When Does Capital Account Liberalization Help More than It Hurts?

Abstract

for comments. 2 The classic illustration is that a borrower will know more than a lender about his own desire and motivation to repay, although the point is more general. This is why banks and other financial institutions play a prominent role in the modern economy: by virtue of their investments in monitoring technologies characterized by economies of scale and scope, they aspire to bridge gaps in the information environment that decentralized markets cannot. These observations are widely cited in support of the notion that information asymmetries are pervasive in financial 1

Costly information, entry, and credit access

“…Given this setup, the first-best allocation of credit is achieved and net output is maximized when cream firms are financed for projects of size  , average firms for projects of size 1, and bad firms are not financed. 5 The concept of cream firms should be interpreted broadly. Their ability to successfully implement the project of size 1   serves to represent high-return firms capable of profitably investing large amounts of capital.…”

“…A number of studies also find that opening capital markets and domestic financial liberalization is only associated with a positive impact on growth in countries with greater law and order traditions or better legal protections for creditors, both of which are likely positively correlated with stronger enforcement of accounting standards (e.g., see Arteta, Eichengreen, and Wyplosz [5], Galindo, Micco, and Ordoñez [29]). There is also direct evidence regarding the potential importance of accounting standards.…”

Financial Globalization and Economic Policies*

“…In both models, capital account liberalization leads to an increase in the volatility of aggregate consumption since agents with access to international financial markets stop participating in risk-sharing arrangements with those who do not have such access. 32 Using broader measures of financial openness, Prasad, Rajan and Subramanian (2007) find evidence of high/low interaction effects among non-industrial countries while Kraay (1998) and Arteta et al (2003) find little evidence of interaction effects.…”

Are Foreign Institutional Investors Good for Emerging Markets?

“…It is well-known that capital account liberalization has strong forecasting power for financial crises (Kaminsky and Schmukler, 2001). It is therefore no surprise that the strengthening of institutions helps both to increase the growth impact from stock market liberalization (see Bekaert et al, 2001, Fuchs-Schündeln andFunke, 2001) and from general capital account liberalization thereby reducing financial fragility (Arteta, Eichengreen andWyplosz, 2001, Edwards, 2001). …”