Sequencing Capital Account Liberalization
Lessons From the Experiences in Chile, Indonesia, Korea, and Thailand
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

This paper examines issues in sequencing and pacing capital account liberalization and draws lessons from experience in four countries (Chile, Indonesia, Korea, and Thailand). The paper focuses on the interrelationship between capital account liberalization, domestic financial sector reforms, and the design of monetary and exchange rate policy. It concludes that capital account liberalization should be approached as an integrated part of comprehensive reform strategies and should be paced with the implementation of appropriate macroeconomic and exchange rate policies.

Abstract

This paper examines issues in sequencing and pacing capital account liberalization and draws lessons from experience in four countries (Chile, Indonesia, Korea, and Thailand). The paper focuses on the interrelationship between capital account liberalization, domestic financial sector reforms, and the design of monetary and exchange rate policy. It concludes that capital account liberalization should be approached as an integrated part of comprehensive reform strategies and should be paced with the implementation of appropriate macroeconomic and exchange rate policies.

I. Introduction

Capital account liberalization can have significant benefits for economic growth and welfare. The benefits arise from: the improved ability to tap savings globally (at lower cost than using only domestic savings); allowing domestic economic agents freedom to choose how and where to borrow, invest, or exchange assets; improvements in resource allocation through increased competition for financial resources; and the increased availability of resources to support investment, and to finance trade, and other significant economic entities. At the same time, however, the opening of the capital account entails certain risks, if not accompanied by the necessary structural reforms and macroeconomic policies.

Against this background, attention needs to be paid to sequencing capital account liberalization with structural measures, especially in the monetary and financial sector, and to pacing liberalization in conjunction with the development of appropriate macroeconomic policies. This paper examines some of the general issues involved in the sequencing and pacing of capital account liberalization and draws lessons from the experience of emerging market economies which have liberalized their capital accounts and which have received large capital inflows—those of Chile, Indonesia, Korea, and Thailand. These countries were chosen in order to illustrate the diversity as well as some of the similarities of approaches toward capital account liberalization. The information reviewed is for the period 1985–96, but has been extended to 1997 in the case of Thailand to include the period leading up to the 1997 crisis.

A complete analysis of the role of capital account liberalization would require a comprehensive assessment of structural and macroeconomic policies. This paper focuses on certain interrelationships and key variables that are considered critical. Specifically, the study focuses on the interrelationships between capital account liberalization and (1) the development of domestic financial markets, instruments and institutions; (2) reforms to foreign exchange and trade systems; (3) the development in countries’ balance of payments; and (4) the role of monetary and exchange rate policy.

The remainder of the paper is organized as follows: Section II discusses a conceptual approach to the orderly liberalization of controls on capital movements; Section III describes the specific country experiences 1985–96; Section IV reviews the lessons from these countries’ experiences; and Section V provides the conclusions.

II. A Conceptual Framework for Orderly Capital Account Liberalization

The conventional view with regard to the liberalization of the capital account is that it should follow liberalization of the current account and the domestic financial system (see for example, McKinnon 1973, 1982; Frenkel 1982; Edwards 1984). Others have argued for simultaneous liberalization of the current and capital accounts (see for example, Little, Scitovsky, and Scott 1970; Michaely 1986; Krueger 1984). Hanson (1994) suggests that a stable macroeconomy and domestic financial liberalization to a significant degree are preconditions to international financial liberalization. While our own assessment does not necessarily contradict these views, the results of the survey indicates that the liberalization of the capital account and other aspects of economic and financial sector reform is a good deal more complex and not readily open to stylized presentations on sequencing. Different components and aspects of the capital account were liberalized at various stages, along with aspects of the current account and domestic financial sector in line with countries’ overall macroeconomic objectives. In some instances liberalizing or easing of restrictions were in response to adverse macroeconomic developments. The survey does, however, lead to broad conclusions about the conceptual framework for an orderly liberalization of the capital account. This framework is discussed below.

A. The Need for an Integrated Approach to Capital Account Liberalization and Financial Sector Reform

The first broad conclusion from this survey is that there is a fundamental need for an integrated approach to capital account liberalization and financial sector reform. It is erroneous to draw sharp distinctions between the public policy approach to the deregulation of the capital account on the one hand, and the approach to the regulation and development of financial markets on the other. Rather capital account liberalization should be treated as an integral part of economic reform programs.

More specifically, the liberalization on direct investment is often a significant part of real sector reforms, while the liberalization of portfolio investment flows is often coordinated with financial sector reforms and the development of financial markets and instruments:

  • Liberalizations of direct investment inflows have often gone hand-in-hand with reforms aimed at strengthening the real sector and export potential of the economy, including reforms to the trade and investment regimes, exchange rate adjustments to improve competitiveness, and liberalization of exchange controls on current international transactions. Such capital account liberalizations have aimed, for example, at supporting the development and restructuring of selective industries and sectors, through management and technology transfers, injections of foreign capital and liberalization of access to trade finance.

  • Liberalizations of portfolio capital flows have tended to be coordinated with domestic financial sector liberalization and reforms—liberalization of interest rates, development of indirect monetary control procedures, and strengthening banks and capital markets.

There are a number of reasons for adopting a coordinated and comprehensive approach to financial sector reforms and capital account liberalization. First, from a macroeconomic and balance of payments perspective, the stage of development and the stability of domestic financial systems have key influences on the growth and composition of capital movements. Such factors are often as important, if not more so, in explaining the volume and nature of the capital flows than the particular regulatory framework for such movements. Countries with developed financial markets and institutions have been better able to attract portfolio capital flows than countries where such markets are just emerging. In some circumstances, concerns about banking solvency or inadequate regulatory frameworks have discouraged foreign investment or encouraged capital flight regardless of the capital control framework. Financial sector weakness may also contribute to currency crises to the extent the weaknesses are seen as limiting the scope or the willingness of authorities to use interest rates to defend the currency; or cast doubts on the prospects of the economy more generally (e.g., recognition that addressing financial sector weakness may have significant budgetary costs); or cast doubts on the political autonomy and integrity/governance of financial institutions.

Secondly, and conversely, the opening of the capital account can have important implications for financial markets and institutions. In many cases, the implications are positive in that the liberalizations help to develop deeper, more competitive and more diversified financial markets. The sophistication of domestic financial markets can also be improved if foreign financial firms are allowed to operate directly in the country. The greater volume of intermediation and increased competition that may accompany capital account liberalizations, however, may also increase pressure on previously protected domestic financial institutions and bring weaknesses to the fore in such institutions. Some countries have been confronted with banking crises when faced with sudden inflows and subsequent sharp reversals in capital flows. The banking sector problems may be exacerbated by significant open positions of banks, or their borrowers. In such cases, adjustments in interest rates and exchange rates can reduce the net worth of financial institutions if they have not developed adequate mechanisms to manage interest and exchange rate risks. Countries with sounder banking systems have been better able to handle reversals in capital inflows since under these circumstances of a strong financial system, banking weaknesses did not constrain interest rate and exchange rate policies.

Third, the efficiency of use of capital flows and thus the extent to which such flows contribute to sustained improvements in economic performance depends on the stage of development and efficiency of the financial domestic system. This in turn may depend on the existence of a well-regulated and supervised financial system, and the elimination of various sources of market failures that may be the legacy of previous financial repression. Consequently, there is a need for sequencing the liberalization of the capital consistent with the reforms of domestic financial markets and institutions.2

Fourth, successful and sustained opening of the capital account requires the existence of a minimum set of instruments, institutions and markets for the effective management of monetary and exchange rate policy with an open capital account. High capital mobility alters the effectiveness of different monetary instruments in achieving the objectives of monetary policy. On the one hand, instruments that impose a high cost or administrative constraint on the banks—as is the case with credit or interest rates ceilings or high nonrenumerated reserve requirements—may be circumvented more easily by disintermediation through the capital account, and therefore become less effective. On the other hand, with an open capital account, monetary instruments which operate on the overall cost of money or credit in financial markets may be transmitted more rapidly to credit and exchange markets and allow the central bank to influence the decisions of financial institutions and markets that operate in its domestic currency, both locally and internationally. Indirect monetary instruments, such as open-market operations, therefore come to play a core role for the purpose of steering interest rates, managing the liquidity situation in the market, and signaling the stance of monetary policy.

Fifth, as a practical matter, the distinction between capital controls and financial regulations may not be straightforward. Indeed, many controls on capital movements are often exercised through regulations on the underlying capital transactions rather than the associated payments and receipts. A number of capital controls are in the form of financial regulatory measures, including reserve requirements which discriminate between residents and nonresidents, or may be the consequence of the particular regulatory frameworks for financial markets and financial institutions. An analysis of the regulatory factors influencing capital movements therefore requires a more complete understanding of overall financial regulatory frameworks, and the extent to which limitations on capital movements are an incidental consequence of the need to protect investors and exercise prudential oversight over financial institutions or a deliberate attempt to influence the volume of capital movements for macroeconomic and balance of payments reasons.

Finally, the dynamics of reforms might also argue for synchronization of domestic financial sector reforms and the liberalization of capital movements. Financial sector reforms often involve a rapid monetization of the economy and a period during which the growth of credit exceeds that of money as agents adjust to the elimination of financial repression.3 Capital account liberalizations are often associated with initial surpluses in the capital account of the balance of payments reflecting the improved investor environment and the return of flight capital.4 If confronted separately, each of these factors can create problems for monetary and macroeconomic management. However, if confronted together, the adjustments in the monetary and external sectors can be offsetting to some extent.5 Thus, the more rapid growth of credit than money following domestic financial sector liberalization would, ceteris paribus, tend to place pressure on the balance of payments. This pressure may be offset through the return of flight capital that may accompany the liberalization of the capital account. Both adjustments of asset portfolios reflect the elimination of financial repression and are in this sense equilibrating. However, circumstances could also arise where the capital inflows contribute to a more rapid expansion in bank credits. In the latter case, simultaneous financial sector and capital account liberalization could compound the macroeconomic management difficulties. This is likely to be a particular concern when there is limited autonomy in monetary policy.

B. The Need to Pace Capital Account Liberalization with Macroeconomic Policy Design

The second broad conclusion from the survey is the need to pace capital account liberalization with macroeconomic policy. What is generally important for managing the volume of capital flows is the overall incentive structure that can give rise to such flows. This incentive structure will be influenced by a number of factors including the particular regulatory frameworks, and as already noted the stage of development and soundness of the financial systems. However, what is also critical is the configuration of interest rates and exchange rates.

As a general proposition, stock-flow portfolio analysis can be applied to analyze the factors influencing capital movements.6 This framework is also useful in distinguishing between the short- and longer-run effects of capital controls. In the short-run, the “grit in the wheels” effect of capital controls might allow a country temporarily to reduce the rate of capital flows but over time investors will adjust their portfolios to reflect portfolio balance considerations. The longer-run impact of controls on capital flows will thus depend on whether the regulations increase or reduce risk adjusted rates of return. The observed capital flight in countries maintaining controls, and the observed net strengthening of the capital account when countries eliminate controls, suggests that capital controls are generally treated by investors as an additional risk factor. This leads to the seemingly perverse conclusion that a country restricting capital flows would have to maintain higher interest rates to compensate for the increased risks. Nevertheless, evidence from curb markets in countries with repressed financial systems would generally support this view. Thus, contrary to the usual assumption that capital controls can help reduce local interest rates and limit outflows, one of the major considerations in capital account liberalization is the management of the inflows that are likely to follow such liberalization in view of the decline in investor risk premiums. Similarly, the degree of protection that capital controls provide to individual markets and institutions will depend on the extent to which there would be second round portfolio adjustments. For example, capital flows into security markets are likely to have an expansionary impact on the balance sheets of domestic banks as well, because of liquidity effects and portfolio adjustments that would follow changes in relative interest rates and assets prices, even if there are controls on inflows to commercial banks.

A portfolio balance approach is complemented with the covered interest rate parity condition which is the consequence of arbitrage between short-term domestic and foreign interest rates, and the discount on the currency in the forward exchange market. The covered interest rate parity condition can be written as follows:

id=if+Fd

where Fd=efeses×100, id is the domestic interest, if the foreign interest rate of the same maturity and Fd, the forward discount for that maturity, es is the rate of exchange (units of domestic currency in terms of a foreign currency) in the spot exchange market, and ef the forward exchange rate on the date of maturity of the interest rate contracts. Thus, where the foreign interest rate and forward exchange rate are predetermined, a country could determine the domestic interest rate or the spot exchange rate, but not both.

With greater freedom of capital movements, short-term interest rates will increasingly be determined by the covered interest rate parity condition. An attempt to set both interest rates and exchange rates which are inconsistent with this condition could give rise to incentives for significant short-term capital flows. The potential magnitude of such flows will, inter alia, reflect the expectations for the currency and the particular exchange rate.

Thus, with increased capital mobility, the capacity to assign monetary and exchange policies to achieve different macroeconomic targets will be increasingly constrained. If monetary policy is targeted to constraining inflation, the exchange rate would not be free, for example, to be used as an expenditure switching instrument to achieve objectives for the current account. Fiscal policy could be used to influence the savings/investment balance to achieve such objectives but not monetary and exchange rate policy. Conversely, if the exchange rate is targeted to achieve objectives for the current account, or if the exchange rate is fixed, monetary policy would be left with little autonomy to achieve domestic stabilization objectives.

Assigning monetary policy, and consequently exchange rate policy, the task of domestic stabilization, may require that either exchange rates or domestic interest rates, or both, are allowed to become more flexible. Higher capital mobility may also result in greater volatility in interest rates or exchange rates in view of the sensitivity of capital flows to changes in market sentiment and the more rapid transmission of shocks and potential contagion affects. Greater flexibility of the exchange rate or interest rates may help discourage short-term speculative flows that exploit inconsistent interest rate and exchange rate alignments. Where capital is attracted by high domestic interest rates as part of a disinflationary program, temporary appreciation of the exchange rate may help to support the disinflationary strategy and allow for a more rapid lowering of domestic interest rates to international levels while meeting the inflation target. Once inflation and interest rates have been brought down, the exchange rate should also adjust to a level consistent with a sustainable balance of payments. The costs would depend on whether export performance would be seriously affected by a temporary appreciation in the exchange rate, as well as whether markets exit to hedge the risks of greater volatility.

One of the risks of assigning exchange rate policy to current account objectives and relying on fiscal consolidation to achieve domestic stabilization with an open capital account is that the authorities’ freedom to deal with speculative short-term flows is likely to be quite seriously constrained by the limited short-run flexibility of fiscal policy. Countries have as a consequence resorted to capital controls in these circumstances. However, the extent to which capital controls can be used to manage the overall volume and structure of capital flows is questionable. Thus, the viability of such an assignment of instruments to targets also appears questionable with the increased volumes of capital flows.

C. Consequences for the Pace and Sequencing of Capital Account Liberalization

The consequences of the above analysis is that capital account liberalization should be integrated with the design of structural and macroeconomic policies. Maximizing the benefits from capital account liberalization while minimizing the risks requires a comprehensive approach to reforms.

A comprehensive approach will generally involve the coordination of the liberalizations of portfolio capital flows with domestic financial sector liberalization and reforms—liberalization of interest rates, development of indirect monetary control procedures, and strengthening banks and capital markets including through improved regulations. Lack of coordination between domestic financial sector and the capital account reforms can create distortions and regulatory incentives for capital movements that are unrelated to the underlying economic conditions, thus risking greater instability in capital movements. At the same time, there would be good reasons to coordinate liberalization of foreign direct investment with reforms aimed at strengthening the real sector and export potential of the economy, including reforms to the trade and investment regimes, exchange rate adjustments to improve competitiveness, and liberalization of exchange controls on current international transactions.

Where financial systems are weak, the preferred policy would be to address the institutional weaknesses in advance of, or concurrent with, the liberalization of the capital account. Countries may also need to rely temporarily on selective capital controls as part of their financial regulatory frameworks where their institutional capacity to implement prudential regulations that reflects international best practice is still developing. However, in view of the fungibility of capital, too much reliance cannot be placed on capital controls in protecting particular institutions and markets.7 Consequently, it is important for countries where necessary to make rapid progress in strengthening financial markets and institutions generally.

A comprehensive approach would also require attention to the establishment of an appropriate and consistent mix of macroeconomic and exchange rate policies. This may well require a reorientation of monetary and exchange rate policy to provide appropriate autonomy of monetary policy in dealing with capital inflows.

Although in general it would be advisable to have well-planned and sequenced reforms, this does not necessarily imply a gradualist approach. Rather it calls for coordinated and concurrent reforms irrespective of the pace of the reforms. It also has to be acknowledged that in some cases a faster liberalization of the capital account than in other areas of the economic and financial sector reform program may be desirable. More rapid capital account liberalization can provide momentum to the overall reform process by weakening entrenched vested interests and the bureaucratic control on private sector activities. It can also help to develop markets by increasing competition and promoting a larger volume of capital flows. In such cases, faster liberalization of the capital account would require similarly rapid progress in the necessary concurrent reforms to domestic financial markets and institutions and in adapting the macroeconomic policy framework. Speeding up these reforms is desirable in any event in view of the limited extent to which countries can insulate themselves from the market.

III. Selected Country Experiences with Sequencing Capital Account Liberalization

This section discusses the four country experiences with capital account liberalization from 1985–96. For each country, a detailed country matrix describing the sequence of reforms to domestic and external transactions is provided in the Appendix with a summary of measures in the text. Domestic reforms have been grouped into reforms to: (a) the financial supervisory and regulatory framework; (b) the development of money markets and instruments; and (c) the development of capital markets, while external reforms are grouped into reforms to (d) the exchange market arrangement and system; (e) direct investment; (f) portfolio investment; (g) the trade regime; and (h) introduction of restrictions on capital flows. Items (e), (f), and (h) distinguish between capital inflows and outflows.8 Appendix Tables also present selected macroeconomic and balance of payments indicators. For reference purposes, information on the stock position for the exchange and capital control regimes is also provided in the Appendix.

A. Chile

The sequencing of Chile’s reforms of domestic and external transactions during the period 1985–96, is summarized in Table 1 and described in Appendix Table 6; selected macroeconomic and balance of payment indicators are presented in Chart 1 and Appendix Table 7. An abstract of the exchange and capital control regime as of April 30, 1997 is provided in Appendix Table 8.

Chart 1.
Chart 1.

Chile: Selected Macroeconomic Indicators, 1985-96

Citation: IMF Working Papers 1997, 157; 10.5089/9781451857450.001.A001

Source: IMF International Financial Statistics, Direction of Trade Statistics, and Information Notice System
Table 1.

Chile: Sequencing of External and Domestic Financial Liberalization, 1985–96 1/

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An x represents relatively minor measures and an X represents major measures undertaken that year.

The peso was devalued twice, the exchange rate band was widened from 0.5 percent to ±2 percent, and the peso was adjusted daily by 1.7 percent per month until August. After August the peso was adjusted daily based on the previous month’s inflation less external inflation.

The peso continued to be adjusted daily based on the previous month’s inflation less external inflation leading to a 10.5 percent depreciation during the year.

The exchange rate band was widened from ±2 percent to ±3 percent on each side of the center rate.

The exchange rate policy to seek a real depreciation of the peso was abandoned and the exchange rate band was widened from

±3 percent to ±5 percent. In addition, the estimated rate of external inflation used in adjusting the exchange rate was lowered from 0.4 percent to 0.3 percent.

The parallel foreign exchange market became an informal legal market in which the exchange rate was freely determined.

The midpoint exchange rate was devalued three times during the year accumulating a total of 3.4 percent, and the reference rate of the peso was appreciated by 2 percent.

The exchange rate arrangement of the peso changed from a peg to the U.S. dollar to a peg to a basket of currencies, the reference rate of the peso was revalued by 5 percent and the exchange rate band was widened from ±5 percent to ±10 percent.

The midpint of the exchange rate band was revalued by 10 percent, and the weights of the reference currency basket were changed.

The weights of the currency basket were changed, and the width of the exchange rate band was increased from ±10 percent to ±12 percent.

After an earlier experience with rapid liberalization and a banking crisis, Chile followed a gradualist approach to reforms. During the period covering 1985–89, the reforms focused on the completion of the restructuring of the banking system, the establishment of indirect methods of monetary control, trade reform, increased scope of transactions by banks, establishment of the autonomy of the Central Bank of Chile (CBC), and the selective liberalization of direct and portfolio capital inflows. Later phases of reforms emphasized the development of financial markets, the adoption of more flexible interest rate and exchange rate policies, and selective relaxation of controls on capital inflows and outflows, accompanied by the introduction of controls on certain capital inflows mainly in 1991 and 1995.

Recovery of the banking system following the earlier banking crisis, and the reversal of the earlier trade protectionist policies, were given priority 1985–87.9 As a result of the earlier banking crisis and external shocks, interest rate liberalization had been reversed. Following the completion of the banking restructuring, the central bank eliminated the practice of announcing indicative interest rates in 1987, and influenced the level of domestic interest rates mainly through open-market operations in its indexed instruments (PRCBs). Capital market activity which had been moderate, was promoted gradually: pension funds were allowed to invest part of their assets in selected domestic stocks beginning in 1985. In 1989, the law established the legal autonomy of the central bank.

Chile’s liberalization of external transactions focused initially on trade liberalization, providing more liberal access to foreign exchange for current international transactions, exchange rate adjustment, and exchange market development. In 1985, previous tariff increases10 were rolled back in two steps and concurrently, the exchange rate was devalued to offset the impact of the lower tariffs, and to bring the exchange rate to a more realistic level. Limitations were eased on payments and transfers for current international transactions, and new instruments were introduced in the foreign exchange market.

Capital account measures were selective and focused initially on liberalizing capital inflows. In 1985, amendments to Chapter XIX of the foreign exchange regulations11 permitted foreign direct investment inflows through debt/equity swaps. However, capital from these investments could not be repatriated for 10 years and profits for four years. Such swaps operations were further promoted in 1987, with the authorization of External Investment Funds.12 Also under an amendment to Chapter XVIII of the foreign exchange regulations, nonresidents were permitted to purchase selected debt instruments, however, the source of foreign exchange and the conversions had to take place outside the official foreign exchange market. Allowable transactions were broadened in 1986, and in 1987, when nonresidents were permitted to invest in publicly offered instrument with the repatriation of the original capital after five years and no limit on profit remittances; and in 1989, the Additional Tax on the repatriation of profits by foreign investors under the Income Tax Law was reduced from 40 percent to 35 percent.

The capital account of the balance of payments showed a marked strengthening and recorded a surplus in 1989 reflecting much stronger foreign direct investment inflows (see Chart 1 and Appendix Table 7). In 1989, monetary policy was tightened to offset accelerating inflation, and portfolio capital inflows increased substantially reflecting the large interest differentials. In this context, the authorities abandoned their previous policy of seeking a real depreciation of the exchange rate, and widened the band for the fluctuations in the exchange rate.13

Beginning in 1990, the authorities emphasized the development of domestic financial markets and instruments. Several measures were implemented to broaden and enhance the efficiency and competitiveness of the stock exchange and local security markets: Trading in futures contracts was introduced in 1990; pension funds could invest more of their assets in equities; and electronic screen-based trading and settlement systems began functioning in 1993. The following year the stock market introduced trading in options, and during 1995–96, the investment activities of pensions funds in the local securities markets were further liberalized. Concurrently, the money and foreign exchange markets were developed. The central bank enhanced its capacity to conduct monetary operations by widening the range of instruments and maturities used in open market operations.14 Under new foreign exchange regulations, all foreign exchange transactions were permitted unless specifically prohibited by the central bank, and the parallel foreign exchange market became an informal legal market in which the exchange rate was freely determined.

In response to the large capital inflows recorded in 1990, the authorities began to liberalize capital outflows. In 1991, residents were allowed for the first time to use foreign exchange obtained in the unofficial market to invest abroad, and the period of investment after which capital could be repatriated by nonresidents was shortened to three years. In 1992, the pension funds were granted limited freedom to invest overseas, and remittances of profits and capital earned on foreign investments were allowed in advance of pre-existing schedules under certain conditions. Foreign inflows were also liberalized by allowing the issue of American Depository Receipts (ADRs), and in 1991 the arrangements for trading shares sold through ADRs were expanded and taxes on dividends were reduced. At the same time, new restrictions were introduced on certain capital flows. In 1991, the central bank introduced a 20 percent reserve requirement on new foreign borrowing except for trade credits with the objective of limiting short-term capital inflows. Subsequently, the reserve requirement was extended to most outstanding foreign borrowing and to foreign currency deposits, and increased to 30 percent. The stamp duties imposed on domestic loans were also extended to foreign loans.

Net capital inflows declined briefly in 1991 as interest rates were reduced, but recovered sharply in 1992. In response to continuing large capital inflows and upward pressure on the exchange rate, the reference rate of the peso was revalued, and modified from a peg to the U.S. dollar to a peg to a basket of currencies, and the fluctuation band for the exchange rate around the central rate of crawl was widened from ±5 percent to ±10 percent. Inflation was constrained through continued fiscal consolidation appreciation, in the real exchange rate, and sterilized foreign exchange intervention.15 (See Chart 1 and Appendix Table 7.)

During the period 1993–96, the pace of capital account liberalization accelerated with a greater emphasis on capital outflows; certain restrictions on capital inflows were also intensified. In 1993, the minimum period that capital must remain in the country was reduced from three to one year, and the time limit for remittances of profits was eliminated. In 1994, foreign portfolio investment outflows were encouraged by allowing life insurance companies, pension funds, banks and mutual funds to invest larger percentages of their portfolios abroad through the official market, allowing domestic banks to invest in financial institutions abroad, and granting individuals access to the formal exchange market for a limited set of capital transactions.16 Capital outflows were liberalized further in 1995–96 by broadening the allowable assets and increasing the limits on foreign investments. Portfolio investment inflows were also encouraged by reducing the minimum size of ADRs issues, lowering the rating requirement for corporations issuing bonds on the international market, and modifying the 30 percent reserve requirement on foreign borrowings. At the same time, due to circumvention of the existing restrictions, the authorities intensified restrictions on certain other inflows. In 1994, reserve requirements on foreign borrowing were required to be held solely in U.S. dollars, and in 1995, the ceiling on credit in Chilean pesos backed by deposits in U.S. dollars was reduced to avoid a circumvention of the reserve requirement on foreign borrowing. The reserve requirement on foreign liabilities was extended to secondary market transactions in ADRs, and to all investment inflows that did not constitute an increase in the capital stock of the bank.

Chile’s overall capital account strengthened, and there were much larger gross capital movements (Chart 1 and Appendix Table 7). Direct investments abroad increased to $1.1 billion in 1996, while foreign direct investment inflows increased to $4.1 billion. The net capital account strengthened to $6.3 billion (9 percent of GDP) in 1996. The current account balance fluctuated and showed some tendency to widen on average. The authorities repaid foreign debt, reducing the surplus in the overall balance of payments. The authorities continued to adapt the exchange rate arrangement, by revising the weights of the currency basket and widening the exchange rate band. The real exchange rate continued to appreciate and the inflation performance continued to improve (see Chart 1).

Chile’s capital account liberalization appears to follow a distinct sequencing, with an initial focus on the completion of the restructuring of the banking system, trade reform, liberalization of the exchange system, and selective liberalization of capital inflows. Subsequently, the emphasis shifted to developing domestic money, bond and equity markets. The capital account liberalization was also combined with the evolution of macroeconomic policies and instruments: instruments for indirect monetary control were strengthen, the exchange arrangement modified to allow for greater flexibility of the rate within a crawling band exchange arrangement. Capital outflows were liberalized in response to a strengthening balance of payments. At the same time, as liberalizing longer-term capital outflows and inflows, Chile introduced selective controls on capital inflows; however, such controls were circumvented and had to be broadened progressively.

B. Indonesia

The sequencing of Indonesia’s reforms of domestic and external transactions during the period 1985–96 is summarized in Table 2, and described in Appendix Table 9; selected macroeconomic and balance payments indicators are presented in Chart 2 and Appendix Table 10. An abstract of the exchange and capital control regime as of July 31, 1997 is provided in Appendix Table 11.

Chart 2.
Chart 2.

Indonesia: Selected Macroeconomic Indicators, 1985–96

Citation: IMF Working Papers 1997, 157; 10.5089/9781451857450.001.A001

Table 2.

Indonesia: Sequencing of External and Domestic Financial Liberalization, 1985-96 1/

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An x represents relatively minor measures and an X represents major measures undertaken that year.

The Rupiah was devalued by 31 percent.

Accepted Article VEI of the Agreements.

Exchange rate movement allowed more flexibility. BI ceased to announce an indicative exchange rate in the morning and instead began announcing buying and selling rates at 3:00 p.m. computed on the basis of a basket of weighted currencies with a spread of ± Rp 15 (compared to ± Rp 10 previously).

Exchange rate movement allowed more flexibility; the buying and selling rates computed on the basis of a basket of weighted currencies wit a spread of ± Rp 22 (compared to ± Rp 15 previously).

Exchange rate movement allowed more flexibility; in June the intervention band was widened to Rp 118 (5 percent) and in September widened to Rp 192 (8 percent).

The economic reforms in Indonesia focused on reorienting the economy to reduce its dependence on the oil sector, expanding the role of the private sector, and encouraging the creation of a competitive non-oil, export-oriented industrial base that would absorb the rapidly growing labor force. The strategy entailed the pursuit of coordinated financial and exchange rate policies, aimed at providing a stable macroeconomic environment, accompanied by wide ranging structural reforms to promote sustained growth and economic diversification. Key elements of reform during 1985–96, included, gradual liberalization of direct investment inflows to promote non-oil exports and economic diversification, maintenance of a competitive exchange rate, trade liberalization and tariff reform, improvements in monetary management, and financial sector reform through liberalization of external inflows, promoting competition in the banking sector, strengthening of financial institutions, and encouraging the growth of the capital market.

In 1985, Indonesia maintained a liberal regime for capital outflows by resident individuals and juridical entities, while prohibiting lending abroad by banks and financial institutions. Limitations on outflows through financial institutions remained in effect throughout the period (see Appendix Table 11). Selective controls applied to capital inflows; direct investment inflows were limited by domestic ownerships requirements; the purchase of equity by foreign investors in the local stock market was prohibited; and limits were imposed on foreign borrowings. Trade policy remained substantially protectionist.

Over much of the period, reforms focused on an opening of the real economy through a gradual promotion of direct investment inflows and liberalization of the tariff system as part of a restructuring of the real economy (see Appendix Table 9). Direct investment inflows were liberalized by expanding the fields where such investments were permitted, by limiting the equity ownership rules to production of certain goods and investments in certain sectors, and by lengthening the period after which a company had to revert to domestic ownership.

The exchange rate was depreciated in 1983 and subsequently in 1986, to bring it into line with market conditions as part of the economic restructuring package. Indonesia also liberalized payments and transfers for current international transactions and accepted the obligations of Article VIII in 1988. The foreign exchange market was developed and the selling of swaps in the foreign exchange market was liberalized. These reforms were associated with greater openness of the economy (as measured, for example, by the ratio of exports plus imports to GDP) and faster economic growth (see Appendix Table 10).

Reforms were undertaken concurrently in the financial and real sectors. These reforms focused initially on establishing the financial markets, institutions and instruments, for a more market-based system. Beginning in 1983, interest rates were liberalized and direct credit controls on the banking system were partially removed. Money market instruments were introduced in 1984. In 1987, institutional reforms were undertaken to strengthen the operations of the capital market, including reforms to the stock exchange and introduction of new capital market instruments. The authorities modified their monetary control framework by shifting toward targeting international reserves. They introduced daily auctions of money market instruments and allowed interest rates and the exchange rate to be more market determined.

The reforms in 1988 emphasized the functioning of the banking system, enhanced bank supervision and development of the money market. Financial sector reform was promoted by permitting greater foreign participation in the financial sector through the licensing of new foreign banks and branches, the creation of a level playing field for foreign and domestic banks, and permitting foreign participation in other types of financial institutions and in the insurance business (see Appendix Table 9). Additionally, reforms were undertaken to improve the functioning of the capital market, including by extending the role of the market in raising funds for investments, lengthening the maturity of money market instruments, and broadening the range of market makers.

Subsequently, in 1989, the authorities liberalized portfolio capital inflows by eliminating quantitative limits on banks’ borrowing from nonresidents. Foreigners were permitted to invest in the stock market, and to acquire up to 49 percent of the ownership of listed stocks. Restrictions on direct investments inflows were also further relaxed and foreign direct investors were allowed to sell foreign exchange directly to commercial banks instead of through the central bank.

In 1990–91, the Indonesian economy began to overheat, the current account deficit widened, inflation accelerated, and interest rates rose substantially. However, in the context of the maintenance of a stable real exchange rate, the increase in interest rates was accompanied by a substantial inflow of foreign capital, and total net private capital flows registered a surplus in 1990 for the first time since 1985 (see Chart 2).17 The foreign capital inflow was mainly in the form of commercial bank borrowing which was converted to domestic currency using the central bank’s swap facility, thus contributing to an increase in the growth of money. Monetary restraint was supported by tightening of fiscal policy in order to curtail domestic demand pressures, however, inflation continued on an upward trend (Chart 2).

Concerned that the inflows through the banking sector were excessive and complicating macroeconomic management, the authorities reimposed in 1991 quantitative controls on off-shore borrowing by banks and state enterprises. They also introduced stricter limits on banks’ open foreign exchange positions and reduced banks’ foreign exchange swap positions as a percentage of their capital base. The limitations on public sector borrowing from abroad remained in place from 1992 to 1996. Nevertheless, the authorities continued to broaden the arrangements for foreign borrowing for trade finance by private entities, including sales of securities to nonresidents and liberalization of foreign direct and portfolio investment through the stock markets as part of their more general economic and financial sector development. These measures were undertaken concurrently with other measures to strengthen the domestic capital markets and the regulatory framework for banking operations.18 In particular, in 1995–96, regulations were issued to strengthen financial institutions through the upgrading of accounting standards to ensure compliance with prudential guidelines and to safeguard against excessive risk taking through derivative tradings.

Large interest differential in the context of a stable exchange rate and very rapid growth in the domestic stock market continued to promote large net private capital inflows in 1992–96. These inflows took the form of both net direct and portfolio flows. The inflows were partly offset by a reduction in official capital inflows and by a widening in the current account deficit. Inflows were also sterilized through auctions of central bank paper and through swap operations in the foreign exchange market. Additionally, the authorities permitted somewhat greater exchange rate flexibility (1994–96).

In the first half of 1997, Indonesia continued to attract foreign investment flows. In response the central bank took measures to restrict the related credit growth including through partial sterilization from sales of central bank certificates, increase in reserve requirements, and reduction in subsidized credit to public enterprises. Initially, Indonesia managed the regional currency crises that began in June 1997, better than its neighbors. This was attributed to stronger fundamentals, including a relatively smaller external current account deficit. Nevertheless, on July 11, 1997, to protect against speculation Indonesia widened the trading band for the exchange rate against the U.S. dollar to 12 percent from 8 percent. Subsequently, concerns also emerged about the stability of the banking system and the Indonesian rupiah came under speculative pressure, and was allowed to float. The authorities also took administrative measures to counteract the pressure on the exchange rate. Nonresidents’ transactions in the forward market were restricted to $5 million per customer, and each bank’s net open position in the forward market was limited to $5 million. The authorities also lifted the 49 percent limit on foreign ownership on new initial public offerings in September.19

C. Korea

The sequencing of Korea’s reforms of the domestic and external transactions from 1985–96 is summarized in Table 3 and described in Appendix Table 12; selected macroeconomic and balance of payments indicators are presented in Chart 3 and Appendix Table 13. An abstract of the exchange and capital control regime as of August 31, 1997 is provided in Appendix Table 14.

Chart 3.
Chart 3.

Korea: Selected Macroeconomic Indicators, 1985–96

Citation: IMF Working Papers 1997, 157; 10.5089/9781451857450.001.A001

Table 3.

Korea: Sequencing of External and Domestic Financial Liberalization, 1985–96 1/

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An x represents relatively minor measures and an X represents major measures undertaken that year.

Accepted Article VUJ of the Agreements.

Adopted the “market average exchange rate” (MAR) system. The MAR for the Korean won-U.S. dollar would be based on the weighted average of the previous day’s interbank rates for the Korean won-US dollar spot transactions. During each busines day, the Korean won-US d exchange rate in the interbank market would be allowed to fluctuate within margins of ± 0.4 percent against the MAR.

The margins within which the exchange rate for Korean won-U.S. dollars in the interbank market allowed to fluctuate daily around the M were widened to ±0.8 percent.

The margins within which the exchange rate for Korean won-U.S. dollars in the interbank market allowed to fluctuate daily around the M were widened to ±1 percent.

The margins within which the exchange rate for Korean won-U.S. dollars in the interbank market allowed to fluctuate daily around the M were widened to ±1.5 percent.

The margins within which the exchange rate for Korean won-U.S. dollars in the interbank market allowed to fluctuate daily around the M were widened to ±2.25 percent.

Throughout the period, the Korean economy was characterized by significant government intervention and a financial sector which lagged the industrialization of the economy. The liberalization of the domestic financial system and the capital account was very gradual and selective, and a comprehensive plan was not adopted until June 1993. Monetary policy was conducted primarily through direct instruments, including ceilings on lending rates and guidance for lending to priority sectors. During the period, interest rate policy played little active role in external management. Developments in the balance of payments position, particularly in the current account, guided the government’s interventions in the foreign exchange market and system, and with respect to transactions related to trade and the capital account.

Faced with a significant surplus in the current account balance of payments over the period 1986–89, the authorities progressively liberalized the import regime through a preannounced schedule of measures. Restrictions on payments for current international transactions were relaxed and Korea accepted the obligations of Article VIII in 1988. Capital outflows were also promoted by liberalizing direct investment, purchases of real estate overseas, and certain portfolio investments outflows by institutional investors. At the same time, the central bank undertook various measures aimed at reducing net capital inflows, including by encouraging the early repayment of external borrowing, tightening of the regulations on foreign commercial loans and foreign bank borrowing, and imposing restrictions on the volume of foreign exchange that could be brought in and sold to domestic banks (see Appendix Table 12). The fiscal position was consolidated to facilitate repayment of official foreign debt. In spite of the exchange measures the overall balance of payments, however, registered a widening surplus as the current account surplus increased to reach 8 percent of GDP in 1988. The authorities used sterilization policies extensively mainly through the issue of large quantities of liquidity controls bonds and the reserve requirement on local currency deposits. The fiscal position also improved and the nominal and real exchange rate appreciated (see Chart 3).

Beginning in 1989, the current account balance of payments began to weaken reflecting the background of a weakening fiscal position (in an attempt to stimulate the economy), an appreciation in the real exchange rate, and rising inflation. The authorities responded by encouraging capital inflows. Some of the earlier measures aimed at limiting capital inflows were reversed—foreign exchange banks were allowed to raise funds offshore through certain instruments, and the limits on the amounts of foreign exchange that could be imported and sold to local banks were raised. The authorities also accelerated the liberalization of direct investment inflows, by lifting the ceilings on the amounts of direct investment inflows automatically approved; replacing approvals with notifications; providing tax incentives; and expanding the sectors where foreign direct investment was permissible. However, with increasing labor costs at home, foreign direct investment registered a net outflow in 1990 as enterprises continued to locate manufacturing abroad. Nevertheless, the financial account registered a surplus reflecting short-term inflows related to trade credits and borrowing for crude oil imports.

Over the period 1988–96, a range of reforms aimed at the development of the domestic money, security and foreign exchange markets. These measures paved the way for a broader opening of the capital account for portfolio capital flows in the 1990s. In 1988 the authorities allowed some initial interest rate liberalization; a four-stage plan for interest rate deregulation was announced in 1991, and a wide range of interest rates were liberalized in 1993. Interest rates on deposits of 1–2 years were liberalized in 1994, followed by liberalization of short-term deposits in two-steps in 1995. The financial system was developed through a number of measures, including strengthening bank supervisory procedures, promotion of a bankers’ acceptance and forward exchange markets, development of market makers, and strengthening the regulations, trading procedures and transparency of the local security markets. Operational improvements were introduced in the capital market with the introduction of the “real-name” system for all financial transactions and the computerization of transactions in the stock market. Various steps were taken to improve and strengthen the regulation and supervision of the financial sector, including through revision of the General Banking Act and related prudential measures pertaining to accounting practices to promote transparency. Monetary stabilization bonds (MSB) were auctioned as opposed to being sold at administratively determined prices, and repurchase agreements using the liquidity control bonds become a major monetary instrument. Korea also moved from a multi-currency peg to the Market Average Exchange Rate (MAR) system to allow market forces to play a greater role in exchange rate determination; the margins for the fluctuation of the exchange rate were also gradually widened.

Concerning capital flows, Korea continued its policy of gradually promoting outflows by progressively liberalizing the limits on outward investments. The liberalization measures included extending the range of financial institutions which were eligible to invest abroad and the ceilings on their overseas investments; extending the range of business eligible for overseas direct investment, and liberalizing purchases of real estate; and allowing residents to retain larger foreign exchange balances abroad, and to invest directly in foreign government bonds and equities up to a limit. As regards capital inflows, in 1992 nonresidents were permitted limited access to the stock market and the types of securities which could be issued abroad by residents was expanded. The limits on foreign investments in Korea were gradually increased, and sectors and markets gradually opened to foreign portfolio investment. For example, total foreign direct investment in domestic equities was increased from 10 percent in 1992 to 12 percent in 1994, 15 percent in 1995, and 20 percent in 1996. In 1996, nonresidents were permitted to invest in domestic bonds through Country funds, and the Korean Bond Fund was listed on the London Stock Exchange.

The net private capital account strengthened sharply in 1991, reflecting an increase in foreign bond issues by Korean corporations, and in 1992 net portfolio inflows nearly doubled reflecting the partial opening of the stock market to foreign investors. Net portfolio investment inflows continued to strengthen in subsequent years, with net private capital inflows reaching $16 billion in 1995. Korea continued to be a net exporter of direct investment, but increasingly become a major net recipient of portfolio investment inflows. These inflows were offset by a weakening in the current account balance of payments, and an increasing surplus in the overall balance of payments. The exchange rate was permitted to adjust to some extent, however, the degree of adjustment tended to be limited. Nominal interest rates were also reduced, although with inflation higher than internationally, the interest differentials with foreign rates remained positive.

Notwithstanding the significant measures undertaken during 1985–96 toward a deregulated financial sector, Korea’s financial sector and capital account transactions continued to be subject to many regulations and government intervention. Moreover, the extent of the effectiveness of certain reforms, for example, interest rate deregulation, is not very clear. Accordingly, further liberalization measures have been scheduled for 1997–2000, provided that stable macroeconomic conditions are maintained or the differential between Korean and international interest rates falls below 2 percent.20

D. Thailand

The sequencing of Thailand’s reforms of domestic and external transactions during 1985 to mid-1997 is summarized in Table 4, and described in Appendix Table 15; selected macroeconomic and balance of payments indicators are presented in Chart 4 and Appendix Table 16. An abstract of the exchange and capital control regime as of September 10, 1997 is provided in Appendix Table 17.

Chart 4.
Chart 4.

Thailand: selected macroeconomic Indicators, 1985–96

Citation: IMF Working Papers 1997, 157; 10.5089/9781451857450.001.A001

Table 4.

Thailand: Sequencing of External and Domestic Financial Liberalization, 1985-August 1997 1/

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An x represents relatively minor measures and an X represents major measures undertaken that year.

On May 4 the Government accepts Article VHI obligations of the IMF Articles of Agreement.

The exchange rate arrangement of the Thai baht changes from being pegged to the U.S. dollar to a managed float.

At the beginning of the period under review, Thailand undertook a major adjustment effort: the baht was devalued by 14.8 percent in 1984, significant fiscal consolidation began and a decisive change was made in the orientation of trade and industrial policies toward export-led growth. Thailand gave priority to promoting capital inflows through tax and institutional reforms while concurrently developing its financial markets. This policy, together with large positive interest differentials and a fixed exchange rate, promoted large net capital inflows. Such inflows contributed to strong economic performance and an increasing opening of the economy. However, concerns about the sustainability of the exchange rate and the solvency of the financial system subsequently resulted in a sharp reversal of capital inflows and a currency crisis.

At the beginning of the period under review, Thailand maintained a relatively open capital account as regards to capital inflows. Under the Alien Business Law of 1972 and the Investment Promotion Act of 1977, the sectors for foreign investment and the screening requirement of such investments had been liberalized. Portfolio investments inflows were treated liberally, although initially exchange controls applied to the repatriation of interest, dividends, and principal. Foreign borrowing could be conducted freely but had to be registered with the Bank of Thailand (BOT).

Over the period, foreign inflows were further promoted through various measures, including: eliminating restrictions on foreign investments and foreign ownership of export orientated industries; the granting of tax incentives to encourage direct investments in special sectors; the granting of tax incentives to foreign mutual funds for investments in the stock market, and the creation of new closed end mutual funds; establishing of rules for foreign debenture issues by Thai companies; reduction of taxes on dividends remitted abroad; and allowing freely the repatriation of investment funds, loan repayments, and interest payments by foreign investors.21 In 1992, the authorities approved the establishment of the Bangkok International Banking Facility (BIBF) which greatly eased access to foreign financing and expanded short-term inflows (see Chart 4); and in 1995 the Provincial International Banking Facility (PIBF) was established which could extend credit in both baht and foreign currencies with funding from overseas.

Payments and transfers for current international transactions were also progressively liberalized, and in 1990 Thailand accepted the obligations of Article VIII. Further liberalizations followed, with the removal of limits on the amounts of foreign exchange that could be purchased or brought in or taken out of the country, the relaxation of surrender requirements, and broadening the uses of nonresident baht accounts and resident foreign currency accounts.

In contrast to the promotion of capital inflows and the liberalization of the exchange system, controls on capital outflows by residents were liberalized only gradually. In 1990 commercial banks were allowed to lend limited amounts to nonresidents in foreign currency, and to approve the repatriation of proceeds from sales of securities; and in 1991 Thai residents were permitted to invest abroad or lend limited amounts to companies that had at least a 25 percent Thai equity participation. This limit was increased in 1994. Purchases abroad of capital and money market securities, foreign direct investments exceeding $10 million, and purchases of real estate remained subject to BOT approval. Insurance companies were permitted to invest abroad under certain circumstances but only up to 5 percent of their total portfolio, while locally issued mutual funds were restricted to investing their total portfolio in the domestic market.

The reforms of domestic financial markets focused initially on the development of the stock market. The Securities Exchange of Thailand (SET) was established in 1975, and the Securities Exchange Act was amended in 1984. A number of subsequent reforms aimed at developing the stock exchange: the Securities and Exchange Commission (SEC) was established in 1989; manual transactions were replaced with an automated trading system in 1991; and in 1992 the Securities Exchange Act and the Public Company Act B.E. 2535 were designed to support and promote the stock market. The Securities Exchange and Public Company Acts allowed public and private companies, listed and unlisted, to issue bonds, and the Thai Rating and Information Services (TRIS) was established as a credit rating agency to aid the development of corporate debt markets. Over the period the number of companies listed on the exchange more than tripled, and the annual average growth in the stock market capitalization was a remarkable 57 percent during 1987–94.

Following a crisis among the finance companies in the first half of the 1980s, measures to strengthen the banking system were introduced in 1985, including strengthened prudential standards and improved on and off site monitoring. However, the banking system continued to have an oligopolistic structure which was reflected in large spreads between deposit and lending rates (see Appendix Table 16). Moreover, the 1997 banking crisis indicated that there were a number of financial sector weaknesses which were not fully addressed following the earlier banking crisis.

Interest rates and credit controls were liberalized gradually, and in 1992 the ceilings on savings deposits and lending rates were removed. Nevertheless, indirect monetary instruments were not well developed, and the authorities relied to a considerable extent on foreign exchange swaps to manage the liquidity effects of capital inflows. In the context of the fixed exchange rate regime, such swaps generally involved the central bank setting a forward exchange rate that did not deviate significantly from the spot exchange rate.

Thailand’s promotion of capital inflows combined with a rapidly growing economy contributed to very substantial net capital inflows in the range of 9–13 percent of GDP between 1989–95 (a much higher percentage than the other countries reviewed in this paper). Net capital inflows were offset initially by repayments of official capital and subsequently by substantial deficits in the current account balance of payments which reached 8 percent of GDP in 1995. Nevertheless the growth of broad money and inflation increased along with the surpluses in the overall balance of payments and in spite of fiscal consolidation (see Chart 4).

The composition of capital inflows evolved over the period and appeared responsive to the regulatory reforms and incentives for capital flows. Net direct investment inflows contributed to the initial strengthening of the capital account, however net portfolio inflows became more important with the subsequent reforms to promote investments in the Thai stock markets, the establishment of the BIBF, and the large positive interest differential. A growing proportion of the net inflows were short-term in nature, reaching 60 percent of the total in 1995. Consequently in 1995, Thailand began to restrict short-term capital inflows by imposing 7 percent reserve requirement on banks’ nonresident baht accounts. These restrictions were extended in 1996, inter alia, to cover new foreign borrowing of less than one year.

In 1996 growth and investment levels deteriorated in the face of an appreciating real exchange rate and capital inflows and exports declined sharply. The large current account deficit, high interest rates, and increasing inflation left the country vulnerable to external shocks and a shift in market sentiment. Moreover, serious weaknesses appeared in the financial system due to exposures to the properly sector and inadequate loan provisioning. High interest rates to counteract outflows aggravated the solvency and liquidity position of many banks and finance companies and resulted in intervention by the authorities to support the financial system. In July 1997, faced with a banking crisis, run on the currency, and large foreign exchange losses, the authorities floated the baht and adopted a managed floating exchange rate.

In response to the currency crisis sales of foreign exchange were restricted for all foreign exchange transactions except those applied to exports and imports of goods and services, and direct and portfolio investment. Banks which had been free to lend to nonresidents subject to open position limits became subject to temporary restrictions on baht lending to nonresidents. Forward outright transactions in baht with nonresidents, and the selling of baht against foreign currencies to nonresidents were temporarily restricted (see Appendix Table 15). However, such measures did not in general prevent the selling of the currency which continued to depreciate.

IV. Lessons From the Country Experiences

While the four country experiences reviewed here are diverse, the approach to and the consequences of the capital account liberalizations contain some lessons for managing such reforms.

A. Sequencing of Reforms

As regards the general approach to capital account liberalization, liberalizations of direct investment inflows were generally undertaken as part of broader strategies aimed at restructuring the real sectors of economies. These strategies included eliminating barriers to trade, initial exchange rate adjustments, liberalization of restrictions on current payments and transfers and acceptance of the obligations of Article VIII of the IMF’s Articles of Agreement, as well as the liberalization and promotion of foreign direct investment inflows. Liberalizations of portfolio capital flows were generally coordinated with domestic financial sector reforms, especially the liberalization of domestic interest rates and moves toward indirect monetary instruments, strengthening of domestic security markets and reforms of domestic banking systems, and foreign exchange market reforms. In Chile and Korea financial sector reforms tended to precede capital account liberalization while in Indonesia capital account liberalization helped to promote the restructuring, and to improve the competitiveness, of the domestic financial system. The currency crisis in Thailand illustrates the risks when the approach to liberalization does not cover all the necessary concurrent reforms. In that case, the strengthening of financial institutions and the development of indirect monetary instruments lagged the liberalization of the capital account.

The approach to the liberalizations of capital inflows and outflows varied depending on the particular priorities adopted by the country. In the case of Korea, management of the current account balance of payments appeared initially to be the overriding consideration, and Korea sought to manage current account surpluses and deficits through regulatory and other changes which influenced capital inflows and outflows. Thailand actively promoted capital inflows while limiting outflows with the objective of supplementing domestic savings and promoting investment and rapid economic growth. Indonesia maintained a relatively liberal regime for capital outflows and gradually liberalized inflows with the aim of attracting foreign capital to assist the restructuring of its economy. Chile also liberalized capital inflows as part of its program of economic restructuring, and liberalized outflows in response to balance of payments considerations.

The pace of reforms varied. Chile and Korea followed a gradual approach to reforms. By contrast, Indonesia liberalized capital outflows early in the reform process; the liberalization of capital inflows occurred much later and more gradually. Thailand opened its economy to capital inflows, especially portfolio investment inflows, much more rapidly than the other countries surveyed but liberalized capital outflows only gradually.

B. Macroeconomic Management of the Liberalizations

Table 5 shows average comparative macroeconomic, financial sector, and balance of payments indicators for the four countries 1985–90, and 1991–96. In all cases, the capital accounts were more liberal in the second period than the first. In all cases, net inflows of private capital accompanied the capital account liberalizations and all countries recorded surpluses in their overall balance of payments. In all cases, portfolio investment flows dominated direct investments. Indonesia’s balance of payments was less affected than the other countries by capital account liberalization, perhaps because restrictions on capital outflows had been liberalized much earlier in Indonesia. In all countries, with the exception of Korea, the surpluses were combined with fiscal consolidation.

Table 5.

Averages of Selected Economic Indicators for Chile, Indonesia, Korea and Thailand 1/

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Source: IMF International Financial Statistics, World Economic Outlook, Information Notice System, and IMF Direction of Trade Statistics, various issues.

The averages cover the years were there is data available.

Excluding official capital.

Interest Differential = Deposit Rate - London Interbank Offer Rate on 3-Month U.S. Deposits.

The overall balance includes: current account, financial account, capital account, and net errors and omissions. Capital account figures are not shown because they are zero throughout the period

Total Capital = Direct Investment + Portfolio Investment + Other Investment - Official Capital + Net Errors and Omissions + Misinvoicing.

The impact of the capital inflows on economic performance, however, varied between the countries. Chile reduced its current account deficit as well as inflation, and also brought down the interest differential with foreign rates and the real deposit rate. The growth of broad money and domestic credit to the private sector were generally constrained in the context of a managed floating exchange rate. In contrast, Korea and Thailand experienced rapid growth of money and domestic credit in the context of stable exchange rates against the U.S. dollar, and in both cases, inflation accelerated and the current account balance of payments weakened. Thailand also faced a currency crisis. In Indonesia, broad money and private credit also grew rapidly, inflation accelerated, the current account remained in deficit, and the Indonesian currency also came under speculative pressure.

How can the differences in performance be explained? One of the differences is that the ratios of broad money and private sector credit to GDP fell in Chile at the same time as private capital inflows increased as a percent of GDP, while the ratios of broad money and private sector credit to GDP increased significantly in the other countries (see Chart 5). Thus in Chile, for a time, net private capital inflows appear to have substituted for domestic intermediation, while in the other countries the inflows were associated with an increase in such intermediation, and with a rapid expansion in credit to the economy. In turn, this may explain the accelerating inflation and the weakening current account performances in the latter countries. Where the credit expansions were also associated with banking sector problems, this can create particular concerns about the efficiency of use of the capital inflows, and thus the sustainability of the balance of payments, and lead to a loss of confidence and capital outflows.

Chart 5.
Chart 5.

Capital Flows, Private Sector Credit, and Current Account Deficit 1985–96

(In Percent of GDP)

Citation: IMF Working Papers 1997, 157; 10.5089/9781451857450.001.A001

What may determine the different monetary and credit developments? Part of the explanation may reflect the fact that Chile had implemented substantial financial sector reforms in the 1980s and adopted strengthened prudential standards earlier than in the other countries. The initial expansion in credit that often accompanies financial sector liberalization may therefore have occurred earlier in Chile than the other countries surveyed, and the strengthened bank supervision may have led to a better pricing of risks and avoidance of banking problems.

Secondly, all of the countries sought to manage capital inflows through their regulatory regimes. In the case of Thailand, the regulatory and institutional framework generally favored such inflows, while other countries sought to limit certain inflows or to liberalize them gradually. As a consequence, net private capital inflows were larger as a percent of GDP in Thailand than in the other countries and a large part of these inflows through the international banking facility were short term in nature, which may have increased Thailand’s vulnerability to a reversal of such flows.

There is no strong evidence that the reintroduction of controls was particularly effective in limiting overall capital inflows. The capital controls may have influenced the composition of such flows, and thus have had some impact in determining whether the net inflows were directed to the domestic banking system. Chile actively sought to discourage capital inflows to the banking system. Indonesia and Thailand also became concerned by the volume of inflows to their banking systems, although in the case of Thailand this was late in the reform process. However, the impact on the growth of bank credit of the introduction of controls in Chile in 1991 and their subsequent intensification does not appear very evident in Chart 5, as private sector credit increased as a percent of GDP after 1991. Also, at a theoretical level it is not clear that a restriction on certain types of inflows would be particularly effective in limiting bank credit expansion in view of the potential fungibility of capital.

Finally, the exchange rate regime differed between the countries. The countries which appeared to manage better the capital inflows followed more flexible exchange rate arrangements. Such flexibility generally created greater autonomy for monetary policy in managing the effects of capital inflows and may itself have help to discourage short-term speculative capital flows. Part of Chile’s successful management of capital account liberalization may be partly attributed to its more flexible management of the exchange rate within a preannounced crawling band. In contrast, Thailand’s maintenance of a fixed exchange rate limited the flexibility of its monetary policy to constrain the growth of money and credit in the face of significant capital inflows. When combined with Thailand’s policy of promoting capital inflows, the fixed exchange rate arrangement may have initially created unrealistic expectations about the rates of return. When market sentiment changed, the result was a sharp reversal of capital inflows.

V. Conclusion

Capital account can have significant benefits for economic growth and welfare. However, achieving the benefits of the liberalization while minimizing the risks requires attention to the sequencing of the reforms and the pacing of capital account liberalization to macroeconomic and exchange rate policies.

What is generally important for managing the volume of capital flows is the overall incentive structure that can give rise to such flows. This will be influenced by the regulatory regime for capital movements, the stage of development and soundness of financial systems, and by the configuration of interest rates and exchange rates.

This study therefore concludes that countries should adopt a coordinated and comprehensive approach to reforms, of which capital account liberalization is an integral part. Such a public policy approach requires attention not only to the sequencing of the regulatory and institutional reforms with the regulatory frameworks which impact on capital movements, but also the design of macroeconomic and exchange rate policies.

Sequencing Capital Account Liberalization: Lessons From the Experiences in Chile, Indonesia, Korea, and Thailand
Author: Claudia Echeverria, Mr. Salim M. Darbar, and Mr. R. B. Johnston