Capital Account Liberalization and the IMF

• Author: Barry Eichengreen and Michael Mussa
• Position: Professor of Economics and Political Science at the University of California, Berkeley/Chief Economist and Economic Counsellor of the IMF and Director of its Research Department

Capital account liberalization may have substantial benefits, but recent experience also underscores its risks. How should liberalization be sequenced and managed to ensure that the benefits dominate?

The growth of international financial transactions and international capital flows is one of the most far-reaching economic developments of the late twentieth century and one that is likely to extend into the early twenty-first century. Net flows to developing countries tripled, from roughly $50 billion a year in 1987-89 to more than $150 billion in 1995-97, before declining in the wake of the Asian crisis. Gross flows to developing countries and more generally have grown even more dramatically, rising by 1,200 percent between 1984-88 and 1989-94. An increasing number of IMF member countries have removed restrictions on capital account transactions in an effort to take advantage of the opportunities afforded by this remarkable rise in international financial flows.

But these developments, as the official community has acknowledged, raise important questions about the role of the IMF in financial liberalization. In September 1996, the Interim Committee (the committee of finance ministers and central bank governors that reviews IMF activities) requested the IMF Executive Board to analyze trends in international capital markets and examine possible changes to the IMF's Articles of Agreement so that the organization could better address the issues raised by the growth of international capital flows. In April 1997, the Interim Committee agreed that there would be benefits from amending the Articles to enable the IMF to promote the orderly liberalization of capital movements. It reiterated this position in a statement issued at the Annual Meetings of the World Bank and the IMF in Hong Kong SAR the following September.

This idea that the IMF should actively promote the liberalization of capital flows has not gone unchallenged. In the wake of the Asian crisis, which has seen sharp reversals of capital flows for a number of countries, officials and academics alike have questioned how desirable capital account liberalization is and whether it is advisable to vest the IMF with responsibility for promoting the orderly liberalization of capital flows.

Growth of capital flows

Powerful forces have driven the rapid growth of international capital flows. Prominent among these are

* the removal of statutory restrictions on capital account transactions, which is a concomitant of economic liberalization and deregulation in both industrial and developing countries;

* macroeconomic stabilization and policy reform in the developing world, which have created a growing pool of commercial issuers of debt instruments;

* the multilateralization of trade, which has encouraged international financial transactions designed to hedge exposure to currency and commercial risk; and

* the growth of derivative financial instruments-such as swaps, options, and futures-which has permitted international investors to assume some risks while limiting their exposure to others.

Above all, technology has played a role. Revolutionary changes in information and communications technologies have transformed the financial services industry worldwide. Computer links enable investors to access information on asset prices at minimal cost on a real-time basis, while increased computer power enables them rapidly to calculate correlations among asset prices and between asset prices and other variables. Improvements in communications technologies enable investors to follow developments affecting foreign countries and companies much more efficiently. At the same time, new technologies make it increasingly difficult for governments to control either inward or outward international capital flows when they wish to do so. All this means that the liberalization of capital markets-and, with it, likely increases in the volume and the volatility of international capital flows-is an ongoing and, to some extent, irreversible process with far-reaching implications for the...