In the past decade, the financial sector has undergone large transformations in most countries around the world. Perhaps the most important factor behind these changes was the enactment of financial liberalization policies. These policies, including market deregulation, privatization of financial intermediaries, strengthening financial sector supervision and regulation, and reduction of barriers to international capital flows, were aimed at increasing the scope for market forces to operate in credit markets, thereby reducing the cost of credit or increase its availability.
At the same time, firms around the world have become increasingly able to access international capital, as controls on capital movements have been gradually dismantled and technology has reduced transaction costs and informational barriers.
Financial liberalization policies were first advocated by McKinnon and Shaw in the 1970s (McKinnon, 1973; Shaw, 1973) especially for developing countries, where state intervention in the financial sector was especially heavy handed. As financial liberalization began to be implemented in the late 1980s and early 1990s, however, evidence emerged that it could lead to undesirable outcomes in some circumstances, including high and volatile interest rates and macroeconomic and financial sector instability. The prevailing view attributed these outcomes to weak institutions, such as property and contractual rights and bank prudential regulation and supervision, or to mismanaged or premature liberalization.
The debate has been equally lively as to the benefits of capital account liberalization in developing countries. Proponents have stressed how access to international capital markets should lower the cost of capital for firms in (presumably capital-poor) developing countries, and provide opportunities for investors to diversify country specific risk. Detractors of capital account liberalization have argued that large international financial flows increase output volatility and complicate macroeconomic management. In extreme cases, sudden stops in inflows can contribute to costly financial crises.