Capital Account Liberalization, Free Long-term Capital Flows, Financial Crises and Economic Development

The main objective of this paper is to review the theoretical issues and available empirical evidence on capital account liberalization. In addition to being of interest in its own right, capital account liberalizations is important to the debate on the New International Financial Architecture (NIFA) and to the post-Doha agenda at the World Trade Organization (WTO) in relation to foreign direct investment (FDI) flows. This paper focuses on developing countries and it considers policy from the perspective of (a) economic development and (b) the global rules of the game rather than the economic policy within individual countries. The paper essentially examines the question: what kind of global economic order in relation to capital flows can best serve the interests of developing countries? Capital account liberalization is an area where economic theory is the most disconnected from real-world events. In analyzing liberalization of capital flows, it is customary to distinguish between short-term (for example, portfolio flows and shortterm bank loans) and long-term flows (for example, FDI). Neoclassical theory suggests that free flows of external capital (including short-term capital) should be equilibrating and help smooth a country’s consumption or production paths. However, in the real world, exactly the opposite appears to happen. Liberalization of the shortterm capital account has invariably been associated with serious economic and financial crises in Asia and Latin America in the 1990s. The proponents of neoclassical theory argue that the case for free capital flows is no different from that for free trade; the former could simply be regarded as a form of inter-temporal trade. The first part of the paper addresses this central controversy in relation to developing countries and specifically asks the following questions: