In June 1979, shortly after winning a landmark election, Margaret Thatcher carried out what her supporters regarded as “one of her best and most revolutionary acts” (Heath, The Telegraph, 2015) and her critics deplored as starting a global trend whose “downside … proved to be painful” (Schiffrin 2016).
What were these actions? Thatcher eliminated restrictions on “the ability to move money in and out” of the United Kingdom. The Telegraph wrote that “in the economic dark ages that were the 1970s” UK citizens could “forget about buying a property abroad, purchasing foreign equities or financing a holiday … The economic impact was devastating: companies were reluctant to invest in the UK as it was tough even for them to move money back to their home countries.” Thatcher abolished “all of these nonsensical rules and liberalized the UK’s capital account.” Thatcher’s move toward financial openness was followed by Germany in 1984 and by other European countries and many emerging market economies in Latin America and Asia over the coming decade.
At its annual meeting in October 1997 in Hong Kong SAR, the IMF put forth its arguments for why countries should keep moving toward full capital account liberalization, the elimination of restrictions on the movement of funds into and out of a country. The IMF’s then–First Deputy Managing Director Stanley Fischer called liberalization “an inevitable step on the path of development which cannot be avoided and should be embraced.” Fischer noted that liberalization ensures that “residents and governments are able to borrow and lend on favorable terms, and domestic financial markets become more efficient as a result of the introduction of advanced financial technologies, leading to better allocation of both saving and investment” (Fischer 1997). While acknowledging that liberalization “increases the vulnerability of the economy to swings in [market] sentiment,” Fischer argued that the potential benefits of opening up the capital account outweigh the costs. As Maurice Obstfeld—the IMF’s former chief economist since 2015—also noted at the time, “economic theory leaves no doubt about the potential advantages” of capital account liberalization (Obstfeld 1998).
But financial globalization also had its critics. Harvard University economist Dani Rodrik argued at the time that the evidence on the benefits of capital account liberalization was elusive, while the costs in terms of increased risk of crises were high. He warned that letting capital flow freely across the world would leave economies “hostage to the whims and fancies of two dozen or so thirty-somethings in London, Frankfurt and New York. A finance minister whose top priority is to keep foreign investors happy will pay less attention to developmental goals” (Rodrik 1998). Even some proponents of capital account liberalization, such as Obstfeld, warned that “this duality of benefits and risks is inescapable in the real world.”
The evidence over the past few decades has proved such views prescient. The benefits of liberalization in terms of increased investment and growth have continued to be difficult to establish, while there are numerous cases of liberalization leading to economic volatility and financial crisis. This in turn has adverse consequences for many in the economy, particularly for those who are not well off. Since 1980, there have been about 150 episodes of surges in capital inflows in more than 50 emerging market economies; about 20 percent of the time, these episodes end in a financial crisis, and many of these crises are associated with large output declines (Ghosh, Ostry, and Qureshi 2016).
Our work adds an additional cost: the impact on equity. Liberalization affects the relative bargaining power of companies and workers (that is, of capital and labor, respectively, in the jargon of economists) because capital is generally able to move across national boundaries with greater ease than labor. The threat of being able to move production abroad can lower labor’s bargaining power and thus the share of the income pie that goes to workers.
The restrictions that countries place on various cross-border financial transactions have been tabulated by the IMF since the 1950s. Using these reports, Chinn and Ito (2006) have constructed a measure that adds up how many restrictions have been in place in different countries and how these restrictions have been relaxed or tightened over the years. The index is available for 182 countries, in many but not all cases from 1970 to 2010, and it ranges from −2 (more restricted capital account) to 2.5 (less restricted). The score of the capital account openness index varies greatly across income groups, with higher restrictions typically recorded in low-income countries (LICs) and lower-middle-income countries (LMICs).
Not every change in this index is likely to represent a deliberate and major policy action, like that of Thatcher’s, to liberalize the capital account. And while Thatcher’s action drew attention at the time, actions by other governments can be difficult to track. We thus try to infer the timing of major policy changes by using large changes in the index. Specifically, we assume that a financial openness episode takes place when the annual change in the indicator exceeds by two standard deviations the average annual change over all observations in our dataset (i.e., exceeds 0.76). This criterion identifies 224 episodes of liberalization, with the majority of them occurring during the last two decades (figure 5.1). The largest number of episodes has occurred during the 1990s and among middle-income countries (MICs).
FIGURE 5.1: Number of Capital Account Liberalization Episodes
Source: Furceri, Loungani, and Ostry (2018).
What happens to output and inequality after an episode of financial globalization? Output growth in the years preceding an episode averages just short of 4 percent, as shown in figure 5.2. It gets a very short-lived boost in the year following an episode (to 4 percent), but that has subsided five years after the episode. Inequality increases, with the Gini rising from about 44 to nearly 45.5 within five years after an episode.
FIGURE 5.2: Growth and Inequality Before and After Capital Account Liberalizations
Output gains are small and short-lived whereas inequality increases persistently after capital account liberalization.
Source: Furceri and Loungani (2017).
We now subject these results to more formal tests. Figure 5.3 tracks what happens to output and inequality following an episode of financial openness. It reports the estimated effect of liberalization, with the dotted lines showing the bounds within which the true effect might lie. The results suggest that capital account liberalization episodes have not had a significant effect on output (any boost is again quite short-lived). However, they have had significant and long-lasting effects on income inequality: following a capital account liberalization episode, the Gini index increases by about 0.8 percent in the very short term—one year after the occurrence of the reform episode—and by about 1.4 percent in the medium term—five years after the occurrence of the reform episode.
FIGURE 5.3: The Effect of Capital Account Liberalization on Output and Inequality
Capital account liberalization reforms have not had a significant effect on output, but have had significant and long-lasting effects on income inequality.
Note: The solid line corresponds to the estimated effect (the so-called impulse-response function—IRF); dotted lines correspond to 90 percent confidence bands.
Source: Furceri, Loungani, and Ostry (2018).
These effects are quantitatively significant. Gini coefficients change slowly over time as previously noted. Changes in the Gini have a standard deviation of 2 percent (that is, nearly 70 percent of the time, when the Gini index changes, it does so by less than 2 percent). The effects shown in figure 5.3 are therefore quite large relative to the standard deviation; simply put, episodes of capital account liberalization lead to big increases in inequality. Figure 5.4 shows that shares of incomes going to the top 1 percent, top 5 percent, and top 10 percent all increase following capital account liberalization reforms.
FIGURE 5.4: The Effect of Capital Account Liberalization on the Top Income Shares
Capital account liberalization increases the shares of income owned by the top 1 percent, top 5 percent, and top 10 percent.
Note: The solid line corresponds to the estimated effect (the so-called impulse-response function—IRF); dotted lines correspond to 90 percent confidence bands. The x-axis denotes time. t = 0 is the year of the reform.
Source: Furceri, Loungani, and Ostry (2018).
In the textbook model of perfect competition, each factor of production—capital and labor—gets its just rewards based on its contribution to a company’s profits. But a more realistic description of the world is one of imperfect competition, where the division of the economic pie is influenced by the relative bargaining power of capital and labor. In his 1997 book, Has Globalization Gone Too Far?, Rodrik argued that capital account liberalization tilts the playing field in favor of capital, the more mobile of the factors of production. Jayadev (2007) argued similarly that “the imminent and plausible threat” by capital that it will relocate abroad causes workers to lose bargaining power and some of their share of income.
Our results, presented in the top panel of Figure 5.5, are indeed consistent with this conjecture: capital account liberalization episodes have significant and long-lasting effects on the labor share of income. In particular, the estimates suggest that reforms have typically decreased the labor share of income by about 0.6 percentage point in the short term—one year after the reform—and by about 0.8 percentage point in the medium term—five years after the reform.
FIGURE 5.5: The Effect of Capital Account Liberalization on the Labor Share
Capital account liberalization reforms leads to long-lasting declines in the labor share of income.
Note: The solid line corresponds to the estimated effect (the so-called impulse-response function—IRF); dotted lines correspond to 90 percent confidence bands. The x-axis denotes time. t = 0 is the year of the reform.
Source: Furceri, Loungani, and Ostry (2018).
As was the case with the Gini measure of inequality, these are big effects. The changes in the labor share have a standard deviation of 2.25 percentage points (that is, nearly 70 percent of the time, when the labor share changes, it does so by less than 2.25 percentage points). Hence, capital account liberalization is associated with large declines in labor shares.
As we noted in chapter 4, the direction of causality is difficult to sort out using econometric analysis. In that chapter we therefore used the narrative histories of specific countries to complement the econometric analysis. Here we use another technique to bolster confidence that it is indeed the policy action that leads to inequality and not inequality that leads to the policy actions. This technique involves the use of industry-level (sectoral) data instead of economy-wide (aggregate) measures of inequality. The idea is that it is quite unlikely that capital account liberalization would be undertaken by governments due to changes in inequality in a particular sector of the economy. As shown in the middle panel of figure 5.5, opening up the capital account leads to a decline in industry labor shares as well.
We also find that the decline in labor shares is higher in industries where capital (e.g., machines) can be more easily substituted for labor in the production process. This is shown in the bottom panel of figure 5.5. In contrast, in industries where machines cannot easily do the job of labor, we find that there is little change in labor shares. This pattern of findings has an intuitive explanation: in industries where labor can be more easily dispensed with, it is more likely to lose bargaining power when the economy opens up to free flows of foreign capital.
The impact of the loss of bargaining power may be more severe for workers in advanced economies than in emerging economies for two reasons. First, companies in advanced economies may be in a better position to make a credible threat to relocate abroad—where wages are lower. Second, in many emerging market economies capital is scarce relative to labor. The arrival of foreign investment capital can raise the demand for labor, mitigating some of the effects of the relative change in bargaining power due to the opening of the capital account.
The impact of capital account liberalization on inequality holds even after several other determinants of inequality—such as openness to trade; changes in the size of government; and regulation of product, labor, and credit markets—are accounted for. Using alternate measures of capital account liberalization provided by other researchers (Quinn and Toyoda 2008) also gives similar results.
What accounts for the weak impact of liberalization on output and the strong effects on inequality? We investigate two key channels conjectured in previous work. First, opening up to foreign capital flows can be a source of volatility—with large capital inflows followed by outflows and vice versa. Critics of liberalization insist that this volatility is a source of crisis. Rodrik (1998), for instance, argued that the sudden outflow of foreign capital from Asian economies in 1997 left them “mired in a severe economic crisis.” Rodrik notes that this is not an “isolated incident” and that “boom-and-bust cycles are hardly a sideshow or a minor blemish in international capital flows; they are the main story.”
Second, while liberalization should expand the access of domestic borrowers to sources of capital, the strength of domestic financial institutions plays a crucial role in the extent to which this takes place. In many countries, financial institutions do not offer a wide range of services and large numbers of people, particularly the poor, do not have access to credit. Such economies are described as having low financial depth—the amount of credit extended is low relative to the size of the economy. Under these circumstances, liberalization may improve financial access mostly of those well-off, which could dampen the output effects while exacerbating the impact on inequality.
We find evidence in favor of both channels: the adverse impact of liberalization on output and inequality is greater when it is followed by a crisis and where financial depth and inclusion are low. To study the first channel, we separated cases in which capital account liberalizations were followed by a financial crisis from cases in which no crisis ensued. The impact of openness on inequality differs markedly between the two cases, as shown in figure 5.6. In particular, when there was a crisis, there was a decline in output of 5 percent and an increase in inequality of 3.5 percent; in contrast, in the absence of a crisis, output increased a bit and there was a smaller increase in inequality.
FIGURE 5.6: The Effect of Capital Account Liberalization on Output and Inequality
The adverse impact of liberalization on output and inequality is greater when it is followed by a crisis and where financial depth and inclusion are low.
Source: Furceri, Loungani, and Ostry (2018).
The effect of liberalization on inequality also differs by financial depth and inclusiveness. We separate countries where financial markets are not very deep from others using an indicator compiled by the Fraser Institute. In countries with high financial depth, output increases and inequality falls; in countries with low financial depth, output falls by 3 percent and inequality goes up by 2.5 percent. Similarly, in countries with low financial inclusion—where very few have access to bank accounts and financial services—liberalization has little impact on output but leads to a sharp increase in inequality.
Rising income inequality within countries has received renewed attention in recent years. Much of the focus has been on advanced and emerging economies; however, many LICs also experienced growing income inequality from the late 1980s to the early 2000s and again more recently. Some observers have pointed out that these periods of rising inequality coincide with increasing openness to foreign capital in these countries (Goldin and Reinert 2012). In comparison to other country groups, LICs currently have greater restrictions on the capital account, and thus have more space to relax such restrictions in years to come. Thus, understanding the consequences of further opening up the capital account is likely to remain in the near future an important policy issue for LICs. In this set of countries, as in the full sample, episodes of capital account liberalization have been followed by increases in inequality, which have been particularly sharp in some countries such as Egypt (figure 5.7).
FIGURE 5.7: Evolution of Gini Before and After Capital Account Liberalization
In low-income countries, capital account liberalization increases income inequality. The long-lasting increases can be observed in countries such as Egypt, Nepal, Uganda, and Bolivia.
Source: Furceri, Ge, and Loungani (2016).
When deciding to liberalize the capital account following the footsteps of high-income countries (HICs), policymakers in LICs should take into consideration these distributional effects and ensure that the supporting conditions are in place so that all segments of society can reap the benefits of opening up. This warrants special attention because, in general, most of these countries have weak financial institutions and access to credit markets is quite limited. More than half of the poorest 40 percent of the population in developing countries are without access to formal banking accounts. Therefore, liberalizing the capital account may exacerbate the bias in accessing financial products in favor of those who are already well-off. Indeed, we find that even within this group of countries, the impact of financial openness on inequality is particularly strong where the extent of development of financial markets and financial inclusion is limited (figure 5.8).
FIGURE 5.8: Effect of Capital Account Liberalization on Inequality in Low-Income Countries
Even within the group of low-income countries, financial liberalization leads to a stronger increase in inequality where the extent of development of financial markets and financial inclusion is limited.
Source: Furceri, Ge, and Loungani (2016).
