How Risky is Financial Liberalization in the Developing Countries

‘Many countries, in Europe but also in Asia, have been able to grow fast over decades while retaining heavy-handed financial restraints. This alone shows that there is no urgency to undertake liberalization, even though that step should clearly be taken somewhere down the road.’ This conclusion appears in a paper by Charles Wyplosz of the Graduate Institute of International Studies, Geneva, published by the Centre for Economic Policy Research.

Professor Wyplosz takes as his starting point the fact that ‘Something has changed in the world of financial crises’. They once could strike anywhere, but they are now confined to developing countries and they hit countries with no serious imbalances. ‘These changes carry profound implications. They challenge the wave of capital liberalization observed over the last decade...They require new thinking among international financial institutions and…the developed countries. They also affect banks and financial institutions which have moved significant parts of their activity to emerging markets’.

The author compares the gradual process of liberalization that occurred after the Second World War in Europe with that of rapid reform which has occurred in some transition countries. The second variety was often based on the idea that ‘financial repression serves only powerful private and political interests apt at thwarting ambitious reforms’.

The paper, through the use of clear examples, shows that financial liberalization can be much more destabilising in developing than in developed countries. ‘Developing countries tend to go through a boom-bust cycle, especially in the case of external liberalization.’ It is pointed out that liberalization can be just one of several measures taken by a reform-minded government. ‘In that case, liberalization can have radically different effects depending on the accompanying measures. Sometimes, of course, financial restrictions obscure and mitigate the effects of other, faulty, policies.’

Professor Wyplosz comes to an unexpected conclusion: his analysis shows that those who argue that restrictions can be self-defeating and those who say their removal leads to destabilising speculation can both be right. This is so because, while it is true that ‘restrictions cannot prevent the collapse of exchange rate when the underlying macro-economic policies are unsustainable’, it is also perhaps true that liberalization ‘opens up a window of fragility that can last several years’. Other lessons drawn from the study are that we have little idea of the precise effects of capital flows on developing countries; that liberalization can reduce foreign exchange pressure in the long run but is initially a source of instability, and, finally, it is surprising how little we can explain about the crises of the nineties. ‘Most countries are potentially guilty of something; when they liberalise their financial markets they are potentially about to face a currency crisis, but no one knows for sure’ where the guilt may lie.

Professor Wyplosz sets out three main conditions for ‘safe’ liberalization. It may be useful to wait until proper economic, financial and, possibly, political infrastructure has been built. Then governments need adequate welfare systems before liberalising, so as to mitigate the inegalitarian effects of free markets. And, thirdly, find the right currency system: more study of the ‘hard peg’ is advocated.

The paper ends with some lessons for the International Monetary Fund. If balance-of-payments crises were confined to developing countries then the IMF would become an institution run by the developed countries but at the service of the developing world. That is not what was intended. And the author adds, ‘The IMF has now tamed its early enthusiasm for liberalization but it has failed to recognise early enough the associated dangers. It has been seen as protecting the lender at least as much as the borrowers.’

The main lesson is, perhaps, that ‘liberalization is a risky step, one in which our knowledge remains rudimentary’.

Notes for Editors:

CEPR is a network of over 500 Research Fellows based throughout Europe, who collaborate through the Centre in research and its dissemination. CEPR helps its Research Fellows to develop projects, obtain their funding, administer them and disseminate their results. The Centre’s research ranges from open economy macroeconomics to trade policy, from the economic transformation of Central and Eastern Europe to regionalism in the world economy. For further information about CEPR, please contact Rita Gilbert, Tel: (44 20) 7878 2917 or email: rgilbert@cepr.org, or contact James Morgan, Tel: (44 20) 8225 7262. Visit our website for a copy of this document or for additional services: http://www.cepr.org

The Author:

Charles Wyplosz is Professor of Economics at the Graduate Institute of International Studies, Geneva and is also a Programme Director in CEPR’s International Macroeconomics research programme and a Research Fellow in CEPR’s Transition Economics research programme.  

 
  
How Risky is Financial Liberalization in the Developing Countries?
Charles Wyplosz

CEPR Discussion Paper  No 2724
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