28 over the nominal exchange rate and allowing it to float freely. However, a free float clearly entails an increase in the variability of the exchange rate and correspondingly greater risks for exporters and importers than a fixed rate system. Countries occasionally have tried to obtain monetary independence and maintain control over the exchange rate for trade by applying a free float to capital account transactions - In effect trying to create another policy instrument. However, the difference between exchange rates in the two markets, and thus the degree of monetary independence, clearly is limited by arbitrage possibilities.

Most of the evidence on the impact of opening the capital account relates to industrialized countries. There has been no analysis of the benefits of risk diversification or even the size of such diversification, except to point out that the volume of gross capital flows has grown far faster than the rest of the balance of payments. Empirical analyses concentrates on two issues: the degree to which foreign capital inflows finance domestic investment and the degree to which uncovered interest rate parity typically is achieved. In general, the results for industrial countries suggest: i) Foreign capital flows (net) finance on average, only 10-15% of investment in indusialized countries. Various authors have argued that this result reflects similarities in savings and investment functions in these countries, similarities in the business cycle across developed countries, policy related shifts within domestic saving/investmen **t** hat do not affect external finance, country size/risk premium effects as well as imperfect capital mobility.

II) Uncovered interest rate parity typically is not achieved even between industrial countries. It is not clear if this is reflects a market failure, econometric difficulties with the model (the estimates typically are a joint test of the hypothesized pattern of expectations and market equilibrium), or variations in the risk premium.

Regarding studies on the developing countries, there are no specific studies of the financing of investment. Some of the studies of foreign capilal inflows in industrial countries include developing countries; this Inclusion (and studies including more smaller industrial economies) suggest that foreign saving represents a larger fraction of investment than in the larger industrial countries. (However, the developing country results may reflect large aid flows to countries with low incomes and/or statistical difficulties, rather than larger private flows.) Data on the gross stak of external debt suggest a high ratio of external debt to domestic capital stock in many developing countries, which is also indicative of large flows.

Regarding Interest rates, many of the studies in developing countries also analyze the extent of uncovered interest parity, usually allowing for a constant risk premium. A number of these studies are of Latin American countries during periods when they followed a policy of using the exchange rate (and in some cases the interest rate) to slow inflation. This suggests the possibility of a "peso" problem In the estimates - that expectations of devaluation may well have been high and even increasing over time but standard, distributed lag approaches to estimating expectations suggest a long period in which uncovered interest parity, even allowing for a constant risk premium, does not hold. In recent periods the 'risk premium" in these countries may have risen because of their external debt overhang-this reflects t only risks of higher taxes (including inflation) to service debt, but also the alternative of investing in external debt, an option that is increasingly feasible given the growing breadth and sophistication of that market. Recent studies of a more diversified sample of countries with more stable macoeconomic environments, suggest that the domestic interest rates tend to follow ;nternational interest rates to a fair degree, after appropriate allowance for a risk premium. These analyses suggest that capital