Sequencing capital account liberalization

Abstract

Capital account liberalization is not an all-or-nothing affair; there are as many ways to approach it as there are financial instruments and types of capital transactions (see box). Capital flows can, for example, be intermediated by the international capital markets (when local nonfinancial agents are permitted to borrow or place funds abroad); by the local capital markets (when nonresidents can access local financial markets and intermediaries); or a combination of both (when local financial intermediaries borrow or place funds abroad). Capital controls can take various forms-including outright prohibitions, licensing and approval procedures, and transaction taxes-each with a different effect on flows. A country may liberalize certain components of its capital account while maintaining controls on others. Although many of the challenges posed by capital account liberalization are no different from those posed by the liberalization of domestic financial systems, capital account liberalization adds an external dimension and urgency to financial sector reforms. Whether capital inflows are channeled through domestic intermediaries or compete with them, the intermediaries will need to be strengthened, either to ensure the efficient use of the capital inflows or because competitive pressures on-and the need to restructure-domestic financial institutions will increase. Moreover, capital account liberalization may induce banks and corporations to take on more foreign exchange risk.