Risks Associated with Capital Liberalisation in Developing Economies Written by Siyaduma Biniza Sustainable capital inflows are often

asserted as conducive to economic growth and development. 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 development strategy to attract foreign capital. However capital liberalisation creates currency and capital volatility risks that can lead to financial crisis which often results in sovereignty risk. Therefore this paper explains the risks that capital liberalisation aggravates in developing countries; and illustrates these risks using the Mexican and South Korean financial crises as case studies. Capital liberalisation refers to reduction in administrative and legislative controls on international capital flows. This is often asserted as promoting investment which leads to economic growth and development because capital liberalisation reduces the cost of capital, encourages portfolio diversification and risk-hedging and reduces market distortions (Glick, Guo & Hutchinson, 2006). However, the relationship between foreign investment and economic growth and development is highly contentious. Moreover the universalistic assertion of the positive impact of capital liberalisation is even more contentious given the recent history of outcomes of capital liberalisation. The Mexican and Asian financial crises are evidence that suggests that capital liberalisation creates unique 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 capital liberalisation and financial crisis. The Asian and Latin American financial crises which followed 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 capital liberalisation according to the degree of financial development, institutional make-up and level of development. The research suggests that capital liberalisation leads to financialisation; which benefits developed economies with high levels of financial development (Glick et al., 2006; Eichengreen et al., 2009). Therefore, developing economies face unique outcomes from capital liberalisation. Developing economies face unique outcomes due to the risks that capital liberalisation exposes them to. This is because of the specific financial, economic and political institutional composition and level of development in these countries. For example, developing economies face the unique risk of having their currency depreciated because of capital outflows. Currency risk is especially the case in developing economies because the countries inadequate 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 have less control over the value of their currency. Therefore a self-fulfilling prophecy can easily occur if investors expect the currency to depreciate which leads to widespread capital outflow; ultimately resulting in currency depreciation due to low demand for that currency (Blecker, 1999). This is because, in the case of a sudden spate of capital outflows, developing countries do not have adequate foreign reserves to maintain a certain exchange rate. Currency risk is closely related to more fundamental risks related to the volatility of capital which can only occur in economies with liberalised capital markets. 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, fragility and contagion risks (Grabel, 2003). Flight risk is the vulnerability that investors will extract their capital from the economy en masse. Flight risk increases the chances of a self-fulfilling prophecy and increases currency risk. Fragility risk is the vulnerability that borrowing will be affected by geographic mismatch, maturity mismatch and volatile capital. Geographic mismatch is caused by financing investment through foreign debt which means borrowers accrue debt that is vulnerable to volatilities in exchange rate and currency risk (Grabel, 2003). Maturity mismatch is the financing of long-term investments with short-term debt which may result in defaulting and vulnerabilities related to currency risk (Grabel, 2003). Investors can also finance their projects with volatile capital that is subject to capital flight. Lastly, contagion risk is the vulnerability that foreign financial or economic crises may spill-over into the domestic economy. All these risks are a direct consequence of capital liberalisation which is a necessary, but not a sufficient, cause of such risks in developing economies. Moreover the risks associated 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 in currency markets and setting off a self-fulfilling prophecy through herding behaviour of other speculators who follow others actions as described above. In other words, when people share a certain belief about the direction of a specific exchange rate which 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 the exchange rate for that currency either leading to an appreciation or depreciation; this is exactly what currency risk is. This is an actual reality in liberalised markets that allow for easy transfer of capital without controls. Therefore the collective action of speculators

leads to a self-fulfilling prophecy through the demand effect on exchange rates in currency markets which causes exchange rate fluctuations. Thus, faced with sufficient changes in currency demand authorities are forced to revalue currencies which may occur earlier than would have been the case without capital flight; even if the economy was on a trajectory that would have led to a revaluation (Blecker, 1999). The significance of self-fulfilling prophecies stems from the importance of information in financial markets due to uncertainty and asymmetry of information (Rodrik, 1998). Therefore, given the precarious nature of financial markets and asymmetry of information, developing economies are always at a risk of capital flight due to capital liberalisation. This is caused by the herding behaviour, lack of credible information in developing economies and inability of investors to differentiate between developing economies (Grabel, 2003). In other words the lack of information in developing economies means that investors have to rely on the actions of other investors who are privy to the similar information and unable to differentiate between developing economies. This increases the risk of capital flight because of herding behaviour and lack of information since capital liberalisation makes it easier for investors to move their capital across national borders. Fragility risk is also affected by this capital flight risk. Firstly, investors might finance investment with capital that is subject to flight risk. Secondly, maturity and geographic mismatch is a consequence capital liberalisation. Maturity mismatch is a consequence of something similar to Minksys argument in the financial instability hypothesis (Grabel, 2003). Private borrowing is done to invest based on expectations about future profits; whereas banks lend to the firms based on expectations about future profitability of their lending. However, these expectations are made under uncertainty which means that there are risk for both banks and firms (Dodd, 2007). Thus, due to uncertainty and the fact that there are risks for lenders and

borrowers, expectations about future profitability affect both the demand and supply for finance which affects actual investment in the economy (Dodd, 2007; Minsky, 1993). The availability of foreign capital may influence the borrowing behaviour in developing economies resulting in fragility risk through these mechanisms. As optimistic expectations about future profits lead to increased investment, which increases income and expectations about future profits, that leads to self-reinforcing spiral of more investment and speculation causing high vulnerability in the economic system (Dodd, 2007; Minsky, 1993). This is because firms become more speculative as expectations about future profits rise with the increasing investment leading to investments made from borrowed capital whose returns are not immediately realised (Minsky, 1993). This results in a sharp rise in leveraged borrowing and lending. Hence, crisis ensues when the speculative behaviour becomes unsustainable and confidence about future profitability is lost leading to reduced lending and borrowing; which affects investment leading to unemployment and an economic bust (Dodd, 2007; Minsky, 1993; Wray, 2009). Similarly, when foreign investors expectations about future profits are high they might invest in a developing economy which increases capital in the economy and allows for more borrowing. Further, the willingness to lend excessively leads to excessive borrowing (Palma, 2000). This leads to fragility as described above. Then, when this situation has become unsustainable or when investors expectations have changed the result may be capital flight which leads to currency crisis and possible a financial crisis. Therefore fragility makes developing economies vulnerable to volatile capital supply of credit and exchange rate fluctuations as a result of capital liberalisation. When this results in financial crisis the impact affects both investors and borrowers which means

that the consequence can spill-over across national borders. This is the risk of contagion which is the extent of currency, flight and fragility risk (Grabel, 2003). These risks were experienced in Mexico during the 1990s. Mexico ran a current account deficit, due to exchange rate pegging in order to reduce inflation, which was financed through a capital account surplus (Stallings, 2003). However, after political upheaval negatively impacted investor confidence leading to less capital inflows and a reduction in the capital account surplus, reserves ran very low and a self-fulfilling prophecy led to capital flight forced the pegging of the currency to breakdown (Sachs, Tornell & Velasco, 1996; Calvo & Mendoza, 1996). The pegged currency became vulnerable to an imbalance between capital and reserves which led to devaluation of the peso and financial crisis after panic led to a run on the capital stock (Calvo & Mendoza, 1996). This scenario is directly linked with the large inflows of foreign capital that followed the era of capital liberalisation in Mexico. The large surges of foreign capital led to easy access to credit, which resulted in increased expectations about the economys prospects and fragility, because of the increased availability of foreign exchange (Palma, 2000). Thus, the situation was very characteristic of the capital volatility and currency risks associated with capital liberalisation. Therefore, as evidenced by Mexico, developing countries are at a capital volatility and currency risks due to capital liberalisation. South Korea is another case of a financial crisis which stemmed from a contagion risk. In the 1990s South Korea liberalised its financial market extensively and in shorter time than all previous liberalisation policies (Chang, Park & Yoo, 1998). Chang et al. (1998) argue that it was this reform and deregulation of the financial markets that made coordinating long-term investment a challenge due to fragility. This capital liberalisation and market reform followed the golden era of state-led development in South Korea. South Korea was seen as one of the shining stars of development which attracted

foreign investors leading to a currency overheat and fragility due to herding behaviour (Stallings, 2003). Thus, a large surge of capital inflows lead to fragility and loss of confidence in the economy resulting in capital flight (Stallings, 2003; Saqib, 2001). However, aside from the fragility and currency overheat, South Korea was also victim to the contagion of the Thailand crisis which spread quickly into Korea, Phillipines and Indonesia (Stallings, 2003). The impact of the Thailand crisis which was a longlasting and widespread crisis was able to spread into South Korea and other Asian countries (Saqib, 2001). The contagion also led investors to believe that the golden years of growth in South Korea were going to end soon. This led to a self-fulfilling prophecy. Thus, the Thai crisis made South Korea vulnerable to contagion risk due to capital liberalisation. In both Mexico and South Korea the International Monetary Fund (IMF) had to step in and rescue the economies. The result was that both countries had to embarked on IMF economic programming which limits government spending, focuses on inflationtargeting and currency devaluation (Stallings, 2003). Thus, the consequence of the crises, which can be attributed to risks that were caused by capital liberalisation, was a loss in sovereignty. Therefore, capital liberalisation made these countries vulnerable to sovereignty risk because of the possibility of financial crisis which was a reality that necessitated IMF assistance in both cases. Due to capital liberalisation consequence of the volatile capital and currency risks was financial crisis a loss of sovereignty.

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