23 liberalization, whether the capital or current account should be opened first. Interest in this question was particularly aroused by the different paths of liberalization in the Southern Cone of South America in the latter half of the 1970s. Chile is generally characterized as liberalizing the current account first, Uruguay and Argentina the capital account first and, in an influential paper, McKinnon (1982) argues that much of Chile's success, relative to Argentina, is due to the different sequencing of their reforms (and to Chile's fiscal surplus as opposed to Argentina's stubborn fiscal deficit). It should be noted, that there is a substantial debate in Chile on the timing of the capital account liberalization and Its role in the crisis of the early 1980s. Of covrse, a number of other favtors were at work and, eventually, all three countries' attempts at liberslLation suffered reverses in the debt crisis (See for example, the works contained in the Corbo-De Melo YVrld Develo e Issue, Carbo, De Melo, and Tybout, Edwards and Cox-Edwards, Hanson (1986), and Harberger (1982)).

The initial view on sequencing (McKinnon (1973)) was that capital account restrictions should be relaxed only after trade reform, and policy makers should 'deliberately avoid an uinusual<sup>or</sup> extraordinary injection of foreign capital" (McKinnon (1973) p. 161.) The rationale for this view is as follows: Current account liberalization typically requires a real depreciation of the exchange rate, to offset the negative effect on the balance of payments of cuts in the average level of protection. In contrast, capital account liberalization tends to produce a real appreciation of the exchange rate. If capital account liberalization were to produce a stable net transfer (capital inflow, less interest payments),' then opening both accounts simultaneously might yield something like the final real exchange rate and resources could then be rallocated in accordance with that objective. However, capital infiow. tnust be paid for, so the initial net transfer following the opening of the capital account is likely to be larger than the final net transfer (See Annex). Moreover, the responsiveness of capital to the pent-up demand for local assets is likely to be much faster than the responsiveness of trade flows to the opening of the current account, leading to an unsustainable appreciation of the real exciiange rate (Frenkel 1982). Hence, opening the capital account before the current account produces incentives for resource allocation that will have to be reversed in the final equilibrium (Krueger (1986)), and could retard the adjustment to the reduction in protection.31 To avoid "unnecessary" resource shifts, a number of authors (for example, Edwards (1984), Frenkel (1982), Khan and Zahler, McKinnon (1973, 1982)) have concluded that it is preferable to open the current account before the capital account.

Theru are, however, some difficulties with this argument. First, the volume of capital resources over time is not nec':sarily the same under the two different sequences of liberalization. Whenever the capital account liberalization occurs, it tends to cause an appreciation; the point is that once protection is reduced in a capital-scarce country, the rate of return is reduced, as discussed in section<sup>A,</sup> decreasing the incentive for capital inflows. Thus, there are less "unnecessary" resource shifts in the current account-capital account sequence in part because there is a smaller stock of capital - the costs this loWer capital stock have to be evaluated relative to the benefits of lower costs of adjustment.

This type of argument has led some authors (Little Skitovsky, and Scott, Michaely, Krueger (1981, 1984)) to argue for simultaneous liberalization of the current and capital accounts. In their view, short run adjustment costs and the opposition to reforms that they generate are an important

# 20 lhs c **is analyzed** in Edwards (1986)

**1Ibis argummen,** of course, reemrbles **the discuuion** of **the** impact of **direct** foreign investment on **the highly ptcted lAtin Amerin eomies duing the** 1960s (for **eample,** Diaz Alejndwro). A number of theortical **studies ugget that** in **the** presence of disortions, **direct forig inve_met can** rdue **welfare.**