Capital account liberalization is the process of removing legal and administrative restrictions on cross-border financial transactions, such as foreign purchases of local shares and bonds, borrowing from foreign lenders, direct investment and residents' investment abroad. These transactions are recorded in the capital and financial account of the balance of payments. A country with a fully liberalized capital account lets money enter and leave for investment with few limits beyond normal tax and anti-money-laundering rules.
It is a separate step from opening the current account, which covers payments for trade, services, income and remittances. Members of the International Monetary Fund that accept the obligations of Article VIII of its Articles of Agreement commit to currency convertibility for current payments, while Article VI still lets them control capital movements. Liberalization is the reverse of imposing capital controls, and it raises a country's capital mobility, with knock-on effects for exchange rates and interest rates.
Capital account liberalization in plain terms
Picture a busy shop that has always kept one narrow door, with a guard checking everyone who comes in or goes out. Opening wide double doors brings in more customers and lets the owner bring in new stock faster. It also means that if a rumour spreads, everyone can rush out at once, and nobody can slow them down.
A sensible owner fits fire exits, trains the staff and checks the floor can take the crowd before opening the big doors. Countries face the same choice with money. Letting foreign savings flow in freely can pay for new factories and lower borrowing costs, but the same openness lets money leave suddenly. That is why most economists stress the order and pace of opening, not just the end point.
History
The Bretton Woods agreements of 1944 deliberately allowed controls on capital, and most countries kept them for decades. The OECD adopted its Code of Liberalisation of Capital Movements in 1961, committing members to progressive opening. The United Kingdom abolished exchange controls in October 1979, and Japan revised its foreign exchange law in 1980. In the European Community, Council Directive 88/361/EEC required member states to free capital movements, with most doing so by 1 July 1990; the principle is now set out in Article 63 of the Treaty on the Functioning of the European Union.
Many emerging economies opened rapidly in the late 1980s and 1990s. In April 1997 the IMF's Interim Committee agreed that the Fund's Articles should be amended to make capital account liberalization one of its purposes, and repeated the call at the annual meetings in Hong Kong that September. The Asian crisis that followed shifted opinion, and the amendment was never adopted.
Sequencing
Ronald McKinnon's 1991 book The Order of Economic Liberalization argued that the order of reforms matters as much as the reforms. The approach later adopted by the IMF's Institutional View on capital flows follows a broadly similar sequence:
- Establish sound fiscal and monetary policy and adequate foreign exchange reserves.
- Strengthen bank supervision and develop domestic financial markets.
- Open to foreign direct investment, which is long-term and hard to withdraw quickly.
- Allow longer-term portfolio investment, then short-term flows and foreign-currency borrowing last.
Each stage relies on the previous one. Opening short-term borrowing before banks are well supervised, for example, lets lenders take on risks that regulators cannot see, which threatens financial stability.
Lessons from the Asian financial crisis
Thailand illustrates the risks of opening in the wrong order. In 1993 it set up the Bangkok International Banking Facilities, which let banks borrow abroad cheaply, mostly short-term and in dollars, while the Thai baht was held in a currency peg. Firms and banks built up large currency mismatch. When the baht was floated on 2 July 1997 and fell sharply, those debts became unpayable, and capital flight spread the crisis to Indonesia, South Korea and others. Malaysia responded in September 1998 by reimposing controls and fixing the ringgit at 3.80 to the US dollar, a move the IMF initially criticised.
Gradual opening in China and India
China accepted IMF Article VIII obligations for current payments in December 1996 but has opened its capital account slowly, through quotas and channels rather than a single change. Qualified foreign investor schemes started in 2002, Shanghai-Hong Kong Stock Connect launched on 17 November 2014 and Bond Connect on 3 July 2017, while the State Administration of Foreign Exchange (SAFE) still manages many flows. The offshore RMB market grew up partly because of these limits. India has also followed a step-by-step path, guided by Reserve Bank of India committee reports chaired by S. S. Tarapore in 1997 and 2006.
Benefits and costs
- Benefits. Access to foreign savings, cheaper capital, deeper markets, diversification for residents and pressure for better policy.
- Costs. Exposure to sudden stops and reversals, and loss of control over interest rates under the impossible trinity if the currency is managed.
- Safeguards. Countries that open often keep macroprudential policy tools and, where needed, capital flow management measures as a backstop.