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Financial liberalization allows market forces to determine the allocation of capital. Models of perfect markets suggest that domestic financial liberalization and international financial liberalization have welfare and efficiency enhancing effects. Thus, prior to the East Asian financial crisis, economists broadly concurred that financial liberalization is desirable. However, the collapse of the “miracle” economies in Thailand, Indonesia and South Korea during the 1997 East Asian financial crisis motivated policymakers and academic scholars to question the indiscriminate advocacy of financial liberalization. During the 1997 crisis, the liberalized economies in Thailand, Indonesia and South Korea experienced sharp recessions and sudden withdrawals of international capital flows, while both China and India, with protected financial economies, emerged unscathed. The crisis raised somber questions on the benefits of financial liberalization and compelled economists to be more circumspect and modify their stance.

Some now argue that a significant cause of financial crises such as the East Asian crisis is the unprecedented emergence of financial liberalization among many developing countries since the 1980s (Tornell, Westermann, Martinez, 2004). Financial liberalization creates scope for innovation and enhances the mobility of risk, but the increasing complexity of financial instruments and risk transfers have also made it more challenging for market participants, supervisors and policy makers to track the development of risks within the financial system and over time. In addition, capital account liberalization may be welfare-enhancing only when there are no serious imperfections in the information and contracting environment (Eichengreen, 2001). As a consequence, some prominent economists such as Rodrik (1998), Krugman (1999) and Stiglitz (2003) have advocated limits on capital flows to moderate irrationally exuberant investors and the erratic boom-bust patterns in financial markets. Yet, while economists continue to caution against rash, premature financial liberalization, they maintain that financial liberalization is advantageous for long term economic growth. However, they recommend that countries develop a sound regulatory structure, legal system and social safety net, prior to financial liberalization.