Introduction

The capital account has been opened, de facto, in the past twenty years by the increase in trade, the internationalization of production, the improvements in communications, and the legalization of foreign currency instruments in a growing number of countries. In line with this de facto opening of the capital account, and the greater reliance on open goods markets, developing country governments naturally are raising questions about fully opening the capital account in a de jure sense. As a background to answering such questions, this chapter surveys the costs and benefits of opening up domestic capital markets and discusses the preconditions to capital account opening and issues of sequencing and pace, including a reexamination of the cases of Uruguay and Chile, which opened their capital accounts fairly early. For purposes of the chapter, a fully liberalized or open capital market is defined as one in which individuals and firms access international financial markets freely, not just one in which the government intermediates capital flows to balance differences in private saving and investment.

The costs and benefits of capital account liberalization

The traditional analysis

The traditional welfare analysis of capital account liberalization is a real theory that focuses on the benefits of allowing foreigners to own more domestic capital (MacDougall 1968). This analysis begins from a situation of autarchy, analogous to the traditional analysis of the welfare implications of free trade, but with only one good.