RDP 2002-03: International Financial Liberalisation and Economic Growth 1. Introduction
January 2002
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So now we have all the benefits of free flows of international capital. These benefits are mammoth: the ability to borrow abroad kept the Reagan deficits from crushing US growth like an egg, and the ability to borrow from abroad has enabled successful emerging market economies to double or triple the speed at which their productivity and living standards converge to the industrial core. But the free flow of financial capital is also giving us one major international financial crisis every two years.[1]
These assertions assume that free capital mobility is enormously beneficial while simultaneously failing to evaluate its crisis-prone downside. But even a cursory glance at history suggests that these gains may be negligible.[2]
Experience suggests that international financial liberalisation can be a mixed blessing. International borrowing helps individual countries smooth consumption and finance productive investment. Foreign investment, particularly foreign direct investment, can facilitate the transfer of technological and managerial know-how. Portfolio investment and foreign bank lending can also contribute to the deepening of the domestic financial market. Some proponents have argued that, by increasing the rewards for good policies and the penalties for bad policies, capital flows can promote more disciplined macroeconomic policies (Grilli and Milesi-Ferretti 1995).
At the same time, financial liberalisation entails several risks. Capital inflows can lead to an appreciation of the domestic currency and adversely affect the trade balance. Large and sudden inflows can fuel rapid consumption growth, rising or sustained high inflation, and unsustainable current account deficits. Financial liberalisation in countries with underdeveloped financial systems can make them more crisis-prone. For instance, a rapid expansion in bank lending, fuelled by capital inflows, can result in a deterioration of bank balance sheets, which in turn can increase these countries' vulnerability to financial crises (Calvo, Leiderman and Reinhart 1993).
While the debate on the merits of capital account liberalisation is not new, it has intensified in the aftermath of the emerging market crises of the 1990s. The Mexican crisis, and the Asian crisis in particular, showed that even countries with high growth rates and sound macroeconomic policies could be severely affected by a rapid reversal of capital flows. These events have prompted proposals that range from ‘throwing sand in the wheels’ of capital movements to the complete prohibition of international financial transactions. Sceptics of measures aimed at limiting capital mobility, on the other hand, argue that these would result in lost investment and economic growth.
The key to this debate is whether the potential benefits of financial integration are sufficient to offset the evident risks. While there is a large body of work that looks at the risks associated with financial liberalisation and capital flows,[3] there has been, until recently, only a few studies that evaluate the benefits of open capital markets. The aim of this paper is to shed some light on this debate by examining both the theoretical links and the empirical evidence on effects of financial liberalisation on long-run economic growth. We also present some new results on the effects of capital flows, with a particular emphasis on the composition of capital flows.
Existing empirical evidence suggests that the link between financial openness and economic growth is weak. While there is some evidence that liberalisation positively affects growth, this relationship is not robust. There is some evidence that the positive impact of foreign investment on growth is conditional upon the existence of relatively developed domestic institutions and sound macroeconomic policy. This result is also not very robust and is sensitive to the measures employed to capture institutional development and policy variables. The new results from this study show that both foreign direct investment and portfolio flows have a significant positive effect on economic growth. The positive effects of portfolio flows are above and beyond their effects on investment, indicating that they also entail externalities that are growth enhancing. The effect of bank flows, on the other hand, is found to be negative. This suggests that the measures of capital account liberalisation used by previous studies may not adequately measure the true extent of a country's financial integration. It also suggests that aggregate measures of capital flows and openness could conceal the different channels through which different types of capital flow might affect growth.
The remainder of this paper is organised as follows. Section 2 looks at some recent trends in capital flows to developing countries during the past few decades. Section 3 briefly reviews the theoretical literature on the macroeconomic effects of capital flows. In Section 4 and 5 we present the relevant empirical evidence. Section 6 concludes.