Abstract

This paper has reviewed analytical issues and economic policy considerations that arise in conjunction with capital account liberalization. Since financial transactions are properly thought of as intertemporal trade, the same arguments that create a presumption in favor of current account convertibility to promote trade in different goods at a point in time create a presumption in favor of capital account convertibility to promote trade in the same goods at different points in time. In particular, impending changes in the age distribution of national populations mean that international capital flows between mature and emerging markets can yield especially important benefits on both sides.

This paper has reviewed analytical issues and economic policy considerations that arise in conjunction with capital account liberalization. Since financial transactions are properly thought of as intertemporal trade, the same arguments that create a presumption in favor of current account convertibility to promote trade in different goods at a point in time create a presumption in favor of capital account convertibility to promote trade in the same goods at different points in time. In particular, impending changes in the age distribution of national populations mean that international capital flows between mature and emerging markets can yield especially important benefits on both sides.

Insofar as domestic distortions prevent the full gains from trade from being realized or even lead international capital flows to have perverse, welfare-reducing effects, the implication is again analogous to that found in the literature on trade policy: the first-best response is to eliminate the domestic distortion at its source, and not to restrict capital flows. This is an argument for prudent, carefully sequenced capital account liberalization, where controls on international financial flows are removed only following significant progress toward the (otherwise desirable) elimination of domestic distortions, not an objection to capital account convertibility itself.

The deeper concerns about capital account convertibility rest on information asymmetries intrinsic to financial markets. Domestically, it is generally accepted that asymmetric information provides a justification for regulation and supervision of financial intermediaries to limit risks to the capacity of banks to absorb adverse outcomes—especially adverse outcomes that rise to the level of systemic threats. If, for example, banks are unable to rapidly liquidate their assets at close to their full value, then bank runs may lead to severe liquidity problems and possibly bank failures with systemic implications; prudential regulations are therefore used to limit unhedged positions in the assets in question. If asymmetric information encourages herd behavior that results in sudden asset price movements, changes in financial flows, and even financial crises, there is in principle an argument for government intervention to inhibit or countervail such behavior if effective means of intervention can be identified. This applies to interventions to resist potentially destructive behavior both in domestic financial markets and in international or cross-border financial relations.

Sound management by the banks themselves is of course crucial to financial stability, but even the best bank managers are not expected to take into account all the systemic—as opposed to bank-specific—implications of their actions. Thus, there is a role for supervision and regulation, especially where problems of asymmetric information are most severe. And where the adverse selection, moral hazard, and excessive risk taking to which asymmetric information gives rise result in (long or short) positions in certain foreign assets that are excessive from the point of view of systemic stability, there may be a case for using taxes and instruments with taxlike effects (differential capital requirements, nonremunerated deposit requirements) to discourage undue reliance on the relevant category of capital account transactions.

Thus, the problem for policymakers seeking to benefit from capital account liberalization is to determine into which category problems afflicting the domestic economy fall. To the extent that the problem is a distortion that can be corrected, the solution is to properly sequence capital account liberalization by removing that distortion at the same time, or before, the capital account is liberalized. Domestic financial market distortions caused by the inadequate harmonization of tax policy, shortcomings in bank supervision and regulation, and implicit or explicit government guarantees of private sector liabilities all belong in this category.71

But to the extent that the problem is information asymmetries that are intrinsic to the operation of financial markets, that cannot realistically be removed, and that give rise to significant systemic risks, this creates an argument for the permanent application of policies designed to influence the volume of certain types of financial transactions. If those policies are operationalized through the use of taxes and taxlike instruments that make their effect felt by altering relative prices, rather than through the use of administrative controls, there is no reason why they should be viewed as incompatible with the still-desirable goal of capital account liberalization.

71

Some information problems fall under this heading as well—for example, problems created by inadequate accounting and auditing practices, inadequate reporting of the short-term foreign liabilities of the private sector, inadequate reporting of the contingent liabilities of the public sector, and inadequate transparency of government policy generally all create information asymmetries that can be attenuated (albeit not necessarily eliminated) if governments adopt internationally recognized standards of financial best practice and comply with the IMF’s Special Data Dissemination Standard. In addition, there is the incentive for markets themselves to solve these problems. The appearance of credit rating agencies, for example, can be seen as an attempt by the market to solve informational problems.

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