**Policy Research|**

**Flnanca Polic and Systems**

WPS 901 This paperajoint product of the Office of the Director, Country Department IV, Latin America and the Caribbean Region, and the Financial Policy and Systems Division, Country Economics Department - is partof a larger research effort to understand financial reformn. It was funded by the Bank'sResearch Support Budget for research project "The Impact of Financial Reform" (RPO 676-13). The paper focuses on the - debate about the sequencing of reform which should come first: the liberalization of capital or current accounts? Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Diane Bouvet, room I6-061, extension 35285 (May 1992, 43 pages).

Increased trade, improved communications, growing internationalization of production, and legalization of foreign currency instruments have increased access to international capital markets. Developing country govemments are beginning to consider complementing increasingly open goods markets with de jure capital account liberalization. To assist this analysis, Hanson surveys the costs and benefits of opening domestic capital markets and including some practical issues.

Capital account liberal a.tion provides greater access to foreign financing for aggregate investment. It also allows individuals to diversify and protect themnselves against risks more easily. But individuals often seek to protect themselves against actual and potential govermment policies. This may lead to reduced domestic saving when the capital account is opened, particularly in an unstable policy environment.

Open capital accounts reduce the ability to tax capital and to conduct monetary policy (under a fixed exchange rate). They also increase a country's exposure to external monetary shocks. But the loss of tax and monetary independence brings an offsetting benefit: the government's incentive to undertake such policies is reduced, which lessens the risk of policy instability. An open capital account also may enhance the ability to conduct fiscal policy, depending on how international investors respond to variations in fiscal deficits. Finally, in evaluating the costs and benefits of legally opening the capital account, it is important to consider just how open the capital account really is and to what extent existing regulations merely shift the burden of implicit taxes onto those with less access to foreign exchange.

Most evidence about the impact of capital account liberalization comes from industrial countries. Available evidence suggests that developing cour:tr es with stable policy environments could benefit from opening the capital account: domestic real interest rates would decline, and there might be a 10 to 15 percent increase in investment, which also might bring better technology and management with it.

Reasonable fiscal balance and a sound domestic financial system are preconditions to successfully opening the capital account. Without these preconditions, capital flight may occur or the government may have to bail out domestic banks. Capital account liberalization can, to some extent, be phased with current account liberalization by legalizing and limiting different instruments and institutions to varyir.g degrees. Finally, trade liberalization programs and exchange rate policy need to be viewed not only in terms of maintaining current account balance but also how they affect the real interest rate and investment, through the capital account.

The Policy Research Working Paper Series disseminates th efindings of work under way in the Bank. An objeciive of the series is to get those findings out quickly, even if presentations are less than fully polished. The ftndings. intcrpretations, and conclusions in these papers do not necessarily represent official Bank policy.

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