The benefits of opening financial markets

Many developing countries fear opening their financial markets to foreign investors because it would expose them to volatile swings in fortune. They worry that riches will rush in one day, only to suddenly rush out the next, leaving economic ruin. A new paper from the U.S. National Bureau of Economic Research finds that this fear is unwarranted.

The authors looked for the effects of liberalisation by probing various countries. They note that the financial crises of the 1990s in Mexico and Southeast Asia convinced many people that rich investors could pull their money out whenever they want and crush economies in their wake.

However, they find little evidence that this is the case:

In 40 countries that had removed restrictions on foreign portfolio investment, 26 experienced a decrease in volatility.

Emerging markets – those generally considered most vulnerable to the negative effects of liberalisation – did not see a significant increase in volatility.

Additionally, countries that liberalised both equity markets and capital accounts saw the greatest reduction in volatility.

In other words, countries that made it easier for foreign investors to buy domestic stocks and also to move money into and out of the country at their individual discretion were the least likely to experience volatility.

Source: Matthew Davis, The Effect of Opening Equity Markets on Economic Volatility, NBER Digest, December 2004; based upon: Geert Bekaert, Campell Harvey, and Christian Lundblad, Growth Volatility and Financial Market Liberalisation, National Bureau of Economic Research, Working Paper No. 10560, June 2004.

For text: http://www.nber.org/digest/dec04/w10560.html

For abstract: http://papers.nber.org/papers/w10560

For more on International Institutions and Growth: http://www.ncpa.org/pi/internat/intdex1.html

FMF Policy Bulletin/ 22 March 2005