Is Capital Market Liberalization The Right Policy?

By Gombak Rock

Capital market liberalization is a term that usually refers to less government regulations and restrictions in the economy for lesser restrictions on both domestic and foreign capital. Most first world countries, in order to remain globally competitive, have pursued the path of capital market liberalization. The European Union is one of the leading examples of capital market liberalization. The EU refers affectionately to capital market liberalization as “the heart of the single market and is one of its ‘four freedoms’. It enables integrated, open, competitive and efficient European financial markets and services”. Free movement of capital in the EU has also stimulated a more general process of economic policy co-operation in the area of capital and payments at international level.
In developing countries, economic liberalization refers more to liberalization or further “opening up” of their respective economies to foreign capital and investments. Three of the fastest growing developing economies today; China,Brazil and India, have achieved rapid economic growth in the past several years or decades after they have “liberalized” their economies to foreign capital. Many countries nowadays, particularly those in the third world, arguably have no choice but to also “liberalize” their economies in order to remain competitive in attracting and retaining both their domestic and foreign investments. However a number of economists believe that externally imposed opening to international capital flows is hazardous and it was the main culprit behind the East Asia financial crises of the 1990s. This brings to the question “Is capital market liberalization the right policy?”

Although trade liberalization in developing countries has had some modest benefits, but the simultaneous current and capital market liberalization have been associated with strong exchange rates and high interest rates, creating problems with productivity, growth and income distribution and development.

If not all commodities are traded, the local currency/foreign currency exchange rate serves as a relative price between traded and non-traded goods, and enters as a key variable to show that liberalizing imports will promote export growth. If import protection is reduced, leading to an incipient trade deficit, the exchange rate adjusts to clear the current account imbalance. That is, a higher exchange rate will stimulate production of exportable and import substitutes with resources transferred from non-traded sectors. That is, liberalization pays off in the form of faster export growth. The underlying assumption is that local resources can be deployed to produce something and balanced trade assures it will find an external market.

In many cases in the past decades, both the trade and capital accounts of the balance of payments have been deregulated simultaneously. The exchange rate is allowed to float, responding to developments in the financial markets rather than imbalances in the current account.

In countries where this package has been applied – more in Latin America and Asia than in sub-Saharan Africa – almost uniformly a combination of high local interest rates and a strong exchange rate has emerged, “diluting whatever benefits concomitant trade liberalization was supposed to bring and often leading to a balance-of-payments crisis in the medium term.”

When capital markets are liberalized, deregulation induces a shift in desired foreign portfolios towards the home market and either asset prices should rise or interest rates fall. In other words, the home currency should begin to appreciate. While this last has happened, high interest rates have also come in the wake of market liberalization.

Policymakers at home may pull back from the local market in a dynamic process. Authorities might well tighten monetary policy in an attempt to keep the current account deficit under control. In the Latin American context, inflation stabilization has been a complementary objective. However the uncomfortable high-interest-rate-and-strong-currency combination, compatible with the present model, “does not provide a solid basis for improved trade performance or investment to support economic growth.”

Making matters worse is the fact that continuing trade deficits can lead ultimately to a dynamically unstable situation – characterized by an underestimation of risk in a classic model. At some point, the underestimation reverses, leading to a massive capital outflow, devaluation and stagflation. Mexico in 1994 and East Asia in 1997 are the most striking recent examples of this.

The adverse effects of capital market liberalization can easily overwhelm whatever small benefits trade deregulation may bring. Thus bring us to the conclusion that capital market liberalization is the right policy (especially to the developing nations) only if any liberalization is precede by liberalising trade, stable macroeconomic policies also need to be in place and the rejection fixed exchange rates. Without applying these conditions before liberalizing capital markets, capital market liberalisation will be hazardous and very risky to the economy.

One Response

  1. So, in conclusion you are all for capital liberalization provided certain measures are put in place to make sure all parties could derive maximum benefits from such liberalization process and at the time its hazardous impacts are minimized.

    I think this very fair statement indeed. This worldwide liberalization phenomenon would be meaningless and counterproductive , if it only enriches certain economies at the expense of the rest. That is why certain international regulatory frame-work must be set up to ensure the system function properly and efficiently otherwise the whole process would be seriously flaw. No responsible country would like to partake in a process that only benefits others but its own people!

    Having said that any over-regulation and over-protective measures must be avoided by all costs, as in long run it would not be in the interest of any economies for not participating in this liberalization process.

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