Introduction and overview

Many countries, developed and developing, are liberalizing their domestic financial markets. Often such liberalization is accompanied by a reduction in regulatory and other barriers to international capital mobility. In the aftermath of several liberalization experiences, however, the compatibility of these reform measures – liberalization of domestic financial markets and opening of the capital account – has been questioned. One of the main reasons is the unfortunate (some would argue anomalous) Chilean experience. Between 1975 and 1977 Chile liberalized its domestic financial market. In 1980 the capital account was liberalized for domestic banks, a policy that some authors regard as one of the main causes of the excessive buildup of foreign debt and the subsequent steep recession that ensued in 1982. For example, analyzing this episode from a macroeconomic point of view, Harberger (1985) argues, “The process of relaxation of capital controls should have been slower and more cautious, with the end in view of not letting the inflow of capital get more than, say, a couple of percentage points above the sustainable level.”

This study discusses whether the 1980 opening of the capital account for domestic banks was indeed an important causal factor in the dismal macroeconomic performance of the subsequent period. In order to sharpen the analysis, the study also examines a number of counterfactual policies, such as liberalizing earlier and maintaining capital controls for banks in 1980, given the other distortions that were present.