Capital Account Liberalization and Exchange Rate Regimes

Topics: Foreign exchange market, International economics, Exchange rate Pages: 20 (6090 words) Published: March 6, 2013

Capital Account Liberalization and the Exchange Rate Regimes

Corresponding author:Associate Prof. Dr. Sule L. Aker
Faculty of Business and Economics
Eastern Mediterranean University
Gazi Magusa, Mersin 10, Turkey
tel: 00903926301260
fax: 00903923651017
Co-author:Assoc. Prof. Dr. Ahmet H. Aker
Cyprus International University
Nicosia, Mersin 10, Turkey

In this study, the relationship between short-term capital flows and currency hedging, interest rates and current account is analyzed. The results show that the major determinant of short-term capital movements is the market interest rates under floating exchange rate system and liberal capital account and free trade conditions. The short-term capital flows in the sample countries are tested with respect to exchange rates (currency hedging), interest rates, and current account.

Jel Classification: F0, F3, F4, G1

Key words: Hot money, short-term capital, exchange rates, economic liberalization, developing countries.

Globalization envisages an international economic and financial system where all factors of production move around the world freely and easily so that the global firms meet no obstacles on their way to maximize profits. In this framework, capital account liberalization was encouraged in developing countries like Argentina, Bolivia, Ecuador, Indonesia, Malaysia, Mexico, Singapore, Turkey, Uruguay, Venezuela in late 1980`s and early 1990`s (Glick and Hutchison, 2005). Developed countries too, suspended capital controls in these two decades: UK (1979), Japan (1980), Australia and New Zealand (1983), Netherlands (1985), France, Sweden, and Denmark (1989), Belgium and Luxembourg (1990), Finland and Austria (1991), Portugal and Ireland (1993), Iceland (1994) removed restrictions on inflow of capital into the country and outflow of capital from their countries. (Saxena and Wong, 1999)

Liberalizing the capital account was a major move for developing countries in the direction of integrating with the rest of the world. But at the same time it was a major challenge, because governments were losing total control on the financial variables and monetary aggregates, and nobody was sure whether they were moving into a new integrated monetary system or into chaos and confusion. For some countries, liberalization took years, and in some others it is not completed yet. Once the liberalization process is started, however, it is true that it becomes more difficult to control the flows. Aizenman and Noy (2009) found that there is two-way feedback between financial and trade openness, so once countries liberalize their trade, financial openness also starts. Capital account liberalization was one of the most important economic policy developments in the last two decades in international economics and the consequence of it is still under examination. There are three lines of thinking in this area: The first line of thinking claims that free capital movements cause financial crises and economic disturbances in the countries implementing this policy and real variables are negatively affected as a result of these movements. The second group insists that it is not the free movement of capital to be blamed, but it is weak financial systems, corrupt officials and unregulated institutions causing financial crises. The third group stresses that crises are the consequences of interferences in the free functioning of the market system. The conclusions of this study suggest that there must be compatibility between the policies about capital account, trade account, and the exchange rate regime. If the country liberalizes its capital account, it would be easier to manage the flows if the country also has a free trade regime and the floating exchange rate system because of the imbedded automatic...
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