Order Information

O C C A S I O N A L   P A P E R      
Capital Account Liberalization and Financial Sector Stability

By a Staff Team Led by Shogo Ishii and Karl Habermeier
©2002 International Monetary Fund
April 12, 2002


          Part I. A Framework for Sequencing

  1.   Overview

  2.   Analytical Issues
        Sources of Financial Sector Instability
        Linkages of Financial Sector Instability with Capital Account
        Contagion and the Influence of Size and Openness

  3.   Sequencing Capital Account Liberalization with
          Other Reforms

        Sequencing: Insights from Country Experiences
        General Principles for Sequencing

  4.   A Suggested Methodology for Sequencing
        Applying the Methodology—An Example

    Part II. The Prudential Framework and Capital Account Liberalization

  5.   The General Framework for Financial Sector Stability
        Development of Financial Markets and Institutions
        Prudential Regulation and Supervision: General Issues
        Improved Risk Management by Financial Institutions
        Capital Controls and Prudential Policies
        Accounting, Auditing, and Disclosure
        Financial Safety Nets and Resolution Policies

  6.   Prudential Regulation and Supervision of Cross Border

        Prudential Regulation and Supervision of Banks
        Prudential Aspects of Offshore Financial Centers
        Nonbank Financial Institutions
        Supervisory Practices

    Part III. Selected Country Experiences with Capital Account Liberalization and Financial Sector Stability

  7.   Countries That Avoided a Financial Crisis
        Austria: Integration into Regional and Global Markets
        Hungary: Resilience to Contagion from the 1998 Russian Crisis
        South Africa: Contagion from the 1997–98 Financial Crises
        United Kingdom: The 1992 ERM Crisis

  8.   Countries That Experienced a Financial Crisis
        Korea: The 1997 Twin Crises
        Mexico: The 1994–5 Crisis
        Sweden: The Early 1990s Twin Crises
        Turkey: The 1994 and 2000 Crises
        Paraguay: The 1995–98 Financial Sector Crisis



    1.  Foreign Ownership and Market Discipline: The Case of Hungary
    2.  Linkages Between the Financial Sector, Capital Flows, and the
         Macroeconomy: Korea and Sweden
    3.  Contrasting Roles of Structural Factors: South Africa and
         Hungary Compared with Turkey
    4.  Risks in Cross-Border Transactions
    5.  Role of the Government in the Financial Sector: Mexico, Korea,
         and Austria
    6.  Selected Country Experiences
    7.  Suggested Sequencing Methodology
    8.  Prudential Policies and Financial System Stability:
         United Kingdom
    9.  Statistically Based Risk Management Techniques
    10.  Capital Controls and Prudential Policies
    11.  Maturity Ladder Approach to Managing Liquidity Risk:
         The Case of Korea
    12.  Recommendations of the Financial Stability Forum to Reduce
           the Risks Stemming from Highly Leveraged Institutions (HLIs)
    13.  Austria: Capital Account Liberalization, 1986–91
    14.  Hungary: Current and Capital Account Liberalization Prior to
           the Russian Crisis
    15.  South Africa: Exchange and Capital Account Liberalization,
    16.  Korea: Interest Rate Deregulation During the 1990s
    17.  Korea: Capital Account Liberalization, 1985–96
    18.  Korea: Key Capital Account Regulations at the Onset of the
           Crisis (mid-1997)
    19.  Mexico: Capital Account Liberalization, 1989–94
    20.  Mexico: Remaining Key Capital Controls in 1994
    21.  Sweden: Capital Account Liberalization, 1980–92
    22.  Turkey: Capital Account Liberalization, 1988–91
    23.  Paraguay: Capital Account Liberalization, 1989–94 86
    24.  Paraguay: Domestic Financial Liberalization, 1990–94


    1.  Liberalizing Specific Capital Flows and Policies to Manage
           the Risks
    2.  Inventory of Capital Controls and Related Measures—Example
    3.  Assessment of Conditions and Vulnerabilities—Example
    4.  Sequencing Capital Account Liberalization with Other
    5.  Corporate Debt-Equity Ratios in Selected Emerging Economies


    1.  A Stylized Representation of Sequencing
    2.  Austria: Capital Flows, 1980–99
    3.  Austria: Short-Term Interest Rate, 1980–99
    4.  Hungary: Real GDP and Consumer Prices, 1990–98
    5.  Hungary: Current Account Balance, Reserves in Convertible
         Currencies, and Gross External Debt in Convertible Currencies,
    6.  Hungary: Outstanding Stock of Nonresident Holdings of
         Government Securities, 1997–99
    7.  Hungary: Nominal Exchange Rate, 1997–99
    8.  South Africa: Net Private Capital Flows, 1981–2000
    9.  South Africa: Stock Exchange Index, Nominal Exchange Rate,
         and, Interbank Rate 1997–99
    10.  United Kingdom: Interest Rates, 1989–94
    11.  United Kingdom: Exchange Rates, 1985–94
    12.  United Kingdom: Net Private Capital Flows, 1985–93
    13.  Korea: Key Real Sector Indicators, 1985–97
    14.  Korea: Current Account Balance and Net Private
           Capital Flows, 1985–97
    15.  Mexico: Nominal Exchange Rate and Real Effective Exchange
           Rate, 1987–95
    16.  Mexico: Net Private Capital Flows, 1980–95
    17.  Mexico: Private Sector Bank Credit, 1980–95
    18.  Mexico: Short-Term Debt to International Reserves, 1991–95
    19.  Sweden: Net Private Capital Flows, 1981–91
    20.  Sweden: Bank Claims on Private Sector, 1981–91
    21.  Sweden: Share Price Index, 1981–91
    22.  Turkey: Consumer Prices, 1980–2000
    23.  Turkey: Real Effective Exchange Rate and Trade Deficit,
    24.  Turkey: Private Capital Flows, 1980–2000
    25.  Paraguay: Growth of Monetary Aggregates, 1988–99
    26.  Paraguay: Net International Reserves and Nominal Exchange
           Rate, 1989–98

I  Overview

A fundamental issue in undertaking capital account liberalization is how to reap the benefits from capital market access while coping safely with the risks associated with international capital flows. Increased attention has been focused recently on the growing frequency of financial crises and the possible role that capital account liberalization might play in contributing to such phenomena. A variety of factors and forces can lead to the emergence of a financial crisis in a specific country. In a world of growing financial globalization and more open capital accounts, events in other countries may have an impact on a country's financial stability. Nevertheless, country experiences indicate that the ability to avoid financial crisis in the context of more open capital accounts often depends upon the ability of financial and nonfinancial institutions as well as the government to manage financial risks in general. At the same time, legal, institutional, and prudential arrangements must be adequate to deal with complex risks associated with increasingly diverse types of capital flows.

In general, the range of factors bearing on financial stability and its linkages with capital flows is very broad. However, as discussed in Chapter II, three basic sources of financial sector instability may be distinguished: disturbances arising from the linkages between the financial sector and the macroeconomy; structural weaknesses in the financial sector; and certain types of government involvement in the financial sector. These three sources of instability can interact in a variety of ways to increase risk. Thus, financial sector stability requires both macroeconomic stability and structural policies and conditions consistent with a sound and efficient domestic financial sector. These structural policies, which are discussed in Chapter V, involve the development of financial markets and institutions; prudential regulation and supervision; risk management and good practices in accounting, auditing, and disclosure; and financial safety nets. Closely associated policies that are not discussed in this paper include policies dealing with insolvency, corporate governance, creditor rights, systemic restructuring of financial and nonfinancial institutions, public debt and foreign exchange reserve management, transparency of public policies, and improved statistics.

Country experiences presented in Part III point to some general principles that are helpful in sequencing and coordinating capital account liberalization with other policies, particularly structural policies to strengthen domestic financial systems. These principles, which are elaborated in Chapter III, emphasize the importance of macroeconomic stability and the choice of an appropriate exchange rate regime while giving priority to financial sector reforms that support macroeconomic stability. They also underscore the need to: coordinate capital account liberalization with different financial sector policies, taking into account the initial condition of financial and nonfinancial entities and their capacity to manage the risks associated with international capital flows; assess the effectiveness of existing capital controls; identify and implement urgent measures in connection with reforms that require a long lead time; and ensure the sustainability of the reforms and the transparency of the liberalization process. The principles point to the desirability, in most cases, of liberalizing long-term flows—especially foreign direct investment (FDI) flows—ahead of short-term flows. At a minimum, any partial early liberalization of short-term flows needs to be accompanied by adequate prudential measures.

Even so, there is no simple method for devising an operational plan for sequencing and coordinating capital account liberalization with other policies. This reflects the reality that capital account liberalization and financial sector development are often mutually reinforcing; therefore, removing controls on one type of flows affects other types of transactions, and hence the financial sector and the economy as a whole. In particular, the effectiveness of any remaining capital controls could be eroded by a partial liberalization. Steps toward capital account liberalization and other policies thus cannot be analyzed in isolation, as the interactions between them are complex and subject to considerable uncertainty. Thus, sequencing will only become tractable once the specifics of a particular case are analyzed.

The design of an operational plan for sequencing will therefore need to be based on a careful assessment of individual countries' circumstances and will require judgment, discretion, and flexibility. When macroeconomic and financial sector conditions are sufficiently good, capital controls could be removed quickly without undue risk. In many cases, however, a gradual approach to capital account liberalization may be required; but a gradual approach would not by itself guarantee an orderly liberalization. Moreover, countries would need to be prepared to change their sequencing plans in the face of changing macroeconomic conditions or emerging signs of vulnerabilities, and in some cases it could be appropriate to adopt a contingency plan that may delay further capital account liberalization until conditions become more favorable. Therefore, care must also be taken in applying approaches that were successful in one country to other countries.

Based on the general principles, a methodology for sequencing capital account liberalization is presented in this paper. This methodology, which is illustrated by an example, involves an assessment of capital controls and macroeconomic and financial sector vulnerabilities, and the design of a plan for sequencing capital account liberalization with financial sector reforms and other policies. The methodology is intended to support a better integration of the domestic and international dimensions of financial sector development and stability in the IMF's policy advice, surveillance activities, and technical assistance involving countries wishing to undertake an orderly liberalization of their capital accounts.