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«Capital Account Liberalization Theory, Evidence, and Speculation Peter Blair Henry The Brookings Institution Global Economy and Development Working ...»

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Capital Account Liberalization

Theory, Evidence, and Speculation

Peter Blair Henry

The Brookings Institution Global Economy and Development

Working Paper #4

Working Paper # 4

Capital aCCount liberalization:

theory, evidenCe, and SpeCulation

Peter Blair Henry

Nonresident Senior Fellow

Global Economy and Development Program

The Brookings Institution

Associate Professor

Stanford School of Buisiness

Stanford University

january 2007

The Brookings insTiTuTion 1775 MassachuseTTs ave., nW WashingTon, Dc 20036 Correspondence to pbhenry@stanford.edu. I gratefully acknowledge financial support from an NSF CAREER Award, the John and Cynthia Fry Gunn Faculty Fellowship, and the Freeman Spogli Institute for International Studies. I thank Anusha Chari, Roger Gordon, Diana Kirk, John McMillan, Paul Romer, and two anonymous referees for helpful comments. Diego Sasson provided excellent research assistance. Finally, I thank Sir K. Dwight Venner and the Research Department of the Eastern Caribbean Central Bank for hosting me in the summer of 1994, when I first started thinking about the issues addressed in the paper.

The views expressed in this working paper do not necessarily reflect the official position of Brookings, its board or the advisory council members.

© The Brookings Institution ISBN: 978-0-9790376-3-4  Contents Executive Summary................................................... 5 Introduction........................................................ 6 Capital Account Liberalization and the Neoclassical Growth Model.............. 8 The Cross-Sectional Approach to Measuring the Impact of Liberalization......... 9 Empirical Methodology.............................................. 10 Evidence......................................................... 11

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Executive Summary Writings on the macroeconomic impact of capital account liberalization find few, if any, robust effects of liberalization on real variables. In contrast to the prevailing wisdom, I argue that the textbook theory of liberalization holds up quite well to a critical reading of this literature. The lion’s share of papers that find no effect of liberalization on real variables tell us nothing about the empirical validity of the theory, because they do not really test it. This paper explains why it is that most studies do not really address the theory they set out to test. It also discusses what is necessary to test the theory and examines papers that have done so. Studies that actually test the theory show that liberalization has significant effects on the cost of capital, investment, and economic growth.

Introduction A capital account liberalization is a decision by a country’s government to move from a closed capital account regime, where capital may not move freely in and out of the country, to an open capital account system in which capital can enter and leave at will. Broadly speaking, there are two starkly different views about the wisdom of capital account liberalization as a policy choice for developing countries.

The first view, Allocative Efficiency, draws heavily on the predictions of the standard neoclassical growth model pioneered by Solow (1956). In the neoclassical model, liberalizing the capital account facilitates a more efficient international allocation of resources and produces all kinds of salubrious effects. Resources flow from capital-abundant developed countries, where the return to capital is low, to capitalscarce developing countries where the return to capital is high. The flow of resources into the developing countries reduces their cost of capital, triggering a temporary increase in investment and growth that permanently raises their standard of living (Fischer, 1998, 2003; Obstfeld, 1998; Rogoff, 1999; Summers, 2000). Motivated in part by the prospective gains from incorporating Allocative Effciency arguments into their economic policies, dozens of developing-country governments from Santiago to Seoul have implemented some form of capital account liberalization over the past 20 years.

The alternative view regards Allocative Efficiency as a fanciful attempt to extend the results on the gains to international trade in goods to international trade in assets. The predictions of Allocative Efficiency hold only where there are no distortions to the economy other than barriers to free capital flows. Because there are many other distortions in developing countries, skeptics argue that the theoretical predictions of the neoclassical model bear little resemblance to the reality of capital account policy. This alternative view is best characterized by an article provocatively titled, “Who Needs Capital Account Convertibility?” (Rodrik, 1998).1 Rodrik’s empirical analysis finds no correlation between the openness of countries’ capital accounts and the amount they invest or the rate at which they grow. He concludes that the benefits of an open capital account, if indeed they exist, are not readily apparent, but that the costs are manifestly evident in the form of recurrent emerging-markets crises.

Since the publication of Rodrik’s polemic, evidence has seemed to mount in support of the view that capital account liberalization has no impact on investment, growth, or any other real variable with significant welfare implications. For example, in his survey of the research on capital account liberalization, Eichengreen (2001) concludes that the literature finds, at best, ambiguous evidence that liberalization has any impact on growth. In another review of the literature, Edison, Klein, Ricci, and Sløk (2004) survey ten studies of liberalization and document that only three uncover an unambiguously positive effect of liberalization on growth. Finally, in their comprehensive survey of the research on financial globalization, Prasad, Rogoff, Wei, and Kose (2003) extend the Edison et al. (2004) survey to fourteen studies, but still find only three that document a significant positive relationship between international financial integration and economic growth. Prasad et al. (2003) conclude that “…an objective reading of the vast research effort to date suggests that there is no strong, robust, and uniform support for the theoretical argument that financial globalization per se delivers a higher rate of economic growth.” In contrast to existing surveys, this article demonstrates that a critical reading of the literature reveals that the textbook theory of liberalization stands up to the data quite well. It is true that most papers find no effect of liberalization on growth. But these papers tell us nothing about the empirical validity of the theory. They perform purely cross-sectional regressions that look for a positive correlation between capital account openness and economic growth, implicitly testing whether capital account policy has permanent effects on differences in long-run growth rates across countries. The fundamental problem with this approach is that the neoclassical model provides no theoretical basis for conducting such tests.

The model makes no predictions about the correlation between capital account openness and long-run growth rates across countries, and certainly does not suggest the causal link needed to justify cross-sectional regressions.

What the neoclassical model does predict is that liberalizing the capital account of a capital-poor country will temporarily increase the growth rate of its GDP per capita. The temporary increase in growth matters, because it permanently raises the country’s standard of living. However, as it is the increase in the level of GDP per capita that is permanent—not its rate of growth—theory dictates that one tests for either a permanent level effect or a temporary growth effect. Testing for a permanent growth effect makes no sense because capital accumulation, which is subject to diminishing returns, is the only channel through which liberalization affects growth in the neoclassical model.

A small but growing branch of the literature takes the time series nature of the neoclassical model’s prediction seriously. It does so by investigating whether countries invest more and grow faster in the immediate aftermath of a discrete change in their capital account policy. In contrast to work that looks for a permanent impact of capital account openness on growth across countries, papers in the policyexperiment genre find that opening the capital account within a given country consistently generates economically large and statistically significant effects, not only on economic growth, but also on the cost of capital and investment.

While the policy-experiment literature removes any serious doubts about whether liberalization has real effects, its findings raise more questions than they resolve. Are the magnitudes of the documented effects plausible? Do the transmission mechanisms emphasized by the theory really drive the results, or are other forces at work? With their focus on aggregate data, papers in the policy-experiment genre do not have enough empirical power to be of any use. Fortunately, a new wave of papers demonstrates how to make progress on these and other important questions by using firm-level data. Analyzing capital account liberalization at the level of the firm instead of the country provides greater clarity about the ways in which liberalization affects the real economy.

Disaggregating the data also brings clarity to the contentious debate on liberalization and crises. Because there are many different ways to liberalize the capital account, when trying to determine whether liberalizations cause crises, it is critical to specify exactly what kind of liberalization you mean. At a minimum, the distinction between debt and equity is critical. Recent research demonstrates that liberalization of debt flows—particularly short-term, dollar-denominated debt flows—can cause problems. On the other hand, all the evidence we have indicates that countries derive substantial benefits from opening their equity markets to foreign investors.

The rest of this paper proceeds as follows. Section 2 presents an organizing theoretical framework. Section 3 reviews the literature on the cross-sectional approach to the macroeconomic effects of capital account liberalization. Section 4 uses the framework from Section 2 to explain why the cross-sectional literature finds no real effects of liberalization. Section 5 discusses the policy-experiment approach to the macroeconomic effects of liberalization. Section 6 discusses problems with the policy-experiment approach. Section 7 reviews recent advances using firm-level data. Section 8 examines whether liberalizations cause crises. Section 9 concludes.

Capital Account Liberalization and the Neoclassical Growth Model

This section illustrates the fundamental predictions of the neoclassical growth model about the impact of capital account liberalization on a developing country. The framework is not novel, but it brings clarity to the discussion of the empirical literature that follows in Section 3.

Assume that output is produced using capital, labor, and a Cobb-Douglas production function with

labor-augmenting technological progress:

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Let s denote the fraction of national income that is saved each period and assume that capital depreciates at the rate δ, the labor force grows at the rate n, and total factor productivity grows at the rate g. Saving each period builds up the national capital stock and helps to make capital more abundant. Depreciation, a growing population, and rising total factor productivity, all work in the other direction making capital less abundant. The following equation summarizes the net effect of all these forces on the evolution of

capital per unit of effective labor:

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Equation (4) gives a general expression of the equilibrium condition for investment. This equation has important implications for the dynamics of a country’s investment and growth in the aftermath of capital account liberalization, because the impact of liberalization works through the cost of capital. Let r* denote the exogenously given world interest rate. The standard assumption in the literature is that r* is less than r, because the rest of the world has more capital per unit of effective labor than the developing country. It is also standard to assume that the developing country is small, which means that nothing it does affects world prices.

Under these assumptions, when the developing country liberalizes, capital surges in to exploit the difference between the world interest rate and the country’s rate of return to capital. The absence of any frictions in the model means that the country’s ratio of capital to effective labor jumps immediately to its post-liberalization, steady-state level. Figure 1 depicts this jump as a rightward shift of the vertical dashed line from ks.state to k*s.state. In the post-liberalization steady state, the marginal product of capital

is equal to the world interest rate plus the rate of depreciation:

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The instantaneous jump to a new steady state is an unattractive feature of the model, because it implies that the country installs capital at the speed of light. There are a variety of formal ways to slow down the speed of transition, but taking the time to do so here would lead us astray.2 The vital fact about the transition dynamics, which would hold true in any model, is that there must be a period of time during which the capital stock grows faster than it does before or after the transition. To see why the growth rate of the capital stock must increase temporarily, recall that in the pre-liberalization steady state the ratio of capital to effective labor (ks.state ) is constant, and the stock of capital (K ) grows at the rate n + g. In the post-liberalization steady state, the ratio of capital to effective labor (k*s.state ) is also constant and the capital stock once again grows at the rate n + g. However, because k*s.state ks.state, it follows that at some point during the transition, the growth rate of K must exceed n + g.

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