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(KAL). Capital flows resulting from KAL are channeled through domestic
intermediaries—either by banks or firms—allowing greater competition and thus
more efficiency. Indeed, countries adopting KAL often see a sudden jump in
economic growth as they move away from financial repression. Yet, many of
them, developing and developed countries alike, subsequently face instability,
with some falling into financial crisis. 13
Most analysts essentially defended KAL by citing the lack of preconditions for
liberalization to explain why crises emerge. They blamed institutional factors such
as corruption, weak enforcement, and limited understanding about how a
liberalized financial sector operates. Policy recommendations thus centered on
fixing those institutional factors, never questioning the virtue of KAL itself. Then
came the 2007/2008 shock in the US, followed by the Eurozone crisis. Institutional
factors in both economies were supposedly strong, well above those in many
emerging markets. Obviously, the early analytical findings went out the window.
Only recently have analysts and scholars admitted early preaching on FSL and
KAL was flawed [see, for example, CIEPR ( 2012 )]. They now admit that the “First
Best” approach of financial liberalization—where frictionless outcomes are
emphasized—is faulty and should be replaced by a “Second-Best” approach in
which financial regulation is given far greater importance, and where capital
controls are no longer taboo. After decades of preaching the virtues of cross-
border capital flows, the IMF finally admitted that some restrictions on capital
flows can help protect an economy from financial turmoil. Central to the analysis is
the need to maintain financial stability and macroprudential policy (IMF 2012 ).
The post-crisis low interest rate policy in advanced economies led to massive
capital flows, most of which wound up in emerging markets, threatening their
financial stability. 14 The resulting exchange rate pressure forced frequent market
intervention to maintain trade competitiveness. But the problem does not end here.
New financial vulnerability was created through bank-led inflows.
With additional funds flowing in from inexpensive sources (non-core or
non-deposits), banks were more willing to take risks. Without foreign exchange
market intervention, inflow-induced currency appreciation bolsters the balance-
sheet of borrowers. And if used to augment bank loans, they can stimulate the
economy to offset the fall in exports. 15 The problem arises when deleveraging or a
13
In the 1990s alone, financial crisis struck Europe (1992/1993), Mexico/Latin America (1994),
Asia (1997), Eastern Europe and Russia (1998). The recent global financial crisis began in the US
and Europe. Crisis contagion has also become less regional and more global. Technology and
information enable financial spillovers by reducing structural distance.
14
Most analysis suggests the easy money policy in advanced economies was less effective than
originally thought. The policy not only failed to strengthen recovery in the US and other advanced
economies, but also provoked global monetary instability through capital flows, including those
led by “carry traders,” who exploit
interest
rate differentials across countries. See
Mckinnon ( 2012 ).
15 The amplified effect of cross-border flows on the supply of credit due to the changing risk
behavior of banks is shown in Valentina and Shin ( 2012 ).
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