Academic journal article IUP Journal of Applied Finance

Capital Flows under Different Modes of Financial Liberalization: Evidence from India and Turkey

Academic journal article IUP Journal of Applied Finance

Capital Flows under Different Modes of Financial Liberalization: Evidence from India and Turkey

Article excerpt

Introduction

Neoclassical theory suggests that international financial liberalization will contribute to boost economic growth through a more efficient international allocation of capital (Obstfeld, 1994; and Eichengreen and Mussa, 1998). However, in practice, in developing countries, liberalization of capital flows has constantly been associated with serious economic and financial crises, such as in Asia and Latin America in the 1990s. There are a number of studies presenting the link between the liberalization of financial system and the economic and financial crises, particularly in developing countries. Williamson and Drabek (1999), for example, indicate that the only difference between the countries that did or did not have economic crisis is the status of their capital account. Their finding is also in line with that of Stiglitz (2000), who concluded that the growth benefits of capital account liberalization are obscured by the costs of associated volatility. It is now well known that premature financial liberalization seriously contributed to the occurrence and the depth of the crises in countries such as Thailand, Korea and Indonesia, even if it was not the origin of the crises. On the other side of the spectrum, India and China managed to avoid the crises and sustained their economic growth (Fisher, 1993).

While the effects of financial liberalization have been much investigated, so far there has been little attempt to explore the link between different modes of financial reforms and observed economic performance. Financial liberalization is not an event, but a process and may not follow the same pattern everywhere. Classification of liberalization episodes based on the path chosen for liberalization is essential, especially for policy implications. The purpose of this study is to fill this gap and to analyze the evolution of two different liberalization episodes (from India and Turkey). We chose these countries because they are two of the fast growing and emerging economies of the past decade, but they follow different paths in the conception and implementation of financial reforms. India's gradualist approach to reform is contrasted with Turkey's financial liberalization, which can well be described as a shock therapy. To carry out this task, our material is plenty. The initial state of the economy before liberalization, the change in financial and economic structure, the change in the nature of capital flows, macro policy response, and the observed economic growth in the context of changing capital flows after liberalization will be the key parameters for our evaluation. Based on an analytic review of liberalization policies applied in two countries, the total outcome of the reforms are considered to assess the extent to which the two different approaches were effective and successful in the development of these economies.

The Liberalization Paths

The policy of financial reform and liberalization has itself raised many problems, both in conception and implementation. Financial reform is not an event, but a process and need not follow the same pattern everywhere. Variation in the mode and content are inevitable. In launching the process of policy reforms, two possible approaches are shock therapy and gradualism, from which the shock therapy model is often recommended due to its ability to disconnect with the previous system immediately. On the contrary, the gradualist approach is less appreciated because of its retarding effect on the reforms as the opposed interest groups often collaborate to decelerate the process that would affect their interests. Marangos (2002) highlights the basics of these two policy approaches in a simple manner, suggesting that the shock therapy model fits well with the interdependent, mutually supportive and interactive character of economic relations, which implies that reforms should be introduced simultaneously.

On the other hand, the gradualist approach is based on the need for well-established economical, political, institutional, and ideological structures before the reforms are implemented. …

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