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International Capital Flows, Financial Reform & Consequences of Changing Risk Perceptions in APEC Economies

Abstract

This paper draws on the empirical results from a number of papers that a multi-country modeling framework to explore the global impacts of financial liberalization in Asia and the impacts of a change in risk premia in Asian economies. It is shown that financial liberalization brings with it large potential gains in the medium term but causes fluctuations in key variables such current accounts and real exchange rates. It is also shown that relative small changes in financial risk can have large real consequences—consistent with the experience of countries during the Asian economic crisis. Structural weakness, excessive un-hedged exposure to foreign debt, a fixed exchange rate regime or a poorly functioning financial system is likely to accentuate the impacts of changes in risk. Open trade in goods and services as well as open capital markets act as a stabilizer for the impacted economies as well as economies outside Asia if the shock is actually a general loss of confidence in an economy.

The policy dilemma is how countries can benefit from the potential gains from financial market liberalization without exposing an economy to the costs of fluctuations in risk perceptions which this paper demonstrates can have large consequences. Rather than building barriers to international capital flows, this paper argues that risk minimization and risk management is likely to be a better approach because although capital controls may help with some shocks, these controls remove an important stabilizing channel for other shocks in the short term. Capital controls also limit access to global capital markets for countries imposing them, which is costly in the medium term. Better risk management should both reduce the likelihood of changes in risk as well as enable lower cost adjustment in the event of certain shocks.

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