Review of International Economics, 9(4), 573–584, 2001

International Financial Liberalization, Capital Flows, and Exchange Rate Regimes: An Introduction Francisco L. Rivera-Batiz and Luis A. Rivera-Batiz*

Abstract This introduction to a special edition of Review of International Economics summarizes a collection of articles that originated in a conference on “Is Globalization of Capital Markets a Boost or a Hindrance to Development?” that was sponsored by the Program in Economic Policy Management (PEPM) at Columbia University during 16–17 April 1999.

1. Introduction In 1999, Robert Alexander Mundell, University Professor of Economics at Columbia University, won the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. This prize, better known as the Nobel Prize in Economics, was awarded for his pioneering research on optimum currency areas, the implications of international capital flows, and the behavior of economies operating under alternative exchange rate regimes. To say that Mundell’s contributions to international economics have been among the most influential in the world over the last 50 years, both academically and in policy circles, may sound like an exaggeration. But it is an understatement. With great foresight, his research has often predated events in the world economy. And his policy prescriptions have landed years later in the drawing boards of those reforming major international organizations and economic policy institutions. Mundell’s early academic contributions to the field of international macroeconomics in the 1950s and 1960s dealt with the constraints imposed by global capital markets on economic policy, long before the term “globalization” became popular.1 His pioneering work on optimum currency areas laid the intellectual foundation for the creation of the European Union and the euro.2 In fact, as early as 1969 he presented the case for a common European currency, which he prophetically called the “europa.” He was then invited to Brussels in 1970 to work on alternative plans for a European currency. Although those plans had to wait three decades to be realized, Mundell’s work throughout the years was the intellectual backbone behind the effort. Mundell’s influence can be seen everywhere in the world. As an example, in 1971, he visited Panama under the sponsorship of the Agency for International Develop-

* Francisco: Room 1033, International Affairs Building, Columbia University, New York, NY 10027, USA. Tel: +1 (212) 854-4478; Fax: +1 (212) 854-5935; E-mail: [email protected]. Luis: Faculty of Management, McGill University, 1001 Sherbrooke West, Montreal, PQ, Canada H3A 1G5. Tel: (514) 398-4053; Fax: (514) 398-3876; E-mail: [email protected]. The authors acknowledge the spirited conference participation of students, faculty and staff of Columbia’s Department of Economics, the School of International and Public Affairs and the PEPM Program. We also wish to thank the other participants in the conference: Graciana del Castillo (Columbia University), Eduardo Fernandez-Arias (Inter-American Development Bank), Peter B. Kenen (Princeton), Frederick Mishkin (Columbia), and Rene Stulz (Ohio State University). The authors are grateful to Maya Haddow, Yi-Ping Ong, Pamela Terry-Shell, and Deborah Wilson for assistance at various stages of the project. © Blackwell Publishers Ltd 2001, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA

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ment, to provide advice on questions relating to the Panamanian currency, the balboa. The country had been dollarized since 1904 and the balboa had a fixed rate relative to the dollar. But as the US dollar began its period of floating, one option was to create an independent paper currency fixed to gold and flexible relative to the dollar. Mundell met with the country’s leader, Omar Torrijos, and recommended to him that Panama continue its dollar standard. Torrijos supported this move and thus the pre-eminent dollarized economy in the Western hemisphere was sustained. Three decades after this episode, other Latin American nations—from Ecuador and Argentina to El Salvador and Honduras—are dollarizing or seriously considering dollarization. In the United States, Mundell has also been deeply influential in the national economic sphere. His advocacy of “supply-side” tax cuts as a measure to face the stagflation that was plaguing economies in the 1970s caught the attention of tax reformers and the Reagan administration in the 1980s. Many believe that the resulting revisions to the US tax codes reducing the top federal tax bracket to 28% contributed to spearhead the booms of the 1980s and 1990s. Throughout the long time period when all of these policy changes were being undertaken, the academic field of international economics continued to use the Mundell– Fleming model of the open economy as its workhorse, embracing it and extending it in myriad directions. Through its impact, the Mundell–Fleming model has shaped— and continues to shape—the thinking of thousands of policymakers at international organizations such as the International Monetary Fund, and at central banks around the world, deepening Mundell’s influence on world economic affairs. The papers in this volume are presented to honor Mundell’s research in openeconomy macroeconomics. Neither of us studied directly under him. Still, we consider him our intellectual grandfather. As graduate students at MIT and the University of Chicago, we were taught international macroeconomics by his students and associates, Rudiger Dornbusch, Jacob Frenkel, Arthur Laffer, and Michael Mussa. The volume begins with a personal and professional profile of Mundell’s work by Michael Connolly, who brings the perspective of a longtime colleague, collaborator, and friend. The following sections summarize the remaining papers in this volume.

2. Fixed Exchange Rates, Dollarization, and Currency Boards The last years of the twentieth century witnessed a series of major financial crises in emerging markets, including the 1994/95 Mexican peso crisis, the 1997/98 East Asian crisis, the 1998 Russian crisis, and the 1999 Brazilian crisis. These crises raised serious concerns about the consequences of an increasingly globalized capital market. In his paper in this volume, Mundell argues that such concerns are misplaced since the blame for the crises must be placed on the failure of current international monetary arrangements. Pegged exchange rates characterized the external payments regimes of the crisis countries. Pegged rates, Mundell has noted (see Mundell (2000)), may be considered as a temporary measure under certain conditions, but they create policy conflicts that cause destabilizing capital flows and eventually lead to currency and financial crises. Under pegged rates, central banks intervene in the foreign exchange market to peg currency values, but they still keep independent monetary policies. The latter, however, may be inconsistent with the long-run stability of the pegged currency values. If a country, for instance, adopts a strong expansionary monetary policy, domestic interest rates can be pushed down, stimulating capital flight. But to keep the exchange rate pegged, the capital outflows require that the central bank continuously sell interna© Blackwell Publishers Ltd 2001

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tional reserves. As reserves dwindle, devaluation expectations grow, producing further capital outflows and magnifying the inconsistency of the expansionary monetary policy with a pegged rate. If the central bank eventually runs out of reserves, a currency crisis occurs, with its destabilizing impact. But the underlying problem is not the capital flows per se, but the policy inconsistency. Mundell also notes that the wild gyrations in the value of the dollar and the yen have contributed to emerging market crises. In the case of the so-called Asian crisis, Mundell argues that the sudden appreciation of the dollar and the depreciation of the yen led to a loss of competitiveness which worsened the current account balance in the crisis countries, and helped fuel the speculative capital outflows that precipitated the debacle. As an antidote to the instability of nominal and real exchange rates under current international monetary arrangements, Mundell proposes monetary integration and the creation of currency areas. He is willing to take this initiative to the limit: “as indeed a dozen EU countries have decided . . . the optimum currency area is not the nation state but a wider area that might conceivably comprise several countries or even the whole world!.” The momentous policy changes in Europe represent only one example of many instituted by nations seeking greater exchange rate stability. Other countries have made unilateral moves to fix exchange rates by using the currencies of other countries as legal tender. In Latin America, a rising number of countries have adopted—or are considering the adoption of—full dollarization. Table 1 shows the list of countries that have adopted the currencies of other nations as legal tender. Among the most recent additions to this list are Ecuador, which became officially dollarized on March 2001, and El Salvador, which officially introduced dollarization measures in 2000. Not included in this list are the many other countries that have considered such moves, including large countries like Argentina and Mexico. Dollarization has costs and benefits. Countries gain by the greater liquidity allowed by the adoption of the dollar, a major world currency. They also import the stability and credibility of American monetary policy. At the same time, dollarization has two major drawbacks: (1) countries transfer their seigniorage to the United States, and (2) they lose economic sovereignty since the US would not adjust its inflation rate to take into account the policy interests of dollarized countries.3 These costs would have to be weighed against the advantages of the dollarization. The adoption of a currency board is another unilateral move used by countries to fix their exchange rates. Under a currency board, a country fixes the exchange rate between its own currency and a major foreign currency. The monetary authority is then committed—by legislative statute or by constitutional mandate—to issue money only against a designated reserve currency, at the fixed rate. There is, as a result, no active monetary policy. Instead, foreign-exchange market intervention automatically affects the monetary base of the system. When the monetary authorities buy foreign currencies, the money supply expands. A sale of foreign exchange contracts the money supply. As a fixed exchange rate regime, the currency board’s monetary actions work automatically to preserve equilibrium in the balance of payments. Table 2 shows the list of countries and regions currently using currency boards. This includes a variety of former European colonies. There are also some transition countries, such as Bulgaria, Estonia, and Lithuania. The largest country with a currency board is Argentina. Are currency boards superior to adjustable pegs as alternative exchange rate regimes? Currency boards have been quite controversial in the policy arena. © Blackwell Publishers Ltd 2001

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Table 1. Countries or Territories With Foreign Currencies as Legal Tender, 2001 Country Andorra

Population 63,000

Bhutan Channel Islands Cocos Islands

1.5 million 140,000 600

Cyprus, northern El Salvador Ecuador Greenland

180,000 6 million 12 million 56,000

Guam Kiribati Liechstenstein Marshall Islands Micronesia Monaco Nauru Niue

150,000 80,000 31,000 60,000 120,000 30,000 8,000 2,000

Norfolk Island Northern Mariana Islands Palau Panama Pitcairn Island Puerto Rico Saint Helena Samoa, American San Marino Tokelau Turks and Caicos Islands Tuvalu Vatican City Virgin Is, British Virgin Is, US

2,000 48,000 18,000 2.5 million 56 3.8 million 6,000 60,000 24,000 1,600

Political status Independent Independent British protectorates Australian external territory Independent Independent Independent Danish selfgoverning territory US territory Independent Independent Independent Independent Independent Independent New Zealand selfgoverning territory Australian external territory US commonwealth

Currency used

Since

French franc and Spanish peseta Indian rupee Pound sterling Australian dollar

1278

Turkish lira US dollar US dollar Danish krone US dollar Australian dollar Swiss franc US dollar US dollar French franc Australian dollar New Zealand dollar Australian dollar US dollar

1948 1797 1955 1974 2001 2001 >1800 1898 1943 1921 1944 1944 1865 1914 1901 >1900 1944

US dollar US dollar NZ and US dollars US dollar Pound sterling US dollar Italian lira NZ dollar

14,000

Independent Independent British dependency US commonwealth British colony US territory Independent New Zealand territory British colony

1944 1904 1800s 1899 1834 1899 1897 1926

US dollar

1973

10,000 1,000 17,000 100,000

Independent Independent British dependency US territory

Australian dollar Italian lira US dollar US dollar

1892 1929 1973 1917

For countries using European currencies, the legal tender currency will switch to the euro in 2002. Sources: Authors’ construction, based on Goldfajn and Olivares (2000).

Some economists argue that adjustable pegs offer beneficial policy flexibility (see Willidmson (1995)). Others, among whom we can count Mundell, favor policy discipline and argue that discretionary policies result in a loss of credibility (see Mundell (2000)). An examination of the comparative performance of alternative exchange rate regimes suggests that countries adopting currency boards have grown faster and © Blackwell Publishers Ltd 2001

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Table 2. Countries or Territories with Currency Boards, 2001 Country

Population

Political status

Currency fixed to

Since

Argentina Bosnia and Herzegovina Bulgaria Brunei Darussalam Djibouti Estonia Hong Kong

35 million 4 million 8 million 344,000 619,000 1 million 6 million

US dollar Euro Euro Singapore dollar US dollar Euro US dollar

1991a 1997 1997 1967 1980 1992 1983

Lithuania

4 million

Independent Independent Independent Independent Independent Independent China Autonomous Region Independent

US dollar

1994

a

Shifting a basket consisting of the US dollar and the euro in 2001. Source: International Monetary Fund (2000).

inflated less on average than countries adopting other regimes, particularly adjustable pegs. Furthermore, adjustable regimes are subject to speculative pressures and currency collapses to a far greater extent than currency boards. Why is it that currency boards can perform better than standard pegs? The answer is not obvious, as it would appear that an adjustable-peg regime could just mimic the behavior of a currency board in circumstances in which currency boards work well. In “Discipline, Signaling, and Currency Boards,” Maria-Angels Oliva, Luis RiveraBatiz and Amadou Sy develop the first model of the choice between currency boards and adjustable-peg regimes (or managed floating), embodying a clear differentiation between these currency regimes. An explanation for currency board superiority hinges on its key institutional features enforcing policy discipline and establishing inflation credibility. A currency board imparts discipline and credibility by two major mechanisms. First, monetary authorities relinquish discretionary monetary policy. Second, a currency board regime includes mechanisms to preclude currency devaluation in the short-run. This is accomplished by requiring parliamentary approval or a constitutional amendment prior to changing the currency regime or undertaking a devaluation. In effect, these mechanisms impose a delay in any possible devaluation, a feature that is not present in adjustable-peg regimes, which rely on surprise devaluations. In a signaling model with two types of governments—differing on whether they have a tough or a weak stance with respect to inflation—the economy’s equilibria can be separating or pooling. In a separating equilibrium, a weak and a tough government would choose different currency regimes. Exchange rate systems can therefore be used to identify the type of government in power. In pooling equilibria, by contrast, both weak and strong governments choose the same currency regime and the latter cannot be used to identify the underlying type of government, weak or tough. Oliva, Rivera-Batiz and Sy show that there are unique separating equilibria in which a weak government chooses a currency board as a discipline device while a tough government chooses a standard peg for its policy flexibility. Paradoxically, the weak government can then outperform the tough government on average. In simulations performed by the authors, currency-board welfare is found to exceed adjustable-peg welfare even when unemployment persistence is strong. These results contradict the common notion that only tough governments will adopt currency boards. The analysis also indicates that currency regime choice should be undertaken carefully. There is no © Blackwell Publishers Ltd 2001

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single regime that is best for all circumstances or under all the possible values of the key economic parameters considered in the paper.

3. Private and Official Capital Flows to Developing Countries: Integration, Volatility, and Procyclicality The last 20 years have seen an explosion of capital flows to developing nations. Table 3 shows that, between 1980 to 1999, annual net private capital flows to developing nations rose by 90%, from $97 billion to $238 billion, adjusted for inflation. As a fraction of gross national product (GNP), net private capital inflows more than doubled during this time period, from 1.6% in 1980 to close to 4% in 1999. The increased globalization of capital has had its discontents. In the aftermath of the East Asian crisis, many academics and policymakers blamed volatile, speculative capital flows for the virulence of these crises and their contagion effects (see, for instance, Krugman (1998) and Radelet and Sachs (1998)). These crises, it is argued, led to a breakdown of international financial transactions and resulted in costly adjustments for the economies of emerging markets. In “International Capital Mobility in Emerging Markets: New Evidence from Daily Data,” Michael Kumhof examines the extent to which financial integration broke down during the East Asian crisis. To test this, he studies deviations from covered-interest parity. The covered-interest parity hypothesis asserts that assets that are similar except for the country of issue and the currency of denomination should yield the same covered returns. This condition implies that the interest differential between money market assets denominated in two different currencies should be equal to the forward premia or discount between the two currencies. In equilibrium, a higher interest rate on a given currency-denominated asset is offset by the loss from purchasing the currency on the spot market and covering the investment by selling the proceeds on the forward market. In other words, the currency of the asset offering a higher interest rate should be at a discount in the forward market. Kumhof examines daily covered interest differentials before and after the 1997/98 East Asian financial crises. The degree of financial integration in emerging and industrial markets is measured by the extent to which covered interbank differentials in three emerging markets—Mexico, Indonesia, and Thailand—and four industrial economies—France, Germany, Ireland, and Portugal–differ from zero. The sample

Table 3. Private Capital Flows to Developing Countries, 1980–1999 (billions of constant 1999 US$)

All developing countries East Asia and Pacific Europe and Central Asia Latin America and the Caribbean Middle East and North Africa South Asia Sub-Saharan Africa Source: World Bank (2000). © Blackwell Publishers Ltd 2001

1980

1999

97 18 20 51 -2 3 8

238 74 38 98 17 4 7

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period goes from April 1996 (Mexico), March 1997 (Thailand), and October 1997 (Indonesia) to January 1999. In contrast to much of the previous literature, Kumhof carefully considers the timeseries properties of the data in his analysis. A common test for covered interest parity is based on an ordinary-least-squares regression of the forward discount on the nominal interest differential. This test, however, is not valid if nominal interest differentials and forward premia are nonstationary and if interest differentials and the forward rate are not cointegrated. Kumhof performs unit-root tests to search for nonstationarity, finding that he cannot reject the hypothesis that emerging markets’ interest differentials and forward premia are nonstationary. He then incorporates nonstationarity into his econometric analysis of covered parity during the East Asian crisis. What does Kumhof find? As predicted by the theory, covered interest differentials in Indonesia, Thailand, and Mexico were close to zero and displayed low volatility before the currency crisis. However, both mean interest differentials and volatility increased dramatically during the crisis. The rise in volatility, though, was far greater in Indonesia and Thailand than in Mexico, where markets are more liquid and the segmentation between forward and money markets is less pronounced. Among the four developed economies studied, only Ireland exhibited large deviations during the East Asian crisis. Covered differential remained close to zero in France, Germany and Portugal. The breakdown of covered interest parity in East Asia during the crisis can be attributed to temporary capital controls, capital market imperfections, and large bank default risk. For instance, Kumhof finds that the covered interest differential was negative in Thailand during the crisis. This was due to the imposition of controls on capital outflows in that country, which were in place until early 1998, when the covered interest differential returned to near zero levels. The Thai capital controls were effective and, as a result, covered interest parity broke down in Thailand, generating negative covered differentials. In Indonesia, on the other hand, Kumhof finds that interest rates increased by more than is justified by the covered parity condition. Domestic interest rates incorporated high risk premia to compensate for the well-known weaknesses of domestic banks’ balance sheets. In “Foreign Aid and the Business Cycle,” Stéphane Pallage and Michel Robe focus on a different type of financial flow—foreign aid—which constitutes a major source of external finance for many developing countries. They utilize data comprising 63 recipient countries between 1969 and 1995 to examine the volatility and cyclical properties of foreign aid flows. Foreign aid is granted in order to finance growth and increase the standard of living rather than as insurance against cyclical instabilities. Pallage and Robe find that developing countries’ foreign aid receipts have been procyclical rather than countercyclical. In other words, foreign aid comes in when there is a boom and leaves when recession sets in. In times of recession, developing countries find themselves facing high interest rates, limitations in the access to capital markets, and—to top it all—receiving less foreign aid. Besides their procyclicality, Pallage and Robe find foreign aid flows to be highly volatile. On average, the volatility of aid receipts is twice as much as the highly volatile recipient country output (the volatility of aid commitments is even higher than that of aid receipts). The high procyclicality and volatility of foreign aid raise key questions about the impact of foreign aid on economic development. In the absence of reliable cyclical insurance mechanisms in developing countries, the procyclicality of financial flows and © Blackwell Publishers Ltd 2001

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foreign aid make very difficult the smoothing of fluctuations in domestic consumption. This feature highlights the importance of seeking insurance mechanisms in developing nations for smoothing out consumption in the face of large output fluctuations. The volatility of foreign aid flows also suggests a link through which aid flows might adversely affect growth. Research on the relationship between volatility and growth concludes that output volatility is negatively related to output growth.4 Finally, Pallage and Robe find greater volatility of multilateral relative to bilateral aid flows (the dominant form of aid). This raises concerns about whether multilateral aid flows might represent a destabilizing rather than a stabilizing factor in development. They may also have negative growth effects. The policy dilemmas arising from foreign aid flows are more acute in the case of African countries, where foreign aid is a major source of resources, averaging 12.5% of disposable income over the sample period. Foreign aid flows are not only highly volatile but also procyclical for almost all African countries. Only two out of 38 African countries studied by Pallage and Robe display countercyclical foreign aid flows.

4. Is International Financial Liberalization a Boost or Hindrance to Development? The last 20 years have witnessed a remarkable liberalization of the international financial transactions of developing countries. From Argentina and Mexico to Korea and Thailand, governments in emerging markets have implemented a wide array of reforms eliminating or sharply curtailing taxes, licensing requirements, exchange controls, and other restrictions on capital flows with the rest of the world.5 The liberalization of the capital account has surfaced in a policy environment that has hailed its potential benefits. The most obvious gain is the increased availability of foreign capital to domestic residents. As Obstfeld (1998, p. 10) summarizes: “International financial markets allow residents of different countries to pool various risks, achieving more effective insurance than purely domestic arrangements would allow. . . . Developing countries with little capital can borrow to finance investment, thereby promoting economic growth without sharp increases in savings rates.” Yet others find little empirical support for a positive link between capital account liberalization and development. Krugman (1993), for example, argues that there is no significant evidence that capital inflows have any strong positive effects on the growth of developing countries. And in an analysis of the connections between capital account liberalization and growth, Rodrik (1998) concludes: “If there is a correlation between openness on the capital account and successful economic performance, it does not stand out.” One of the questions of gravest concern in policymaking circles is the effect of international financial liberalization in the presence of bank fragility. Has increased financial integration contributed to the spate of banking crises in emerging markets? In “Bank Fragility and International Capital Mobility,” Enrica Detragiache shows that full integration—which occurs when domestic banks, and domestic investors in general, are able to participate abroad freely—reduces the probability of bank runs. However, greater financial integration that does not go all the way up to full integration (that allows investors but not banks to access world markets) can make bank runs more likely. Furthermore, an increase in foreign interest rates can cause a bank run. Detragiache develops a dynamic model with a specialized financial intermediary and two agents—depositors and business firms—that rigorously illustrates why partial liberalization might be counterproductive even if full liberalization is welfare-increasing. © Blackwell Publishers Ltd 2001

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Liberalization can contribute to generate a bank run in the domestic market when domestic investors are allowed to buy foreign assets but domestic financial intermediaries lack access to international capital markets. If domestic depositors switch to buy foreign assets when liberalization occurs, banks will not be able to obtain the resources needed to face banking runs and capital outflows, resulting in a breakdown of financial intermediation. In this situation, greater financial openness will result in lower welfare levels for the business sector, the sector that has been borrowing from the banks. Depositors, on the other hand, benefit from investing abroad; they can therefore win or lose depending on the deadweight loss of bank runs and the amount of assets held abroad. Why is it that financial liberalization can cause instability? Detragiache’s model emphasizes the asymmetry between investors and financial intermediaries under liberalization. Financial openness means that foreign assets compete with domestic assets. High returns abroad create incentives that lead investors to shift funds across borders. But under less than full financial integration, banks do not have access to long-term loans in international capital markets. As a result, as domestic asset-holders take deposits away from banks to invest them abroad, the domestic financial intermediaries may face a run. Under full integration, that is, with banks having the same access to foreign markets as the investor, the asymmetry collapses and international financial liberalization is welfare-increasing. In this case, banks can offset the withdrawal of funds by borrowing long-term abroad to finance domestic loans. There is no bankrun problem disrupting the loan process. A key policy implication is that speeding up the process of liberalization toward full integration can reduce the probability of a crisis. In “International Financial Liberalization and Economic Growth,” Ross Levine examines the latest evidence on the connections between capital account liberalization and economic growth, concluding with an optimistic view on the issue. Indeed, he states that “international financial integration can promote economic development by encouraging improvements in the domestic financial system, with positive ramifications for long-run productivity growth.” The existing literature on this topic has examined the linkages between capital flows and growth by focusing on the effects of openness on capital accumulation. Instead, Levine presents growth effects that do not work through increased capital stocks. He notes that the dismantling of restrictions to international capital flows can accelerate growth by boosting total factor productivity. This connection is highly significant because, he argues, the empirical evidence suggests that total factor productivity is a most important factor accounting for cross-country differences in economic growth. Levine’s analysis rests on evidence of two linkages: (1) international financial liberalization increases the efficiency of the domestic financial system, and (2) the increased efficiency of domestic financial systems exerts a heavy impact on economic growth by boosting total factor productivity in the economy. After discussing the ample evidence on the connections between increased efficiency of financial systems and growth, he explores two distinct links between capital account liberalization and domestic financial efficiency. First, liberalization increases financial productivity by enhancing the liquidity of the domestic stock market. Second, by permitting a foreign banking presence, international financial liberalization in turn increases the efficiency of the domestic banking system. In determining whether international financial liberalization is associated with greater stock-market liquidity, Levine examines the behavior of the value-traded ratio © Blackwell Publishers Ltd 2001

582 Francisco L. Rivera-Batiz and Luis A. Rivera-Batiz (total shares traded on the stock market exchange divided by GDP) in 15 episodes of liberalization for which data were available. In 14 out of the 15 countries, he finds strong evidence that stock-market liquidity rose after the country eased restrictions on international capital flows (in one country, liquidity fell but not significantly). Levine also finds strong evidence that easing restrictions on foreign bank entry improves the quality, pricing, and availability of banking services directly and indirectly. Using bank-level accounting data from 80 countries over the period of 1988 to 1995, he reports the results of regressions examining how foreign bank presence affects domestic banking’s before-tax profits and overhead costs. The foreign-bank-presence variable is negatively associated with bank profits and overhead costs, suggesting that foreign banks spur competition and make national banking markets more efficient. In “Foreign Portfolio Investments, Financial Liberalization, and Economic Development,” Vihang Errunza presents evidence indicating that liberalization has profound effects on the cost of capital and the type of financing. One of the contributions of this paper is examining alternative concepts of financial liberalization. Errunza uses official liberalization, increases in net US capital flows, the introduction of ADRs and the introduction of country funds to measure liberalization in emerging markets. The effects of these variables on domestic financial markets are analyzed by conducting a before-and-after analysis. The exercise shows that market capitalization to GDP, value traded to GDP, turnover ratio to GDP, and number of listed companies tend to increase after liberalization initiatives. Liberalization is also linked to greater equity market development and a reduced role of bank financing, which is the dominant form of outside financing in Japan, in Germany and in developing countries but which has experienced serious difficulties in recent years. Two popular claims about the consequences of financial liberalization are debunked. First, the data shown by Errunza stand in stark contradiction with the commonly voiced claim that volatility increases following financial liberalization. In fact, unconditional volatility—as measured by the standard deviation of returns—is reduced by liberalization, squarely contradicting the popular notion that liberalization is bad because it gives rise to volatile markets. Second, the popular claim that the correlation of domestic and US market returns increases with liberalization also fails to hold. Errunza concludes by stating that, although the evidence that foreign portfolio investments provide benefits to emerging markets is strong, the adequate preconditions must be in place to ensure such benefits. Prudent regulatory measures, adequate informational infrastructure, and market-oriented reforms must precede liberalization if a country is to maximize the potential gains from liberalization and minimize its costs. He says: “First and foremost, the developing countries should create an environment that would encourage the return of flight capital and attract (and retain) foreign capital flows on a permanent basis.” The issue of capital flight has been one of enormous concern for countries liberalizing their capital account. Despite the overall expansion of capital flows to emerging markets, many developing nations have not shared in the increased capital inflows. For example, in 1998, the Latin America and Caribbean region together with the Europe and Central Asia region received $87 billion in net private capital inflows, excluding foreign direct investment (FDI). But in sub-Saharan Africa, this balance was negative that year, with the region suffering a net private capital outflow of $1 billion. In fact, excluding FDI, private capital inflows to sub-Saharan Africa were either negative or negligible during the 1980s and 1990s. This situation applies as well to a number of developing nations in other regions of the world. For instance, when both officially recorded and unrecorded capital flows are © Blackwell Publishers Ltd 2001

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taken into account, capital flight from some former Soviet Republics has been massive. Some studies estimate Russian capital flight to have totaled $150 billion between 1992 and 1999—see Cooper and Hardt (2000) and Abalkin and Whalley (1999). In the paper, “International Financial Liberalization, Corruption, and Economic Growth,” Francisco Rivera-Batiz examines the nature of capital flight and its implications regarding the liberalization of international financial transactions. He develops an endogenous growth model of a developing country that is plagued by two sets of distortions. First, the economy is closed to international financial transactions. Second, its governance is plagued by corruption. The barriers to international financial transactions create a shortage of capital in the developing economy, which tends to raise local rates of return to capital. However, corruption acts as a tax on the profits made by innovating firms and entrepreneurs in the country, reducing their profitability and causing a drop in technological change. As a result, corruption acts to reduce the rate of return to capital.6 Rivera-Batiz examines the growth effects of international financial liberalization within this framework. He finds that this policy initiative can result in an increase or a decrease in the economy’s long-run growth. A drop in growth is obtained when the level of corruption is high enough to cause domestic rates of return on capital before liberalization to drop below those in the rest of the world. Opening the capital account in this case generates capital flight, which causes the economy’s innovation infrastructure to further collapse, reducing the rate of technological change and causing output growth to decline. On the other hand, if the level of corruption in the economy is sufficiently low, the capital account liberalization will serve as a boost to the country’s growth. In this case, foreign capital flows into the economy and stimulates innovation and growth. Capital flight has induced policymakers in many poor countries to introduce capital and exchange controls, to block the outflows that would result if liberalization were to occur. Rivera-Batiz notes, however, that the first-best policy in this context is to intervene to reduce or eliminate corruption. If this is accomplished, then the next move would be an opening of the capital account. On the other hand, introducing international financial liberalization without the appropriate domestic policies in place to control corruption is bound to result in a magnification of domestic distortions and could result in a decline of economic growth.

References Abalkin, Leonid and John Whalley, “The Problem of Capital Flight from Russia,” mimeo, Center for the Study of International Economic Relations, University of Western Ontario (1999). Caprio, Gerard, Izak Atiyas, and James A. Hanson (eds.), Financial Reform: Theory and Practice, Cambridge: Cambridge University Press (1994). Cooper,William H. and John P. Hardt,“Russian Capital Flight, Economic Reforms and US Interests: An Analysis,” Report for Congress, Congressional Research Service (March 2000). Edwards, Sebastian, Crisis and Reform in Latin America: From Despair to Hope, Oxford: Oxford University Press (1995). Goldfajn, Ilan and Gina Olivares, Full Dollarization: The Case of Panama, mimeo, Rio de Janeiro: Pontificia Universidade Catolica (2000). International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions 2000, Washington, DC: International Monetary Fund (2000). Krugman, Paul, “International Finance and Economic Development,” in A. Giovannini (ed.), Finance and Development: Issues and Experience, Cambridge: Cambridge University Press (1993):11–28. © Blackwell Publishers Ltd 2001

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Krugman, Paul, “What Happened to Asia?,” mimeo, Department of Economics, Massachusetts Institute of Technology (1998). Lucas, Robert, “Why Doesn’t Capital Flow from Rich to Poor Countries?” American Economic Review 80 (1990):92–6. Lukauskas, Arvid and Francisco L. Rivera-Batiz (eds.), The Political Economy of the East Asian Crisis and its Aftermath: Tigers in Distress, Cheltenham: Edward Elgar (2001). McKinnon, Ronald and Huw Pil, “Credible Liberalization and International Capital Flows: The Overborrowing Syndrome,” in Takatoshi Ito and Anne O. Krueger (eds.), Financial Deregulation and Integration in East Asia, Chicago: University of Chicago Press (1996):220–45. Mundell, Robert A., International Economics, New York: Macmillan (1968). ———, “Uncommon Arguments for Common Currencies,” in H. G. Johnson and A. Swoboda (eds.), The Economics of Common Currencies, London: George Allen & Unwin (1973a):114–32. ———, “A Plan for a European Currency,” in H. G. Johnson and A. Swoboda (eds.), The Economics of Common Currencies, London: George Allen & Unwin (1973b):143–73. ———, “Currency Areas, Exchange Rate Systems and International Monetary Reform, mimeo., paper presented at the Universidad del CEMA, Buenos Aires, April 17 (2000). Obstfeld, Maurice, “The Global Capital Market: Benefactor or Menace?” Journal of Economic Perspectives 12 (1998):9–30. Radelet, Steven and Jeffrey Sachs, “The East Asian Financial Crisis: Diagnosis, Remedies and Prospects,” Brookings Papers on Economic Activity (1998):1–74. Ramey, Gary and Valerie A. Ramey, “Cross-Country Evidence of the Link Between Volatility and Growth,” American Economic Review 85 (1995):1138–51. Rodrik, Dani, “Who Needs Capital Account Convertibility?” Essays in International Finance, Vol. 207, Princeton University, Department of Economics, International Finance Section (1998). Williamson John, What Role for Currency Boards?, Washington, D.C.: Institute for International Economics (1995). World Bank, Global Development Finance, Washington, DC: World Bank (2000).

Notes 1. This body of work was collected in Mundell (1968). 2. See Mundell (1973a,b). 3. Unlike members of a common currency area, which have a share in the ownership and control of the union’s central bank, members of the dollarized world simply transfer sovereignty to the central bank controlling the supply of the currency used as legal tender, whether the Federal Reserve Board, or the European Central Bank, or another monetary authority. 4. See Ramey and Ramey (1995). 5. For a survey of the reforms in a variety of developing countries, see Caprio et al. (1994), Edwards (1995), McKinnon and Pil (1996), and Lukauskas and Rivera-Batiz (2001). 6. This implies that, despite a shortage of capital, the economy may display low rates of return. This is one additional explanation for the puzzle discussed by Lucas (1990).

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