Capital Account Liberalization for a Small, Open Economy

We survey the ongoing debate on pros and cons for an early and comprehensive liberalization of capital flows by emerging economies. We examine the main theoretical assumptions that would lead to positive effects on output growth and consumption volatility and reflect them with recent literature on market imperfections and information deficiencies. We find little evidence for a positive effect of free capital flows on economic growth and stability for emerging economies. We apply these main results to Vietnam as an example for an open emerging economy and discuss the main explanatory factors that may lead to negative impacts of an early and premature liberalization of capital flows. For small, open economies, absorption capacity for capital is limited. Excessive capital inflows might cause Dutch disease phenomena and asymmetric information might trigger an inefficient use of capital. In particular, we stress potential negative impacts of capital flows on the currency risk premium. Finally, we argue that for a partly dollarized economy as Vietnam a premature liberalization of capital flows might significantly increase financial sector instability. In conclusion, we emphasize the importance of a prudential sequencing of capital account liberalization and strong domestic institutions such as an independent central bank, proper financial regulation and supervision and macroeconomic stability as necessary pre-conditions.