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inflows have distorted the benefits of free trade as a result of the loss of competitiveness for the emerging markets. Whilst sterilisation or fiscal contractions can combat the appreciation, they are costly methods and hence politically unpalatable.

Sixth, capital controls can be used in a developing country as a source of revenue for the government when tax collection is difficult, or to allocate credit without risking capital flight (Johnston and Tamirisa, 1998.) Additionally the tax may be welfare improving in accordance of the Theory of the Second Best if they are used to correct an existing distortion, market failure or negative externality. Seventh, liberalising the capital market offers access for domestic investors to risky foreign investments and holdings which when unhedged can cause widespread insolvency in the event of large currency movements.

Eighth and perhaps the most important is that the inherent volatility of capital flows – particularly if not supported by credible regulation and sound macroeconomic policies – can lead to sudden reversals which cause developmentally and financially costly crises. Reinhart et al. (2003) point to the phenomenon of the “sudden stop” (Calvo, 1998) and reversals of capital experienced by developing countries, where they are suddenly unable to borrow and consequently unable to service their debt. Even countries with excellent track records such as Korea and Malaysia were victims of this, thus emerging markets are said to have a low debt tolerance. This experience is contrasted with that of a developed country, whose high debt tolerance enables it to use counter-cyclical policy in response to a negative shock, whilst a developing country has to tighten, intensifying the shock. Finally, the costs of crises are huge; Eichengreen (2004) estimated that crises countries suffered a 25% loss of income over the last twenty five years as a result of the crises, with an average annual cost of all the crises being $100 billion.

In mid summary it is worthy to note that the benefits of liberalisation are too large to ignore; indeed the inevitable momentum of developing countries liberalisation illustrates this. However, the costs being both numerous and potentially devastating are enough to justify public policy efforts, and perhaps multilateral efforts, to encourage more stable flows and discourage highly reversible volatile flows or to slow down the liberalisation process.

Whilst full capital liberalisation is seen as the most efficient outcome for a developed country by a majority of economists, the path for an emerging market is less clear cut. The rapid elimination of all capital controls was treated as an essential element for emerging markets in the 1990’s, prompting discussion in April 1997 to make it a concrete long term policy target in the IMF articles of agreement. The subsequent Asian crisis beginning in mid-1997 was both devastating and prolonged, despite the region’s previous stability, sound macroeconomic fundamentals and unprecedented size of international rescue packages (upward of $100 billion). For this new breed of crises the interplay of fast capital account liberalisation and a vulnerable financial sector were largely to blame. The result was to force a major rethink on capital market liberalisation and has brought support for reducing capital account liberalisation in emerging markets, although so far without international consensus.

Whilst other candidates have been proposed as a causal factor for crises to shift the blame from capital account liberalisation – including the macroeconomic fundamentals, exchange rate regime, degree of prudent supervision, and crony capitalism – capital account liberalisation stands tall as the most common denominator. Williamson et al (2003) utilised a simple correlation between the Asian crisis countries and each explanatory candidate previously mentioned to demonstrate that “…there is an almost-perfect fit, with countries that had liberalised (scored LL or L) being exactly the ones that succumbed to the crises.” There was one exception, Singapore, which was highly liberalised but interestingly had utilised an anti-speculative capital control. The same correlation can be shown for the Latin American countries that suffered speculative attacks in the 1980’s. Even Soros (1999) himself likened the role of increasing capital mobility to a “wrecking ball” in its ability to cause financial crises. It is simplistic and anachronistic to suppose that sound economic fundamentals provide a solid defence against crises. Whilst unsound fundamentals were largely to blame for the older crises in the 1980’s, the new round of crises in the 1990’s, notably the Asian crisis, occurred despite largely sound policies. Indeed it was the sound fundamental policies which enabled these emerging markets to take on so much short term currency mismatching foreign debt.

The most common argument against capital controls remains the benefit for a country to borrow on the international market to achieve higher growth. However, controls (or restricted liberalisation), if well implemented, will not necessarily undermine a country’s ability to borrow. An emerging market country must consider whether there are sufficient additional benefits to perfect capital mobility to a stylised partial liberalisation, given the devastating negative effects of crises. Empirical findings are mixed: Quinn (1997) and Rodrik (1998) disagree on the presence of a relationship between liberalisation and growth; whilst qualitative studies emphasise that the lion’s share of benefits are to be reaped from FDI and long term capital. Consequently the improved stability from imposing controls on volatile short term capital may outweigh the minor benefits. Rogoff (2002) succinctly explains that when restricting capital flows the “real debate is about debt instruments”, highlighting that debt does not possess the risk sharing properties of FDI and equity flows and thus the most vulnerable to major reversals and subsequently crises. Consequently if controls are utilised they need only to be strategic and limited, focusing on changing the structure of debt.

In conclusion, the experience of the Asian Crisis has shown that while sound macroeconomic fundamentals are a pre-condition to avoid the crises of old, they were not sufficient to avoid the new kind. The tendency to blame the weaknesses of the financial sectors is plausible, but ultimately financial systems need time to mature and thus rapid liberalisation was the wrong answer given the circumstances. A brief foray into possible capital restrictions has shown that as a temporary measure restrictions can be put in place that sharply reduce the probability of a crisis at little cost to the benefits of capital flows. However, rather alarmingly, the inertial trend towards liberalisation continues at a rapid pace whilst many of the original vulnerabilities remain. It is unfortunate to postulate that the future promises many more financial crises, both old and new.

References

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Calvo, Guillermo A., 1998, “Capital Flows and Capital Market Crises: The Simple Economics of Sudden Stops,” Journal of Applied Economics, CEMA, Argentina, Vol. 1, No. 1, November 1998, pp. 35-54.

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