Capital Account Liberalization, Real Wages, and Productivity

Capital account liberalization in developing countries reduces the cost of capital, temporarily increases investment, and permanently raises the level of GDP per capita.

In the late 1980s developing countries all over the world began easing restrictions on capital flows. A decade later many of the same nations experienced a string of financial crises, triggering a debate over the relative merits of capital account liberalization as a policy choice for developing countries. Critics claim that liberalization brings few benefits and high costs. But recent surveys show that capital account liberalization in developing countries reduces the cost of capital, temporarily increases investment, and permanently raises the level of GDP per capita.

In the process of debating the costs and benefits of capital account liberalization, both critics and apologists have neglected the labor market. While it is important to understand how opening up affects prices and quantities of capital, there had been no systematic evidence on the behavior of wages in the aftermath of that policy change, almost two decades after the advent of capital account liberalization in the developing world.

In Capital Account Liberalization, Real Wages, and Productivity (NBER Working Paper No. 13880), authors Peter Blair Henry and Diego Sasson attempt to fill that gap. They find that in a sample of 18 developing countries that opened their stock markets to inflows of foreign capital between 1986 and 1993, the average annual growth rate of the real wage in manufacturing jumped from 1.3 percent per year in non-liberalization periods to an average of 8.6 percent in the year liberalization occurred and each of the subsequent two years. The temporary 7.3 percentage-point increase in the growth rate of the real wage permanently drives up the level of average annual compensation for each worker in the sample of liberalizing countries by about 752 US dollars, an increase equal to more than a quarter of their annual pre-liberalization salary.

Opening the stock market to foreign investment drives up real wages in the manufacturing sector of developing countries without eroding profitability, according to the authors' data. Because workers gain, and owners of capital do not lose, the authors question why countries wait so long to liberalize.

The authors are cautious in addressing this question because the evidence they present applies only to manufacturing. In the absence of data on wages in agriculture, or services, they cannot conclude that capital account liberalization improves aggregate welfare. Integration into the world economy during the 1980s and 1990s increased the ratio of skilled-to-unskilled wages in developing countries. Easing restrictions on capital inflows may have contributed to the widening of the gap. Therefore, while it may not cause distributive conflict within manufacturing, liberalization may create winners and losers across other sectors, with attendant political economy implications for the decision of whether and when to open up.

Nonetheless, the evidence the authors present demonstrates that trade in capital has significant consequences for the real economy beyond its impact on prices and quantities of capital. All else equal, capital account liberalization raises the average standard of living for a significant fraction of the workforce in developing countries.

-- Les Picker