Chapter 2 Literature Review
2.5 Capital Flow Liberalization
2.5.1 Merits And Demerits Of Capital Flow Liberalization
Financial liberalization has created new channels for resource transfers from developed to developing countries, but it has also generated conditions wherein such transfers can easily be reversed with serious consequences in terms of instability (Gabriele et al., 2000). These flows have been observed to be confined to a small group of countries and many developing countries have faced an acute shortage of foreign funding, while the few that have some degree of access to global finance are confronted by the challenges of volatility and sustainability.
The liberalization of foreign capital flows has been cause for concern since the financial crises of the late 1990s and is distinct from the liberalization of trade flows (Akçelik et al., 2015). The empirical literature has debated the positive or negative effects of short-term capital flows, giving rise to two distinct views, with many others in between. The first school of thought supports the view that the liberalization of global financial flows promotes economic performance. In contrast, opponents of this view argue that there is no connection between capital account openness and the growth of the economy (Akçelik et al., 2015). For instance, Stiglitz and Ocampo (2008) and Stiglitz (2004) argue that, in most cases, the liberalization of foreign capital flows has led to increased economic instability. In between these two opposing views, are scholars who stress that capital account liberalization has both benefits and costs, but the benefits are maximized when countries achieve a certain level of institutional development. However, most countries have begun to introduce capital flow measures (CFMs) to manage the adverse impacts of volatile capital flows, particularly those of a short-term nature. Notably, liberalization of capital flows has often been followed by financial crises (Dell‘Arricia et al., 2008, Pinto and Ulatov, 2010). The risks associated with capital account openness can be severe in economies that have yet to reach significant levels of financial institutional growth (Akçelik, Başçι, Ermişoğlu, and Oduncu 2015).
Other scholars believe that inherent capital flow volatility, reflected most severely in sudden stops
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(Calvo and Reinhart, 1999), hot money (Stiglitz, 2000) and capital flight leads to adverse effects particularly during economic downturns in economies with limited absorptive capacity (Kose, Prasad, and Terrones, 2003) and low investor protection (Lemmon and Lins, 2003).
Well before the GFC, several countries had adopted plans to liberalize cross border capital flows and had progressed fairly rapidly, especially in emerging Europe, China and India. While the speed of liberalization declined slightly with the start of the global crisis, the general trend across the globe is to increase free movement of capital flows. Capital flow management systems have been observed to cause more costs and problems to the overall economy such as increasing indiscipline in financial markets and public finances; reduced availability of external funding and misallocation of financial resources and have also deprived investors of diversification opportunities (Stiglitz and Ocampo, 2008). However, the move towards free cross border mobility of capital flows shows countries’ appreciation of the positive role played by foreign capital flows. At the household or firm level, foreign financial flows promote the efficiency of resource distribution and the performance of local financial markets (Obstfeld, 2009). Foreign direct investment inflows improve technological advancement and information dissemination. Removal of global capital flow restrictions is more beneficial and less risky if an economy’s financial sector has attained a certain threshold level of development (Kose, Prasad, Rogoff, and Wei, 2009, Dell'Ariccia et al., 2008,). Given this, liberalization of capital flows can promote financial and institutional growth, but it requires good planning, timing and sequencing to ensure that the merits of capital flow management exceed the costs (IMF, 2012; 2012a). However, previous studies’ failure to find a positive relationship between growth and liberalization could be the result of incorrect hypothesis specification (Henry, 2007) and lack of recognition of the indirect benefits of financial openness for economic growth, such as macro-economic discipline and financial development (Kose et al., 2009). It could also be due to lags in the impacts of capital flow liberalization on growth. Some economies such as China and India have experienced continuous economic growth despite relatively closed capital accounts (Kose et al., 2009, Prasad, Rogoff, Wei, and Kose, 2005). In summary, it is important to note that the advantages of liberalization are highest when economies have attained a specific level of financial market growth (Dell‘Arricia et al., 2008, Kose et al., 2009, Prasad and Rajan, 2008, Alfaro et al., 2004). Nonetheless, liberalization can expose economies to significant risks, especially when a sufficient level of financial market growth is not attained. This was the case in the Mexican 1994-95 crisis; the Russian crisis of 1998 and the Asian
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crisis of 1997-98 (Dell‘Arricia et al., 2008, IMF, 2012a, Prasad and Rajan, 2008, Kose et al., 2009).
There is need to carefully manage liberalization as exceeding the thresholds for financial and institutional development can lead to rapid capital flow fluctuations. Large and volatile financial flows are risky even to advanced markets with highly developed financial markets (IMF, 2012b).
However, Mishkin (2009) points out that financial liberalization can indirectly promote financial deepening and that foreign banks encourage competition and institutional quality. In addition, institutional reforms promote improved financial reporting and disclosure. Dell‘Ariccia et al.
(2008) support these views through case studies of Czech Republic, Estonia and Lithuania. The findings of previous studies on the impacts of capital flow liberalization are mixed, with a new strand of literature vigorously opposing full capital flow mobility. Magud, Reinhart, and Rogoff (2011) further argue that, given capital controls, an economy is able to maintain an independent monetary policy and is able to determine the composition of foreign capital flows.
In terms of the correlation between capital flow liberalization and economic performance, there is ongoing debate on the positive or negative effects of short-term financial flows. Proponents of free cross border mobility of capital flows support the idea that financial liberalization promotes economic growth (Asongu and De Moor, 2017, Prasad et al., 2005). However, opponents of such a policy argue that there is no correlation between capital account opening and gross domestic product (GDP) (Stiglitz, 2004). Scholars whose views fall in between these extremes have argued that liberalization of the capital account has both benefits and costs which are influenced by the level of institutional development (Pinto and Ulatov, 2010, Dell‘Arricia et al., 2008). According to Kaplan and Rodrick (2001), capital flow controls can be beneficial as was the case with the Asian and Malaysian crises.
Globalization of financial markets and the volatility of international capital flows impact on the operations of domestic and world financial markets (Carp, 2014). In addition, free mobility of global capital flows has promoted interdependence between global markets, spurring growth in related economies. The positive effects of globalization can be achieved through introducing and maintaining sound macro-economic policies, robust financial regulation and sound supervision frameworks. In most cases, financial crisis has been preceded by huge foreign capital inflows, with destabilizing effects on domestic markets. For example, the 2007 subprime crisis was characterized by market failure and market distortions (Carp, 2014).
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