Beyond Sequencing - What does a risk-based analysis of core institutions, domestic financial and capital account liberalization reveal about systemic risk in Asian Emerging Market Economies?

Policy analysts are unanimous in advising free trade in goods and services as a means of improving economic performance. Since the late 1980s, this advice has been extended to exchange and capital account controls. Real-economy and trade reform, followed by domestic financial and then capital account opening [hereafter (KAO)] in virtually all OECD member countries is widely viewed as a success. By contrast, the proliferation of financial crises provoked by volatile capital flows in emerging market economies (EMEs) raises serious doubts over the unconditional advocacy of KAO, common in the mid-1990s. Indeed, external crises are often treated as common phenomena, even though capital account crises differ radically from conventional current account crises. It is unsurprising that empirical analysis has failed to yield conclusive results of the benefits of KAO for EMEs, as the high frequency and costs of KAO-related financial crises might outweigh their benefits.

The rationale for KAO appeals to the most fundamental insights of welfare economics: that independent economic agents who engage in utility and profit maximising behaviour will also maximise the collective interest.or put another way, that free markets allocate resources in an efficient and socially acceptable way. While the results may not be perfect, the failed import substitution programmes in Latin America in the 1950-60s, and the implosion of central planning regimes in the Soviet Union, Eastern Europe, Cuba and North Korea provide vivid counterfactuals. But, despite a consensus that free trade and domestic financial liberalisation [hereafter (DFL)] are efficiency enhancing, there is a suspicion dating from the intellectual founders of the Bretton Woods system (Harry Dexter White and John Maynard Keynes) that domestic and international financial markets are quite different and that (volatile) capital flows should be constrained.

Fifty years later this distinction has become increasingly blurred with widespread DFL and the ubiquity of transnational firms. In fact, the efficiency arguments and initial conditions for DFL and KAO are basically the same; good institutions.as are their pitfalls: asymmetrical information, moral hazard, opaque transparency, .rational. herd behaviour, financial panic, etc.:

• International (domestic) financial decontrol promotes a more efficient allocation of resources from high-savings countries (entities) to low-savings countries [and reduces the user cost of capital];
• It allows a country (entity) to smooth the time profile of its consumption and investment over time [thus effective KAO can be seen as depending on efficient inter-temporal gains from trade]1;
• It also allows firms and households to diversify away from country (individual or firm) specific risk [inter-spatial substitution] and offers an expanded choice set.

In short, the defining characteristic of international financial decontrol is the stringent constraints it imposes on the consistency of overall economic policy.i.e., the nexus between rational microeconomic and institutional structures, sustainable macroeconomic policies, sound banks and viable exchange rate regimes. Empirical evidence that the positive effects from KAO are confined to the OECD and higher-middle income EMEs appears to confirm the necessity of minimum standards of social infrastructure (i.e. rule of law, property rights, prudential supervision, financial transparency, etc.), adequate macroeconomic stability, and efficient financial systems before launching large-scale capital account liberalisation2. These initial conditions qualify rather than vitiate the case for KAO, as they ultimately determine how and at what speed KAO is achieved.

Against this backdrop, assessing the specific risks attached to DFL and KAO, and especially systemic financial risks (i.e. the liquidity and structural risks that compromise the solvency of financial systems) is a pressing priority, as almost all EMEs have opted for some degree of capital account liberalisation since the late-1980s, usually out of necessity3. Indeed, given the irresistible attractions of foreign direct investment (FDI)4, the current policy debate focuses not on .if..but on how and at what speed to implement KAO (Eichengreen 1998). The problem is the lack of an operational model, even though only a few policy analysts challenge the mainstream orthodoxy that KAO is beneficial to EMEs, under most conceivable circumstances (see Bhagwati 1998 and Rodrik 1998)5.

This controversy raises important issues. Is the .new orthodoxy. based on robust empirical evidence? Do all countries gain from international financial liberalisation? How important are initial conditions concerning macroeconomic stability, the rule of law, property rights, financial transparency, the quality of bank management and the sequencing of DFL and KAO?

Unfortunately, a statistical fog obscures this debate. Although core institutions are critical, few measures are available for EMEs. Informative indicators of capital account controls are even rarer. Moreover, most empirical studies have concentrated on the impact of KAO on economic growth, rather than on the pressing policy issues of systemic risk and crisis prevention. Last, but not least, our analytical tools were mostly developed for current account crises in an era of limited capital mobility, rather than for crises provoked by shifts in capital flows that are likely to dominate the start of the third millennium.

This paper is in six parts. Section 1 presents a survey of optimum policy sequencing and the role of KAO on economic performance. Indicators for DFL and KAO6, as well as our risk-based approach to their implementation are sketched out in Section 2. Mainstream views on capital controls and the neglect of initial conditions in big bang. approaches to KAO are surveyed in Section 3. Section 4 presents an indicator of the quality of core institutions. This is then mapped vis-à-vis foreign debt leveraging, external liquidity constraints, and the effective degrees of DFL and KAO.for eleven crisis EMEs and an eclectic control group. Major characteristics of capital account crises are also outlined using a risk-based analysis. Section 5 presents simple empirical estimates of systemic risk using the BIS.s Early Warning System database for external vulnerability, FX pressure, and banking system stress, for 24-EMEs. A summary and conclusions are presented in Section 6.

The views expressed in this paper are the views of the authors and do not necessarily reflect the views or policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms..

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