If financial openness is more costly for developing countries, why have so many undertaken liberalisation in recent years?

Financial liberalisation in the developing world

Total value of stocks traded (% GDP)
225

200

175

150

125 East Asia & Pacific (developing only) Europe & Central Asia (developing only) 75 Latin America & Caribbean (developing only) Middle East & North Africa (developing only) OECD members 25

100

50

0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Financial liberalisation in the developing world

Interest rate spreads (lending rate minus deposit rate)
30

25

20

East Asia & Pacific (developing only) Europe & Central Asia (developing only)

15

Latin America & Caribbean (developing only)

Middle East & North Africa (developing only)

10 South Asia

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Financial liberalisation in the developing world

Net inflows of portfolio equity (in current US$)
Billions 60

50

40 East Asia & Pacific (developing only) 30 Europe & Central Asia (developing only) Latin America & Caribbean (developing only) Middle East & North Africa (developing only) South Asia

20

10

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-10

-20

Good news, bad news?

Financial liberalisation is more costly for developing countries

Domestic financial liberalisation

Capital account liberalisation

Greater fluctuation in output gap in developing country compared to developed country note that variation is much larger in developing country after t = 0.

Costs of financial liberalisation

Financial fragility and vulnerability to crisis
Annual GDP Growth (%) 8 Annual GDP growth: Latin America and Caribbean 6 4 2 0 1975 -2 -4 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 Portfolio equity (current US$) 25 Portfolio equity in Latin America & Caribbean (developing only) 20 15 World annual GDP growth 10 5 0 Millions

In 1996, five Asian economies (South Korea, Indonesia, Malaysia, Thailand and the Phillipines) received net private capital inflows amounting to US$93.0 billion. One year later in 1997, they experienced an estimated outflow of US$12.2 billion. Access to foreign capital flows as a means of financing lead to a leveraging process in the public and private sector, which in turn led to questions about the sustainability of the crisis. Increased dependence on foreign investment. Crowding out effects?

-5
-10 -15

Annual GDP Growth (%) 15

Value of stocks traded (% GDP) 80 70

10 60 Annual GDP growth: Thailand 50 0 1991 -5 Value of stocks traded (% GDP): Thailand -10 10 -15 0 20 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 30 40

Costs of financial liberalisation

Constraints on policy flexibility
Inflows Current account balance all developing countries ex. China, Russia, Middle East Net external financing all developing countries ex. China, Russia, Middle East Increase in reserves all developing countries ex. China, Russia, Middle East 1992-97 avg. -96.7 2003-08 avg. -38.9

225.6

470.0

39.7

218.6

Gains from financial liberalisation

Financial repression

Gains from financial liberalisation

Improved risk sharing mechanisms

Removal of capital controls allow risk sharing, through global diversification of portfolios. This allows higher-yield (higher-risk) investment to be undertaken for the same level of risk, i.e. more projects can be considered (Obstfeld, 1994).

Gains from financial liberalisation

Alleviation of capital scarcity

Is it worth it?
Empirical evidence of gains

Have developing countries experienced faster economic growth?

Not significant!

Is it worth it?
Empirical evidence of gains

Have developing countries experienced increased investment?

Not significant!

Is it worth it?
Empirical evidence of gains

Have developing countries experienced lower inflation?

Not significant!

Then, why liberalise?

Are the costs exaggerated?

Then, why liberalise?

Political economy considerations

Then, why liberalise?

Political economy considerations

The Washington Consensus

Fiscal policy discipline Redirection of public spending from subsidies

Tax reform
Interest rates that market determined Competitive exchange rates Trade liberalisation Liberalisation of inward foreign direct investment Privatisation of state enterprises Deregulation Legal security for property rights

Conclusion
To liberalise or not to liberalise?

Current account convertibility and capital account convertibility are two completely different concepts, with different implications altogether.

Discussion