The Search for a Framework
ADBI series on Asian Economic Integration and Cooperation
Edited by Masahiro Kawai and Mario B. Lamberte
Chapter 6: Crises, Capital Controls and Financial Integration
Eduardo Levy-Yeyati, Sergio L. Schmukler and Neeltje van Horen 6.1 INTRODUCTION Since the early 1990s, emerging economies have been rapidly integrating with the international financial system. Financial integration has manifested in many ways, including financial liberalization of previously closed economies, larger cross-border capital flows, entry of foreign banks, and participation of domestic firms in international markets. In particular, as firms go abroad, part of the domestic market activity has migrated to international markets. Capital is raised in international markets and securities are traded in international stock exchanges, in addition to domestic ones.1 This process of financial integration has been fueled by the belief that it encourages better allocation of resources and risks worldwide, and ultimately promotes higher growth.2 Two factors have emerged to threaten this financial integration. Firstly, a series of crises erupted when countries opened up to capital flows, which led to some reservations regarding the net benefits of outright financial liberalization.3 Secondly, capital controls have emerged as a way to mitigate financial integration.4 In times of crises, controls on capital outflows have been used to stem reserve losses, currency devaluations, and the collapse of the banking sector. Two such well-known cases are those of Malaysia during the East Asian crisis of 1997–98 and Argentina during its 2001–02 collapse.5 In tranquil times, controls have been used to avoid the currency and maturity mismatches that short-run foreign flows can produce, and to mitigate the currency appreciation that tends to negatively affect trade balance and domestic production. In fact,...
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