Lessons and Policy Implications for Asia's Emerging Economies

Over the past decade, the ten CEE countries have achieved a high degree of market integration and macroeconomic stabilization as part of their accession process. Capital account opening formed part of the increasing integration of these countries into the world economy. EU accession and OECD membership were two important institutional anchors for their international financial integration. Although the pace of the capital account liberalization varied across the ten countries, three common features can be identified in the sequencing of this process: (i) restrictions on FDI were removed before financial flows were liberalized; (ii) capital inflows were liberalized before capital outflows; and (iii) long-term capital flows were liberalized before short-term flows.

Over the 1995-2004 period the level of international financial integration in the ten CEE countries was low in comparison to the Euro area average and the group of emerging Asian countries. While in the beginning of the period, international financial integration was higher in the group of gradual liberalizers, since 1998 the countries that have rapidly liberalized their capital account have experienced a faster increase in their international financial integration than the group of gradual liberalizers. Over the same period, the increase of international financial integration in the CEE was high in comparison to the group of nine emerging Asian economies but low in comparison to the increase in the Euro area. The group of fast capital account liberalizers experienced faster growth of their financial openness than the group of gradual liberalizers.

A common feature of changes in the composition of the gross stocks of assets and liabilities has been an increase in the share of FDI and a decrease in the portfolio debt. To the extent that FDI-based financing is perceived as promoting risk sharing, this change can be seen as positive.

As a consequence of large capital inflows in recent years, the net external position in the ten CEE countries has changed dramatically from the mid 1990s. In 2004, their average net external position as a percentage of GDP was significantly larger than the average for the Euro area and the group of emerging Asian countries. Since 2000, the group of fast liberalizers has experienced larger net capital flows than the gradual liberalizers.

In the ten CEE countries, financial openness appears to be 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 to be negatively associated with capital controls.

While large capital inflows are in principle desirable for relatively low-income countries, they also pose the potential risk of sudden stops leading to large economic and financial imbalances. Coping with large capital inflows is a difficult task for macroeconomic policy. Since the underlying reason is real, there is not much monetary policy can do. The obvious response is to tighten monetary policy to prevent aggregate demand from overheating. With a fixed exchange rate, inflationary pressures result in a real appreciation, a loss in international competitiveness, and a widening current account deficit. With a flexible exchange rate, the central bank may be more successful in keeping inflation low, but at the cost of a nominal appreciation of the currency, with the same effect on competitiveness and the current account. We argue that fiscal policy is the more appropriate policy instrument for dealing with large capital inflows. Tightening the fiscal stance helps to reduce the risk of economic overheating. We argue that more effective spending controls and improved budgeting procedures rather than higher taxes will best promote macroeconomic stability.

There is also a role for prudent banking and financial market supervision in steering clear of credit booms and asset price bubbles that make such scenarios more likely, but also for reducing the vulnerability of the financial sector and the exposure of the government to implicit liabilities that can result from a capital account crisis. Governments would be well advised to keep substantial safety markings both with regard to deficits and debt to assure that they can respond to a sudden stop with the necessary financial rescue of the banking system and a fiscal expansion to partly absorb the fall in aggregate demand.

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