Introduction

The increase in trade, the increasing internationalization of production, and improvements in communications, together with the legalization of foreign currency instruments in a growing number of countries, have led to a de facto liberalization of the capital account. In line with the greater reliance on open goods markets and a de facto opening of the capital account, governments of developing countries naturally are raising questions about fully opening the capital account. As a background to answering such questions, this chapter surveys the existing literature on opening up domestic capital markets, much of which was written prior to the debt crisis, as it applies to the current situation.

A liberalized or open capital market here is defined as one in which individuals and firms can access international financial markets freely, not just one in which the government intermediates international capital flows to balance differences in private saving and investment. In fact, private agents in many developing countries currently have greater access to international capital markets than their governments, particularly given the possibilities that private agents have for collateralizing their debt. This situation is a dramatic reversal of the situation of the late 1970s, when governments of developing countries intermediated large volumes of foreign funds at low real interest rates while private agents lacked comparable access to international capital.

This survey begins with a brief summary of the costs and benefits of liberalization of capital accounts paying particular attention to the issue of the loss of policy effectiveness and noting the new theories of capital flows based on international portfolio diversification of risky assets, which raise the possibility of benefits from capital-account liberalization that are not linked solely to higher investment rates.