Sequencing Capital Account Liberalization
| Author | R. Barry Johnston |
| Position | Chief of the Exchange Regime and Market Operations Division in the IMF's Monetary and Exchange Affairs Department |
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A country that is liberalizing its capital account faces the challenges of strengthening financial institutions to ensure they are capable of operating in a more market-oriented system and deciding how to achieve monetary aims and maintain macroeconomic stability in a freer, more open environment.
Although fears about the risks associated with capital account liberalization have been reawakened by Asia's financial crisis, it is still a more attractive option for many developing countries than capital controls. First, there is much evidence that capital controls have not prevented outflows. Second, when countries eliminate controls, they usually experience stronger inflows, at least initially, as international investors and residents who had placed their capital abroad react to the improved investment environment. Capital inflows can improve a country's balance of payments, smooth temporary shocks to income and consumption, reduce borrowing costs, and spur economic growth.
Capital account liberalization is not without risk, however. If capital inflows are not used efficiently, the markets may question their sustainability and the capacity of the recipient country to service its external debt. A loss of confidence could trigger reversals of capital flows and, in their wake, balance of payments difficulties and currency and banking crises.
Capital account liberalization is not an all-or-nothing affair; there are as many ways to approach it as there are financial instruments and types of capital transactions (see box). Capital flows can, for example, be intermediated by the international capital markets (when local nonfinancial agents are permitted to borrow or place funds abroad); by the local capital markets (when nonresidents can access local financial markets and intermediaries); or a combination of both (when local financial intermediaries borrow or place funds abroad). Capital controls can take various forms-including outright prohibitions, licensing and approval procedures, and transaction taxes-each with a different effect on flows. A country may liberalize certain components of its capital account while maintaining controls on others.
Although many of the challenges posed by capital account liberalization are no different from those posed by the liberalization of domestic financial systems, capital account liberalization adds an external dimension and urgency to financial sector reforms. Whether capital inflows are channeled through domestic intermediaries or compete with them, the intermediaries will need to be strengthened, either to ensure the efficient use of the capital inflows or because competitive pressures on-and the need to restructure-domestic financial institutions will increase. Moreover, capital account liberalization may induce banks and corporations to take on more foreign exchange risk.
The liberalization of capital flows can thus be viewed as one aspect of financial sector liberalization, in which the role of the authorities is, first and foremost, to establish an appropriate regulatory framework. A comprehensive liberalization of capital transactions and transfers does not signify an abandonment of all rules and regulations applying to foreign exchange transactions. Regulations may have to be strengthened in a number of areas, including prudential regulations related to nonresident and foreign exchange transactions and transfers.
* Shares or other securities of a participating nature
* Bonds or other debt securities
* Money market instruments
* Collective investment securities
* Derivatives and other instruments
Controls on capital and money market transactions may apply to purchases made locally by nonresidents or sales or issues carried out abroad by residents (inflows), or to sales or issues carried out locally by nonresidents or purchases made abroad by residents (outflows).
* Commercial credits
* Financial credits
* Guarantees, sureties, and financial backup facilities
Controls may apply to inflows (credits provided to residents by nonresidents) or outflows (credits provided by residents to nonresidents).
Controls may apply to inward and outward direct investment, liquidation of investment, or purchases and sales of real estate made locally by nonresidents and purchases of real estate made abroad by residents.
Controls may be applied to nonresident deposits and bank borrowing abroad (inflows) and to...
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