The Impact Of Financial Liberalisation

I usually publish only the abstracts when highlighting research papers, but this one’s so fascinating and not a little controversial from a Malaysian perspective, that I’m taking excerpts from the introduction instead (excerpts, emphasis added):

Rethinking The Effects Of Financial Liberalization
Fernando A. Broner & Jaume Ventura

...The conventional view, part of the so-called Washington Consensus, was quite optimistic regarding the effects of financial liberalization...

Mounting empirical evidence (reviewed later) suggests that this conventional view was wrong however. Some of the richer emerging markets have indeed received substantial capital flows. But the experience of other rich emerging markets and most of the poorer ones is that capital flows have been quite small or even negative. Overall, there is no evidence that financial liberalization systematically increases investment or growth in emerging markets. Capital flows have also been highly volatile and procyclical, and there is evidence that financial liberalization has increased both output and consumption volatility. There is also evidence that financial liberalization has made domestic financial markets more unstable and prone to crises. Perhaps the most robust finding is that the effects of financial liberalization vary substantially across countries. Specifically, the effects of financial liberalizations depend on whether the liberalizing country is rich or poor, on whether it has developed or underdeveloped financial markets, and on whether it has high- or low-quality institutions.

A digression: the conventional view suggests that developing countries with low levels of capital (i.e. savings) benefit from foreign capital as it is generally cheaper because there’s far more of it. Investors would benefit from investing in capital-scarce countries because the marginal return on capital would be considerably higher than it would be in more developed countries.

There should therefore, in theory, be a systemic tendency for capital to flow from developed countries to less developed countries. Financial liberalisation, which reduces the barriers to foreign capital flows, should amplify this tendency even further. One of the greatest puzzles in international economics is that this doesn’t happen.

To help explain this conundrum, the authors here develop a theory based on symmetrical debt enforcement, where the inability of countries to discriminate against foreign debt holders results in two potential equilibria - if domestic institutions are stronger and debt contract enforcement likely, then inward capital flows results, otherwise we'll see capital flight:

Let us ask finally why financial liberalization has led to capital flows that are volatile and procyclical and has raised the instability of domestic financial markets. The two effects discussed above suggest that two equilibria are possible depending on investor sentiment. If domestic savers are pessimistic and think that the probability of default is high, they will prefer to send most of their savings abroad. In this case, default affects mostly foreign debts and countries will prefer to default ex-post, confirming the pessimistic beliefs. This equilibrium with small or negative capital inflows always exists. If instead domestic savers are optimistic and think that the probability of default is small, they will keep their savings at home. In this case, default would affect mostly domestic debts and countries will prefer not to default ex-post, confirming the optimistic beliefs. This equilibrium with substantial capital inflows exists only if domestic savings are high relative to foreign borrowing. We describe these equilibria and show how changes in investor sentiment can generate macroeconomic volatility and procyclical capital flows.

Those this framework fit Malaysia? Not exactly – we’re a middle income country with a high savings rate, relatively deep financial markets, and a decent regulatory regime (at least, I think so). That suggests that we should be receiving more than our fair share of capital flows, both direct and portfolio investment. But that simply isn’t the case – the data shows considerable capital flight over the last decade, not net capital inflows.

I’m inclined to chalk this one up to the drastic measures introduced in the aftermath of the 1997-98 financial crisis – capital controls can be construed as a kind of “default”, in that investor funds are trapped in-country. And that reduces the level of trust in government policy among domestic agents as well, thus leading to domestic capital flight, irrespective of the state of financial liberalisation. You could probably with justice also argue that the capital controls introduced in 1998 represented a step back from financial liberalisation.

Even though controls were almost wholly lifted 5 years ago, investor confidence hasn’t fully returned – the empirical evidence is that countries that undergo crises and/or discriminate against foreign investors tend to be serial offenders, which makes investors even more cautious.

I and many others thought the 1998 measures were a mistake at the time, and the evidence has been piling up that supports that view.

Technical Notes:

Broner, Fernando A. & Jaume Ventura, "Rethinking The Effects Of Financial Liberalization", NBER Working Paper 16640, Dec 2010