Financial Regulations in Developing Countries: Can They Effectively Limit the Impact of Capital Account Volatility?

Abstract

After more than a decade of financial sector liberalization, both of domestic markets and of international financial transactions (capital account liberalization), policymakers in many developing countries remain concerned about the effects that large and highly volatile capital flows have on their financial systems. This is not surprising given the increasing evidence that, in sharp contrast to policy objectives, financial crises have become more frequent following financial liberalization. However, in spite of the tremendous costs associated with the resolution of crises and signs of discontent among the population with the outcome of some reforms, to date there is no significant evidence indicating a reversal of the reform process. With few exceptions (mostly of temporary nature) developing countries have not gone back to the era of highly controlled domestic financial markets or closed capital accounts. While one could advance a number of hypotheses explaining this "commitment to reforms", developing countries' decisions and actions seem to indicate that policymakers perceive capital inflows as a necessary component to achieve growth and development. Rather than severely restricting the movement of capital, many countries have intensified their attempts to strengthen their domestic economies, and especially their financial systems. The hope is that if only the right policies could be designed to insulate domestic financial sectors from the volatility of international capital flows, countries could enjoy the benefits of both additional foreign capital for growth and stable domestic financial systems.