Financial Crises: Revisiting Capital Account Liberalization

Posted by Anis Chowdhury on 31 August 2009

Financial Crises: Revisiting Capital Account Liberalization

Anis Chowdhury and Iyanatul Islam[1]

It is now well recognized that financial liberalization – domestic financial sector deregulation and opening of capital account of the balance of payments – played a large role in the recent and past financial crises. There is now a large volume of literature on the links between financial liberalization and crises, but this note is not about that.[2]

Suffice it to say, however, that countries that have effective prudential regulation for their domestic financial sector and sensible control over short-term capital flows found that their banking and financial sector was largely unaffected by the turmoil in the global financial markets.[3] The banks of these countries were prevented from the lure of “toxic” assets in the US due to restrictions on capital account convertability. Additionally, some of these countries, especially in East and Southeast Asia, are able to handle the current crisis better due to their large foreign currency reserves, the importance of which they have learned from the Asian financial crisis of 1997-98.

However, it is surprising to see how little progress has been made in terms of re-enacting effective prudential regulation and sensible capital control. It seems there is a general sense of scepticism about the role of government. For example, in writing about the lessons from the Asian crisis, Jeffery Frankel noted, “This implies the need for a greater role for governments in the domestic financial system, but governments are not perfect either. Capital controls must be used sparingly…”[4]

The scepticism seems to be deepest when it comes to capital account restrictions, and the faith in the efficacy and virtue of an open capital account continues to dominate. We see, for example, in the wake of the Asian financial crisis, comments like, “In the long run, policies should aim to reduce the vulnerability of the financial sector by encouraging adequate risk-management through financial reform, strengthened supervision, and regulation. It is noted that greater exchange rate flexibility and the maintenance of open capital accounts may also create incentives for managing risks effectively.”[5]

In 2005, the Independent Evaluation Office of the International Monetary Fund (IMF) found that to deal with large capital inflows, the IMF advocated tightening fiscal policy and greater exchange rate flexibility.[6] In a few instances, it recommended further liberalization of capital outflows. The IMF was in principle opposed to the use of temporary controls, either on inflows or outflows. Its view was that they were not very effective, especially in the long run, and could not be a substitute for the required adjustments in macroeconomic and exchange rate policies. However, it became much more accommodating of the use of capital controls over time, albeit as a temporary, second-best instrument.

The World Bank which also promoted capital account liberalization notes in the wake of the current financial crisis, “Capital restrictions might be unavoidable as a last resort to prevent or mitigate the crisis effects. …Capital controls might need to be imposed as a last resort to help mitigate a financial crisis and stabilize macroeconomic developments.”[7]

Thus, capital account control is still seen as either a second best response or last resort once a crisis breaks out. It is not considered as part of governments’ macroeconomic policy armoury to protect their countries from the hazard and risk of financial crises in the first place. This is because there is reluctance among the Bretton Woods institutions and neo-liberal economists in recognizing short-term capital flows as a culprit.

Central banks of the developing countries need to have some controls on capital flows. This will give central banks control over monetary aggregates and hence monetary policy independence to keep real interest rates low, stabilize employment and keep inflation at a moderate level. In short, restrictions on short-term capital flows, popularly known as “hot money”, are needed to remove the pro-cyclical bias of macroeconomic policies.

These restrictions can slow the speed of capital outflows when a country is faced with the possibility of a sudden and destabilizing withdrawal of capital during a time of uncertainty. They can also break the link between domestic and foreign interest rates, so that crisis-hit economies can conceivably pursue expansionary monetary and credit policies as a means of growing their way out of debt or a recession without having to worry about possible capital flight and the weakening of the currency.

There are, of course, many critics of capital controls. However, they must accept that the Mundell-Fleming model conceived of capital flows as largely money-market flows or at most money and bond markets flows. An important development in the world economy in the late 1990s was the shift of international capital flows from the fixed income market – both money and bond flows – to the equity market – both portfolio equity flows and FDI.

A decline in policy interest rates to support small and medium size enterprises and structural change can raise expected corporate earnings. This can lead equity prices to rise and attract foreign investors with extrapolative expectations to buy more equities. Therefore, equity effect of lower interest rates can be larger than the money-bond market effects to overturn standard Mundell-Fleming results.

Thus, capital account openness should not be viewed as an all-or-nothing proposition. The increased importance of equity flows has increased the effective scope of a capital account policy of semi-openness. A capital account can be open to equity flows – both portfolio and FDI, but closed to money and bond flows.

Epstein, Grabel and Jomo (2003)[8] have examined capital management techniques, to refer to two complementary (and often overlapping) types of financial policies: policies that govern international private capital flows and those that enforce prudential management of domestic financial institutions. Based on their study of Chile, Colombia, Taiwan Province of China, India, China, Singapore and Malaysia during the 1990s, they have found that policymakers were able to use capital management techniques to achieve critical macroeconomic objectives. These included the prevention of maturity and locational mismatch; attraction of favoured forms of foreign investment; reduction in overall financial fragility, currency risk, and speculative pressures in the economy; insulation from the contagion effects of financial crises; and enhancement of the autonomy of economic and social policy.

There is, however, no single type of capital management technique that works best for all developing countries. Indeed policy makers can choose from a rather large array of effective techniques depending on the circumstances of their respective countries.


[1] Anis Chowdhury is Professor of Economic, University of Western Sydney, Australia; currently working at UN-DESA, New York. Iyanatul Islam is Professor of International Business, Griffith University, Australia; currently working at ILO, Geneva. The views expressed here are entire of the authors and should not be ascribed to the UN-DESA or to the ILO.

[2] See Carmen Reinhart and Kenneth Rogoff (2008) ‘The Aftermath of Financial Crises’, Also see Barry Eichengreen (2003) Capital Flows and Crises, MIT Press

[3] Notable among these countries are India, China and Chile. Of course these and other developing countries suffered from the crises through various transmission channels such as declines in trade, remittances, foreign direct investment and foreign aid and higher borrowing cost. But their banking and financial sector remained largely unaffected.

[4] Remarks made at the at the May 1999 session of the Korea economic working group sponsored by the Korea Economic Institute of America at the World Bank,

[5] Moreno, Ramon, Gloria Pasadilla and Eli Remolona (1998), “Asian Financial Crisis: Lessons and Policy Responses”, Center for Pacific Basin Monetary and Economic Studies, Federal Reserve Bank of San Francisco, working paper PB98-02.

[6] IMF (2005), Evaluation of the IMF's Approach to Capital Account Liberalization, Independent Evaluation Office, IMF.

[7] World Bank (2009), Global Monitoring Report 2009: A Development Emergency, pp. 47-48)

[8] Epstein, Gerald, Ilene Grabel, Jomo K. S. (2003), “Capital Management Techniques In Developing Countries: An Assessment of Experiences from the 1990's and Lessons For the Future” paper presented at the XVIth Technical Group Meeting (TGM) of the G-24 in Port of Spain, Trinidad and Tobago, February 13-14, 2003.