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Risks of Capital Liberalisation in Developing Economies by Siya Biniza.pdf

Risks of Capital Liberalisation in Developing Economies by Siya Biniza.pdf

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Published by Siya Biniza
This is an analysis of the risks associated with capital liberalisation in developing economies. The approach is focused understanding the unique challenges and outcomes of capital liberalisation in developing economies. Therefore, the paper is a an analysis of the risks associated with capital liberalisation in developing economies. Thus the paper concludes that capital liberalisation creates currency and capital volatility risks that can lead to financial crisis which often results in sovereignty risk. These risks are illustrated using Mexican and South Korean financial crises as case studies.
This is an analysis of the risks associated with capital liberalisation in developing economies. The approach is focused understanding the unique challenges and outcomes of capital liberalisation in developing economies. Therefore, the paper is a an analysis of the risks associated with capital liberalisation in developing economies. Thus the paper concludes that capital liberalisation creates currency and capital volatility risks that can lead to financial crisis which often results in sovereignty risk. These risks are illustrated using Mexican and South Korean financial crises as case studies.

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Published by: Siya Biniza on Jun 23, 2013
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09/16/2013

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Risks Associated with Capital Liberalisation in Developing Economies
Written by Siyaduma Biniza
 Sustainable capital inflows are often asserted as conducive to economic growth anddevelopment. This argument has been more strongly asserted in the case of developing countries due to low levels of domestic capital and investment. Hence,many developing countries liberalise cross-border capital flows as a developmentstrategy to attract foreign capital. However capital liberalisation creates currency andcapital volatility risks that can lead to financial crisis which often results in sovereigntyrisk. Therefore this paper explains the risks that capital liberalisation aggravates indeveloping countries; and illustrates these risks using the Mexican and South Koreanfinancial crises as case studies.Capital liberalisation refers to reduction in administrative and legislative controls oninternational capital flows. This is often asserted as promoting investment which leadsto economic growth and development because capital liberalisation reduces the costof capital, encourages portfolio diversification and risk-hedging and reduces marketdistortions (Glick, Guo & Hutchinson, 2006). However, the relationship between foreigninvestment and economic growth and development is highly contentious. Moreoverthe universalistic assertion of the positive impact of capital liberalisation is even morecontentious given the recent history of outcomes of capital liberalisation. The Mexicanand Asian financial crises are evidence that suggests that capital liberalisation createsunique currency crisis and capital volatility risks in developing economies (Glick et al.,2006). There is a wealth of literature that tries to understand the relation between capitalliberalisation and financial crisis. The Asian and Latin American financial crises whichfollowed a period of neoliberal policies such as capital liberalisation in the countries of 
 
these regions are what seem to have sparked this debate (Palma, 2000; Grabel, 2003).But there are some conflicting explanations for the root causes and implications of these crises. Moreover, there is ample literature on the different impacts of capitalliberalisation according to the degree of financial development, institutional make-upand level of development. The research suggests that capital liberalisation leads tofinancialisation; which benefits developed economies with high levels of financialdevelopment (Glick et al., 2006; Eichengreen et al., 2009). Therefore, developingeconomies face unique outcomes from capital liberalisation. Developing economiesface unique outcomes due to the risks that capital liberalisation exposes them to. Thisis because of the specific financial, economic and political institutional compositionand level of development in these countries. For example, developing economies facethe unique risk of having their currency depreciated because of capital outflows.Currency risk is especially the case in developing economies because the countriesinadequate foreign reserves and self-fulfilling prophecy due to the volatility of capital(Grabel, 2003). The risk of capital liberalisation in developing countries is that they haveless control over the value of their currency. Therefore a self-fulfilling prophecy caneasily occur if investors expect the currency to depreciate which leads to widespreadcapital outflow; ultimately resulting in currency depreciation due to low demand forthat currency (Blecker, 1999). This is because, in the case of a sudden spate of capitaloutflows, developing countries do not have adequate foreign reserves to maintain acertain exchange rate. Currency risk is closely related to more fundamental risks relatedto the volatility of capital which can only occur in economies with liberalised capitalmarkets.Liberalisation of capital is a necessary condition for the risks associated with volatility of capital. But capital liberalisation is not a sufficient condition for these risks.
 
Liberalisation increases vulnerability of developing countries to capital flight, fragilityand contagion risks (Grabel, 2003). Flight risk is the vulnerability that investors willextract their capital from the economy en masse. Flight risk increases the chances of aself-fulfilling prophecy and increases currency risk. Fragility risk is the vulnerability thatborrowing will be affected by geographic mismatch, maturity mismatch and volatilecapital. Geographic mismatch is caused by financing investment through foreign debtwhich means borrowers accrue debt that is vulnerable to volatilities in exchange rateand currency risk (Grabel, 2003). Maturity mismatch is the financing of long-terminvestments with short-term debt which may result in defaulting and vulnerabilitiesrelated to currency risk (Grabel, 2003). Investors can also finance their projects withvolatile capital that is subject to capital flight. Lastly, contagion risk is the vulnerabilitythat foreign financial or economic crises may spill-over into the domestic economy. Allthese risks are a direct consequence of capital liberalisation which is a necessary, butnot a sufficient, cause of such risks in developing economies. Moreover the risksassociated with volatile capital are closely connected with currency risk.For example capital flight may result from currency speculation and herding behaviour. This happens sufficient number of create speculative bubbles by speculating incurrency markets and setting off a self-fulfilling prophecy through herding behaviourof other speculators who follow oth
ers’ actions as described above. In other words,
when people share a certain belief about the direction of a specific exchange ratewhich leads them to speculate in currency markets in order to make a quick earning,the change in demand for the currency they are speculating on directly affects theexchange rate for that currency either leading to an appreciation or depreciation; this isexactly what currency risk is. This is an actual reality in liberalised markets that allow foreasy transfer of capital without controls. Therefore the collective action of speculators

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