubts about the prospects of monetary integration (for example, after Denmark rejected the Maastricht Treaty and the United Kingdom and Italy withdrew from the EMS in 1992), the French franc came under severe downward pressure. Firm action, particularly the raising of domestic interest rates, was needed to demonstrate the authorities’ commitment to the exchange rate target.
Gradual Liberalization in Italy
Although proposals for reform of Italy’s extensive exchange control system were circulated from the beginning of the 1980s, and parliament had been offered draft laws designed to implement a positive control system, the precarious economic situation, characterized by high inflation and a fragile balance of payments, substantially delayed the reform. The traditional fear that lifting controls would lead to tax evasion (with funds flowing especially to Switzerland) also played a role, and Italy was one of the few industrial countries that (from 1976) treated violations of exchange control regulations as criminal offenses. At the same time, the need to ease restrictive domestic regulations and increase the efficiency of the domestic financial markets was urgently felt. Finally, the safeguard measures, under which derogation from EEC obligations had been allowed since 1981, were lifted in 1987.
After the EEC liberalization directive of 1988 had been adopted, Italy introduced a positive system of capital controls while maintaining restrictions on short-term transactions. This change was viewed in the financial markets as a sign of strength and led to substantial inflows, which were also attracted by the country’s high interest rate differential vis-à-vis Germany. Temporary measures were taken to dampen inflows by reintroducing a reserve requirement on incremental foreign exchange deposits lo discourage borrowing in foreign currencies. In an atmosphere of much-improved confidence, all controls were lifted just ahead of the deadline of July 1, 1990 imposed by the EEC directive.
After the signing of the Maastricht Treaty and establishment of the EMU. financial market participants came to view the EMS as already having evolved into a quasi-monetary union in which the exchange rates no longer needed to be adjusted. The Italian lira had traded at the upper end of the fluctuation margin since 1990. This sentiment reversed abruptly when Denmark rejected the treaty in a June 1992 referendum. Markets took a fresh look at the EMU process and noted that Italy was far from being in conformity with the Maastricht criteria for joining the EMU. In particular, fiscal deficits remained high. Strong pressures developed, and despite substantial interventions, the lira was devalued on September 14, 1992. This devaluation, however, was followed by further attacks. On Black Wednesday (September 16), the ERM memberships of the pound sterling and die lira were suspended. Apparently Italy, in a fundamentally weaker economic position than France, was not able to maintain exchange rate stability in the face of full capital mobility. The changed external circumstances, casting doubt on the ability of Italy to fulfill the Maastricht criteria for joining the EMU, eventually exerted pressure on Italy to tighten fiscal policy. The policy adjustments helped stabilize the exchange rate, and the lira eventually returned to the ERM with a central parity approximately 20 percent lower than the previous parity.
In European countries, net capital inflows followed liberalization and deregulation when the reforms were perceived as signs of strength. While inflows may help maintain the momentum to lift capital controls on outflows, they may also diminish the disciplinary effect on macroeconomic policies. When the authorities are seen as backtracking on macroeconomic stabilization efforts, the liberalized environment allows any reversal of investor sentiment to be quickly translated into capital outflows. This may have been the case for countries such as Italy in the run-up to the 1992–93 EMS crisis. Large inflows of capital, based on market perceptions of a quasi-monetary union, may have given the Italian authorities a false sense of security regarding the need for ongoing stabilization and reform efforts. Spain and Portugal were also severely hit by that crisis.
In the European case, peer pressure has been an important factor in encouraging countries to liberalize capital movements. When Germany and France had both agreed to fully liberalize capital movements and enact supporting legislation to that effect, a strong political incentive to follow suit was provided to other countries that were initially reluctant to liberalize. This suggests that pressure from regional or international organizations, such as the European Union or the OECD, may be more effective once there is momentum toward liberalization from a number of countries and when the number of similar countries that have liberalized exceeds some threshold.
