Capital Account Liberalization and the Exchange Rate Regimes

I. INTRODUCTION
Globalization envisages an international economic and financial system where all factors of production move around the world freely and easily so that the global firms meet no obstacles on their way to maximize profits. In this framework, capital account liberalization was encouraged in developing countries like Argentina, Bolivia, Ecuador, Indonesia, Malaysia, Mexico, Singapore, Turkey, Uruguay, Venezuela in late 1980`s and early 1990`s (Glick and Hutchison, 2005). Developed countries too, suspended capital controls in these two decades: UK (1979), Japan (1980), Australia and New Zealand (1983), Netherlands (1985), France, Sweden, and Denmark (1989), Belgium and Luxembourg (1990), Finland and Austria (1991), Portugal and Ireland (1993), Iceland (1994) removed restrictions on inflow of capital into the country and outflow of capital from their countries. (Saxena and Wong, 1999)

Liberalizing the capital account was a major move for developing countries in the direction of integrating with the rest of the world. But at the same time it was a major challenge, because governments were losing total control on the financial variables and monetary aggregates, and nobody was sure whether they were moving into a new integrated monetary system or into chaos and confusion. For some countries, liberalization took years, and in some others it is not completed yet. Once the liberalization process is started, however, it is true that it becomes more difficult to control the flows. Aizenman and Noy (2009) found that there is two-way feedback between financial and trade openness, so once countries liberalize their trade, financial openness also starts. Capital account liberalization was one of the most important economic policy developments in the last two decades in international economics and the consequence of it is still under examination. There are three lines of thinking in this area: The first line of thinking claims that free capital movements cause financial crises and economic disturbances in the countries implementing this policy and real variables are negatively affected as a result of these movements.

The second group insists that it is not the free movement of capital to be blamed, but it is weak financial systems, corrupt officials and unregulated institutions causing financial crises. The third group stresses that crises are the consequences of interferences in the free functioning of the market system. The conclusions of this study suggest that there must be compatibility between the policies about capital account, trade account, and the exchange rate regime. If the country liberalizes its capital account, it would be easier to manage the flows if the country also has a free trade regime and the floating exchange rate system because of the imbedded automatic adjustments that would reduce the speculative gains. Otherwise the incompatibility may bring about deep and long-lasting financial and economic crisis. The globalization of huge amount of capital is affecting domestic economic variables in countries when it is entering into the economy, and it is also making an important impact when it is leaving the country. The negative effects of cross-border movements of capital can be reduced with floating exchange rates, because the difference between expected and the nominal values are exhausted very quickly and speculative gains are small under floating exchange rates. CAPITAL ACCOUNT LIBERALIZATION

Many developing countries liberalized their capital accounts in 1980`s and 1990`s to attract more of the international capital to finance their economic growth and budget deficits. Capital is scarce and expensive in many developing countries because of two reasons: Firstly, governments prefer to borrow from local sources thus crowding out other potential borrowers, particularly in the private sector. This is exacerbated by the fact that countries with low incomes will generate low level of borrowable funds. This situation is often accompanied by higher risks and lack of stability. As a result, interest rates are generally high. One remedy to this situation is to increase the availability of capital by attracting capital from abroad –both for short, as well as for long run purposes. This is the main rationale behind developing countries lifting restrictions on capital movements.

The question is what factors are affecting the inflow and outflow of short-term capital under different exchange rate regimes? It is assumed in this study that capital inflows and outflows are affected by some macroeconomic variables more than others. Exchange rates, interest rates and current-account are on the front-line. When short-term capital is entering, foreign-exchange loses value and domestic currency appreciates. Imports become cheaper and exports become more expensive, increasing the current account deficit. If exchange rates are flexible, as imports increase and exports go down, domestic currency starts losing value (foreign currency appreciates) and the system corrects itself, current account deficit decreases. But if the country is not on the floating exchange rates, domestic currency is not allowed to lose value, current account deficit continues running at high levels, draining the foreign exchange in the country. This situation carries the country to devaluation. So when the country is under floating exchange rate regime, smaller fluctuations keep the country on the trend. But if the country is under fixed, pegged or anchored exchange rate regime, the stickiness causes the economy to divert away too much from the trend, then it has to undertake a much more radical step to come back to the trajectory.

Capital moving-in also affects the interest rates if the country has already undertaken financial domestic liberalization. Short-term foreign capital goes to a country because of higher returns. Fernandez-Arias (1996) found that the international return factor explains more than 60 percent of capital inflows to 13 developing countries, while the domestic investment climate explains 12 percent and country-credit worthiness is even less important. So it is expected that, as short-term capital moves into the economy, domestic interest rates will fall relative to the period before carrying the implications that indirectly economic growth will increase and unemployment will decrease. The effect of the outflow of short-term capital may increase domestic interest rates, indirectly reducing growth and employment if it causes scarcity of capital in the domestic economy. So short-term domestic interest rate is assumed to be an important factor affecting short-term capital flows.

The balance on the current account (net current account balance) also has an effect on the movements of short-term capital. If the country is on floating exchange rates, the value of domestic currency depreciates, increasing exports. Higher exports will provide the foreign exchange needed. If the country is on more inflexible regimes, domestic currency does not depreciate, exports will not increase, and foreign exchange scarcity continues, maybe creating second markets or black markets of foreign currency. If a country is under fixed, pegged or anchored exchange rate regime for some reason, it should not liberalize its capital account, because at one point or another, the inflow or outflow of short-term capital will cause a misalignment between the expected exchange rates and nominal exchange rates. This misalignment may take the economy to disequilibrium in the current account. The results of the regression analysis in this study show that movement of short-term capital is correlating with interest rates significantly and strongly with short-term capital movements during the floating exchange rate periods, so the interest rates remain high when the country needs capital, and they go down when the need diminishes, adapting automatically to the demand-and-supply conditions. II. LITERATURE REVIEW

Some authors believe that the problem of crises is related to free capital movements and floating exchange rates and free capital movements cause wide fluctuations even if the country is on floating exchange rates (Aliber, 2000).

Wyplozs (2001) draws attention to the sequence and pace of liberalization, and he underlines two ways of approaching the lifting of controls on capital account: The first one is gradual liberalization “starting with domestic financial markets and moving cautiously on to external integration”. The second way is “all-at-once” liberalization not to give opportunity to some interest groups to build resistance against liberalization. He argues that in both cases capital account liberalization takes countries to crises. McKinnon (1991) also suggests that the sequence of events is important in liberalization and suggests that firstly the domestic goods market should be liberalized. Then the country should open the current account and following that domestic financial liberalization should be completed. Only after these three steps capital account should be opened starting with the long-term assets.

Blejer and Castillo (1998), referring to the capital account liberalization experiences of Mexican and Uruguay, state that only under strict monetary and fiscal policies exchange rate stabilization can be achieved and short-term capital must not be the major source of financing current account deficits. Kaminsky, Lizondo and Reinhart (1998) also include excessive credit growth and the exchange rates among the indicators of financial crises. Many authors connect the financial crises of the last two decades to capital account liberalization of countries and they draw attention to destabilizing effect of inflow and outflow of short-term capital. The threat was realized as early as 1970`s, when James Tobin (1978) proposed the famous Tobin’s tax on short-term capital flows. His suggestion was to tax short-term capital and this way short-term capital flows would be more restricted, and they would not be leaving the countries so easily, because they had to pay taxes.

Even IMF First Deputy Managing Director Stanley Fisher warned countries and said “liberalization without a necessary set of preconditions in place may be extremely risky” (IMF Survey, 1998). Some of these preconditions were; a sound macroeconomic policy framework; a strong domestic financial system; and a strong autonomous central bank. (Johnston, 1998) Based on this study in 53 countries (1980-1995) Demirguc-Kunt and Detragiache (1998) found that the chance of bank crises increase after financial liberalization especially in a weak institutional environment thus the study supports Fisher and Johnston’s arguments. Weller (2001) also states that “evidence shows that financing is not necessarily going where it is supposed to go in a less regulated environment, thus opening the possibility for crises. In Korea, additional liquidity was used to fund speculative overseas investments, for example, loans to Russia”.

The argument that foreign capital can fund the growth projects is challenged by many. Rodrik (1998), in his study of 23 countries in Asia, Latin America and Sub-Saharan Africa in the years 1975-1989 found that capital account liberalization does not lead to higher per capita GDP growth, higher investment as share of GDP or lower inflation. Similarly, the Director of Economics and Research Department of IMF Raghuram Rajan (2006) in a controversial stand stated that there is no relationship between hot money coming in and growth in developed and developing countries. Other than Tobin tax, many scholars suggested capital controls to protect the countries from the adverse effects of short-term capital flows. Some proposed controlling the incoming capital and some others stressed restrictions on outgoing flows. The famous example is Krugman`s (1998) comments on South East Asian financial crises where he proposed temporary restrictions on capital outflows in the countries “unsuitable for either currency unions or free floating” when they face the danger of currency crises. Malaysian Prime Minister Mahatir stopped outflow of capital in September 1998, one year after Malaysia let riggit to float and according to some after he read “An Open Letter to Prime Minister Mahatir” (Krugman, 1998).

Capital controls do not have negative effects on the economy, according to Rodrik and Velasco (1999). In their research on Chile, Colombia and Malaysia, they found that capital controls did not reduce the inflow of capital into these countries; they only altered the “maturity composition of loans from abroad without –at least in South American cases- reducing the overall volume of flows”. Also the presence of capital controls reduces the probability of currency crises. (Eichengreen et al., 1995) There are also sovereignty complaints about capital movements around the globe (Rohwer, 1997).

Arguments for capital account liberalization rest on the idea that capital, which is one of the factors of production, will be more efficiently allocated globally if it is allowed to move freely. Calvo, Leiderman and Reinhart (1996) found that return on capital is much higher in developing countries since 1980`s compared to returns in industrialized countries. The aim was “channeling funds towards financing more production projects” thus achieving economic growth (Reinhart and Tokatlidis, 2001). Quinn (1997) too, finds a positive correlation between capital account liberalization and economic growth. The Governor of Asian Development Bank Haruhiko Kuroda (2005) expressed his views on the subject in more general terms and pointed out that those countries that have liberated their trade regime and integrated with global capital markets grow more and they are more successful in reducing poverty in their countries relative those that did not. In their research on 90 developing and emerging market economies Glick and Hutchison (2000) identified 160 crises between 1975-1999 and concluded that countries with restricted capital flows have currency problems 12.7 percent of the time and countries with free flow of capital have 6.8 percent on the average. Authors also suggest that capital controls give a signal of bad economic policies, lax policy discipline and coordination, and government corruption (Glick et al., 1996).

In 1950`s and 1960`s many different sometimes contradictory views were expressed on fixed versus floating exchange rate systems. Earlier works suggest that fixed and floating exchange rates might have different affects on the goods market and the capital markets (Robert Mundell 1961. If the exchange rate is fixed, as capital moves in, the interest rate goes down and the capital inflow will not cause too much disturbance on the rest of the economy (Obstfeld, 1985). When international short-term capital entering into the country is a small amount, its effect could be lowering the interest rates few percentage points. However international short-term capital flows today are far exceeding hundreds of billions of dollars. Short-term capital flows to only developing markets is 311 billion dollars in one year. (Activeline, 2005. As Osakwe and Schembri (1999) state, “the recent rash of currency crises and fixed exchange rate collapses in Latin America and East Asia provides ample evidence that the typical fixed or pegged exchange rate regime is virtually impossible to sustain in a world of liberalized financial flows, small transaction costs, and large pool of mobile capital”.

III. THE MODEL
The model is designed to find out how factors like the difference between the nominal exchange rates and expected exchange rates, short-term domestic interest rates, and current account are correlating with short-term capital movements in different exchange rate regimes. Both exchange rate regimes are under liberal capital movements and free trade conditions. Short-term portfolio investment is taken as the dependent variable and the difference between nominal exchange rates and expected exchange rates, short-term interest rates and current account are the independent variables in the model. Thus, short-term capital is a function of the difference between the nominal exchange rate and expected exchange rate (ERn – ERe), short-term domestic interest rates (i), and current account balance (CA) as is represented by the function below:

f (sK) = f ((ERn – ERe ), i, CA)
It is assumed that short-term capital flows in-and-out of the country will be affected by these three variables and the relationship between the short-term capital flows and the three variables will be different under different exchange rate regimes. To find out the relationship, multiple regression analysis is used for seven countries; Argentina, Mexico, Singapore, South Korea, Sweden, Thailand, and Turkey. Many more countries could be analyzed, but finding complete short-term data was difficult. The seven countries selected have the necessary conditions such as, they were all under fixed, pegged or anchored exchange rate regimes for a long time, and after the crises they let their currencies to float. So there is data when these countries had fixed, pegged, or anchored exchange rate regimes and when they were floating their currencies under free trade and open capital account conditions.

The first variable; the difference between nominal exchange rates and expected exchange rates (ERn – ERe) is assumed to be one of the factors attracting short-term capital where speculators may gain from buying and selling a currency (currency hedging). If nominal exchange rates are higher than the expected exchange rates, the investors want to buy more domestic currency; because it is cheap (they can buy more local currency with the same amount of dollars, for example). As the value of domestic currency appreciates, investors sell the local currency (buy more dollars with the same amount of local currency). The difference between the dollars spent to buy the local currency and the dollar purchased with the appreciated local currency is the gain of the investor. If expected exchange rate is a higher, investors will assume that the value of local currency against foreign currencies will fall (devaluation), so holding foreign currency will be more profitable. This is when speculators expect devaluation in the future and they want to sell the local currency as soon as possible before it starts losing value. Thus, higher nominal exchange rates attract investors, and higher expected exchange rates repel them.

The investors buy and sell local currency according to their expectations, thus the nominal exchange rates must converge toward the expected exchange rates if the currency is floating. The second factor affecting the short-term capital flows is the short-term domestic interest rates, i. The relationship is straightforward: Higher interest rates must correlate with positive changes in capital inflows. Lower interest rates are expected to correlate with capital outflows. However, because the data is quarterly, the interest rates may have positive or negative correlations with short-term capital flows. If it is positive correlation, it means higher interest rates attract more short-term capital and low interest rates are associated with outflow of capital. If the correlation is negative, it means that short-term capital inflow lowers the domestic interest rates, and outflow of capital raises them. In both cases, the correlation is expected to be significant.

The third variable effecting the changes in short-term capital flows is the current account balance in the balance of payments of the countries, CA. If the national currency of the country appreciates, imports become cheaper and exports and nontradables become relatively more expensive. Imports increase and exports decrease increasing the current account deficit. If the country is on fixed, pegged, or anchored exchange rate regime, the value of exchange rate does not change and current account deficit increases for a long time. When the current account deficit becomes unbearable, the monetary authorities devalue the local currency. If the country is on floating exchange rates however, as imports increase and exports decrease, the value of domestic currency loses value, because foreign exchange becomes scarcer. As local currency loses value and foreign exchange gains value, imports become more expensive and exports and nontradables become relatively cheaper. Imports go down, exports increase, consumption of nontradables increase, the current account moves towards balance. The country does not have to go through financial and economic crises, devaluation, and economic contraction. The fluctuations in the value of the exchange rate adjust the value of the currency with the other financial and economic variables.

Some of the short-term capital is transferred to domestic firms for them to finance imports and some to fund export production. These transfers are also called trade credits and they form part of the flow of short-term capital. If the short-term capital inflows correlate positively with current account, then they are financing exports production, because the more capital goes in, the larger the trade surplus. If the short-term capital is financing imports, then the inflows must be correlating negatively with current account, because the more funding comes in, the higher the imports and the larger is the trade deficit. 1. Method

The general linear regression formula is presented below:
sK = α + β (ERn – ERe) + γ i + δ CA + e(1)
sK is the short-term capital flows,
α is the constant term,
β is the coefficient of correlation between short-term capital flows and (ERn – ERe), ERn is the nominal exchange rates,
ERe is the expected exchange rates,
γ is the correlation coefficient of short-term interest rates, i is the short-term domestic interest rates,
δ is the correlation coefficient of current account,
CA is the current account balance,
e is the error term.

2. Data
For short-term capital flows, data on portfolio investment is used. The figures are in US dollars. A simplifying assumption is made and it is assumed that citizens of the country and foreign investors have similar investment choices in the country under question, because the capital account is already liberalized. Thus, the inflows in assets and liabilities are considered as short-term capital moving in (+), and the outflows in assets and liabilities are considered as short-term capital going out (-). Market exchange rates are taken as the nominal exchange rates. The figures are the value of the national currency for one US dollar. The expected exchange rates are calculated using the real effective exchange rate (REER) index. According to the base year’s value, each quarter’s expected exchange is calculated. The interest rates are yearly percentages. Short-term interest rates are domestic interest rates for the shortest possible period. Finally, current account is gathered from the balance of payments accounts of the countries in the related periods. The totals are in US dollars. So all variables of different countries are measured in US dollars to achieve some standardization. All data used is quarterly data.

At least eleven periods before the crises when countries were under fixed, pegged, or anchored exchange rate regimes (for all the seven countries) are analyzed to see the correlations between short-term capital flows and the other three variables. Again at least eleven periods after the crises when the countries have floating exchange rates is calculated with regression analysis. The purpose is to find the effects of independent variables on short-term capital flows under different exchange rate regimes. IV. RESULTS OF REGRESSION

Table 4 – Floating exchange rates

One of the most remarkable findings is that the correlation between short-term capital movements and interest rates is significant for all countries under floating exchange rate except Singapore and Thailand as can be seen in Table 4. For Thailand none of the variables are significant under fixed or floating exchange rates. Maybe the political instability is interfering with the financial and economic system and causing inconsistencies. Also, the interest rates in Singapore are not market interest rates. So the lack of correlation in these two cases does not dispute the findings of the article. Equations for floating exchange rate period after dropping the insignificant variable(s) are as follows: Argentina;

sKar = -19645.913 + 1.461 (ERnar– Erear) – 1.682 iar + 0.882 CAar (2) Mexico;
sKme = 12011.302 – 0.806 ime + 0.808 CAme(3)
South Korea;
sKko = 3037.122 -1.198 (ERnko – EReko) + 1.313 iko – 0.506 CAko(4) Singapore;
sKsi = -144.997 + 0.588 (ERnsi – EResi)(5)
Sweden;
sKsw = -10384.303 + 0.818 (ERnsw – EResw) + 0.479 isw(6) Turkey;
sKtu = 5236.16 – 0.411 (ERntu – ERetu) – 0.572 itu(7) As can be observed from the above equations, in the floating period, interest rates are significantly correlating with short-term capital movements and coefficient of correlation is close to 50 percent or higher in the sample countries. It is 168.2 percent in Argentina (equation (2)), 80.8 percent in Mexico (equation (3)), 131.3 percent in South Korea (equation (4)), 47.9 percent in Sweden (equation (5)), and 57.2 percent in Turkey (equation (7)). The negative sign could be implying that as capital moves in, domestic interest rates fall. The positive sign is what is expected; as interest rates increase, short-term capital moves in the country. A shorter period data would show the relationship much better.

The second finding about floating exchange rate regime in these countries is that the difference between nominal exchange rates and expected exchange rates are significantly correlating in most of the sample countries except in Mexico. In Mexico, relationship is weaker; short-term capital and variable (ERnme– EReme) move together 70 percent of the time (equation (3)). In the other countries the significance is high as is observed in Table IV; in Argentina 0.077, in South Korea 0.035, in Singapore 0.035, in Sweden 0.022, and in Turkey 0.044. The coefficients of correlations are also high: 1.461 for Argentina (equation (II)), -1.198 in South Korea (equation (4)), 0.588 for Singapore (equation (5)), 0.818 for Sweden (equation (6)), and -0.411 for Turkey (equation (7)). The correlations show that in the floating period, there are short-term capital movements for exchange rate speculation. The short-term capital movements and current account correlate in Argentina (equation (2)) and Mexico (equation (3)) positively, which can be interpreted as short-term capital inflows is related with the export sectors in these two countries. This is not surprising considering the oil and other exports of these countries. Short-term capital movements correlate negatively with current account in South Korea (equation (4)), which shows that short-term capital moves in as trade credits to finance imports in South Korea.

In the fixed exchange rate period of the sample countries most variables did not have significant correlations as is observed in Table 3. This result can be interpreted as when exchange rates are fixed, there are no systematic relations between the variables in question. The short-term capital movements are temporary and inconsistent. In two countries, Singapore and Mexico there were three correlations. In Singapore the short-term capital flows correlated significantly with interest rates. As is seen in Table 3, the significance of correlation is 0.013 and γsi coefficient of correlation is 1.098. So in the fixed exchange rate period, interest rates were used as an instrument to attract foreign capital in Singapore. In Mexico short-term capital movements are correlating with the difference with nominal exchange rates and expected exchange rates and with current account.

The two variables move together 99.7 percent of the time and the changes in (ERnme – EReme) affect the short-term capital movements by -1.415. As the difference grows, short-term capital leaves the country expecting devaluation. The short-term capital also correlates with current account in Mexico under fixed exchange rates. As one can see in Table 3, the two variables move 95.7 percent of the time together and coefficient is 54.7 percent. It means Mexico is receiving trade credits for its export sector, because the coefficient is positive. Considering the oil production and in-bond plants on the Mexico-US border, the inflow of capital to finance exports and re-exports could be understood. V. CONCLUSION AND POLICY SUGGESTIONS

In this study, the relationship between short-term capital flows and exchange rate regimes is analyzed. It is found out that the sample countries receive more short-term capital flows or fewer outflows under fixed, pegged, or anchored exchange rates. However, they are more prone to financial crises because of that. So the authorities in developing countries should decide between two alternatives: To select fixed, pegged, or anchored exchange rates if they want to attract more short-term capital with higher risk of financial crisis, or to select floating exchange rates if they agree to fewer short-term capital inflows with less financial crisis. The factors affecting the short-term capital movements under fixed exchange rates and under floating exchange rates are analyzed, as well. It is found that the major factor effecting the short-term capital movements in-and-out is the market interest rates in the countries under floating exchange rates. The differences between nominal exchange rates and expected exchange rates are the second important factor for most of the sample countries, like Argentina, South Korea, Singapore, Sweden, and Turkey. So some investors are entering these countries for currency hedging. Current account is an important factor in floating period, too, especially for these countries where international trade is a major sector in the economy.

So there is no free lunch. If developing countries try to attract short-term capital to finance their development projects, they have to pay for them either as high interest rates or as speculative gains on the value of their currencies.

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