Capital Account Liberalization and Economic Growth: Evidence From Emerging Market Economies


Abstract. Financial globalization has altered the world economic architecture over the past few decades. The economies are liberalizing their financial sectors by reducing government regulations and restrictions on capital flows across borders. The capital account liberalization is a critical policy decision for the Emerging Market Economies (EMEs). This research work aims at exploring the impact of capital account liberalization on economic growth in the 17 emerging economies over the period 1991 - 2015. The generalized method of moments (GMM) system technique is applied using different de facto and de jure measures of capital account openness. The empirical results indicate that only foreign direct investment (FDI) affects economic growth positively and significantly in the EMEs while the coefficients on all the other measures of capital account liberalization remain statistically insignificant.

The findings suggest that FDI is the most beneficial and stable capital flow which imports sophisticated techniques of production, promotes a competitive environment, encourages innovations and inventions and hence promotes economic growth in the emerging economies.

Keywords: Capital account liberalization, Economic growth, Foreign direct investment, Generalized method of moments


    Financial liberalization has gained substantial importance in the current globalized world. In the quest of exploring its outcomes, the researchers mainly focus on its effects on economic growth. Theoretical literature suggests that the capital account liberalization encourages an efficient allocation of financial resources, induces financial sector development and provides risk diversification opportunities. Recognizing these potential advantages, the policy makers of industrial economies have taken steps towards financial liberalization over the last three decades. Many researchers attribute the efficiency gains in these advanced economies to liberalized capital markets. McKinnon and Shaw (1973) explain that the financial openness would promote economic growth by encouraging investment and capital accumulation.

    Financial liberalization also puts a favorable impact on productivity due to easier access to profitable investments opportunities and efficient allocation of funds (Kose et al. 2009). In a more sophisticated context, the capital inflows from rich to poor nations may improve the allocative efficiency of investment, alleviate credit constraints and provide lucrative investment opportunities (Acemoglu and Zilibotti, 1997). According to a neoclassical viewpoint, the international capital market liberalization transfers capital from capital-abundant to capital-scarce economies. The cheaper capital in low-income economies encourages investment and promotes economic growth. However, a policy prescription of rapid capital account liberalization in economically less developed countries has been controversial. Some economists advocate the benefits of financial liberalization while others point out some potential risks on the basis of past bad experiences of East Asia and Latin America.

    Financial globalization gained popularity in the mid-1980s. The financial markets perform a vital role in the development process of an economy by providing information to the agents about optimal allocation of finances and international diversification. However, there are many concerns over financial liberalization in the wake of global financial crunch experienced by different countries around the globe. The previous two decades have witnessed two cases of massive capital flows to emerging markets. The first wave of crisis started in the 1990s and ended rapidly after bringing Asian financial crisis. The recent case is the increased financial flows from industrialized countries to emerging market economies. However, the nature and composition of financial flows are found to be different in both cases.

    The strategy of minimum restrictions on capital flows has been encouraged on the basis of expected improved allocation of financial resources and better risk diversification possibilities. It is strongly assumed that the liberalization of financial flows benefits developing countries because they are relatively capital-poor economies with a higher marginal product of capital. However, the increased capital flows may cause currency and financial crises. The 2008 financial crisis gave a jerk to the global financial regulatory setup and a new debate on the costs and benefits of financial openness started. The experience of capital account liberalization in emerging markets provides many opportunities as well as challenges for the economic policy makers. The core objective of this study is to explore the impact of capital account liberalization on economic growth in emerging market economies exclusively.


    The empirical research does not give a clear explanation of the benefits of financial openness in emerging market economies. Many studies suggest a positive association between financial liberalization and GDP growth but several others are unable to discover any significant link. Quinn (1997) utilizes IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) to develop a financial openness index for a large group of developed and developing economies. The empirical results suggest a positive nexus between financial openness and economic growth. Bailliu (2000) finds that capital account liberalization stimulates growth through financial development in case of developed countries. Arteta et al. (2001) discover a more supportive role of financial openness in advanced countries than in developing economies. Bekaert, Harvey, and Lundblad (2001) find that the capital account liberalization affects GDP growth positively in emerging countries.

    Ross Livine (2001) finds a favorable influence of financial openness on output growth by bringing improvements in domestic financial setup. O’Donnell (2001) points out that the growth impacts of financial liberalization are different in different countries depending on their economic structures and institutional quality. Soto (2003) explores the contribution of capital account liberalization on GDP growth in 72 economies over the period 1985-1996. The empirical results indicate that the foreign direct investment affects GDP growth positively and significantly. Bonfiglioli (2005) examines the effects of financial openness on total factor productivity, investment and GDP growth for 57 economies. He reveals that the capital account liberalization does not significantly influence capital accumulation but it enhances productivity and economic growth. Kose et al. (2006) discover a positive contribution of FDI...

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