This dissertation explores the relationship between Capital Account Liberalization and economic growth in the Mauritian economy using time series variables for the period 1976 to 2009. Theoretically, opening capital account is desirable since it results in an increase in capital inflows and eventually expands economic growth. However the empirical evidences with regard to theoretical predictions are in some instances debatable. Also, numerous techniques are employed in the literature to quantify these restrictions on capital flows. In order to find the relationship of capital account liberalization and growth, the Autoregressive Distributive Lag (ARDL) technique for long run relationships and Error Correction Model (ECM) for short run dynamics are explored. The findings of this dissertation suggest that the Capital Account Liberalization indicator provided by Chin and Ito (2008) is negatively correlated with economic growth while net capital inflows has a positive relationship with growth both in the long run and short run. The results showed that trade openness is an important determinant of economic growth but inflation and market capitalization decelerate economic growth.
Keywords: Capital Account Liberalization, net capital inflows, Economic growth
Chapter 1: Introduction
With the advent of globalization, most developed and developing countries removed restrictions on capital flows (Appendix A-figure 1.1) to benefit further from the process of economic globalization. Since the 1980s, Capital Account Liberalization (CAL) has been one of the most important economic policies recommended to developing countries for economic growth. Many low and middle income countries experienced the fastest global growth over the last 30 years. This coincidence of timing support the causal arguments that free capital flows were contributing to growth. Additionally, a majority of economists and international organization share the opinion that financial opening can stimulate economic growth by increasing investment and economic efficiency.
Adam (1999) notes that "Many African economies have undergone comprehensive reforms, in terms of liberalization of markets (both for goods and [financial assets])".Consequently, since the end of 1980s, Mauritius slowly liberalized its capital account as it was difficult to maintain a closed capital account in the era of economic integration. However, only in the year 1994 the liberalization of capital controls were completed when Mauritius has accepted the obligation of Article VIII sections 2,3 and 4 of the International Monetary Fund(IMF) Articles of Agreement on 29 September 1993. Whether liberalization acts as a catalyst for the growth and development of the island is the main issue of the dissertation. Nevertheless, it is worthwhile to note that Gross Domestic Product (GDP) of Mauritius has risen from Rs 63,905,564,466 (1994) to Rs 274,495,802,066 (2009) showing that the country has developed into a relatively large domestic market.
From a theoretical perspective, the neoclassical model emphasizes that Capital Account Liberalization enables a more efficient international allocation of resources and benefits both lenders and borrowers leading to higher productivity and growth. The theory of allocative efficiency draws heavily on the predictions of the standard neoclassical growth model established by Robert M. Solow (1956). Consequently, consumers are offered more opportunities to invest abroad and diversify their portfolios. It is argued that by means of allocative efficiency, Capital Account Liberalization allows financial resources to flow freely form capital-abundant countries, where expected returns are low, to capital-scarce countries, where expected returns are normally high. Hence a low cost of capital will lead to investment and a rise in output (Edison et al. 2004). Therefore, theoretically it is an inevitable step for poor countries to open their capital account to experience economic development.
However, we can't ignore the fact that Capital Account Liberalization entails some potential risks. Evidence shows that countries that liberalized their capital account such as Malaysia, the Philippines, Thailand and Korea were more vulnerable to the Asian crisis. While, countries that maintained capital controls for example, India and China were less influenced by the crisis. This has led to the general conclusion that capital controls is a solution and a guard against crises. This conclusion is not reliable since in the absence of sound policies even capital controls do not provide security. For instance, India experiences a severe crisis in 1991 despite of stricter controls in place. As laid out by Mckinnon (1991) and Eichengreen and Mussa (1998) for capital account to be successful, it depends on a variety of preconditions such as macroeconomic stability, the presence of better institutions and a sound financial sector. It is fair to say that all liberalization entails some degree of risk if implemented in unfavourable circumstances in the absence of supporting policies.
Experiences with liberalization are quite varied. A large number of studies have examined the impact of Capital Account Liberalization on economic performance; some papers got a positive effect, other show no effect and some have experienced mixed results as in the case of Eichengreen (2001) and Prasad et al. (2003). Differences in results arise depending on the measure of liberalization employed. Is it noteworthy to note that very little studies have focused on the impact of liberalization on growth in the Mauritian context which further motivated the choice of the dissertation title.
The main purpose of the study is to analyse the effect of Capital Account Liberalization on the Mauritian economy. During the last 30 years, the economy has evolved but the main issue is whether Capital Account Liberalization has contributed positively in the country. Does Mauritius benefit from capital inflows after removing controls on exchange rate? Therefore to measure the extent of Capital Account Liberalization, the Kaopen indicator proposed by Chinn and Ito (2008) has been employed. Additionally, net capital inflows as a percentage of GDP will be considered in order to find whether there is a positive relationship between Capital inflows and economic growth in the country.
Chapter 2 of the study concentrates on the theoretical and empirical review of the literature. The first section englobes the theoretical aspects of capital account liberalization and growth and also sheds light on its criticisms. The second section, empirical review of literature, considers the results obtained by researchers from analyzing the relationship between capital account liberalization and economic growth.
Chapter 3 focuses on the trend and composition in capital flows in the Mauritian economy.
Chapter 4 discusses the methodology of the study. The Auto-Regressive Distributed Lag (ARDL) model is employed to explain the long run and short run dynamics of the effect of capital account liberalization and economic growth in Mauritius.
The results are presented in chapter 6 and limitation of the dissertation is considered.
In chapter 6, conclusion and recommendations are given to enhance and to take full advantage of capital account liberalization.
Chapter 2: Literature review
This section is divided into two parts firstly the theoretical aspects of Capital Account Liberalization on growth is considered while the second part focuses on empirical facts.
2.1 Theoretical Perspective
Capital Account Liberalization
By definition, capital Account Liberalization is the result when a country's government takes the decision to ease restrictions on capital flows, thus allowing capital to enter freely and leave the country at will. The capital account in a country's balance of payments covers a variety of financial flows mainly foreign direct investment (FDI), portfolio flows (including investment in equities), and bank borrowing between the host country and foreign countries. It is possible, in principle, to control these flows by placing restrictions on those flows going through official channels.
Normally, capital control can be of two types namely de jure or de facto. De jure capital controls arise through the application of legal barriers or policy implementation while de facto controls crop up with barriers in the ordinary course of capital flows. The most common capital account restrictions include exchange controls or qualitative restrictions on capital movements, dual or multiple exchange arrangements and taxes on external financial transactions. These restrictions can take various forms such as putting limits on domestic bank' foreign borrowing, controlling foreign capital that enter into the economy, imposing limits on various sectors of the industry in which foreigners can invest, and restricting the ability of foreign investors to repatriate money earned from investments in the domestic economy.
2.1.1 Impact of Capital Account Liberalization on the economy
Theoretically it is believed that a world economy without capital mobility will produce less output and create less economic welfare. For instance, in the presence of capital controls countries would be constrained to invest only in domestic savings and this would limit economic growth in potential capital-importing countries. Economic models evoke that an open capital account will ensure an efficient allocation of world savings. Figure 1.2 below shows the so-called Metzler (1960) diagram representing savings and investment schedules for two countries described as "home" and "foreign". rh indicates the interest rate for "home" while "foreign" savings are paid an interest rate of rf , where rh < rf . Firstly, the case of perfect capital immobility is examined, equilibrium is given by A and A' as shown in figure 1 for the "home" and "foreign" country respectively.
Figure 1.2: Metzler diagram, capital flows from "home" to "foreign" country
Capital inflows
Capital outflows
I
I
S
S
I*
I*
S*
S*
A
A'
Savings, s
Investment, I
Savings, s
Investment, I
Interest rate, r
Interest rate, r
rf
r
rh
Source: Moore, Winston (2010)
Secondly, the case for perfect capital mobility is considered with the assumption that citizen of either country is allowed to move freely their savings to and from the country. The equilibrium is reached at interest rate r, which is above rh but below rf as illustrated in figure 1.2. Capital flows from "home" to "foreign" to benefit from comparatively higher interest rates which result in an expansion in aggregate savings at home. In the absence of capital flows investment in the "foreign" country increases above that obtained in the equilibrium. Finally with capital flows, the agents in both countries are better off, as savers in the "home" country are able to benefit from higher interest rates, while those in the "foreign" country are capable to expand their investment by making use of relatively cheaper funds.
Fischer (1999) advocates that Capital Account Liberalization is viewed as an "inevitable step on the path of development which cannot be avoided and should be embraced". Historical evidence demonstrates that the most advanced economies have open capital accounts. The most powerful motivation for Capital Account Liberalization is that the potential benefits of liberalization outweigh the costs. Potential benefits include increased access to a larger and more diversified pool of funds by investors (local and foreign), resulting in greater opportunities for portfolio diversification.
Similarly, Soto (2003) points out four theoretical reasons for Capital Account Liberalization promoting economic growth: firstly, the possibility of separating investment decisions from saving decisions; secondly, there is an increased interaction with foreign countries and technology acquisition; thirdly risks through portfolio diversification is reduced; lastly, domestic financial market is enhanced through greater competition in the banking system and higher liquidity in the equity market. Therefore Capital Account Liberalization is a process that cannot be ignored by developing countries to develop their domestic markets both locally and internationally.
The evolution of Capital Account Liberalization varies across developed and developing countries depending on their macroeconomic policy, balance of payment strength and the extent of economic liberalization. Boughton (1997) noted "no country can share in the benefits of international trade unless it allows capital to move freely enough to finance that trade…" Economic theory has proposed several arguments that highlight the benefits of Capital Account Liberalization in developing countries. Several theoretical models put emphasis on the fact that globalization of finance can contribute to increase growth rate and to reduce macroeconomic volatility. These two highly important benefits are discussed as follows:
Firstly, globalization of finance can help to promote growth and result in a more efficient reallocation of capital around the world. In particular, the removal of barriers to free movement of capital will cause the latter to move from places where it is abundant to places where it is scarce because the return on new investment is higher where capital is limited. Eventually, the amount of saving and the level of physical capital in poor countries can be positively influenced. As predicted by the neoclassical model liberalizing capital account of a capital-poor country will increase the growth rate of its Gross Domestic Product (GDP) per capita in the short term. The temporary increase in growth does matter because it permanently raises the standard of living of a country.
Secondly, with the diversification of risks provided by the process of international financial integration, the globalization of finance can reduce both output and consumption volatility in developing countries. By channeling further capital to developing countries, financial integration can help to diversify production and this may reduce the volatility of output. On the other hand, a greater integration with the rest of the world may lead to an increase in the specialization of production based on comparative advantage considerations. However, in the latter case, developing economies can become more prone to shocks that are specific to industries.
2.1.2 Controversies of Capital Account Liberalization on growth
Capital movements have been subject to much debate over the past years and economists from different schools of thought disagree that free flow of capital are essential for maximizing gains from trade and promote world economic welfare. For instance, within the neoclassical tradition itself, Stiglitz (2000) criticizes short-term speculative capital flows. He argued that liberalization could make capital flows more unstable, regardless of the type of macroeconomic policy applied by developing countries. Financial crisis could even be aggravated making the economies more vulnerable which eventually discourage investments.
Similarly, Rodrik (1998) follows the same line, arguing that financial liberalization would tend to raise the systemic risk, because a given market would be affected by another's crisis. Both Stiglitz and Rodrik admit that capital flows are subject to asymmetric information [1] . The consequence of such information gaps lead to several problems such as adverse selection [2] , moral hazard [3] , and herding [4] that affect the financial markets in particular. Normally, such asymmetries can lead to inefficiencies whereby in the extreme, they can cause costly financial crises.
However, even proponents of Capital Account Liberalization acknowledge important risks associated with it. It is worth to mention that the East Asian economic crisis is cited as an example by those who opposed Capital Account Liberalization. Fischer (1999) states that Capital Account Liberalization does not necessarily cause financial crisis, nevertheless high capital mobility can easily drive an emerging country to be more exposed to outside shocks by complicating macroeconomic management.
In general, potential costs of Capital Account Liberalization consist of overheating the economy due to capital flow, causing an excessive expansion of aggregate demand and increasing volatility in prices. Through contagion and spillover effects, capital account shocks tend to spread quickly across countries, thereby, reflecting herd behaviour among investors. However, Barry Eichengreen (1999) states that it is not financial liberalization that is the root of the problem of crises but rather weak management in the financial sector, followed by the absence of prudential supervision and regulation, whose consequences are magnified by liberalization.
Further, Prasad et al. (2003) believed that Capital Account Liberalization in developing countries is not associated with economic growth. Research has shown that Capital Account Liberalization promotes growth to countries that have reached a certain institutional threshold; which according to Kose, Prasad and Taylor (2009) a threshold that most developing nations are yet to achieve. The constraint that most developing countries faced is not the need for external investment but the lack of investment demand.
Ostry et al. (2010) support the view that capital controls tend to reduce the volatility of financial macroeconomic performance and discourage long term capital outflows thereby promoting growth. According to Magud and Reinhart (2006) the literature on capital controls considers "the six fears" of capital flows:
Fear of appreciation: capital inflows result in an upward pressure on the value of the domestic currency thereby making producers less competitive in the international market which is harmful both to exports and to the economy.
Fear of "hot money": Usually for a small economy, a large injection of money in the country may cause distortions and eventually a sudden deterioration if foreign investors try to leave at the same time.
Fear of large inflows: Large volumes of capital inflows can cause disorder in the financial system.
Fear of loss of monetary autonomy: it is almost impossible to have a fixed or even highly managed exchange rate, monetary policy autonomy and open capital markets. Particularly, when central banks intervene in the exchange market to buy foreign currency so as to reduce the appreciation of the exchange rate, they effectively increase the domestic monetary base. Hence increasing interest rates will lead to more capital inflows since foreign investors would rush in to benefit from higher yields.
Fear of Asset Bubbles, raised by Ocampo and Palma (2008): This is an important issue in the 2008 financial crisis, since the bursting of the real state bubble was the root cause of the banking crisis around the globe.
Fear of capital "flight": As noted by Grabel (2003) and Epstein (2005) in the event of a crisis or contagion capital may rapidly leave a nation hence affecting the economy further. Hence the overall investment climate, political and economic instability, and asymmetric information motivate capital flight.
To sum up, Capital Account Liberalization if well managed will surely stimulate savings and investment, efficiency and economic growth. It is inevitable for countries wishing to take advantage of these benefits to maintain closed capital account in an open world economic system. However, experiences demonstrate that capital account is not free from criticisms and can lead to crises. Thus in order to reap the benefits of liberalization, there should be the presence of effective prudential regulation, banks should be encouraged to recognize risks, authorities enabled to monitor threats to ensure the stability of the financial system and sound macroeconomic policies adopted to manage capital flows efficiently.
2.2 Empirical Review
2.2.1 Capital Account Liberalization promotes growth
In the early 1990s, following a substantial increase in private capital flows to developing countries Capital Account Liberalization emerged as a topic of intense debate among policy makers and economists. It is worth to mention that private capital flows in sub-Saharan Africa increased almost five fold over the past seven years, from USD 11 billion in 2000 to USD 53 billion in 2007. Clearly this indicates that private capital became an increasingly important source of international finance and liberalizing capital account helps a country to grow efficiently in the world economy. Consequently, different papers have tried to identify the relationship between Capital Account Liberalization and economic growth however mixed results are experienced.
One of the most famous cited paper that identify a positive relationship between Capital Account Liberalization and growth is Quinn (1997). The latter shows that Capital Account Liberalization is significantly essential to long-term growth. To perform the analysis, Quinn's considered 58 countries over a period of 1960 to 1989. The author coded the degree of capital controls and constructed a continuous index to measure the extent of liberalization. He found that the change in Capital Account Liberalization has a strong significant effect on the growth in real GDP per capita. Other authors have considered Quinn's index in their studies and indeed the index seem to support the benefit of Capital Account Liberalization.
To support the view that Capital Account Liberalization promotes economic growth Eichengreen and Leblang (2003) estimated the impact of macroeconomic variables on growth of GDP per capita at country level. However, the sample was restricted to 39"middle high" and "high" income countries, as defined within the World Bank data for a period of 1988 to 2003. They reached the conclusion that capital account liberalization fosters growth.
A time series analysis was conducted for Pakistan by Muhammad Shahbaz (2008) to analyse the effect of Capital Account Liberalization and economic growth in the country. The author used advanced ARDL technique to estimate the long run relationship and short run dynamics for Pakistan. The study considers the following equation:
LGDPC= α0 + α1 LCA + α2 CV + εt
Where LGDPC is the Gross Domestic Product per capita (Log), LCA refers to Capital Account Openness (Log) while CV is the Control Variables. He found out that Capital Account Openness promotes economic growth in the long run. Further he found that the Control Variables considered in the study such as investment activities boost economic growth while inflation retards economic growth in the country. Also, human capital enhances the potential of the country for even longer and substantial growth. Therefore, the opening of the capital account in Pakistan has proved to be beneficial for the economic growth in the long run.
A study conducted by the London economics (2010) use the kaopen index, a measure of capital openness provided by Chinn and Ito (2007). Chinn and Ito (2007) have calculated the degree of capital openness for around 183 countries. The dependent variable used in the study is the real GDP growth while the independent variables consist of primary school enrolment rate, secondary school enrolment rate, kaopen indicator for capital openness, dummy variables for domestic crises and international crises are analysed. Results showed that capital openness alone and at times of domestic crises has a neutral association with growth, but indicate a significant positive association with growth during international crises (crisis occurring outside of the country of interest).
2.2.2: Considering Channels and institutional conditions for growth
Some empirical studies reached mixed results. For instance, Edwards (2001) investigates the impact of Capital Account Liberalization on GDP per capita and productivity growth. The aim of Edward's study was to analyse if emerging countries experienced different behavior in regard to capital account openness and growth. The author has employed a cross section sample of 65 countries, with data gathered from the period 1975 to 1997. To measure liberalization he used the indicator supplied by Quinn for the years of 1973 and 1988. He suggested that capital account openness reduced growth for countries at lower levels of income, but promotes growth in industrial countries and in the richer emerging market economies. In other words, a positive effect is shown only when the financial system is sophisticated, however without this condition the effect is negative.
The result obtained by Edwards (2001) is similar to the conclusions drawn by Klein and Olivei (1999) that is the existence of a developed financial system is an important factor in determining the effects of liberalization on growth. However, Edward's findings have been questioned by Edison, Klein, Ricci and Slock (2002). The latter arrived at the conclusion that the relationship between Capital Account Liberalization and growth is stronger in emerging markets (particularly in Asia) rather than in developed countries.
Another interesting work is presented by Soto (2003) but the study does not use liberalization policy indicators. The author analyzes if liberalization has an impact on economic growth and whether the taxation of capital flows would be favorable to the country. In his study, he uses a panel of 72 countries over a period of 1985 to 1996. Further, he divides capital flows into Foreign Direct Investment (FDI), portfolio equity flows, portfolio debt flows and bank inflows. The results reveal that FDI and bank inflows have a positive and significant relationship on economic growth. Generally, as observed by many studies, FDI remains an important ingredient for growth and it is considered as the most important capital inflow that has long term benefits on the growth of a country.
Another research work done for developing countries by Fabrizio Carmignani (2008) found that CAL has a rather strong positive impact on growth. However, this impact occurs through financial development and trade openness. Most recently, de Vita and Kyaw (2009), using a sample of 126 countries for the period 1985-2002, examined the relationship between FDI and portfolio investment flows on the economic growth of low, lower middle and upper middle income countries. They arrive at the conclusion that only developing countries which have reached a minimum level of economic development and absorptive capacity are able to benefit the growth-enhancing effects of both forms of investment inflows.
2.2.3: Arguments not in favour of Capital Account Liberalization
Most empirical studies of Capital Account Liberalization make use of a dummy variable from the annual report of the IMF, "Exchange Arrangements and Exchange Restrictions". This index has been used by a number of authors such as Alesina, Grilli and Milesi-Ferreti (1994), Rodrik (1998), klein and Olivei (2001) amongst others. However, many researchers argued that this model too general and fails to measure the intensity and change of controls.
Early studies were generally not supportive between the link of Capital Account Liberalization and growth. One of such analyses by Alesina, Grilli and Milesi-Ferretti (1994), considered the association of capital account openness with growth in 20 industrial countries from the period 1950s to the 1990s. The openness was captured by the share of years in which transactions on capital account were unrestricted, as indicated by the relevant lines of the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). They found that growth effects were small and insignificant. One weakness of the indicator is that it records only the presence or absence of controls rather than actual degree of restriction.
The findings of Edwards (2001) and Klein and Oliver (1999), showing the presence of developed financial system is important for liberalization to have effect, has been statistically proven by a study conducted in Bangladesh by Omar K. M. R. Bashar & Habibullah Khan (2007). The effect of Capital Account Liberalization on growth was tested by using a cointegration and error correction methods using quarterly data for 29 years. The results reveal that the coefficients of trade liberalization and Capital Account Liberalization policy variables were insignificant. This implies that these policies were largely ineffective in boosting the country's economic growth.
One of the explanations for the failure of trade and capital account reforms is the weak supply responses and the lack of credibility of announced reforms that hindered the growth of the country. Normally it is believed that poor country like Bangladesh would not be able to take advantage of any comprehensive set of liberalization measures unless the preconditions such as basic infrastructure and good governance are in place.
The most widely-cited study of the correlation of Capital Account Liberalization with growth is Rodrik (1998). In a sample of 100 industrial and developing countries over a period of 1975-1989, he regress the growth of GDP per capita on the share of years, that is, when the capital account was fully open as measured by the binomial IMF indicator. The control variables he considered are initial income per capita, secondary school enrolment, quality of government, and regional dummies for East Asia, Latin America and sub-Saharan Africa. However, he finds no link between capital account liberalization and growth and questions whether capital flows enhances economic efficiency.
The extent of capital mobility has been measured by actual capital inflows and outflows as a percentage of GDP by Kraay (1998) but the latter did not find any relationship between capital account openness and growth. Also, Lane and Milesi-Ferretti (2001) have used the annual measure of portfolio and direct investment assets and liabilities as a percentage of GDP as a long run indicator of financial openness. However this measure can fluctuate from year to year, since capital flows are endogenous. Nevertheless, changes in these measures over longer period are likely to be indicative of changes in openness.
2.2.4 Remarks on econometric methodology
The empirical evidences discussed do not provide a very clear answer on the effect of Capital Account Liberalization on growth. The difference among studies is due to the difference in samples, periods, and most importantly to the index itself. Eichengreen (2001) proposed several possible reasons for different results obtained in Quinn's and Rodrik's papers. Firstly, Quinn' sample contains fewer developing countries than Rodrik's and secondly the time period used by Quinn is smaller. Finally both used different capital account indicator to measure liberalization.
All of these measures, despite their increasing sophistication and fineness, suffer from a variety of similar shortcomings. Some studies include both developing countries and developed countries in their sample due to the fact that these countries implemented the process of Capital Account Liberalization at different times. For example, Reisen and Fischer (1993) noted that developed countries liberalized in the late 1970s while developing countries liberalized in the early 1980s which explain the different results obtained by researchers.
