The Benefits Of Capital Liberalization

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Free capital mobility has been reigned into the world economy during the 20th century without dispute. Many countries that used to have very tight regulation on capital flow or completely prohibited it, all started easing their controls. All in attempts to take part of the ever globalizing economy and its array of benefits including diversification of investment and other factors which increase productive capacity. On the eve of this step towards globalization came with it, many financial crisis bringing up the question; does capital liberalization have the benefits which were once perceived? A topic that was once widely accepted was thrown into the forefront of economic debate. With many economists strongly advocating the benefits of capital…show more content…
A major flaw with capital mobility is that capital flow is very pro-cyclical. Since investors try to maximize their investments by investing in countries that are booming and avoiding those in recession (Stiglitz, 2000). As a result, economies receive capital inflow when they are not in need of it, while capital flows out during or before a recession when the economy is weak leading to instability of the financial market of that country. In all short term capital flow is very volatile, as it can come in at any time and flies whenever expectations of the economy worsen. Where as long term capital is much less volatile and namely direct investment has the benefits of increasing productive capacity through technology transfer and/or new management techniques (Forbes, 2005). An argument proposed by those who support capital account liberalization believe that capital controls on short term inflows can dampen the environment for investment, this is simply not true as China had very strict capital controls on capital inflow while being one of the greatest recipients of Foreign Direct investment (FDI) (Stiglitz, 2000). Not only does capital inflow controls not reduce FDI it also prevents asset bubbles from being created. Asset bubbles are the distortion of the value of assets. Asset bubbles can be created by excess…show more content…
This trade off is known as the trilemma where policy makers can only accomplish at most 2 out of the 3 goals. The three goals include (1) Fixed Exchange rates (2) Perfect Capital Mobility and (3) Monetary policy independence. For example, China had very closed capital account in the 1990s; they slowly embraced capital liberalization as result to attempt to keep a steady exchange rate their monetary authorities had to intervene. They bought foreign currency and injected the economy with more domestic currency to keep the value of their nominal currency down. As a result, they have accumulated a massive amount of foreign reserves, as will as giving up monetary policy as a tool for macroeconomic control (Glick, 2009). If the economy were to have flexible exchange rates and perfect capital mobility it will reduce the ability for the central bank to create an interest rate differential. This is because if the interest rate increases, they’ll be a large capital inflow pushing the interest rates down. If interest rates fall interests, capital will flow out causing interest rates to increase. As a result with perfect capital mobility the domestic interest rate is always equal to international rate of interest. By having capital controls, it allows the central bank, the
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