Capital Account Liberalization: Theory, Evidence, and Speculation

Two decades of cross-country regressions found no relationship between capital account openness and economic growth, which earlier surveys read as a verdict against the textbook case for liberalization. This survey argues those regressions never tested the theory. In the neoclassical growth model, liberalizing a capital-poor country’s capital account permanently lowers its cost of capital and permanently raises the level of GDP per capita, but raises the growth rate only temporarily, because capital accumulation – subject to diminishing returns – is the only channel available and long-run growth differences come solely from total factor productivity, which the capital account regime does not touch. So a regression of average growth on the fraction of years a country was judged open “do[es] not provide a test of any causal theory”; Henry adds a worked example in which a country that liberalizes halfway through a twenty-year window genuinely gets a temporary growth boost yet, because its openness share is 0.5 against an always-open comparator’s 1.0, the regression returns a negative coefficient. Reoriented to what theory predicts – do the cost of capital, investment and growth move in the years right after a country opens? – the evidence lines up: across 18 developing countries that opened their stock markets between 1986 and 1993, stock markets revalue by roughly 26 to 30 percent in real dollar terms, dividend yields fall by 5 to 75 basis points, the growth rate of the capital stock rises from 5.4 to 6.5 percent a year between the five years before and after, real private investment growth rises by 22 percentage points in an eleven-country sample, and GDP-per-capita growth rises about a percentage point a year. Henry then turns the same scepticism on these results. The revaluation is small relative to what large capital-labour gaps should imply, and he canvasses three explanations – incremental rather than one-shot liberalization (which he rejects, since later openings move prices little and continuous investability measures give a cumulative dividend-yield fall of only about 140 basis points), genuinely lower returns in developing countries because weak institutions depress total factor productivity, and persistent return differentials from capital market imperfections and weak investor protection. He shows the aggregate investment response cannot be financed by the initial country fund (Chile’s 37.7 million dollar Toronto Trust fund accounts for under 5 percent of the extra capital implied by its subsequent 2.2 percentage points of abnormal annual capital-stock growth), and argues the country-fund date is a proxy for a broader opening rather than the whole inflow. He is blunter still about growth: with capital growth up about one percentage point and an output elasticity of capital near one-third, liberalization “cannot raise the growth rate of GDP per capita by much more than one-third of a percentage point,” so the one-point estimate “is implausibly large,” and the measured jump in TFP growth from 0.19 to 1.82 percent a year cannot be attributed to liberalization within the model, because contemporaneous inflation stabilizations, trade liberalizations, privatizations and Brady debt relief supply an accounting for it that the theory does not. Firm-level work resolves some of this and complicates the rest: firm revaluations do track firm-specific changes in systematic risk, and the average firm’s capital stock growth exceeds its pre-liberalization mean by 3.8 percentage points a year, but investment does not respond to firm-specific changes in the equity premium at all – which Henry calls “a powerful blow to the Allocative Efficiency view.” On crises, he insists the answer depends on which liberalization is meant: crises also occur under capital controls and are positively correlated with them, the median stock market liberalization predates the Mexican crisis by five years and the Asian crisis by nearly ten, and the proximate cause was short-term dollar-denominated bank debt, whose reversal in the five Asian crisis countries amounted to nearly 80 billion dollars in a single year while portfolio flows fell by about half and stayed positive. His bottom line is that debt-flow liberalization – especially short-term and dollar-denominated – “can cause problems,” while “all the evidence we have indicates that countries derive substantial benefits from opening their equity markets to foreign investors,” and that the profession’s attachment to cross-sectional growth regressions reflects tradition and “a professional obsession” with policies that raise steady-state growth rather than anything the theory supports.

Do finite horizons matter? The welfare consequences of capital account liberalization

Cross-sectional regressions have repeatedly failed to find robust effects of capital account liberalization on investment or GDP per capita, and Gourinchas and Jeanne (2006) found that the welfare gain from integration, measured over an infinite consumption stream, is small. This paper argues both findings are what the neo-classical model should predict and that neither settles whether liberalization is worth doing, because the theory predicts a temporary growth effect with a permanent level effect, and because the standard welfare measure spreads a gain concentrated in the first years over an infinite horizon on which the two consumption paths eventually coincide. Working in a calibrated infinite-horizon Ramsey model with Cobb-Douglas production (beta = 0.96, capital share 0.3, depreciation 0.06, output growth 1.012, population growth 1.022, log utility), the authors assume the liberalizing economy faces the world interest rate immediately and so jumps to the integrated steady state at once – an assumption made explicitly “to abstract from speed of convergence issues” – while the autarkic economy climbs there gradually from the same starting point, the population-weighted capital stock of 1995 (1.96, against a steady state of 3.97). They then compute the Hicksian consumption-equivalent gain over horizons from five years to infinity for 81 non-OECD countries. The timing result is the paper’s core empirical claim: “95% of the increase in annual consumption from capital account liberalization accrues in the first 10-15 years after the opening.” Consequently the same welfare difference reads very differently depending on the normalising horizon. In the baseline, where the economy pays interest on the inflow in perpetuity and never repays principal, the average infinite-horizon gain is minus 3.46 percent of annual consumption – financing costs outweigh the gain – while the five-year figure is 19.02 percent, and the numbers decline monotonically with the horizon, crossing zero around 35 to 40 years. The gain scales with initial capital scarcity: 51.47 percent at five years for the most capital-scarce quartile of countries, against minus 0.90 percent for the most capital-abundant quartile. The robustness exercises mostly preserve the horizon result while showing how sensitive the level is to the debt contract: allowing conditional convergence with country-specific earnings-price ratios gives 9.89 percent at five years and minus 8.35 percent at infinity; imposing the Obstfeld-Rogoff transversality condition, so principal and interest are settled only at infinity, gives 29.32 percent at five years and a positive 4.97 percent at infinity; a 50-year amortising contract gives 18.22 percent and minus 4.12 percent; starting from 1960 rather than 1995 capital stocks, when gaps were wider, gives 32.03 percent at five years. Adding a normally distributed technology shock (mean 1, standard deviation 0.03, described by the authors as “not a realistic shock … used for illustrative purposes”) makes the contract form decisive: with a non-contingent debt contract the computed gains turn sharply negative at every horizon, whereas an equity-like contract that suspends payments in bad states “comes close to the case of an economy that liberalizes and does not need to make repayment.” The authors’ conclusion is methodological and carefully bounded: they “do not claim that policies that lead to permanent effects on TFP and growth are not important,” only that finite-horizon evaluation “may be more appropriate and policy-relevant” for policies with temporary growth and permanent level effects.

Peter Blair Henry | Macro Paper Warehouse

Capital Account Liberalization: Theory, Evidence, and Speculation

Do finite horizons matter? The welfare consequences of capital account liberalization