Why do financial crises draw much attention from the public? Speculative attacks or turbulence in the foreign exchange markets make headlines in the news, but it is usually the consequence of the crises that interest people the most. More specifically, people tend to think that financial crises create negative impacts on the real economy, and that such economic turmoil can lead to political turmoil as witnessed in Indonesia during the Asian crisis of 1997-98. However, as Gupta, et al. (2000) and Angkinand and Ito (2004) show, it is not always the case that financial crises lead to output losses, but that financial crises can even lead an economy to experience an expansion. Regardless of what statistical analysis has found, the perception that financial crises lead to negative consequences on the real economy is quite prevalent.
While many researchers have attempted to theorize or empirically study what can contribute to the occurrence of a crisis, some have investigated the factors that can lead to crises with output losses (Bordo, et al. (2001), Glick and Hutchison (2001), Gupta, et al. (2000), Hutchison and Noy (2001, 2002a,b)). While macroeconomic or institutional factors have been investigated as possible contributors to the occurrence of a crisis or its output losses, capital controls have been also discussed as one of the main contributors (Glick and Hutchison (2001), Bordo, et al. (2001)). The discussion on the role of capital controls heightened especially during the Asian crisis. Krugman (1998) advocated implementing capital controls as an extraordinary policy for an extraordinary situation such as a financial crisis. In 1998, Malaysia’s prime minister M. Mahathir tightened capital controls in an attempt to insulate his country from negative waves from the Asian crisis.
Although Mahathir’s policy drew much attention from both academia and policy makers, the evaluations of his capital control policy are far from settled. Dornbusch (2001) argues that in retrospect, Malaysia’s quick recovery from the crisis is not because of Mahathir’s capital control policy, but because of relatively benign macroeconomic conditions prior to the crisis. Kaplan and Rodrik (2001), on the other hand, claim that Mahathir’s capital controls policy was as effective as an IMF-supported stabilization program could be, and thus helped the country to recover quickly. Despite its controversy, interestingly, there is not much empirical literature investigating the link between capital account openness and the output performance of the crisis-afflicted economies. This link is the focus of this paper.
This paper will look into 141 currency crisis episodes for 62 countries (22 industrialized countries (IDC), 40 less developed countries (LDC), and 29 emerging market countries (EMG)) between 1975 and 2002, and examine the effect of capital account openness on the output losses of the crisis-afflicted countries. The lack of empirical analysis on the link between financial openness and output losses associated with crises can be partly explained by the lack of measures on the extent and intensity of capital controls. To overcome this issue, I use the index on the openness regarding capital account transactions from Chinn and Ito (2002). The merit of this index is that it can refer to the intensity of capital controls, which has been always an issue when empirical analysis is conducted on the role of capital controls. As for the measures on the output losses associated with crises, I use the methodology from Angkinand and Ito (2004) and investigate the association of the post-crisis output loss with the level of capital account openness as well as its rate of change (i.e., financial liberalization).
I find that a higher level of financial openness reduces the likelihood of a currency crisis for industrialized countries and less developed countries, but not for emerging market countries. Also, having a higher level of financial openness prior to a currency crisis will help industrialized countries to experience smaller post-crisis output losses as well as a shorter duration of such losses. These positive effects of open capital accounts are not found in less developed countries. For emerging market countries, on the other hand, a higher level of financial openness prior to a crisis appears to make the duration of post-crisis output contraction longer.
The analysis on how the post-crisis level of financial openness, controlled for by post-crisis macroeconomic conditions, affects post-crisis output losses is interesting. That is, while a higher post-crisis level of financial openness helps to lower the magnitude of post-crisis output losses for industrialized countries, it appears to increase the size of output losses for developing and emerging market countries. For the group of emerging market countries, it is found that the negative effect of a higher level of financial openness lasts as long as three years after the crisis. Also, I find that Mahathir’s method of restricting capital flows immediately after the breakout of a crisis does not have any effect on the post-crisis output performance. In short, the level of openness in capital accounts prior to a currency crisis only matters for industrialized countries, but once a crisis occurs, further financial liberalization may worsen the post-crisis output contraction for less developed and emerging market countries. Furthermore, the effect of the post-crisis level of financial openness on post-crisis output performance seems to be independent of institutional developments, such as corruption level, law and order, and bureaucratic quality.
The paper proceeds as follows. Section 2 reviews the theoretical links between capital account openness, currency crises, and output losses. Section 3 discusses the issues regarding the data and measurement of important variables. In Section 4, non-parametric analysis on the link is conducted, followed by empirical analysis in Section 5. The concluding remarks are given in Section 6.
