Financial liberalisation and macroeconomic management in the open economy

Conventional wisdom suggests macroeconomic stabilization and structural reform programmes should be implemented in the continued presence of administrative controls on the cross-border movement of financial capital. This view is based on empirical observation of the "over-borrowing syndrome," a phenomenon that has afflicted many developing nations undertaking comprehensive liberalisation programmes. The example of Chile in 1974-83 is seminal, but far from unique. "Over-borrowing" episodes abound across both geographical and temporal dimensions. Even mature, industrialised economies are not immune. In the European context, the phenomenon has been labeled the "Walters' Critique" of the European Monetary System and appears to have afflicted Spain, Sweden and the United Kingdom in the late 1980s.; This thesis offers complementary macro and micro economic frameworks to analyse "over-borrowing" episodes. These highlight the potential interactions between market failure in the domestic financial system and inflows of short term international capital--the proverbial "hot money"--through the foreign exchanges when liberalisation is implemented. Indigenous deposit taking banks fail in their special role as efficient information conduits to the non-bank private sector. Self-sustaining, but ultimately unsustainable, credit driven consumption booms can emerge as the decisions of rational actors are distorted by the creation of over optimistic expectations or triumphalist euphoria about the success of structural reform. These booms are destined to culminate in financial crisis, capital flight, devaluation and deep, prolonged recessions.; The models suggest structural economic reform should be implemented gradually, with complete integration of the domestic financial system into international financial markets delayed until the end of the reform process. The preferred capital controls are non-interest bearing reserve requirements on foreign owned deposit liabilities of domestic banks. Direct controls on consumer credit are possible second best policy options.; An empirical analysis of EMS data lends support to the hypothesis that "over-borrowing" is associated with high credibility of the stabilization programme (at least in the Spanish case). Moreover, it suggests the institutional design of exchange rate regimes can have important implications for exchange stability during the simultaneous implementation of structural reform.