As many have argued, economic theory leaves no doubt about the potential advantages of capital account liberalization. It can allow the international capital market to channel world savings to their most productive uses across the globe. Developing countries with little capital can borrow to finance investment, thereby promoting their economic growth without requiring commensurate increases in their own saving. But equally, there is little doubt about the existence of genuine hazards of openness to foreign financial flows. This duality of benefits and risks is simply a fact of life in the real world.
The experience of countries with financial opening/openness bears this out. As Ostry and others (2009) and many subsequent studies have shown, the link between financial globalization and economic growth turns out to be complex. While some capital flows such as foreign direct investment boost long-run growth, the impact of other flows is weaker and critically dependent on a country’s other institutions (the quality of its legal framework; protection of property rights; level of financial development; quality of financial supervision) and how openness is sequenced relative to other policy changes.
Moreover, openness to capital flows has tended to increase economic volatility and the frequency of crises in many emerging markets and developing economies. As a recent study (Ghosh, Ostry, and Qureshi, 2016) has shown, about 20% of the time, surges end in a financial crisis, of which one-half are also associated with large output declines—what one might call a growth crisis (see chart). The ubiquity of surges and crashes gives credence to the claim by Harvard economist Dani Rodrik that “boom-and-bust cycles are hardly a sideshow or a minor blemish in international capital flows; they are the main story.
