Capital Account Liberalization and International Financial Integration

In this section we present an overview of the pace and sequencing of capital account liberalization in the ten CEE countries before their accession to the European Union and analyze the degree of their international financial integration³ to date.

At the beginning of the transition to market economies, all ten CEE countries had closed capital accounts. Capital account liberalization was part of their integration into the world economy. However, the pace was country-specific reflecting different initial conditions and macroeconomic development.⁴ As a first step, current account convertibility was achieved between 1994 and 1996 as part of IMF membership obligations.⁵ For the Czech Republic, Hungary, Poland, and the Slovak Republic, the application for OECD membership in 1993-1994 was an additional catalyst for capital account liberalization. But most importantly, the prospect of EU membership and the accession negotiations provided an institutional anchor for capital account liberalization in all CEE countries. Since the free movement of capital among member states and between member states and third countries is part of the EC Treaty,⁶ EU accession required full capital account liberalization. A schedule of steps for capital account liberalization was negotiated between each CEE country and the European Commission. Deviations from this schedule were allowed only in circumstances that had the potential to undermine the conduct of monetary and exchange rate policies. Transitional arrangements allowing some restrictions to be maintained beyond the entry into the EU were implemented for all CEE countries mostly with respect to politically sensitive areas such as the acquisition of agricultural and forestry land and real estate.

Regarding the pace of capital account liberalization, we can distinguish two groups of countries. First, the Baltic countries and the Czech Republic had abolished most restrictions on capital transactions by 1995. In contrast, Hungary, Poland, the Slovak Republic, and Slovenia opened their capital accounts more gradually, achieving full liberalization in 2001-2004. We include Bulgaria and Romania in this latter group, as they joined the EU only in 2007.

Table A1 [ PDF 52.6KB | 3 page ] in the Appendix summarizes the experience of the CEE countries with capital account liberalization and managing large capital inflows. Three common features can be identified: (i) Restrictions on FDI were removed before portfolio flows were liberalized; (ii) Capital inflows were liberalized before capital outflows; and (iii) Longterm capital flows were liberalized before short-term flows.

The traditional approach for assessing capital account openness is to look at legal restrictions on cross-border capital flows (de jure measures). There are more than 60 measures that can be grouped into direct (administrative) and indirect (market-based) restrictions. The IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) provides pertinent information. It has been used to construct quantitative measures of capital account openness ranging from binary measures (0/1 dummy variables) (Grilli and Milesi-Ferretti, 1995) to more sophisticated indices of financial openness (Chinn and Ito, 2006; Miniane, 2004; Mody and Murshid, 2005; Quinn, 2003). Table A2 [ PDF 39.7KB | 1 page ] in the Appendix reports the capital controls in place at the end of 2006 in the ten CEE countries. The number of controls on capital transactions ranges from two in Romania to 11 in Poland. All ten countries maintain controls for real estate transactions, and with the exception of Hungary, all have specific provisions with respect to commercial banks and institutional investors.⁷

However, these de jure measures have several shortcomings that may prevent them from accurately capturing the extent of capital account openness (Kose et al., 2006). First, the AREAER information is related to foreign exchange restrictions, which do not necessarily limit capital flows. Second, they do not reflect the enforcement of capital controls nor their effectiveness. Finally, other financial regulations, such as prudential caps on the foreign-exchange exposure of domestic banks, restrict capital flows in practice, but they are not counted as capital controls.

An alternative approach to measuring capital account openness is to use de facto measures that reflect international financial integration (see for example Prasad, et al, 2003; Kose et al, 2006; Lane and Milesi - Ferretti, 2006). Such measures are based on actual capital flows and more accurately reflect the capital account openness in practice. To illustrate the extent of capital account liberalization in the CEE countries, we analyze the evolution of the sum of gross external position, i.e., the sum of foreign assets and liabilities, as a ratio to GDP⁸ as an indicator of international financial integration. We draw on the database constructed by Lane and Milesi-Ferretti (2006). Their data set has the advantage of being able to account for valuation effects and correcting for cross-country differences in data definitions and variable construction. It covers 145 countries over the period 1970-2004.

Figure 8 [ PDF 44.8KB | 1 page ] shows the evolution of the cross-country average⁹ of this indicator over the period from 1995 to 2004 in the ten CEE countries, the Euro area¹⁰ and the group of Emerging Asian economies.¹¹ Over the entire period, international financial integration was lower in the ten CEE countries than in the Euro area and the group of Emerging Asia countries. While it was higher for the group of gradual liberalizers early on, the countries that have liberalized their capital accounts fast experienced a stronger financial integration since 2000.

Table 1 [ PDF 44.8KB | 1 page ]shows the gross and net foreign asset positions in 1995 and 2004 in the ten CEE countries. We also present the averages for the Euro area and Emerging Asia.

Over the period from 1995 to 2004, the gross external position of the CEE countries increased from an average of 81.1 percent of GDP in 1995 to 158.3 per cent of GDP in 2004. This increase is larger than the corresponding figure for Emerging Asia, where the gross external position rose from an average of 124.9 percent of GDP to 220.5 percent of GDP. However, it is lower than the corresponding increase in foreign assets in the Euro area countries.

Over the whole period, the group of fast liberalizers experienced faster growth in gross external position relative to GDP than the group of gradual liberalizers. In 2004, the gross external position was above the CEE average for Estonia, Latvia, Hungary, Bulgaria and the Czech Republic, while the lowest levels were for Romania, Lithuania and Poland. The increase of international financial integration during the period from 1995 to 2004 was greatest for Estonia, Latvia, Romania, Slovenia and Lithuania.

What explains these cross-country differences in international financial integration? Empirical studies¹² suggest a number of factors underlying cross-country financial openness, including financial development, institutional quality, trade openness and capital controls. Figure A1 [ PDF 47.9KB | 2 page ] (Appendix) shows partial correlations between the gross stock of foreign assets and liabilities as percent of GDP and several underlying factors suggested by the empirical literature. The data cover the ten CEE countries over the period from 1995 to 2004. Although the information in these simple correlations is limited, the results are suggestive. They indicate that financial integration is positively associated with domestic financial development (measured as private credit as percent of GDP and stock market capitalization as percent of GDP), institutional quality and trade openness and negatively associated with capital controls. These results should only be taken as indicative as they reflect unconditional partial correlations. A more formal analysis is required to identify causal relationships between these underlying factors and financial openness.

Over the period from 1995 to 2004, the ten CEE countries experienced large net capital inflows and, as a consequence, dramatic changes in their net external positions. As shown in Figure 9 [ PDF 46.1KB | 1 page ], net capital flows into the CEE countries as a percentage of GDP were significantly larger than in Euro area and the Emerging Asia. Since 2000, the group of fast liberalizers has experienced larger net capital inflows than the gradual liberalizers. This is in contrast to the improving net external positions of Emerging Asia and the Euro area.

Figure A2 [ PDF 56.2KB | 4 page ] in the Appendix shows the evolution of the composition of gross stocks of foreign assets and liabilities in the CEE countries over the 1995-2004 period. A common feature is the high share of portfolio debt in foreign assets and liabilities. This reflects the dominant role of the banking sector in financial intermediation and the large size of government securities markets in the CEE countries¹³.

Table 2 [ PDF 38.6KB | 1 page ] shows the composition of the stocks of external liabilities in the CEE countries in 1995 and 2004. The low share of portfolio equity in capital inflows in 1995 reflects the low level of capital market development and poor corporate governance in these countries. Only the Czech and Slovak Republic stand out for larger shares of equity in total foreign liabilities. This may be explained by the relative strength of the enterprise sector in these countries and their historical economic and trade links to Germany and Austria. Another factor may have been that the privatization of the industrial sector in these two countries was implemented by giving citizens shares in domestic companies. Note that the Czech Republic is the largest portfolio investor in the Slovak Republic.¹⁴

With the exception of Latvia, the share of FDI in total liabilities has increased, while that of external debt has decreased in all countries. Compared to the gradual liberalizers, the group of fast liberalizers has a large share of FDI and a small share of debt in total foreign liabilities.

Excessive reliance on debt for financing current account deficits is commonly regarded as a sign of vulnerability to financial shocks, while FDI-based financing is perceived as promoting risk-sharing (see Kose et al, 2006; Lane and Milesi-Ferretti, 2006). From this point of view, the changes in the composition of gross stocks of foreign liabilities in the CEE countries over the past decade seem positive.

Table 3 [ PDF 40.9KB | 1 page ] reports the composition of the foreign assets of CEE countries in 1995 and 2004. Foreign exchange reserves and portfolio debt dominate the composition of external assets in these countries. Following the liberalization of capital outflows and increase in cross-border assets trade, the shares of FDI and portfolio equity have surged, in particular in Estonia, Hungary, Slovenia and the Czech Republic. To the extent that the private sector in the CEE counties becomes more internationalized, it is likely that the FDI and portfolio equity outflows will further increase.

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