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Explaining Capital Account Liberalization in Latin America: A Transitional Cost Approach

Published online by Cambridge University Press:  13 June 2011

Sarah M. Brooks
Ohio State University


In the past three decades governments around the world have lowered barriers to international capital flows. This movement is widely attributed to the forces of globalization, as developed nations moved toward relative convergence on international financial openness. Yet developing nations with much to gain from openness to foreign investment moved only hesitantly and inconsistently in this direction. Analysis of two decades of capital account liberalization in Latin America and the OECD reveals that nations in Latin America with weaker domestic financial sectors face higher risks of transitional dislocations following liberalization and move less aggressively toward openness. In the OECD, by contrast, financial weakness is associated with greater movements toward capital account opening, as transitional costs are lower and governments are better equipped to ameliorate them. Examination of the transitional costs of liberalization thus helps to explain how market pressures may impede, rather than promote, market-oriented reform in Latin America.

Research Article
Copyright © Trustees of Princeton University 2004

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1 The capital account is that portion of a country's balance of payments on which flows of capital (debt, equity, direct and real estate investment) are recorded across borders. Eichengreen, Barry et al. , “Liberalizing Capital Movements: Some Analytical Issues,” Economic Issues 17 (Washington, D.C.: IMF, 1999), 2.Google Scholar

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3 These transactions refer to international currency, over-the-counter, and derivative transactions; Bank of International Settlements, “Consolidated International Banking Statistics for End-1997” (Basel, Switzerland: Bank for International Settlements, May 1998)Google Scholar, available at

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5 I am grateful to Leo Bartolini for generously sharing these data. See Bartolini, Leonardo and Drazen, Allan, “When Liberal Policies Reflect External Shocks, What Do We Learn?” Journal of International Economics 42 (May 1997)CrossRefGoogle Scholar.

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36 Haggard and Maxfield (fn. 17). The time series in their analysis ends, however, in 1990.

37 Chile reduced its unremunerated reserve requirements to zero in 1998 as economic conditions improved, but it has kept them on the books for future use; see Sebastian Edwards, “Capital Flows, Real Exchange Rates and Capital Controls,” in Edwards (fn. 19); Francisco Nadal-De Simone and Prirtta Sorsa, “A Review of Capital Account Restrictions in Chile in the 1990s,” International Monetary Fund Working Paper 52 (Washington, D.C.: IMF, April 1999). Lukauskas and Minushkin (fn. 17) argue that “strong economic conditions gave Chile's government the confidence to reopen its financial markets on its own terms” (p. 716).

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51 Countries are no less vulnerable to external shocks where the governments has committed to a peg or currency board. In this case, quelling outflows of capital involves either drawing down foreign currency reserves or raising domestic interest rates. While the former constrains the ability of the government to defend the currency peg, the latter increases the likelihood of default in the domestic financial sector. To the extent that increased volatility in terms of trade diminishes the ability of domestic producers to service existing loans, higher interest rates threaten to push the domestic financial sector further toward crisis. Goldstein, Morris and Turner, Phillip, “Banking Crises in Emerging Economies: Origins and Policy Options,” BIS Economic Papers 46 (October 1996), 9.Google Scholar

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54 Williamson (fn. 19).

55 Higher fiscal deficits may also be harmful to domestic banks, as increased interest rates prevent access to credit by potential private sector borrowers; Quispe-Agnoli and McQuerry (fn. 53), 4.

56 Like terms of trade fluctuations, foreign-exchange volatility for developing countries is typically much greater than it is for industrialized countries in the wake of financial liberalization; see Haus-mann and Gavin (fn. 49). Procyclical flows exaggerate the effects of these shocks. Rogerio Studart, “The Banking System and Credit in Argentina, Brazil, Chile and Mexico” (Paper presented at the Conference on Domestic Finance and Global Capital in Latin America, Federal Reserve Bank of Atlanta, November 1-2,2001), 1.

57 Goldstein and Turner (fn. 51) found that fluctuations in international interest rates explain one-half to one-third of the variation in capitalflowsto emerging markets in the 1990s (p. 10).

58 This may be either a liquidity crisis or a financial crisis, depending upon the situation; Studart (fn. 56).

59 Bartolini and Drazen (fn. 29).

60 Author interview with Amaury Bier, executive secretary of the Ministry of Finance (Ministério da Fazenda), Brasilia, Brazil, June 1999.

61 The structural pension reform would create a financing gap in the pay-as-you-go system, as workers began diverting payroll contributions to individual accounts. Author interviews with officials in Social Security and Finance Ministries and with authors of the pension reform proposal, Brasilia and Rio de Janeiro, Brazil, 1998-99.

62 Indicators focus on macroeconomic criteria, including country income, inflation history, government finances, and political risk; see Cantor, Richard and Packer, Frank, “Determinants and Impacts of Sovereign Credit Ratings,” Federal Reserve Bank of New York, Research Paper 9608 (New York: FRBNY, 1996)Google Scholar; International Monetary Fund, International Capital Markets (Washington, D.C.: IMF, 1999)Google Scholar.

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65 The price refers to the interest rate spread over the LIBOR (London Inter-Bank Offered Rate). Ul Haque, Mathieson, and Mark (fn. 63).

66 IMF, Private Market Financing for Developing Countries, World Economic and Financial Surveys (Washington, D.C.: IMF, 1992), 64.Google Scholar

67 For strength of the financial sector, see Klein and Olivei (fn. 4).

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70 Eichengreen and Leblang (fn. 47), 2.

71 Mever (fn. 68).

72 Goldstein and Turner (fn. 51), 7-8.

73 Sterilization involves measures by the central bank to offset the effects of capital inflows on domestic monetary variables (such as money supply and interest rates). Purchases or sales of domestic securities, for instance, are offset by sales or purchases of foreign exchange by the central bank. Kaminsky, Graciela, Lizondo, Saul, and Reinhart, Carmen, “Leading Indicators of Currency Crises,” IMF Staff Papers 45 (Washington, D.C.: IMF, March 1998)Google Scholar; Cantor and Packer (fn. 62).

74 Goodman and Pauly (fn. 2), 57.

75 Haggard and Maxfield (fn. 17), 37; Goodman and Pauly (fn. 2).

76 See Organización Internacional del Trabajo, Panorama Laboral (Lima, Peru: Oficina Regional para Las Americas, 1999)Google Scholar, Quinn and Inclan (fn. 6) argue that even in the developed world, wage benefits for unskilled workers are difficult to obtain and are modest relative to those of highly skilled laborers (p. 776). On inequality, see Quinn (fn. 38); Kose, Prasad, andTerrones report that while output volatility declines in morefinanciallyintegrated economies, consumption volatility increases; see Ayhan Kose, M., Prasad, Eswar, and Terrones, Marco, “Financial Integration and Macroeconomic Volatility” (Paper presented at third annual IMF Research Conference on Capital Flows and Global Governance, Washington, D.C., November 7-8, 2002), 2,Google Scholar

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79 Garrett (fn.32).

80 Murillo, M. Victoria, “Political Bias in Policy Convergence: Privatization Choices in Latin America,” World Politics 54 (July 2002)CrossRefGoogle Scholar.

81 Quinn and Inclán (fn. 6). Similarly, Rodrik and van Ypersele (fn. 72) argue that without international coordination on capital taxation, capital mobility may not be a political equilibrium when workers are politically influential.

82 In July 2002 Brazil's EMBI+ spread over comparable U.S. Treasuries went beyond 2400 basis points, far above the 830 bps in January 2002. After the first round of voting, the bond spread reached 2250 bps. Charles Roth, “Emerging Market Giants Distance Themselves from Brazil Woes,” Dow Jones Newswires (October 11,2002),

83 Boix (fn. 6), 57.

84 Chinn, Menzie and Ito, Hiro, “Capital Account Liberalization, Institutions and Financial Development: Cross-Country Evidence” (Manuscript, University of California, Santa Cruz, May 2002)CrossRefGoogle Scholar.

85 Major alternatives to Chinn and Ito's index, which include more than one region or decade, include Klein and Olivei's SHARE, which measures the proportion of years in which capital controls are present (fn. 4), and Quinn's index, which measures intensity of capital controls in a 0-4 point scale. Quinn's data are not coded for continuous years, however, and thus are not amenable to time-series analysis employed in this study, see Quinn (fn. 38).

86 Beck, Thorsten, Demirgüç-Kunt, Asli, and Levine, Ross, “A New Database on Financial Development and Structure” (Washington, D.C.: World Bank, June 1999)Google Scholar. This variable has also been used by King, Robert and Levine, Ross, “Finance and Growth: Schumpeter Might Be Right,” Quarterly Journal of Economics 3 (August 1993), 108Google Scholar; Levine, Ross, Loayza, Norman, and Beck, Thorsten, Financial Intermediation and Growth: Causality and Causes, World Bank Policy Research Paper 2059 (Washington, D.C.: World Bank, February 1998)Google Scholar; Klein and Olivei (fn. 4); Chinn and Ito (fn. 84).

87 Beck, Demirgüç-Kunt, and Levine (fn. 86).

88 Demirgüç-Kunt and Detragiache (fn. 47); Kaminsky and Reinhart (fn. 53).

89 Kaufman, Robert R. and Segura-Ubiergo, Alex, “Globalization, Domestic Politics, and Social Spending in Latin America: A Time-Series Cross-Section Analysis, 1973-97,” World Politics 53 (July 2001)CrossRefGoogle Scholar.

90 See Swank, Duane, “Codebook for 21-Nation Pooled Time-Series Data Set: Political Strength of Political Parties by Ideological Group in Capitalist Democracies,” polisci/Swank.htm (accessed November 6, 2003)Google Scholar.

91 Where social protection systems are better funded in Latin America, increased spending in one area, such as unemployment, will on average leave more resources available to fund other social policies, such as job training, disability, and pensions.

92 Importantly, this measure is included in all specifications of the empirical model along with the ratio of private sector assets.

93 Eichengreen and Leblang (fn. 47), 2.

94 A notable exception is Venezuela, which issued rated sovereign debt since 1977; Standard and Poor's, “Sovereign Ratings History since 1975” (December 2002),

95 Cantor and Packer (fn. 62).

96 Grilli and Milesi-Feretti (fn. 6); Chinn and Ito (fn. 84) also argue that rapid price changes can cause distortions in economic decision making and that high and moderate inflation discourage financial intermediation.

97 I am grateful to an anonymous reviewer for this observation.

98 See Goodman and Pauly (fn. 2); Klein and Olivei (fn. 4); Bartolini and Drazen (fn. 5); Edison et al. (fn. 4); and also Johnson, Barry and Tamirisa, Natalia, “Why Do Countries Use Capital Controls?” IMF Working Paper 98/181 (Washington, D.C.: IMF, December 1998)Google Scholar.

99 An important drawback of this measure, however, is its failure to capture the government's ability to finance budgetary outlays. Indeed, high government consumption in the OECD nations may represent political commitments to social welfare, rather than simply a lack offiscaldiscipline and financial repression. A measure of the overall state budget balance as a percentage of GDP was included as a control in the empirical analysis but was dropped due to a failure of significance and high collinearity with GovCon. See Johnson and Tamirisa (fn. 98); Chinn and Ito (fn. 84).

100 For government consumption and capital controls, see also Chinn and Ito (fn. 84); Grilli and Milesi-Feretti (fn. 6); Klein and Olivei (fn. 4), 17.

101 Haggard and Maxfield (fn. 17), 37.

102 Chinn and Ito (fn. 84), 4.

103 Grilli and Milesi-Feretti argue that low real interest rates are a sign offinancialmarket repression and thus of the weakness of the domestic financial sector; Grilli and Milesi-Feretti (fn. 6); see also Johnson and Taminsa (fn. 98).

104 Klein and Olivei (fn. 4) 15.

105 Bias might arise from the evidence that financial crises have strongly deleterious effects on domestic banking sectors, and may also alter government disposition toward capital account liberalization. See Klein and Olivei (fn. 4); for debate on the effect of crisis on capital regulation, see also Haggard and Maxfield (fn. 17).

106 Klein and Olivei (fn. 4) and Chinn and Ito (fn. 84) include country and region fixed effects. However, the drawback to using fixed effects is that such measures treat nation-specific heterogeneity as a constant over the period of observation.

107 An alternative to censored regression for analyzing continuous, but bounded dependent variables is the use of a logistic transformation ln(x/l - x). There are several reasons why such a transformation is not optimal in this case, however, including the absence of theoretical grounding for the imposition of the logistic functional form on the data. At the same time, OLS regression on logistic transformations of bounded dependent variables has been shown to be inefficient and biased. See Manning, Richard, “Logit Regressions with Continuous Dependent Variables Measured with Error,” Applied Economics Letters 3 (1996), 183–84CrossRefGoogle Scholar; Sapra, Sunil, “Bias and Inefficiency of an Ordinary Least Squares Estimator for Logit Regressions with Continuous Dependent Variables Measured with Error,” Applied Economics Letters 5 (1998), 745–46CrossRefGoogle Scholar.

108 For the standard Tobit, where data are censored at 0, the extent and direction of bias can be shown to be downward and in proportion to the degree of censoring. This proof does not hold in the case of censoring at a point other than zero, as in the case of the present analysis. Sigelman, Lee and Zeng, Langche, “Analyzing Censored and Sample-Selected Data with Tobit and Heckit Models,” Political Analysis 8, no. 2 (2000), 175.Google Scholar For the bias introduced by OLS regression on censored data, see also Greene, William, “On the Asymptotic Bias of the Ordinary Least Squares Estimator of the Tobit Model,” Econometrica 49 (March 1981), 505–13CrossRefGoogle Scholar.

109 For discussion of the likelihood model of the two-limit Tobit, see Maddala, G. S., Limited Dependent and Qualitative Variables in Econometrics (New York: Cambridge University Press, 1983), 160–62CrossRefGoogle Scholar.

110 This is an unconditional fixed effects Tobit model, which can be estimated with country indicator variables with Stata 7, which does not have a command for a parametric conditional fixed-effects model; Stata 7, vol. 4 [Su-Z] (2001), 474.

111 Sigelman and Zeng (fn. 108), 170; Long, J. Scott, Regression Models for Categorical and Limited Dependent Variables (Thousand Oaks, Calif.: Sage, 1997), 207–8Google Scholar.

112 Maddala, G. S., Introduction to Econometrics, 2nd ed. (New York: Macmillan, 1992), 341;Google Scholar cf. Sigel-man and Zeng (fn. 108), 170. Sigelman and Zeng demonstrate that the use of the Tobit in the absence of censoring can produce biased estimates, dramatically altering patterns of significance. In this case, Tables 1 and 2 estimate both the OECD and the Latin America core model specifications in Tobit and FGLS, and the patterns of significance remain the same. Nevertheless, based on Maddala's proof, we assume that the FGLS estimates for Latin America are unbiased and efficient, while the Tobit estimates are the same for the OECD.

113 Given the well-known characteristics of time-series data, namely, temporally and spatially correlated errors, ordinary least squares methods may be problematic for the regression analysis. I employ a variant of feasible generalized least squares (FGLS) regression that produces point estimates on the basis of estimations of the autocorrelation parameter. In this case, I assume an AR(1) process and correct for country-specific heteroskedasticity. This method produces coefficients that are interpretable just as OLS estimates. Beck, Nathaniel and Katz, Jonathan, “What to Do (and Not to Do) with Time-Series Cross-Section Data,” American Political Science Review 89 (September 1995)CrossRefGoogle Scholar; Kmenta, J., Elements of Econometrics, 2nd ed. (Ann Arbor: University of Michigan Press, 1997), 121.CrossRefGoogle Scholar All confidence intervals reported are two-tailed.

114 I follow Chinn and Ito (fn. 84) in the use of lags of the independent variables to diminish the possibility of reverse causation and to diminish cyclical correlations.

115 Greene, William H., Econometric Analysis (Englewood Cliffs, N.J.: Prentice-Hall, 1993), 435.Google Scholar

116 Edison et al. (fn. 4).

117 Quinn and Inclan (fn. 6); Kastner, Scott and Rector, Chad “Partisan and Electoral Cycles in Capital Controls Policies” (Manuscript, 2002)Google Scholar. Alternatively, the coefficient on partisanship in the OECD may reveal the effect of a missing variable, such as unionization. As Garrett and Lange argue (fn. 32), the context of high union density and centralization allows governments of the left to adopt more market-oriented measures than right governments can in the same contexts.

118 Beck, Demirguc-Kunt, and Levine (fn. 86) point out that in developing countries, the central bank typically plays a more important role than private institutions in allocating resources in the economy.

119 Cameron, David, “The Expansion of the Public Economy,” American Political Science Review 72, no. 4 (1978)CrossRefGoogle Scholar; Katzenstein, Peter, Small States in World Markets: Industrial Policy in Eurcpe (Ithaca, N.Y.: Cornell University Press, 1985)Google Scholar.

120 In the OECD nations, by contrast, the level of foreign currency reserves (Reserves) is negatively and significantly associated with capital account openness across specifications in Table 1, lending evidence to the view that balance-of-payments needs generate an important source of pressure for inter-nationalfinancialopening; see Johnson andTamirisa (fn. 98).

121 Quinn (fn. 38), 534.

122 Diaz-Alejandro (fn. 14), 10–11.

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