Capital account liberalization

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Capital account liberalization refers to country government deciding to move from a closed capital account system to more liberalized open system. The objective is to allow the fund to move freely in and out of the country, which will help foster growth in an economy and help drive sustainable macroeconomic policies in developing countries. Capital inflows provide important resources for economic development but there are two different views on the wisdom of capital account liberalization in the emerging market and developing countries in terms of capital outflow from the country. Capital Inflow is defined as capital coming into the country through means of foreign direct investment, like buying shares in the company or buying companies already in the domestic market. Where as Capital Outflow is when assets move out of the country that occurs when investor sell their investments.

There are three benefits of Capital account liberalization economically that includes diversification, efficiency gains and intertemporal optimization. According to economic theory capital will move into the developing countries and emerging markets from advanced economies.

The first benefit of capital account liberalization in developing countries and emerging markets is that it will increase capital inflow in the absence of restrictions in developing country domestic market. Developing countries who are often short of capital and can gain from inflow of capital from foreign investments. As there will be less cost of capital due to liberalization of its capital accounts. As pointed out by (Fischer, 1998, 2003; Obstfeld, 1998; Rogoff, 1999; Summers, 2000). The flow of resources into the developing countries reduces their cost of capital, triggering a temporary increase in investment and growth that permanently raises their standard of living [2] .

This increases investment that promotes growth as capital will be able to move freely move abundant to scarce place in developing countries and emerging markets. That will result in efficient allocation of capital and help provide access to international networks, all of which further raise productivity and growth. Furthermore in terms of intertemporal optimization the capital can enable country to borrow from the rest of the world and to smooth its consumption stream in times of temporary recession. For example capital flows to emerging market economies in the 1990s, from just over US$40 billion in 1990 to about US$298 billion in 1997 [3] . As the diagram 1 show ( See attached documents)

The second benefit there will be diversification of risks with inflow and outflow of capital from the country. As foreign investment allow "domestic agents to diversify country-specific risks that cannot be diversified within the domestic equity market" [4] . That is only possible with the help of foreign direct investment (FDI) and banking transaction that developing country is limited to. This inflow and outflow from developing country and emerging market will help creates market discipline that will hopefully result in efficient allocation of resources and higher productivity growth. On the other hand, "a greater integration with the rest of the world may lead to an increase in the specialization of production based on their comparative advantage"

(Fischer 1998) The theoretical rationale for capital account liberalization is based primarily on the argument that free capital mobility promotes an efficient global allocation of savings and a better diversification of risk, hence greater economic growth and welfare. [5] 

Third benefit is that there can be efficiency gains made in the domestic market because capital account liberalization will allow the transfer of technology made through trade and companies entering the market made. That will result in the country expanding financially. Development can be made in areas like financial intermediates, direct and indirect financing, and there will be more activities in banking sector and stock markets. This will help developing county to improve their procedure and that might help them bring more credibility and help improve there efficiency stimulate innovation, and improve productivity of their domestic institutions

(Quinn 1997) finds a positive association between capital account liberalization and economic growth but Grilli and Milesi- Ferretti (1995) and Rodrik (1998) fail to find any such relationship [6] .

This brings us to the point costs associated with the liberalization of capital accounts in emerging markets and developing countries. The benefits of fully capital account have not been fully thought off as the labialization has meant that developing countries and emerging market are vulnerable to financial instability. As Stiglitz argued " argued that: "Financial and capital market liberalization was at the core of the problem" [7] Furthermore in regards to the frequency of crises Stiglitz added: "This change is related to financial and capital market liberalization." [8] 

The first problem is that Liberalization can cause excessive investment that can lead to currency appreciating that will undermining export competitiveness. As developing countries have witnessed a sharp rise in 'hot money' and portfolio investments in recent years.

The second problem is that developing countries and emerging markets are that capital flows bring with them volatility, that could in danger the economy financial stability because of the weak regulatory system they have in place that could lead to higher crisis since developing country lack social and fiscal security nets unlike in the developed country have in place.

Chang and Velasco (2000), The volatile nature of capital inflows and outflows has been indicated as one of the main factors behind financial instability in developing countries. The presence of large amounts of short-term capital flows can expose the borrower country to costly liquidity runs [9] . For instance in 1997 developing countries (as a whole) received short-term capital inflows of 43.5 billion dollars in 1998, in the wake of the Asian crisis, they suffered from an outflow of 85 billion dollars [10] .

The third problem is that capital flows might not enter a country at the right time. But they can leave a country quickly at a time when they are badly needed. The most serious problem arises if there is a reversal of capital flows on a large scale. As the experience of the 1997-98 financial crises in South-East Asia and Russia in 1998 have shown, risks associated with capital inflows also include the sudden (unexpected and large-scale) reversal of some type of flows, particularly short-term inflows. [11] 

Calvo (1998a), for instance, showed that the shorter the maturity of the debt structure, the higher the probability that a large capital reversal may bring about balance of payment crisis with dramatic

consequences for the respective economy (i.e. widespread bankruptcies, destruction of local credit channel and obsolescence of human capital. [12] 

Sudden capital outflow can have a negative impact on the exchange and interest rates. For example "several financial crisis in Mexico, Southeast Asia and Turkey in the 1990s point to the preeminent role of unregulated short-term portfolio flow in precipitating a financial crisis" [13] 

As written in the 1920's by Ragnar Nurkse who wrote about the "destabilizing capital flows" and then in 1970's Charles Kindleberger described the role of capital in driving "manias, panics and crashes". [14] 

There is major issue that due to the moral hazard problem if there is asymmetric information in the domestic economy. However, under asymmetric information, markets become inefficient and negative effects of liberalization such as adverse selection, moral hazard and herd behavior can emerge. As Eichengreen (2001) concludes that the literature finds, at best, ambiguous evidence that liberalization has any impact on growth. [15] 

The research has shown that Capital account liberalization and its impact of on developing economy has been a mixed bag that has both its negative and positives. As pointed out by (Quinn 1997) who finds a positive association between capital account liberalization and economic growth but Grilli and Milesi- Ferretti (1995) and Rodrik (1998) fail to find any such relationship. Capital account liberalization on one hand has allowed developing countries to borrow from the developed economics, it has brought in capital investment that has is seen to be bringing prosperity. Where the capital cost fall and helps increase output per worker

On the other hand it has brought with it number of financial crisis like the one experienced in the 1997-98 financial crises in South-East Asia and Russia in 1998 have shown, risks associated with capital inflows also include the sudden unexpected reversal of short-term inflows. As Stiglitz " argued that: "Financial and capital market liberalization was at the core of the problem"

Contrary to believe that liberalization of capital brings growth is not accurately a prime example of that is India and china that achieved growth without capital account liberalization. Furthermore developing countries don't have adequate regulatory system in place to protect itself from to financial disruptions that are not of their making as government relinquish control of the flow of capital into country and going out. As Ragnar Nurkse wrote in 1920's that "destabilizing capital flows" and then in the 1970's Charles Kindleberger described the role of capital in driving "manias, panics and crashes".

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