Strengthening Access to Foreign Capital

Effective strategies to enhance access to private foreign capital can provide a significant boost to economic growth and poverty reduction, but the benefits of such access can be realized only in proportion to a country’s level of institutional development.3 The rule of law, shareholder protection, adequate prudential regulation and supervision, and finan­cial transparency are significant determinants of whether capital account openness—to enhance access to foreign capital—is beneficial or harmful.

Enhanced access can be achieved by a combination of two approaches:

• Attracting foreign investors and lenders to a domestic market by promoting foreign direct investment, foreign portfolio investment, bank financing from abroad, and infrastructure financing through public-private partnerships.

• Facilitating access to international capital markets by domestic entities, a move that requires certain preconditions of policy environment and institutional pre­paredness, including credit rating and investor relations.

In addition to sectoral reforms, implementation of those approaches will require finan­cial sector policies that strengthen access to financial services domestically by developing markets, institutions, and infrastructure; that improve investment climate, information provision, and governance; and that are well designed and properly sequenced for capital account liberalization.

Foreign capital can play an important role in developing local financial markets. The timing and use of foreign capital, however, should be selected in a manner that supports its contribution to domestic market development and that limits the cost of additional risk. Accordingly, foreign capital is often best used first to facilitate real sector and institu­tional reforms, including banking and corporate sector restructuring through privatization (Johnston and Sundararajan 1999). Capital account liberalization should start with the liberalization of foreign direct investment, which helps import the superior technology and management expertise needed to implement operational reforms in financial institu­tions and corporations. Foreign technology and ownership also promote competition and export growth.

Foreign investors also can serve as an important source of demand for local securities. Liberalizing portfolio investment in equity securities widens and diversifies the investor base for local markets, and it enhances market discipline on issuers in particular and on macroeconomic management more generally (Sundararajan, Ariyoshi, and Otker-Robe 2002). Opening up to portfolio inflows, however, may increase volatility in market prices, at least for emerging-market economies in the short run (Kaminsky and Schmukler 2003). If one is to limit rollover risk, it is often better to liberalize market for longer-term debts before shorter-term maturities.

However, capital account liberalization should closely complement the domestic market development strategy. For example, allowing short-term capital flows for certain instruments and sectors—with adequate prudential safeguards—can support money and exchange market development. Similarly, the well-planned opening of inflows of foreign portfolio investment can add to the liquidity of domestic equity markets.

Well-developed risk-management capacities of local investors and financial institu­tions can help domestic financial markets benefit from foreign capital without subjecting markets to excessive stress. Cross-border capital flows, in essence, amplify the wide array of risks already prevailing in liberalized domestic financial markets, including credit, liquidity, market, interest rate, exchange rate, and operational risks. Thus, the risk man­agement capacities of financial institutions and domestic investors have to be strong and sophisticated enough to assess and manage higher degrees of risk in all areas. For example, in hindsight, financial institutions and corporations in South Korea and Thailand (before the Asia crisis) did not adequately assess and manage the risks associated with foreign bor­
rowing and lending. Increased openness to cross-border capital flows also requires a closer monitoring of macroprudential risks to assess the effects of shocks on financial system soundness, and adjustments in macroeconomic policies to limit volatility in key prices.

In addition, it is often desirable to achieve some level of depth in domestic financial markets before exposing markets to potentially volatile capital flows (Ishii and Habermeier 2002). In the presence of a solid domestic institutional investor base, local money, equity, and bond markets are likely to be more resilient against economic and financial shocks that may trigger capital outflows. Potential market volatility and high interest rates resulting from a withdrawal of foreign capital are more manageable and short lived when domestic investors can act as counterparties to foreign investors. Thus, an adequate base of domestic investors can serve to cushion the effect of external shocks, particularly when the nature of the shock is a foreign, rather than a domestic, contagion, thereby foster­ing greater financial stability. This observation once again highlights the importance of developing institutional investors as a critical component in the sequencing of financial market reforms and development.

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