29 mobility, although imperfect, may have reduced domestic interest rates by as much as _5_ percentage points compared to the autarchic situation.

This analysis suggests that developing countries would obtain some benefits from opening up the capital account, even leaving aside the benefits from trading in riWky assets. 'he financing of the 10-15% of investment, suggested by the developed country studies, would be welcome in many developing countries, especially if accompanied by improved technology and management. The potential reduction in the interest rate also seems fairly sizeable.

The sequencing and speed of capital account liberalization remain important issues. The preconditions for capital account liberlization are a sound fiscal/monetary situation and a reasonably sound and liberalized domestic financi system. The need for fiscal control is perhaps best illustrated by the experience of some countries in Latin America. Large public sector deficits were financed increasingly with exteral funds. When exchange rate policy became clearly inconsistent with the fiscal deficit and external borrowing became clearly unsustainable, capital flight ensued and additional borrowing was done to sustain the exchange rate. Given the magnitude of the policy errors, capital flight would have developed in any case. However, the degree of openess of the capital account certainly contributed to the capital flight and excess borrowing.

The rationale for a reasonably liberalized and sound financial system has no corresponding illustration. However, it is important to adjust financial regulations such as reserve requirements, capital requirements, portfolio composition (including limits on offshore investments) and interest rate limitations, as well as labor restrictions, so that domestic institutions do not face unfair competition from foreign institutions. If the regulatory framework favors external institutions significantly, then it eventually may lead to bankruptcy of domestic institutions and require costly government support for depositors. Similarly, unless the domestic institutions, are reasonably sound, then allowing foreign institutions Into the domestic market is likely to put excessive pressure on domestic institutions. Either the government must clean up the portfolios of domestic institutions, or the institutions must be allowed to earn high enough profits to recuperate themselves, before liberalization.

The sequencing of capital account and current account liberalization has been analyzed at length. Conventional wisdom seems to be that the current account should be liberalized before the capital account. The argument is that the responsiveness of financial flows to capital account liberalization typically would lead to an unwarranted real appreciation of the real exchange rate and an incorrect allocation of investment between tradeables and non-tradeables. However, this argument neglect the points that a) whenever the capital account liberalization occurs it would tend to cause a real appreciation and b) the amounts of resources available to an economy would be greater if the capital account were liberalized earlier. The positive impact of capital account liberalization on resource availability has led some authors to argue for simultaneous current and capital account liberalization. Other authors have pointed out that the optimum sequencing of liberalization depends on the type and size of distortions prior to liberalization.

The traditional literature on sequencing current and capital account liberalization seems to consider capital account liberalization as occurring all at once, while current account liberalization can - take place at various rates witness the whole argument regarding the appropriate pace of cutting protection. In fact, capital account liberalization also can take place over time - various instruments and institutions can be legalized at different times and the size of operations can be limited to varying degrees, although such limitations are probably less effective than similar trade limitations.