The Issue of Capital Account Convertibility - A Post-Currency Crisis Perspective

The process of globalization has gathered momentum due to the rapid increase in cross-border capital flows stimulated by trade liberalization and the rapid diffusion of information technology. The International Monetary Fund spearheaded the issue of freer capital mobility or capital account convertibility in order to spread the benefits of globalization to developing economies. However, a spate of currency crises and resulting sudden capital flow reversals plunged countries that had achieved miracle growth rates with open capital accounts into economic turmoil. This paper reviews the first-best case for free cross-border flow of capital or capital account liberalization and the second-best case for capital controls in a world riddled with domestic distortions. These distortions are identified in terms of asymmetric information that are intrinsic to capital or financial market transactions and non-information market failures that occur due to structural weaknesses in developing countries. The rationale for capital controls, the pre-conditions and sequencing of their removal in order to achieve sustainable capital account convertibility are reviewed. A typology of currency crises that have occurred recently and their proximate causes are identified. In particular, it is shown that the Asian currency crisis was precipitated by a massive influx of unhedged short-term capital denominated in foreign currency to countries with fragile financial sectors and weak corporate governance. The paper distils lessons from the recent financial crises and reviews the three-pronged case for the reform of international financial architecture to mitigate the frequency of crises and the virulence of crisis contagion due to sudden capital flow reversals.