TERM PAPER

Capital Account Liberalization and Inequality .

Name: Faria Hossain

ID: 19105037
Course code: ECO431

Submitted to respected Prof. Farzana Munshi

 Introduction
Capital account liberalization is the process by which a country's government transitions from
a closed capital account system, in which capital cannot freely move in and out, to an open
capital account system, in which money can freely move in and out. It is a well-known policy
that many emerging economies undertake as part of their economic policy reform program to
remove limitations on capital movement. Liberalization, it is commonly acknowledged,
prepares the way for more development projects and capital market investment, which extends
local financial goals and leads to a more robust global economy.
On the other hand, a currency crisis is a sharp and unexpected drop in the value of a country's
currency. However, this loss in a value has a negative impact on the exchange rate, meaning
that a unit of domestic currency can no longer be traded for as much in foreign currency as it
once could. Other variables, such as capital inflows and outflows, are also affected by
currency crises. The majority of the time, a currency crisis occurs unexpectedly, but it can
also be predicted.
In the midst of the currency crisis, an important argument on capital account restriction
emerges. Liberalization of the capital account has a significant role in strengthening domestic
financial organizations and revising neoliberal policies. The question of whether liberalization
precedes a currency crisis or whether a currency crisis precedes a more open economy is a
common one.
By studying the distributional repercussions of capital account liberalization for a large
(unbalanced) panel of 149 countries from 1970 to2010, this paper adds to the empirical
literature on the effects of financial globalization on inequality. The paper's main contribution
is to use a large panel dataset of advanced, emerging, and low-income economies to provide
robust evidence of the effects of capital account liberalization on inequality, whereas previous
papers have focused primarily on within-country experience (Larrain, 2015) or on a smaller
set of countries (Das and Mohapatra, 2003). We also present empirical evidence for some of
the mechanisms at work, such as the level of financial development, the occurrence of
financial crises, and the impact on labor shares through which money flows.
 Literature Review
Currency crises are, without a doubt, caused by both internal and foreign influences. The most
typical reasons of the financial crisis are severe banking and financial weakness, country
competitiveness, investor irrationality, and economic penalties (Summers,2000). A disinclined
devaluation of the nation's currency indicates a crisis when the government is under
significant market pressure (Peksen and Son, 2015). When confronted with this predicament,
the administration is likely to take the required steps to avoid further calamity while taking
into account the political context. The research on international monetary policy has provided
a wealth of information about the relationship between crises and liberalization. A central
claim in this literature is that the currency crisis causes liberalization of the capital; however,
Pepinsky (2012) argues that the opposite is true.
The literature on capital account liberalization suggests that in times of crisis, governments strive
to create an open economy to encourage capital owners to invest more. In times of crisis, the
International Monetary Fund (IMF) encourages countries to build an open economy so that
governments can obtain financial assistance from overseas traders. However, the IMF's inability
to forecast the source of a problem and assist a struggling economy has led many East Asian
countries to conclude that the IMF is incapable of playing a suitable role (Choi,2001). Pepinsky
(2012) investigates currency crisis variables such as growth, spending, and savings, concluding
that the crisis diminishes the likelihood of an open economy. When a country is in the midst of
an economic crisis, currency countries with stronger economies may attack the weaker economy.
As a result, many countries in crisis turn to closed economies to avoid foreign invasion.
Furthermore, receiving foreign aid during a crisis results in a high amount of debt, which might
lead to a larger problem in the long run (Rajan, 2007). Depending on the situation, countries may
opt to liberalize or shut their economies. Appendix A depicts how different countries reacted to
capital movements following the currency crisis. Indonesia, Korea, and Thailand chose capital
controls, whereas the Philippines selected the opposite path.
Nonetheless, there is a substantial debate about whether countries that remove capital outflow
controls are more likely to have a crisis. The neo-classical school of thought asserted in the
1990s that an open economy is more efficient than a restricted one. Several countries that
liberalized their economy, however, experienced economic disasters (Nidugala,1997). Glick,
Guo, and Hutchison (2006), on the other hand, argue that in order to determine the impact of
liberalization on the crisis, more attention must be paid to the context in which a country
implements policy reforms. Changes in the exchange rate versus the US Dollar before and after
the crisis are shown in Appendix B. Malaysia implements a fixed capital outflow, but Indonesia's
currency fluctuates more in the post-crisis period than in the pre-crisis period. The specific
characteristics of countries that choose to liberalize may be the primary cause of currency crises.
The crisis is less likely to hit countries with an open economy and robust financial and political
stability. Countries adopting capital controls, on the other hand, can avoid capital outflows that
can lead to a currency crisis. Based on historical experience, a country may face a crisis even
after regulating its capital account. Despite having a closed economy, India experienced a
currency crisis in 1991. Although capital account liberalization improves macroeconomic
stability, not all liberalized systems are linked to economic resilience. Appendix C shows that
capital account rigidity in industrial countries is much lower than in underdeveloped countries.
The rate of openness in emerging countries is generally slow. If liberalization is done on the spur
of the moment, it may not be beneficial to the economy. For illustration, abrupt deregulation of
state monopolies might lead to private monopolies and shady pricing practices.

Methodology
This section of the article outlined the capital account liberalization research plan, technique,
methodology, and data gathering method, as well as how it affects the currency crisis. After
reading various scholarly journals and book chapters on capital account liberalization and
currency crises, the research for this paper was conducted. Jstor was used to identify
innumerable academic papers, and a search engine such as Google was utilized to collect data.
Graphs and figures from the IMF eLibrary were utilized to supplement the evidence. This
quantitative investigation, as well as qualitative research from scholarly journals, supported
our findings. For citation, a proper website was used.
This paper's technique for assessing the impact of capital account liberalization policies on
inequality is based on the work of Cerra and Saxena (2008) and Romer and Romer (2010),
among others. This method is especially well adapted to determining the dynamic reaction of
a variable of interest in the aftermath of a shock (a capital account liberalization episode in
our case). Estimating a univariate autoregressive inequality equation and determining the
accompanying impulse response functions are part of the process.
𝑔𝑖𝑡 = 𝑎𝑖 + 𝛾𝑡 + ∑ 𝛽𝑗𝑔𝑖,𝑡−𝑗 𝑙 𝑗=1 + ∑ 𝛿𝑗𝐷𝑖,𝑡−𝑗 + ∑ 𝜗𝑗𝑋𝑖,𝑡−𝑗 𝑙 𝑗=1 + 𝜀𝑖

where g is the annual change in the (log of the) Gini coefficient; D is a dummy variable equal
to 1 at the start of a capital account liberalization episode and zero otherwise; ai are country
fixed effects included to control for unobserved cross-country heterogeneity of inequality as
well as the fact that inequality is measured using income data in some countries but
consumption data in others; tare time fixed effects to control for the fact that inequality is
measured using income data in some countries but consumption data.

CONCLUSION

The goal of this research is to examine the influence of capital account liberalization policies
on inequality using empirical evidence. We find that capital account liberalization episodes
are associated with a statistically significant and persistent increase in inequality, using an
unbalanced sample of 149 countries from 1970 to 2010. In example, we find that capital
account liberalization measures have increased the Gini coefficient by around 0.8 percent on
average in the very short run.
Capital account liberalization is a type of global trend that brings with it a slew of financial
benefits. Countries with an open economy and strong political and political stability are less
vulnerable to crises. Countries with weaker economies, on the other hand, may experience a
crisis even after assuring unfettered capital outflows. Keeping in mind that governments in
crisis prefer a closed economy than a liberalized one since there is less financial and political
stability in a closed economy. Changes in capital outflow policies are heavily influenced by
the country's circumstances. Many emerging and underdeveloped countries prefer closed
economies in times of crisis due to the significant dominance of international market forces.
Because there is less currency domination in advanced countries, they may choose to maintain
currency liberalization.

REFERENCE

Choi, C. (2001). Korean Currency Crisis and the Reform of International Financial Institutions.
Journal of International and Area Studies, 8(1), 19-39. Retrieved April 13, 2021, from
http://www.jstor.org/stable/43111431
Cerra, V., & Saxena, S. (2002). What Caused the 1991 Currency Crisis in India? IMF Staff
Papers, 49(3), 395-425. Retrieved May 7, 2021, from http://www.jstor.org/stable/3872503
Ganesh Kumar Nidugala. (1997). Capital Liberalisation and Currency Crisis: Experience of
Mexico and India. Economic and Political Weekly, 32(29), 1803-1810. Retrieved May 6, 2021,
from http://www.jstor.org/stable/4405648
Glick, R., Guo, X., & Hutchison, M. (2006). Currency Crises, Capital-Account Liberalization,
and Selection Bias. The Review of Economics and Statistics, 88(4), 698-714. Retrieved April 13,
2021, from http://www.jstor.org/stable/40043029
Rajan, R. (2007). Financial Crisis, Capital Outflows, and Policy Responses: Examples from East
Asia. The Journal of Economic Education, 38(1), 92-108. Retrieved April 13, 2021, from
http://www.jstor.org/stable/30042754
Summers, L. (2000). International Financial Crises: Causes, Prevention, and Cures. The
American Economic Review, 90(2), 1-16. Retrieved May 6, 2021, from
http://www.jstor.org/stable/117183
Peksen, D., & Son, B. (2015). Economic coercion and currency crises in target countries. Journal
of Peace Research, 52(4), 448-462. Retrieved May 6, 2021, from
http://www.jstor.org/stable/24557431
Pepinsky, T. (2012). Do Currency Crises Cause Capital Account Liberalization? International
Studies Quarterly, 56(3), 544-559. Retrieved May 6, 2021, from
http://www.jstor.org/stable/23256804
Appendix