Capital Account Liberalization, The Cost of Capital, and Economic Growth

Three things happen when emerging economies open their stock markets to foreign investors. First, the aggregate dividend yield falls by an average of 240 basis points. Second, the growth rate of the capital stock increases by an average of 1.1 percentage points per year. Third, the growth rate of output per worker rises by 2.3 percentage points per year.

Capital account liberalization policies have fallen from favor in recent years. Initially they were touted as a way to permit financial resources to flow from capital abundant countries, where expected returns on investment are low, to capital-scarce countries, where expected returns are high. The inflow of capital was expected to reduce an emerging economy's cost of capital, to increase investment, and to raise output. However, opponents of capital account liberalization have argued that it does not generate greater efficiency and, in fact, invites speculative money flows, thus increasing the likelihood of financial crises with no positive effects on investment and output.

In Capital Account Liberalization, The Cost of Capital, and Economic Growth (NBER Working Paper No. 9488), author Peter Blair Henry finds that the initial predictions about capital account liberalization hold true in actual practice. Three things happen when emerging economies open their stock markets to foreign investors. First, the aggregate dividend yield falls by an average of 240 basis points. Second, the growth rate of the capital stock increases by an average of 1.1 percentage points per year. Third, the growth rate of output per worker rises by 2.3 percentage points per year.

According to the author, because the cost of capital falls, investment soars, and the growth rate of output per worker increases when countries liberalize the stock market, the recently popular view that capital account liberalization brings no real benefits seems untenable.

In the late 1980s and early 1990s a number of developing countries liberalized their stock markets, opening them to foreign investors for the first time. The author uses these 18 countries as the basis for his research. The approximate 240 basis point decline in dividend yield reflects an average of yield of 5 percent in the five years prior to liberalization versus an average yield of 2.6 percent in the five years following liberalization. The growth of the capital stock rose from an average of 5.4 percent in the pre-liberalization period to 6.5 percent in the post-liberalization period. Finally, the output per worker rose from an average of 1.4 percent pre-liberalization to 3.7 percent post-liberalization.

Henry points to several issues regarding capital account liberalization that we need to understand better, such as whether the policy causes financial crises when adopted. He suggests that moving from aggregate-level data to firm-level data should enhance our general understanding of the process by which the effects of liberalization are transmitted to the real economy.

-- Les Picker