Financial Liberalization & Financial Crises: No Smoke Without Fire

What role has financial liberalization, including capital account liberalization, played in recent financial crises in emerging markets? What policy conclusions should one draw from this?

You can’t have smoke without fire. Recent economic history would suggest that neither can you have financial crises without weak macroeconomic fundamentals. Certainly, capital flows can increase vulnerability to, and the amplitude of, emerging market crises. Moreover, it is often capital flow reversals that signal the onset of financial crises in dramatic fashion.

While it is true that prohibiting global capital flows would prevent or dampen many economic crises, it does not necessarily follow that this is the appropriate policy course. If you can’t have smoke without fire, then it’s also true to say that you can’t have fire without tinder. Removing all tinder would surely prevent future fires, but we should not forget that learning to use fire was one of homo sapiens’ most important social evolutions.

This this is not to say that all capital flows are good flows, or even that restrictions on flows could not yield a pareto improving outcome. It is simply recognition that a certain degree of international mobility of capital is critically important if emerging and developing economies are to have some chance of converging with advanced economies.

The theory is pretty simple (indeed, in common with many economic models, often overly simplistic): allowing countries to borrow from eachother, for instance by running a Current Account deficit, allows countries to engage in consumption smoothing and to invest significant sums up-front to improve long term productive capacity. In conventional economic terms, therefore, it is not only possible, but normal, and even desirable, for developing nations to import capital, so long as it is not wastefully diverted to short term consumption.

From the lender’s perspective, at a certain stage of development the number of profitable domestic investments becomes increasingly limited, giving rise to too much capital chasing too few projects. In formal terms, there are declining marginal returns to capital invested. It makes sense, therefore, for nations with a surplus of savings to channel these funds to more productive uses. In theory, therefore, international capital mobility should be a win-win prospect, and capital account liberalization – both in, obviously, and out, so that investors provide capital in the first place safe in the knowledge that they can remove it if necessary – makes eminent sense.

So far, so simple. Unfortunately, we all know that sometimes, if you play with fire, you get burnt. In the global economy, there are periodic crises which result in rapid capital flight, and steep contractions in economic output in the affected nations. As previously stated, such crises rarely if ever take place in the absence of at least some macroeconomic weakness. The extent of the crisis, however, could well be related to the nature of the capital inflows.

There is a world of difference between long-term Foreign Direct Investment, short-to-medium term (but reasonably easily reversible) Portfolio Investment, and short-term ‘hot money’ chasing yield on international money markets. Capital flows that are easily reversible are clearly a source of vulnerability in the event of crisis, or even perceived crisis. Foreign Direct Investment is typically much less mobile or prone to flight.

In a 1998 paper, Dani Rodrik argues that it was reversals in capital flows that sparked the Asian financial crisis in 1997. He notes that South Korea, Indonesia, Malaysia, Thailand and the Philippines together saw a turnaround (from $93bn inflow to $12bn outflow) in capital flows amounting to 10% of their collective GDP between 1996 and 1997 alone. There does not even have to be reverse in capital flows; even a sharp slowdown or sudden stop can have a dramatic impact. In relation to Mexico’s Tequila crisis of 1994-5, Dornbusch and Werner (1994) noted that “it is not speed that kills, it is the sudden stop”.

Rodrik goes on to note that far from being isolated incidents, Balance of Payments crises were the norm in emerging markets. Consequently, he is sharply critical of the IMF’s past missionary zeal in insisting that capital account liberalization be pursued rigorously in emerging markets. His eloquent conclusion is worth repeating:

“The greatest concern I have about canonizing capital-account convertibility is that it will leave economic policy in the typical “emerging market” hostage to the whims and fancies of two dozen or so thirty-something country analysts in London, Frankfurt, and New York. A finance minister whose top priority is to keep foreign investors happy will be one who pays less attention to developmental goals. We would have to have blind faith in the efficiency and rationality of international capital markets to believe that these two sets of priorities will regularly coincide.”

Radelet and Sachs (1998) also conclude that flighty capital, particularly that of a short-term nature, and the contagion effect were largely to blame for the East Asian crisis, albeit catalyzed by policy mistakes.

Rodrik and Kaplan (2001) examine the comparative experiences of Malaysia, Korea and Thailand in the aftermath of the 1997 financial crisis. They find that Malaysian policies, including the use of capital controls, “produced faster economic recovery, smaller

declines in employment and real wages, and more rapid turnaround in the stock market.” than did IMF mandated programs in Korea and Thailand.

Stiglitz (2002), among others, would later add their voice to the chorus of criticism of the so-called Washington Consensus, of which capital account liberalization was one of the ten founding principles.

Kaminsky (2008) and others have noted the speed with which a Balance of Payments crisis striking one country can quickly come to strike others through a process of contagion. In the late 1990s, for instance, crisis spread within days from Thai epicenter to Malaysia, Indonesia and the Philippines. The Russian crisis spread to countries as diverse as Brazil and Pakistan. Moreover, Kaminsky and Reinhart (2000) found that the countries most affected by capital flow reversals were those that borrowed        from the same group of international banks who sought to quickly rebalance their lending portfolios to reduce risk, calling in loans across emerging markets.

Kaminsky looks in particular at the extent to which emerging markets lost access to bond and syndicated loan markets in the aftermath of the Mexican, Russian and Asian crises of the 1990s. She finds that high levels of integration with international capital markets can expose “countries to sudden stops even in the absence of domestic vulnerabilities.” (emphasis added) although she concludes that “larger reversals tend to occur in countries with banking and current account problems.” That is to say that she found some evidence of smoke without fire, but large amounts of smoke tended to derive from very real fires. Although she accepts that capital controls may be beneficial in countering sudden stops in the short-term, she concludes that they can be detrimental over the longer term.

Perhaps the most striking policy about turn in the recent history of Multilateral Financial Institutions has been that of the IMF in relation to capital controls. Although they retain a bias towards capital account liberalization, they appear to have learned the lessons of recent financial crises and now advocate carefully designed capital controls with clear, identifiable macroeconomic and financial stability policy goals in certain circumstances.

For instance, the IMF (Habermeier, Karl et al., 2010 & 2011) has recently set out in some detail when capital controls are best adopted in an emerging market context, and how they should be implemented. It appears therefore, that in respect of controls on the capital account the correct lessons were learned – as Winston Churchill said of the Americans – after all other possibilities had been exhausted.


Calvo, Guillermo A.; 1998; Journal of Applied Economics; “Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops”. 

Dornbusch, Rüdiger and Werner, Alejandro; 1994; Brookings Papers on Economic Activity; “Mexico: Stabilization, Reform and No Growth”.


Habermeier, Karl et al.; February 9, 2010; IMF Staff Position Note; ‘Capital Inflows: The Role of Controls’


Habermeier, Karl et al.; April 5, 2011; IMF Discussion Note; ‘Managing Capital Inflows: What Tools to Use?’


Habermeier, Karl,  Kokenyne, Annamaria and Baba, Chikako; August 5, 2011; IMF Staff Discussion Note; ‘The Effectiveness of Capital Controls and Prudential Policies in Managing Large Inflows’.


Kaminsky, Graciela L. and Reinhart, Carmen; 2000; Journal of International Economics; “On crises, contagion and confusion.”


Kaminsky, Graciela L.; 2008; NBER Working Paper Series; ‘Crises and Sudden Stops: Evidence from International Bond and Syndicated-Loan Markets’


Radelet, Stephen and Sachs, Jeffrey; 1998; NBER Working Paper Series; ‘The Onset of the East Asian Financial Crisis’.


Rodrik, Dani; February 1998; ‘Who needs capital account convertibility?’


Rodrik, Dani and Kaplan, Ethan; 2001; ‘Did the Malaysian Capital Controls Work?’


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