# **Capital Account Liberalization**

It is widely acknowledged that the sudden withdrawal of capital from Asia played a primary role in the 1997-98 crisis. This followed a huge inflow of capital<sup>into the</sup> region in the years leading up to the crisis, resulting from a relatively<sup>significantdegree</sup> of capital account liberalization in the crisis-affected countries in the early 1990s. (See Table 5.1 earlier in this chapter.) It was widely believed that financial<sup>liberalization in</sup> general, and capital account liberalization in particular, were essential stepping<sup>stoneson</sup> the path to economic growth. It was thus recommended (some say by the Washington Consensus) that developing countries open their capital accounts,<sup>and thesecountries</sup> embraced the idea wholeheartedly. The East Asian crisis (and its aftermath)<sup>has altered</sup> that thinking to a great extent. Wyplosz (2001 b) even declares, "A silver lining of<sup>the</sup> recent crises is that the liberalization activism of the 1990s is _nowpass."_<sup>_248_</sup> Nonetheless, financial liberalization as an ultimate goal is not dead and the way to proceed towards its achievement has engendered considerable debate.

Academic studies over the last decade have found the relationship between<sup>capital</sup> account liberalization and growth to be generally positive, but not strong.<sup>Tenof these</sup> studies conducted between 1994 and 2001 were reviewed by IMF staff<sup>whofound the</sup> conclusions to be about evenly split between a finding of a "positive'<sup>relationshipand</sup> that of "no effect".<sup>249</sup> Those studies with a finding of "positive" were conducted<sup>more</sup> recently (2000-2001). One study was reported as having a "mixed" result.<sup>This study</sup> was conducted by Arteta, Eichengreen and Wyplosz (2001) who found "somewhat more evidence of a correlation between capital account liberalization and growth when<sup>we</sup> allow the effect to vary with other dimensions of openness."<sup>250</sup> The authors go on to explain that sequencing of reforms plays a role in the effect of capital account liberalization (although they found this to be more robust in the 1980s than in the 1970s or 1990s), but macroeconomic imbalances are potentially more harmful than<sup>the lack of</sup> trade openness under capital account liberalization.

The review of these studies (plus the results of the IMF's own study of 38 developing countries for the period 1980 to 1999) found that the channels<sup>throughwhich</sup> capital account liberalization can positively impact growth include the following:<sup>25'</sup>

- For developing countries, all forms of capital inflows can increase investment. In the case of domestic investment specifically, liberalization does have a positive effect in raising that as well.

- Capital account liberalization (particularly FDI) can bring technology spillovers but primarily in countries that have a highly educated workforce, which enables it to exploit such spillovers.

- Capital account liberalization can lead to a deepening of domestic<sup>financial</sup> markets (more so in the case of portfolio flows than FDI); however, it<sup>can</sup> also result in severe financial difficulties if the appropriate institutional framework is not in place.

While most regions of the world have been opening their capital accounts throughout the 1980s and 1990s, there are differences in degree of opening within developing countries across regions. The developing economies of Asia have been trending toward openness since the 1970s - in FDI as well as in portfolio<sup>and barnkflows,</sup> 92