Capital Account Liberalization and Financial Sector Stability

International Monetary Fund

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2002
• eBook ISBN: 9781589060852

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Part I A Framework for Sequencing

I Overview

A fundamental issue in undertaking capital account liberalization is how to reap the benefits from capital market access while coping safely with the risks associated with international capital flows. Increased attention has been focused recently on the growing frequency of financial crises and the possible role that capital account liberalization might play in contributing to such phenomena. A variety of factors and forces can lead to the emergence of a financial crisis in a specific country. In a world of growing financial globalization and more open capital accounts, events in other countries may have an impact on a country’s financial stability. Nevertheless, country experiences indicate that the ability to avoid financial crisis in the context of more open capital accounts often depends upon the ability of financial and nonfinancial institutions as well as the government to manage financial risks in general. At the same time, legal, institutional, and prudential arrangements must be adequate to deal with complex risks associated with increasingly diverse types of capital flows.

In general, the range of factors bearing on financial stability and its linkages with capital flows is very broad. However, as discussed in Chapter II, three basic sources of financial sector instability may be distinguished: disturbances arising from the linkages between the financial sector and the macro-economy; structural weaknesses in the financial sector; and certain types of government involvement in the financial sector. These three sources of instability can interact in a variety of ways to increase risk. Thus, financial sector stability requires both macroeconomic stability and structural policies and conditions consistent with a sound and efficient domestic financial sector. These structural policies, which are discussed in Chapter V, involve the development of financial markets and institutions; prudential regulation and supervision; risk management and good practices in accounting, auditing, and disclosure; and financial safety nets. Closely associated policies that are not discussed in this paper include policies dealing with insolvency, corporate governance, creditor rights, systemic restructuring of financial and nonfinancial institutions, public debt and foreign exchange reserve management, transparency of public policies, and improved statistics.

Country experiences presented in Part III point to some general principles that are helpful in sequencing and coordinating capital account liberalization with other policies, particularly structural policies to strengthen domestic financial systems. These principles, which are elaborated in Chapter III, emphasize the importance of macroeconomic stability and the choice of an appropriate exchange rate regime while giving priority to financial sector reforms that support macroeconomic stability. They also underscore the need to: coordinate capital account liberalization with different Financial sector policies, taking into account the initial condition of financial and nonfinancial entities and their capacity to manage the risks associated with international capital flows; assess the effectiveness of existing capital controls; identify and implement urgent measures in connection with reforms that require a long lead time; and ensure the sustainability of the reforms and the transparency of the liberalization process. The principles point to the desirability, in most cases, of liberalizing long-term flows—especially foreign direct investment (FDD flows—ahead of short-term flows. At a minimum, any partial early liberalization of short-term flows needs to be accompanied by adequate prudential measures.

Even so, there is no simple method for devising an operational plan for sequencing and coordinating capital account liberalization with other policies. This reflects the reality that capital account liberalization and financial sector development are often mutually reinforcing; therefore, removing controls on one type of flows affects other types of transactions, and hence the financial sector and the economy as a whole. In particular, the effectiveness of any remaining capital controls could be eroded by a partial liberalization. Steps toward capital account liberalization and other policies thus cannot be analyzed in isolation, as the interactions between them are complex and subject to considerable uncertainty. Thus, sequencing will only become tractable once the specifics of a particular case are analyzed.

The design of an operational plan for sequencing will therefore need to be based on a careful assessment of individual countries’ circumstances and will require judgment, discretion, and flexibility. When macroeconomic and financial sector conditions are sufficiently good, capital controls could be removed quickly without undue risk. In many cases, however, a gradual approach to capital account liberalization may be required; but a gradual approach would not by itself guarantee an orderly liberalization. Moreover, countries would need to be prepared to change their sequencing plans in the face of changing macroeconomic conditions or emerging signs of vulnerabilities, and in some cases it could be appropriate to adopt a contingency plan that may delay further capital account liberalization until conditions become more favorable. Therefore, care must also be taken in applying approaches that were successful in one country to other countries.

Based on the general principles, a methodology for sequencing capital account liberalization is presented in this paper. This methodology, which is illustrated by an example, involves an assessment of capital controls and macroeconomic and financial sector vulnerabilities, and the design of a plan for sequencing capital account liberalization with financial sector reforms and other policies. The methodology is intended to support a better integration of the domestic and international dimensions of financial sector development and stability in the IMF’s policy advice, surveillance activities, and technical assistance involving countries wishing to undertake an orderly liberalization of their capital accounts.

II Analytical Issues

For the purposes of this paper, a “stable financial system” is characterized as one in which there is a high degree of confidence that financial institutions can continue to perform their contractual obligations, intermediation, and wealth management services without interruptions and outside assistance. In a stable financial system, participants can confidently transact in the key markets at prices that reflect fundamental forces and that do not vary substantially over short periods when there have been no changes in fundamentals. Stable systems for payments and settlements, and adequate liquidity in key markets, are an integral part of a stable financial system.¹

What constitutes “key institutions” and “key markets” is important in defining financial system stability. Generally, banks are viewed as the key institutions because instability in the banking system has a greater capacity to generate systemic contagion than difficulties elsewhere in the financial sector (via greater susceptibility to runs and the operation of the payments system). Problems at key nonbank institutions also have the potential for significant spillover effects. Key markets include money and foreign exchange markets, government securities and corporate bond markets, equity markets, and derivatives markets.

No financial system will be entirely stable in the sense of being free of risk. All financial institutions are exposed to fluctuations in the market values of financial instruments (market risk) and to the possibility of default (credit risk). The risks of individual investments can be reduced through portfolio diversification and related risk management techniques; but there will always remain some irreducible or systemic risk, reflecting the vagaries of the business cycle and the prospects for long-run economic growth, among other factors. Attempting to eliminate systemic risk is neither feasible nor would it be economically efficient.²

Institutional arrangements, including government regulation, will have a profound effect on the type and degree of financial risk-taking in an economy, and hence on the level of systemic risk. In particular, institutional arrangements need to address potential sources of market failure. These failures may lead investors to take either too much risk or too little, relative to what would be efficient.

Sources of Financial Sector Instability

Three basic sources of financial sector instability may be distinguished.³ First, linkages between the financial sector and the macroeconomy lead to the endogenous generation of disturbances in both. Business cycle theory holds that overoptimism or “irrational exuberance” during a boom leads to over-lending and excessive use of leverage, through, among other ways, the use of margin trading and derivatives, further fueling unsustainable price and output developments. Eventually the boom comes to an end, and the financial system finds itself in a crisis that is to a considerable extent of its own making. Herding behavior, both during the upswing and the subsequent downturn, plays a central role in this type of financial system instability. Market liquidity can dry up during a rapid downturn, further contributing to the decline in asset prices and economic activity. These macroeconomic-financial crises are often not confined to the domestic economy, but manifest themselves also in balance of payments and exchange rate disturbances; and may be affected by the degree of capital account liberalization that a country has undertaken.

Second, structural weaknesses have played a central role in many cases of financial system instability or failure. These weaknesses have proven to be particularly hazardous whenever a country has recently undergone a change in policy regime, such as financial deregulation or capital account liberalization.

Structural weakness can take many forms that may include:

• shortcomings in money, foreign exchange, and securities markets, and in monetary policy instruments that can impede price discovery and appropriate risk management;
• weaknesses in public debt and foreign exchange reserves management;
• deficiencies in the legal system, including in the enforcement of property rights and contracts, in insolvency procedures, in prudential regulation, and in rules governing accounting, disclosure, and transparency that can encourage excessively risky behavior, impede the resolution of existing problems, and prevent the development of a sound credit culture;
• lack of the necessary skills or prudence, and fraudulent activity, by bank managers and owners;
• weaknesses in public administration or governance, including in statistical agencies that do not provide adequate data, or in supervisory agencies that are subject to political pressures;
• inappropriate deposit insurance and lender-of-last-resort policies that can contribute to overly risky behavior by banks and other financial institutions.⁴

Third, certain types of government involvement in the financial sector have not been conducive to the sector’s efficient operation or longer-run stability. Lending policies of government-dominated banks are often not set on purely commercial grounds. Credit may be directed toward risky operations, or lending rates may be kept artificially low. These policies entail an implicit subsidy (or quasi-fiscal) element that will eventually affect banks’ earnings and capitalization. Similarly, regulations on deposit interest rates often set these rates at a low level and thus impose an implicit tax on depositors. Controls on capital outflows have routinely been used in such cases to discourage depositors from seeking higher returns abroad. The problems caused by these policies can remain hidden in banks’ accounting, in some instances for a very long time. If public finances are weak and extensive use is already being made of central bank financing, which may fuel inflationary pressures, the credibility of deposit guarantees may eventually come into question and the banking system may suffer large-scale withdrawals, leading to disintermediation and other complications that may severely disrupt real activity. In countries with state-dominated banking systems, market-oriented instruments of monetary policy also tend to be less well developed, a situation that may hamper the development of deep and liquid financial markets.

These three sources of financial system instability can interact in a variety of ways, usually reinforcing each other to increase the risk of financial sector problems. For example, weaknesses in prudential regulation and supervision may exacerbate the macroeconomic boom-bust cycle, and inappropriate government involvement in the financial system may be associated with a lack of effective prudential regulation and supervision.

Linkages of Financial Sector Instability with Capital Account Liberalization

One focus of the policy debate surrounding financial sector stability is the role that capital mobility and international financial integration may play in the stability of financial sectors. Many of the factors cited as contributing to financial sector instability have become the subject of efforts to improve the architecture of the international financial system. Comprehensive and detailed assessments of financial sector stability are a central element of these endeavors, and seek to identify aspects of individual countries’ financial systems that are conducive or detrimental to their stability, with a view to avoiding financial crises, especially those that could spill over national borders and have a systemic impact on the global economy. Capital account liberalization can have both positive and negative effects on the stability of the financial system.⁵

Benefits of Capital Account Liberalization

Capital account liberalization can improve economic growth and support an efficient allocation of resources; and can have favorable ...

Table of contents

• Cover Page
• Copyright Page
• Content Page
• Preface
• Part I. A Framework for Sequencing
• Part II. The Prudential Framework and Capital Account Liberalization
• Part III. Selected Country Experiences with Capital Account Liberalization and Financial Sector Stability
• References
• Boxes
• Footnotes