2.5 Conclusion about strengths and weaknesses of existing measures and future implications for a methodology development
In this brief conclusion, two key topics derived from the preceding discussion are summarized: firstly, a description of the main strengths and weaknesses of the different CAL measures, and then secondly, the key findings from the empirical trend analysis.
Strengths and weaknesses of CAL measures
In the financial economics literature, there are numerous measures of capital mobility and control. These measures have been reviewed here with respect to two dimensions:
data sources (country and industry perspectives) and with regard to the scope of the analysis (categories of measures). A few conclusions were drawn from the above review with respect to the strengths and weaknesses of CAL measures.
27 It is worth adding that there are a few empirical studies that have tried to present the problem of avoiding capital control regulations.
Firstly, measurement methodology has a large impact on understanding and defining the CAL process. There are factors that determine whether regulations are limited to the books or enforced in real economic life. As the categories of capital flows are imprecise, so are the legal regulations based on them, which can cause different effects from those anticipated by governments. Also, market participants may have an incentive to circumvent capital control regulations and shift capital across borders in order not to be detected by government agencies. These techniques are similar to tax evasion and money laundering (see Mathieson, Rojas-Suarez, 1992, De Boyrie, et al, 2001 and Forbes, 2007). Secondly, there is a lack of agreement / consistency with regard to the defining binary characters of the rules-based measures, which introduces heterogeneity in their application, and in the conclusions drawn, as well as leading to a potential source of measurement error. This measurement error might also be caused by the gradual nature of the CAL process (see Henry, 2006).
Apart from the gradual character of the CAL process, there is a leaking problem that cannot be observed by policy-makers or researchers. For instance, there are market players, who act before the rules are legislated or leak information to private investors (see Henry, 2000a, b). The other aspect about the rules-based measures is that they only concentrate on the narrowness of stock market liberalisation. These SML measures could be more useful than broad indicators of CAL for testing the economic growth theory (see Henry, 2003, 2006) as they identify episodes of large changes in CAL. However, this creates a narrow focus on stock market liberalization.
In contrast to the unspecified easing of restrictions indicated by movements in the SML indicators, there is no theoretical ambiguity about the expected impact of lifting restrictions on the flow of capital into the stock market of a developing country.
However, the SML measures present some weaknesses since investments in shares are linked with a higher risk of using stock market liberalization data to examine the impact of CAL on economic performance.
The other concern is the frequency of the indicators. In the majority of the empirical analyses, indicators are annual. However, stock market data is calculated daily or monthly. This daily or monthly frequency allows a precise analysis of the CAL processes,
especially in the context of pointing out the announcement of dates or leakage problems (see Henry, 2000, 2003, and 2006).
Thirdly, the quantitative measures, built on the assumption of the gradual character of the CAL process, might also be correlated with other factors, such as privatization, macroeconomics, stabilization programmes, etc. (see Lane and Milesi-Ferretti, 2001, 2005; Henry, 2006). This can lead to noise in the data and measurement error, which suggest there is scope for proposeding improved CAL measures. One of the new measures proposed in this chapter is a more disaggregated measure using the IMF’s database methodology with the purpose of capturing the variations between sectors or firms, apart from through the stock exchange.
The key findings from the empirical trend analysis
The CAL trends analysis confirmed that the minority of countries seem to be following the partial path of capital flow liberalization. Thus, two-thirds of countries in the sample were either partially liberalized or totally non-liberalized countries. The only exception derives from the analysis of the SML indexes and Chanda’s indicator. These two measures suggested that the majority of countries liberalized fully-capital flows with respect to the stock exchange market.
Three waves of the capital account liberalization process were distinguished, and these were before the 1980s, the 1990s and then the 2000s. An exception to this CAL trend is the Kray and Sway (DATE) index, which fluctuates considerably. A first wave of liberalization begins before 1980 when 20% of countries removed capital control regulation. This minor fraction of liberalized countries was caused by financial consequences of the debt crisis that began in 1982 with the Mexican weekend, together with the US savings and loan crisis of the 1980s.
The second wave started at the beginning of the 1990s. It included 23 other countries, plus those that reversed their CAL liberalisation during the first wave (such as Venezuela, Uruguay, Paraguay, Peru, Costa Rica and Ecuador). The other currencies and banking crises in the 1990s had effects on negative currency fluctuations, especially in Latin America and Asia. The third wave, at the beginning of 2000, mainly included emerging and developing countries from South America and Africa.
There are some weaknesses in the on/off measures: these measures only consider the existence of administrative controls and they do not distinguish between restrictions on capital inflows and outflows. The analysis of Lane and Milesi-Ferretti’s (DATE) financial globalization indicator demonstrates that there were significant increases in capital flows that happened in the 1990s and 2000s, not only just in the 1990s as the CAL on/off measures advocated. In addition, these capital flow index patterns confirmed that a majority of the impact was done through direct investments and portfolio investments flows, which could serve as evidence of the process of learning how to avoid capital control regulations. In other words, investors learn how to avoid the regulation on capital flows over the years, so when the regulations were imposed a second time in the 1990s, the market participation had knowledge of how to avoid them. It is also important to mention that there was intensive development of financial innovation and technology that gave market participants more ways to transfer money across country borders.
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Chapter 3: Economic growth and financial instability as determinants of