Payment Systems & Infrastructure; Economic Theory & Research; Banks & Banking Reform; Capital Markets and Capital Flows; Settlement of Investment Disputes; Fiscal & Monetary Policy; Financial Intermediation; Financial Economics
Summary: Inherent in pursuing openness to international capital flows is an awareness that it brings both benefits and risks. Much of the current debate is about how best to balance them. Major benefits for developing countries include access to a broader menu of investment sources, options, and instruments, as well as enhanced efficiency of domestic financial institutions and the discipline of capital markets in conducting domestic macroeconomic policy. By easing financing constraints, the greater availability of international finance can extend the period for implementing needed adjustments. From the perspective of emerging market economies, the author highlights two sources of risk: the host governments' policy of liberalizing capital controls before having established the macroeconomic, regulatory, and institutional foundations required for capital openness. A shift in foreign leaders' and investors' sentiments and confidence, not necessarily related to a particular country's long-term creditworthiness. Risk management demands judicious strategies for both corporate and financial institutions and national policy. At the institutional level, with the advances in technology and communications, financial risk management practice has improved significantly in recent years through the use of statistical models, such as value at risk, computer simulation, and stress testing. At the national level, with the worldwide trend toward democracy, the author argues that managing the risks of financial openness will require developing national mechanisms through which to provide insurance to citizens-through the marketplace or through redistributive policy-and thus to avert political pressure for capital controls. To succeed, open democratic societies have to balance the threat of capital exit, made easier by the opening of capital markets, with the political voice of citizens-demanding protection through redistribution, social safety nets, and other insurance-like measures. These insurance measures have been critical increasing the tension between politics and financial openness in OECD countries. Indeed, cross-country empirical analysis confirms that countries that spend a large share of their GDP on social needs (education, health, and transfer payments) are more open to free international capital flows, and also score high on measures of political and civil liberty.
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