Download Book Review of "Who Needs to Open the Capital Account?"

Journal of International Economics 90 (2013) 232–235
Contents lists available at ScienceDirect
Journal of International Economics
j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / j i e
Book reviews
Olivier Jeanne, Arvind Subramanian, John Williamson, Who Needs
to Open the Capital Account?, Peterson Institute for International
Economics, 2012
The empirical relevance of theories of international risk sharing is an
issue of long-standing interest in international finance. While international trade in financial assets brings many potential welfare gains, it
also entails significant risks. As part of the larger debate about financial
globalization, the extent to which policy-makers should allow foreign
capital to flow into their economies remains a controversial issue.
Following the advice of academics, many emerging market policy
makers opened up their capital markets to foreign capital in the late 1980s
and early 1990s. In the aftermath of a spate of financial crises in the late
1990s however, a heated debate over capital account liberalization has
consumed the profession. Opponents of capital account openness
maintain that hot money flows of international capital flee emerging
economies at the first sign of trouble and the financial crises that ensue
impose massive costs on these economies. Further, opponents cite
evidence from a series of studies suggesting that the role of capital
account openness for financing growth is ambiguous at best. This swing
in the academic pendulum has not been lost on developing country
policy makers who have increasingly taken to imposing a variety of
capital controls to curb foreign capital inflows, effectively reversing the
process of capital market openings that began in the 1980s.
A new monograph by Olivier Jeanne, Arvind Subramanian and John
Williamson, Who Needs to Open the Capital Account?, revisits the issue of
capital market integration and draws attention to the wide diversity of
capital account policies around the world ranging from some countries
adopting complete openness, to others with market-based prudential
controls (notably Brazil) to others with tight restrictions on their capital
accounts (such as China).
The authors set out to uncover the lessons and implications of
global financial crises for capital account policies in developing and
emerging countries. They argue that unlike free trade in goods that
took place under the aegis of international rules and multi-lateral
institutions such as the WTO, free trade in financial assets did not
happen by design but rather under a vague promise of an economic
growth dividend and primarily because under the world order of global
finance, “advanced country club” status required that free capital
mobility be embraced and because capital controls were seen as vestiges
of economic backwardness.
The introduction reviews the evidence regarding capital flow
volatility in both developed and emerging countries during the global
financial crisis and discusses the resurgence of capital controls with a
focus on the recent Brazilian foray into taxing capital inflows. The authors
then present the case for prudential capital controls which provides a
discussion about the distinction between prudential controls designed to
mitigate the volatility of foreign capital inflows and protectionist controls
aimed at maintaining persistent currency undervaluation.
The evidence about the impact of capital account liberalization
on economic growth using a “meta regression” approach is presented
where the authors argue that the diversity of capital account policies is
consistent with a lack of conclusive evidence about the benefits of free
capital mobility on economic growth. Following this the evidence
disaggregated by the type of capital flow (portfolio equity, debt, FDI and
bank flows) is reviewed.
While the authors maintain that their focus on capital controls is
technical rather than ideological and circumstance dependent, they also
argue that there is no rationale to promote totally free trade in financial
assets. The book concludes by proposing an international code of good
practices that embodies capital account policy norms including desirable
capital controls. The authors highlight a need for an international
consensus about a framework of rules that legitimizes the use of
appropriate capital controls (“good controls”) and discourages harmful
ones (“bad controls”). According to the authors, the basic difference
between good and bad controls is that the former correct distortions that
occur under free markets while the latter create distortions. In particular,
they favor transparent, price-based prudential measures, such as a
counter-cyclical tax on capital inflows to curb boom–bust cycles in asset
prices generated by these flows. The authors argue that controls like the
Chinese case, have negative global spillover effects such as repressing
domestic demand combined with reserve accumulation to maintain
capital account surpluses are inappropriate and harmful as they are
protectionist and not prudential in nature.
It is important to note that the economic rationale for capital account
liberalization draws upon the notion of allocative efficiency or the
neoclassical view that capital account openness allows financial
resources to flow from capital-abundant countries, where expected
returns are low, to capital-scarce countries, where expected returns are
high. The flow of resources into capital-scarce countries in turn is
expected to reduce the cost of capital, increase investment, and raise
output in the recipient countries (Fischer, 1998, 2003; Henry, 2007;
Obstfeld, 1998; Rogoff, 1999; Summers, 2000). Jeanne, Subramanian and
Williamson (2012) are skeptical of the case for free capital mobility that
relies on allocative efficiency and instead maintain that the push to
liberalize capital accounts over the last few decades was driven by a
“foreign finance fetish.” Consistent with arguments in Bhagwati (1998),
Edison et al. (2004), Eichengreen (2001), Kose et al. (2009), Rodrik
(1998), and Stiglitz (1999, 2000, 2002), the authors consider the evidence
regarding the benefits of capital account openness for investment and
economic growth unconvincing and the costs in the form of recurring
financial crises in emerging markets immediately obvious.
To make their case the authors adopt a “meta-regression” approach
that involves running more than 2300 regressions using six de jure and
de facto measures of financial liberalization, three different ways of
specifying financial liberalization (as an initial level, a change and an
average), twelve disaggregated measures of financial liberalization,
various time horizons, time-series and panel approaches, threshold
effects and conditioning variables.
Unfortunately the analysis suffers from the critique leveled by
Henry (2007) against the wide body of literature that seeks to
examine the impact of capital account openness on real variables such
as investment and growth—namely, most of these papers tell us
nothing about the empirical validity of the theory they set out to test.
Book reviews
The neoclassical model provides no theoretical basis for conducting
cross-sectional tests of a permanent relationship between capital
account openness on growth and therefore does not suggest the
causal link needed to justify cross-sectional regressions (Henry,
2007).
In contrast, papers in the policy-experiment genre that take the
predictions of neoclassical theory seriously find that in the immediate
aftermath of capital account liberalization, the cost of capital falls,
investment rises as does economic growth and the effects are economically meaningful and statistically significant. However, while the
impact on the standard of living or per capita incomes is permanent,
the growth impact is temporary and lasts only during the transition
between the autarkic and liberalized steady states. Theory suggests
that one tests for either a permanent level effect on per capita incomes
or a temporary growth effect. Therefore it is not surprising that analyses
that test for a permanent growth impact of capital account openness do
not find statistical significance—the neoclassical model provides no
theoretical rationale to expect such a relationship.
Therefore the justification for running over 2300 regressions with
noisy data and an analysis that is untethered from the theory the
authors set out to test is not clear. The exercise creates a false sense of
precision and fails to provide a compelling analytical approach. As an
example, the IMF's AREAER measure which the authors use as one of
the main capital account openness measures provides no information
on the specific aspect of the capital account the country liberalized
and neither can any index that is based on such data. Therefore, it is
unclear how to map that variation in such an index to a wellarticulated model for the purpose of empirical estimation (Henry, 2007).
For instance, neoclassical theory predicts that liberalizing capital
inflows will lead to effects on the cost of capital, investment and growth.
Without knowing the distinction between capital inflows and outflows
from the AREAER measure, it is unclear how one would use this measure
to use the theory to guide empirical analysis. Using data and measures
that do not correspond or at best loosely correspond to what theory
predicts is far from convincing.
In advancing the theoretical rationale for prudential capital controls
the authors focus on boom–bust cycles in capital inflows to identify and
prescribe policies to mitigate externalities generated by an amplified
build-up in external debt during capital-inflow booms which in turn
lead to costly deleveraging if there is a sudden stop in these flows. The
case for counter-cyclical prudential controls is the same as for the
macro-prudential regulation of the financial sector. Its objective is to
design measures that make agents internalize their contributions to
systemic risk to curb the destabilizing impact of capital inflow booms
and busts.
It must be noted that the models used by the authors to develop
the case for prudential controls all rely on external debt to generate
excessive leverage build-ups during capital inflow booms. There is a
general consensus that the distinction between debt and equity is an
extremely important one when discussing the benefits of capital
account openness. Since debt does not embody the risk-sharing
aspects of international equity flows, excessive reliance on external
debt (especially foreign-currency denominated bank loans that
generate currency mismatches on balance sheets) can cause financial
distress as we have seen in many an emerging-market crisis. It is also
important to observe that in contrast to the sharp reversal in debt
flows during recent emerging-market crises, net portfolio equity
inflows remained more stable.
Given that the type of capital inflow that appears to generate the
greatest systemic vulnerability is an excessive reliance on short-term
external debt, it is not clear why the authors favor a counter-cyclical tax
that ought to be applied to all capital inflows, albeit of varying
magnitude depending on the inflow type. It is also not obvious why
domestic macro-prudential regulations that directly address a build-up
of excessive leverage in the financial system would not suffice. The
authors' suggestion that a diversification across wide range of policy
233
instruments (domestic macro-prudential regulations and capital
controls) would serve to enhance the effectiveness and compliance of
regulatory measures is not particularly convincing especially when we
consider the empirical evidence regarding the impact of capital controls
on real variables.
Using data that differentiates between capital controls on different
categories of assets, Klein (2012) finds that with a few exceptions,
there is little evidence of the efficacy of capital controls on the growth
of financial variables, the real exchange rate, or GDP growth casting
doubts about assumptions behind recent calls for a greater use of
episodic controls on capital inflows. Combined with the evidence on
the adverse real effects of restrictions on capital inflows such as on
financing constraints faced by firms (see for example, Forbes, 2007) it
is not clear that capital controls should be a “regular instrument of
economic policy” as the authors suggest. On balance, it is not obvious
that the way forward is towards a more dirigiste international regime
where government-designed controls act as sands in the wheels of
international finance.
The book is targeted to an international policy audience. While the
evidence presented may give the impression of rigor, it does not survive
closer examination. Readers in policy circles may be advised that the
arguments favoring capital controls advanced by the authors have not
yet been established in theory or in fact.
References
Bhagwati, J., 1998. The capital myth: the difference between trade in widgets and dollars.
Foreign Affairs 77, 7–12.
Edison, H.J., Klein, M.W., Ricci, L.A., Sløk, T., 2004. Capital account liberalization and
economic performance: survey and synthesis. IMF Staff Papers 51, 220–256.
Eichengreen, B., 2001. Capital account liberalization: what do cross-country studies tell
us? World Bank Economic Review 15, 341–365.
Fischer, S., 1998. Capital account liberalization and the role of the IMF. Should the
IMF pursue capital-account convertibility. Essays in International Finance, no. 207.
Princeton: International Finance Section, Department of Economics, Princeton
University, pp. 1–10.
Fischer, S., 2003. Globalization and its challenges. American Economic Review 93, 1–30.
Forbes, K.J., 2007. The microeconomic evidence on capital controls: no free lunch. In:
Edwards, S. (Ed.), Capital Controls and Capital Flows in Emerging Economies: Policies,
Practices, and Consequences. University of Chicago Press, Chicago and London,
pp. 171–202.
Henry, P.B., 2007. Capital account liberalization: theory, evidence, and speculations.
Journal of Economic Literature 45, 887–935.
Klein, M., 2012. Capital controls: gates versus walls. NBER Working Paper 18526,
Cambridge, MA.
Kose, M.A., Prasad, E.S., Rogoff, K.S., Wei, S.-J., 2009. Financial globalization: a reappraisal.
IMF Staff Papers 56, 8–62.
Obstfeld, M., 1998. The global capital market: benefactor or menace? Journal of Economic
Perspectives 12, 9–30.
Rodrik, D., 1998. Who needs capital-account convertibility? Should the IMF Pursue
Capital-Account Convertibility. Essays in International Finance, no. 207. International Finance Section, Department of Economics, Princeton University, Princeton,
pp. 55–65.
Rogoff, K.S., 1999. International institutions for reducing global financial instability.
Journal of Economic Perspectives 13, 21–42.
Stiglitz, J.E., 1999. Reforming the global economic architecture: lessons from the recent
crises. Journal of Finance 54, 1508–1521.
Stiglitz, J.E., 2000. Capital market liberalization, economic growth, and instability.
World Development 28, 1075–1086.
Stiglitz, J.E., 2002. Globalization and its Discontents. Norton, New York and London.
Summers, L.H., 2000. International financial crises: causes, prevention, and cures.
American Economic Review 90, 1–16.
Anusha Chari
CB #3305 Department of Economics, University of North Carolina at
Chapel Hill, Chapel Hill, NC 27599, United States
Tel.: +1 919 966 5346; fax: +1 919 966 4986.
E-mail address: [email protected].
http://dx.doi.org/10.1016/j.jinteco.2013.01.002