Capital Flows and Financial Market Openness

The Growth Report, str. 51-52.

Commission on Growth and Development

Economists would readily agree that financial openness is beneficial in the long run. No one now advocates capital controls for America or the European Union. But analysts will also confess to considerable uncertainty and some disagreement about the timing and sequencing of moves to open up.

None of the sustained, high-growth cases that we know about were particularly quick to open their capital accounts. Yet developing countries have come under considerable pressure from international financial institutions and economic commentators, urging them to unlock the financial gates. Whether this is good advice seems to us to depend heavily on whether the economy is diversified, its capital markets mature, and its financial institutions strong.

Even if one thinks controls on capital inflows and outflows are desirable at certain stages of growth, are they feasible? Can they be effective? There are indeed many ways of circumventing capital controls, and financial markets have proven exceptionally creative in exploiting them. But policies that actively discourage speculative, short-term capital inflows have proven useful in turbulent times. The fact that controls may be leaky and imperfect does not seem a decisive argument against them. Many other policies—taxes, for example—are also leaky and imperfect. That is not a reason to abandon them altogether; merely a reason to implement them better.

Developing countries like to exercise some control over the exchange rate, both to maintain the competitiveness of their exports, and also to offset damaging bouts of exchange rate volatility. Capital controls allow a developing country to do this while also controlling inflation. Absent controls, large capital inflows give central bankers no choice but to let the currency strengthen or to accumulate reserves, a policy which implies a loss of monetary control. To put the same point slightly differently: every country wants and needs to control inflation. If it also wishes to exercise some independent control over the exchange rate (for competitive reasons or just to control volatility), then it needs capital controls.21

This is why many countries favor capital controls until such time as the structural transformation of the economy is well advanced. It is difficult to be precise as to when exactly the point of “well advanced” is reached. And the exact timing of when the controls should be lifted is a controversial matter. Some believe that middle-income countries, economically diversified, and with diversified and deep local financial markets and strong links to the world economy are better off with an inflation-targeting regime, allowing relatively free capital flows and flexible exchange rates (“dirty floats”). But to avoid damaging currency overvaluations, such economies would be well advised to maintain a strong fiscal position that would permit them to accumulate international reserves without loss of monetary control.

21 The proposition more precisely is that if a country has an open capital account and manages its exchange rate it will not be in control of the money supply. Thus, it is dependent on other instruments to manage inflationary pressures; fi scal policy being the obvious candidate. Fiscal policy is a very imperfect substitute for monetary policy in dealing with inflation.