CAPITAL ACCOUNT LIBERALIZATION AND ECONOMIC PERFORMANCE IN MALAYSIA

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CAPITAL ACCOUNT LIBERALIZATION AND ECONOMICPERFORMANCE IN MALAYSIA

(Loo Yi Huan - Joyce) 

This study examines the impact of capital account liberalization on economic growth in Malaysia from 1970 to 2004. It uses two measures of capital account openness, namely de jure (an index of liberalization) and de facto (the volume of capital flows). The empirical results based on the modified growth model demonstrate that the de jure measure of capital account liberalization shows an adverse effect on growth in Malaysia. However, the de facto measure shows a robust positive effect on economic growth. The results also highlight that the effect of capital account liberalization on growth is contingent on a country’s level of financial development and the quality of its institutions.

Introduction

The past decade has witnessed a dramatic increase in international capital flows from developed countries to developing countries. Many developing countries implemented trade and financial liberalization programmes in the late 1980s including their capital accounts, hoping to fuel economic growth by attracting foreign investment. Nevertheless, the financial crises in Mexico, East Asia, Russian and Latin America in the early and late 1990s gave increased prominence to the debate over the benefits and costs of capital account liberalization. These crises occurred in the wake of increasing financial openness, prompting some economists to question the perceived benefits of open capital accounts (Rodrik, 1998). Instead, liberalization invites speculative money flows and increases the likelihood of financial crises with no discernible positive effects on investment, output, or any other real variable with nontrivial welfare implications (Rodrik, 1998; Stiglitz, 2002). On the other hand, many economists argue that the traditional theoretical benefits of increasing financial openness outweigh any potential costs (Fischer, 1997). Such benefits include greater risk diversification opportunities, a more efficient global allocation of resources and increased discipline on domestic policymakers.

(Tang Cheah Ying - Eva)

According to Singh (2002), one of the most controversial issues in examining the relationship between financial liberalization and long-term economic performance is capital account liberalization. This is because it is the area where there is the greatest disconnection between economic theory and actual events in the real world. Neoclassical theory suggests that the external capital flows should be equilibrating and help smooth a country’s consumption or production paths. The proponents of neo-classical theory argue that the case for free capital flows is no different than that for free trade. A good starting point in analyzing the link between capital account liberalization and long-term economic performance is the broad-brush approach adopted by Singh (1997). He suggests that the experience of developed countries is very useful for developing countries. This is because the developed countries have operated under a regime of relatively free trade and capital flows for nearly two decades. The experience of these countries therefore provides a useful test case for assessing the benefits of liberalization and globalization. The evidence suggests that the economic performance of developed countries, namely The United States, Japan, Germany, United Kingdom, The G7 countries, EU15 and OECD, has had less than impressive in the post 1980 s. For example, The GDP growth, the productivity growth and employment in the 1980 s and 1990 s under a liberal regime of private capital flows were much lower than that achieved in the 1950 s and 1960 s.

Rodrik (1998) examined the effects of capital account liberalization on economic performance in developing countries. The indicator of capital account liberalization employed was the proportion of years from 1975 to 1989 the where the capital account was free of restrictions. His study controlled other relevant variables to the as initial income, initial secondary school enrollment, the index of the quality of government institutions and regional dummies for a sample of 100 developed and developing countries from 1975 to 1975.

(Ong Beng Fung - Bieber)

He found no relationship between the capital account liberalization in these countries and three indicators of economic performance, namely GDP per capita growth, share of investment in GDP and inflation. In other words, there was no evidence in the data that countries without capital controls grew faster, invested more or experienced lower inflation. The objectives of this study are two-fold. First, it examines the impact of capital account liberalization on economic growth in Malaysia. Second, this study further investigates whether a country with better financial development and good institutions would derive a higher growth effect from capital account liberalization. Representing an extension of previous empirical work, this study provides direct testing of the effect of capital account liberalization on growth. It also investigates the roles of financial market development and institutions channels to further establish empirical validity for the effect of capital account liberalization on economic growth.

Four motivations give rise to this study. First, Malaysia imposed capital controls on inflows and account transactions in the beginning of 1994 after the late 1993 capital flight, and later fixed the exchange rate in September 1998 due to the 1997–1998 East Asian The Singapore Economic Review 1350022-2 financial crisis. However, both of these capital control episodes were gradually dismantled and lifted in August 1994 and the early 2000s, respectively. These capital control measures created an ideal laboratory to investigate the effect of capital account liberalization on economic growth in Malaysia.2 Second, although much research has examined this issue (Singh, 1997, 2002, 2003; Stiglitz, 2000, 2002; Quinn, 1997; Rodrik, 1998; Krol, 2001; Eichengreen, 2001; Levine, 2001; Eichengreen and Leblang, 2003; Klein, 2005; Quinn and Toyoda, 2008; Klein and Oliver, 2008), the empirical results are generally inconclusive. One explanation is an increased probability that countries will experience financial crises when they open up their financial markets to foreign capital. In addition, good institutions may be needed to ensure that countries enjoy the benefits of financial globalization.

(Goh Fang Yi)

Third, to the best of our knowledge, no empirical studies have been undertaken to assess the effect of capital account liberalization on economic growth in Malaysia. Fourth, some authors argue that capital account liberalization has both direct and indirect effects via financial market and institutional channels (Edison et al., 2002; Eichengreen and Leblang, 2003; Klein, 2005; Bekaert et al., 2005; Klein and Oliver, 2008). Therefore, it is crucial to evaluate whether the effect of capital account liberalization on growth is subject to the country’s level of financial depth and the quality of its institutions. This provides another view of the way policies tend to work, instead of expecting to find a direct negative or positive effect from capital account liberalization on growth.

Quinn (1997) found that the change in capital account liberalization had a strongly positive and significant effect on economic growth in 58 cross-countries from 1960 to 1989. In contrast and similar to Rodrik’s (1998) finding, Kraay (1998) also found no evidence that the combination of open capital accounts and strong financial systems were correlated with long-term economic performance in large cross-sections of countries. In another view, Klein and Oliver (2008) viewed financial depth as an endogenous variable in the process linking financial liberalization and economic growth. They found that capital account liberalization had a substantial impact on growth via the deepening of a country’s financial system. However, this applies only to a subsample of highly industrialized countries. Klein and Oliver (2008) concluded that the beneficial effects of capital account liberalization, at least with respect to promoting financial depth, were achieved only in an environment in which there was a constellation of other institutions that can usefully support the changes brought about by the free flow of capital.

(Kang Sing Yee)

Edwards (2001) addressed the hypothesis that capital account liberalization had different effects in high and low income countries. Using Rodrik’s (1998) controls but Quinn’s (1997) measure of the intensity of capital account restrictions in 1973 and 1988, he claimed that liberalization boosted growth in the 1980s in high income countries but slowed it in low income countries. The dummy variable for capital account openness enters negatively; in other words, while the interaction term between capital account openness and per capital income enters positively. Edwards (2001) further showed that the significance of capital controls evaporates when the IMF index used by Rodrik (1998) was substituted for Quinn’s (1997) more differentiated measure. Thus, it is tempting to think that the absence of an effect in previous studies is a statistical artefact. There is some suggestion that capital account liberalization is more beneficial in more financially and institutionally developed countries.

The remainder of this study is organized as follows. The next section describes the empirical model and econometric methodology. The third section explains the data employed in the analyses and the fourth section reports and discusses the estimation results. The final section presents a summary and conclusions.