IV Experiences with Gradual Liberalization

Introduction Experience with Gradual Liberalization in Japan In the course of the 1980s, a general trend toward the liberalization of capital movements emerged in Japan's motives for capital controls were a mix- the face of growing disillusionment regarding the ef- ture of exchange rate and industrial policy consider- fectiveness of capital controls. In eliminating restric- ations. Controls on inward direct investment formed tions, most advanced economies followed a cautious part of domestic industrial policy and restricted the approach. Typically, authorities moved gradually to overall share of foreign ownership in companies in avoid jeopardizing exchange rate and monetary sta- various industries.23 Although formal controls were bility. Countries that had liberalized capital move- eased in 1967, 1973, and 1979, investment inflows ments substantially in the 1960s but were forced to remained low (Figure 4.1). A prior-approval system reintroduce controls were reluctant to prematurely was in place, and a decisive answer on a request for liberalize again. It was considered that if liberaliza- permission to invest was given only after a signifi- tion were once again reversed, the economic and po- cant (and varying) waiting period. This approval litical costs would be high. Gradual liberalization process could be used to discourage or retard invest- was linked to reform in other policy areas, both do- ment. The high domestic saving rate (and associated mestically (such as the deregulation of the domestic current account surplus) reduced the extent to which financial sector and changes to the monetary policy direct investment inflows were required to finance strategy) and externally (with respect to the ex- industrial development, in contrast to the situation in change rate regime). many other countries. In this section, the gradual approach to capital The 1980s saw a number of significant changes in liberalization is exemplified by the experiences of Japanese capital controls, as the domestic financial Japan and France. Japan dismantled capital con- system developed and international pressure to dereg- trols and deregulated the domestic financial sector ulate and liberalize intensified. Changes in the sav- over several decades and has only very recently es- ings and investment balances between sectors over tablished a fully liberalized environment. The the 1970s were a key factor leading to reforms. In- Japanese experience is one of the most interesting creasing government budget deficits made banks' tra- and complicated examples of capital account liber- ditional obligation to purchase bonds at below-market alization. In Europe, the Federal Republic of Ger- rates more burdensome, while corporate borrowing many and the Netherlands were the only advanced requirements were falling as growth slowed following countries to gradually dismantle capital controls in the oil price shocks that occurred during that time. In the 1970s. Other countries followed in the 1980s, addition, there was a growing tendency for corpora- encouraged by a general improvement in the eco- tions to invest liquid funds in instruments in the Gen- nomic climate. Among those countries, France's saki market, which were not subject to interest rate experience is discussed at some length, because the ceilings, rather than in regulated bank deposits.24 The clear linkages to other policy areas were explicitly addressed and also because it provided an example for other countries, such as Italy, Spain, and some 23A key objective of industrial policy was to prevent the smaller European economies. In contrast, the takeover of innovative Japanese companies by foreign competi- United Kingdom, Australia, New Zealand, and tors. See Ito (1992) and Argy and Stein (1997) for a more detailed discussion of Japanese industrial policy. some of the Nordic countries liberalized their capi- 24The Gensaki market was a market for repurchase agreements tal controls more rapidly. Their experiences are dis- in which nonfinancial institutions were able to participate. Non- cussed in Section V. residents were allowed to access the market from 1979 onward.

©International Monetary Fund. Not for Redistribution Experience with Gradual Liberalization in Japan

Figure 4.1 Japan: Foreign Direct Investment, 1970-98 (Percent of GDP)

Sources: IMF, International Financial Statistics (Washington), various issues; Thomson Financial; and Bank of Japan.

problems that the banking sector faced owing to these vestments with the proceeds. Fukao (1990) argues developments led to strong domestic pressure on the that this restriction was relatively ineffective after government to reform the financial system. 1980 because Japanese nonbank residents were not The progress in deregulating the domestic finan- subject to the quotas. This enabled large corpora- cial system coincided with a changing attitude to- tions, facing low transaction costs, to engage in inward capital controls from 1979 onward. In De- terest arbitrage. The real demand principle also lost cember 1980, the exchange control system was its effectiveness after 1980 because revisions in the changed from a negative one in which cross-border December 1980 law liberalized borrowing, lending, capital flows were forbidden unless explicitly per- and depositing in foreign currency at freely deter- mitted to a positive system in which capital flows mined interest rates and allowed corporations to were allowed unless explicitly prohibited. While take positions that resembled the effect of a for- the switch to a positive system was certainly a land- ward contract.25 mark event in the liberalization process, the practi- Key changes resulted from the so-called yen/dol- cal importance of the revision was reduced by sev- lar agreement between the Japanese and U.S. author- eral significant exceptions, the most important of ities that was signed in 1984. Faced with a strong which were the preservation of the system of ad- dollar and a rapidly worsening current account ministrative procedures for direct investments (dis- deficit in 1983, the U.S. authorities argued that half cussed above); restrictions on the operations of of the deficit was caused by the bilateral trade deficit banks; and the real demand principle, which with Japan. Furthermore, the United States argued required forward foreign exchange transactions to that the Japanese policy restricting capital move- be linked to underlying trade transactions. The lim- ments and discouraging the international use of the ited development and extensive regulation of do- yen as a transaction currency contributed to the mestic financial markets also raised transaction weakness of the yen. In the course of 1983, Japan costs, thus restricting capital flows (Takeda and and the United States agreed to set up a working Turner, 1992). Finally, limits remained on the share group to study the misalignment of the yen/dollar of foreign assets that could be held by institutional exchange rate. The final report of the ad hoc Work- investors (although these were gradually lifted in ing Group on Yen/Dollar Exchange Rate Issues, pub- the 1980s). lished on May 29, 1984, led to a renewed accelera- A key remaining restriction on the operations of Japanese foreign exchange banks was the system of yen-conversion quotas that limited the banks' abil- 25 The real demand principle was eventually abolished in April ity to borrow foreign currency and make yen in- 1984.

©International Monetary Fund. Not for Redistribution IV EXPERIENCES WITH GRADUAL LIBERALIZATION

tion in the deregulation of both Japan's capital con- Because of the limited effectiveness of these restric- trols and domestic financial markets.26 tions, they were abolished in April 1989. Liberalization directly following the yen/dollar Administrative procedures for inward direct in- agreement covered several aspects of financial mar- vestment were eased and simplified on several occa- ket regulation. Measures stimulating capital out- sions, and from 1992 prior approval was required flows included the easing of eligibility require- only for investment in the agriculture, forestry and ments and other restrictions on the issuance of fishing, mining and petroleum, and leather indus- yen-denominated bonds in Japan by nonresidents tries. Nevertheless, inward direct investment flows (Samurai bonds). Furthermore, the sale of foreign remained low until the late 1990s—much later than certificates of deposit and commercial paper in in most other industrial countries. The increase in in- Japan was allowed. With regard to capital inflows, vestment inflows in the late 1990s appears, at least key measures included the abolition of the conver- in part, to reflect domestic economic reforms. For sion quotas imposed on Japanese foreign exchange example, following the Japanese financial market re- banks and the abolition of the withholding tax on form, direct investment in the financial and insur- Euroyen bonds issued by Japanese residents. The ance sectors increased significantly. liberalization of the Euroyen market was a further Outward direct investment increased dramatically direct result of the yen/dollar agreement, although between 1987 and 1991, even though the necessary it occurred more slowly. Subsequent to the agree- approval process also included a waiting period. In ment, changes were clearly made part of a transi- addition to the role played by better-functioning cap- tion to a deregulated financial system, in contrast to ital markets, the strong yen, in the second half of the some earlier ad hoc liberalization measures. 1980s, encouraged Japanese firms to open manufac- Significant liberalization of both domestic and in- turing plants in other parts of Asia, Europe, and the ternational financial markets in Japan also took United States. Pressure from the United States re- place outside the framework of the yen/dollar agree- garding the size of its bilateral current account ment. The trend toward more market-determined deficit with Japan was also a factor in stimulating interest rates, which started in the 1970s, continued. foreign direct investment outflows. New financial markets and financial instruments were allowed to evolve and to coexist alongside reg- Responses to the Reforms ulated instruments, leading to the development of some parallel markets. To dampen the immediate The substantial changes during the 1980s largely impact of interest rate deregulation on the financial completed the transition from a system with strong system, restrictions, such as high minimum amounts capital controls into a system with virtually free cap- or particular maturity standards, were initially im- ital movements. Some of the remaining restrictions posed on the newly established instruments. These were removed in the early 1990s, and remaining requirements were then gradually eased in subse- controls on interest rates were removed in 1994. De- quent years. velopments from the mid-1980s were shaped by the In December 1986, the Japanese Offshore Market relationship between the progressive international- was established, providing Japanese foreign ex- ization of the Japanese financial system and the change banks with a market in which their interna- more gradual removal of controls on the domestic fi- tional activities could be developed. In addition, it nancial system. Profitable arbitrage opportunities enabled foreign banks to access the Japanese market. between domestic and international yen markets en- The market was free of domestic regulations, such as couraged banks to use interoffice accounts and inter- interest rate controls, deposit insurance, reserve re- bank borrowing to fund their international activities. quirements, and withholding tax. Funds in offshore Banks engaged in short-term offshore borrowing (in accounts, however, could not be transferred to on- foreign currencies) to fund long-term foreign cur- shore accounts. Japanese banks could circumvent rency lending to Japanese residents.27 Surprisingly, these measures by depositing foreign borrowings despite Japan's large current account surplus, Japan- with foreign branches and subsequently reborrowing ese banks were (on a net basis) capital importers in these funds through onshore interoffice accounts. the late 1980s.28 The use of the offshore markets enabled Japanese banks to expand lending while avoiding the Bank of Japan's informal guidelines on do- 26Frankel (1984) provides a summary of the events leading up mestic lending. (Lending from offshore was not to the establishment of the working group, including a discussion of a possible misalignment in bilateral exchange rates. He argues that although the stated purpose of the agreement was to bring 27Segmentation rules for offshore activities were also less strict about a yen appreciation, the changes agreed to were, in practice, than those applied domestically. more likely to put (temporary) downward pressure on the value of 28This position was reversed in the early 1990s, when Japanese the yen. banks reduced their Euromarket operations.

©International Monetary Fund. Not for Redistribution Experience with Gradual Liberalization in Japan

covered under the guidelines.) Japanese nonbank the authorities.32 While Japanese and world short- residents who wished to invest in foreign currency term capital markets were integrated from around bonds were also keen to borrow in foreign currency 1980,33 arbitrage does not seem to have been so to fund those investments in order to eliminate their complete in other parts of the Japanese financial exchange rate risk. sector. Takeda and Turner (1992) attribute this un- Nonfinancial corporations also made increasing evenness in development to the determination of the use of deregulated financial markets and the associ- authorities to limit any disruption to the domestic ated increased availability of credit. That reduced banking system. their dependence on banks and weakened the tradi- In response to the lower domestic borrowings by tionally close relationships between banks and cor- nonfinancial corporations, banks were forced to in- porations as large nonfinancial corporations increas- crease their lending to smaller firms and households ingly raised funds directly from securities markets. to maintain their size and earnings, thereby increasing Capital account liberalization made it easier for cor- their exposure to real estate. Between 1985 and 1990, porations to raise funds offshore. Despite the fact the share of bank lending outstanding to the manufac- that the Japanese savings rate is high by interna- turing sector fell from over 20 percent to 15.5 percent, tional standards, an increasing proportion of bonds while the share to households and the real estate sec- was issued offshore (for example, in Euromarkets).29 tor almost doubled to 25.5 percent. During the 1980s, Domestic market regulation encouraged offshore international expansion by Japanese banks, which al- bond issues at the expense of domestic issues, allowed them to avoid a number of domestic constraints though the differences between the two diminished and meet the needs of Japanese manufacturers who during the late 1980s as eligibility and collateral re- were expanding abroad, was also significant.34 The quirements in the domestic markets were eased.30 expansion probably stemmed from a desire to build Similarly, foreigners preferred to access Japanese up market share, which may have induced a willing- savings through the Euroyen market. Portfolio in- ness to accept lower profit margins than other banks. flows were limited through much of the 1980s but Meanwhile, monetary policy in the second half of increased strongly during 1989-91 as a monetary the 1980s was focused on the exchange rate following policy tightening led to higher interest rates. the Louvre accord, resulting in lower interest rates After 1984, portfolio outflows show a substantial that helped sustain growth and finance consumption increase (Figure 4.2). Factors other than those dis- and housing investment. Debt levels rose rapidly.35 As cussed above may also have contributed to this in- asset prices boomed, firms borrowed to invest in fi- crease. First, an increase in limits on the amount of nancial assets, increasing their vulnerability to asset foreign securities held by Japanese institutional in- price movements.36 The net portfolio outflow slowed vestors in 1986 led to higher foreign security hold- sharply from 1985 to 1989, possibly in response to ings, particularly by insurance companies.31 Second, (and further contributing to) asset price rises. Despite the strong appreciation of the yen after the Plaza the asset price boom, consumer price inflation re- agreement in September 1985 was followed by a remained low, rising above 2 percent only in April 1989. laxation of monetary policy in February 1987, and It was, therefore, difficult to ascertain the extent to interventions in the foreign exchange market to sup- which the asset price increases represented a stock ad- port the dollar followed the 1987 Louvre agreement. justment following the reforms, or a bubble. The expansionary monetary policy contributed to both capital outflows and the asset price inflation that characterized the late 1980s. 32Osugi (1990), p. 14. The coexistence of free and regulated markets 33Ito (1992) illustrates this on the basis of covered interest par- contributed to the gradual transition from a regu- ity calculations. In contrast, prior to 1980, capital controls appear lated to a free system, although free markets some- to have been at least partially effective in insulating Japanese financial markets. Fukao (1990) argues that controls tended to be times resulted in a more rapid deregulation of re- effective when initially introduced, but that their effectiveness stricted markets than had initially been intended by gradually eroded. 34An indication of the extent of the overseas expansion of financial institutions is provided by foreign direct investment data. 29Bond issues by Japanese corporations (both foreign and do- Osugi (1990) documents that foreign direct investment by bank- mestic) rose from ¥1.7 trillion in the year ending March 1980 to ing and insurance companies exceeded that by manufacturing ¥6.8 trillion in the year ending March 1985, and to ¥21.8 trillion companies between 1985 and 1987. in the year ending March 1989. Offshore issues rose from around 35The debt level of nonfinancial corporations increased from 40 percent of total issues in 1980 to around 60 percent in 1989. 101 percent of GDP in 1985 to 135 percent in 1990. For the 30Issuing costs were also generally lower offshore (see Takeda household sector, debt as a share of disposable income rose from and Turner, 1992). 68 percent to 96 percent in the same period. 31Fukao (1990) notes that institutions did not invest offshore to 36The ratio of financial assets to liabilities for the manufactur- the maximum extent permitted, suggesting that the new limits ing sector rose from about 0.6 at the beginning of the 1980s to were not binding. more than 1 in 1988. 25

©International Monetary Fund. Not for Redistribution IV EXPERIENCES WITH GRADUAL LIBERALIZATION

Figure 4.2. Japan: Portfolio Flows, 1975-99 (Percent of GDP)

Sources: IMF, International Financial Statistics (Washington), various issues; Thomson Financial; and Bank of Japan.

In hindsight, it is clear that asset prices were sig- controls depended on a well-functioning administra- nificantly overvalued and that prudential standards tion, including the central bank, which was responsi- should have been tightened earlier. The bubble even- ble for the execution of capital controls. Domestic tually burst in 1990, following increases in interest deregulation would also have facilitated greater di- rates and guidelines limiting real estate lending by rect investment inflows and therefore stimulated banks. Lower economic growth, combined with ris- competition and innovation in product markets. ing interest rates and falling asset prices, reduced the The subsequent problems in the Japanese banking debt-servicing capacity of borrowers, placing banks sector do not appear to have been directly related to under pressure. Banks also suffered losses on their capital account liberalization as such or to the spe- equity holdings. Facing new Basel capital-adequacy cific approach taken. Instead, the problems are more requirements and experiencing increased difficulty in likely to be rooted in the gradual and partial approach raising funds on the share market, banks sought to re- taken to domestic financial market deregulation (see duce their international role. In addition to banks' dif- Hoshi, 2000). The authorities' initial reluctance to see ficulties in raising new equity capital, their funding fundamental changes in the domestic financial sys- costs on money markets rose as their credit ratings tem resulted in the existence of parallel markets for a fell. Banks' focus, therefore, shifted from gaining period, with regulations varying between them. Do- market share to increasing their earnings and prof- mestic deregulation reduced banks' access to funds at itability. Figure 4.3 shows that the stock of Japanese regulated interest rates, placing pressure on their banks' foreign liabilities peaked during 1989-90. costs of funding. At the same time, capital account liberalization (and financial sector deregulation) allowed nonbank corporations to increase access to Evaluation capital markets. Because this took place before line- Given the Japanese industrial and exchange rate of-business segmentation within the financial sector policy objectives, the gradual approach taken by the was fully removed, banks lost significant lending op- Japanese authorities to capital account liberalization portunities and were forced into an increased expo- has generally been well advised, although the formal sure in the real estate market. This exacerbated the and informal control system for cross-border capital asset price boom and left banks vulnerable to asset flows should probably have been abolished a decade price swings. Unlike the situation in some other earlier, in line with the removal of restrictions in most countries, exposure to international losses were not a other advanced economies. In addition, completing prime factor in the banking crisis. International ex- domestic deregulation prior to capital account liber- pansion by banks (partly in response to the slow re- alization would have reduced some of the pressures moval of domestic controls), however, may have re- on the banking system. The relative effectiveness of duced their ability to adjust to domestic losses. 26

©International Monetary Fund. Not for Redistribution Gradual Liberalization in France in the 1980s

Figure 4.3. Japan: External Position of Banks and Nominal Exchange Rate, 1980-2000

Source: IMF, International Financial Statistics (Washington), various issues.

In addition, the changes in the monetary transmis- oil price shock later in the year, the government em- sion mechanism following domestic deregulation barked on expansionary policies. Following a change and external liberalization were recognized only at a of government in 1981, a program of nationalization relatively late stage, delaying the monetary policy (including of the banking sector) was announced, response to the very strong credit expansion that ulti- going against the mainstream of developments in mately caused the asset price bubble. At the same other industrial countries and eroding confidence in time, supervisory policies and risk-management international financial markets.38 Although the nation- practices by the banks did not keep pace with the in- alization of the financial sector was in response to do- creased appetite for risk experienced after financial mestic concerns and was not aimed at restraining repression ended. In fact, there are some indications cross-border capital movements, considerable out- that credit standards fell as banks sought to maintain flows ensued. market share in the face of increasing competition.37 A series of repeated speculative attacks on the ex- Accounting standards should also have been up- change rate and forced devaluations in France from graded at an earlier stage, enhancing transparency 1981 until 1983 helped to reshape the French eco- and market discipline. This episode shows that the nomic strategy. In a period of just 18 months, the retention of some controls during a gradual liberal- French franc was devalued three times by a cumula- ization process is no substitute for sound macroeco- tive 25 percent vis-a-vis the deutsche mark, as in- nomic and prudential policies. vestors shied away from reflationary policies and nationalization of financial institutions. Speculation was initially countered by a further tightening of capital Gradual Liberalization in France controls, which sharply increased differentials be- in the 1980s tween domestic and euro interest rates (Figure 4.4). Measures taken included steps to prevent evasion by In 1979, France joined the EMS while maintaining using leads and lags in current account transactions a relatively tight set of capital controls. In order to lift and prohibiting all forward transactions by importers France out of the recession that followed the second and exporters. Although the controls certainly suc- ceeded in dampening certain categories of short-term 37Banks had traditionally operated with interest rate spreads that were largely fixed, and therefore profitability was determined mainly by market share. Deregulation placed downward pressure 38Government involvement in the economy was extensive. This on interest rate margins while also leading to greater competition nationalization process added companies accounting for around between lenders for market share. Kanaya and Woo (2000) note 15 percent of industrial activity and raised government control of that banks reduced credit standards during the asset price boom in the banking sector to 85-90 percent (Barker, Britton, and Major, their attempts to continue lending. 1984).

©International Monetary Fund. Not for Redistribution IV EXPERIENCES WITH GRADUAL LIBERALIZATION

Also, commercial and financial activities of French Figure 4.4. France: Interest and Exchange industry and banks tended to be diverted to other Rates, 1980-95 centers (for example, financing divisions of French car manufacturers were set up in Switzerland). The ineffectiveness of controls increased rapidly as tech- nological innovation enhanced the possibilities for evasion by lowering the transaction costs of cross- border flows. A major reorientation of economic policies occurred in France in 1983, as the authorities accepted that it was not possible for economic policies to de- viate significantly from those in neighboring countries. A major reformulation of the financial and industrial strategy was supported by a move toward stability-oriented macroeconomic policies. Elements included an opening up of markets, encouraging ra- tionalization of French industry through increased Source: Thomson Financial. competition, and the gradual deregulation and liberalization of financial markets. The authorities considered preserving exchange rate stability vis-a-vis neighboring European countries, however, to be of speculative flows, they did not alleviate the downward paramount importance. Therefore, progress in liber- pressures on the exchange rate while the substantial alizing capital movements was made dependent on balance of payments financing need remained. Even the simultaneous strengthening of the EMS mecha- undertaking further tightening until 1983, including nisms, as well as on improved EC procedures to severely curtailing foreign travel allowances, proved bring about economic convergence. insufficient. The reorientation of France's economic strategy in On the basis of an analysis of capital account items, 1983 led to major changes in policy implementation. Davanne and Ewenczyk (1989) conclude that the con- This reorientation encompassed a major deregula- trols were effective to a certain extent in containing tion of the financial sector in stages, which eventu- speculative flows, provided there was no buildup of ally needed to be supplemented by the liberalization French franc assets by nonresidents (which could then of capital controls. The disinflation process, accom- be converted to other currencies without contravening panied by an increase in real interest rates, influ- the exchange control regime). Nonetheless, controls enced the functioning of the French financial mar- did not provide protection when external imbalances kets. The treasury could finance its budget deficit in were large. Outflows continued both through the cur- a nonmonetary way and the commercial banks could rent and capital accounts, and were accommodated by issue bonds. A key role was played by a substantive double-digit rates of domestic credit growth as a re- reform of the public debt market, greatly enhancing sult of expansionary monetary policies aimed at stim- foreign interest in the French capital market. The fi- ulating the French economy. Official interventions to nancial market reforms, in turn, enabled the Banque cover the net financing gap and support the exchange de France to abolish the quantitative credit control rate resulted in a visible depletion of official reserves, mechanism (1985), as well as to reform the money which, in turn, further eroded financial market confi- market. In France, there was thus a well-thought-out dence. In the face of continued macroeconomic im- sequencing in which deregulation of the financial balance, controls were not only ineffective but also sector, restoration of positive real interest rates, and began to impose real economic costs. more market-oriented ways of maintaining monetary The economic costs of controls included the burden control were implemented while capital controls of the bureaucratic procedures, particularly for com- were still being used. When the French macroeco- mercial banks and enterprises that were active in the nomic situation strengthened—the current account international capital markets. Moreover, the system moved to equilibrium in 1984—and the financial invited evasion, as strategic enterprises obtained dero- sector was considered able to withstand foreign gations from the existing control system, leading to competition, capital controls were gradually with- competitive distortions relative to other enterprises.39 drawn. The authorities' declaration of their intention to do this was an important political signal.

39In contrast, the policy objective of the French authorities of In 1984-85, controls on direct investment were ensuring that strategic firms benefit from adequate financial con- gradually eased; first, intra-EEC investment flows, ditions had attracted additional foreign capital inflows. and then flows originating from or destined for

©International Monetary Fund. Not for Redistribution Gradual Liberalization in France in the 1980s non-EEC countries, were liberalized. The prior- adjusted. Nevertheless, the EMS crises demonstrated authorization requirements for direct foreign invest- that even if the fundamentals were more or less cor- ment were eliminated in early 1986. By that time, rect and exchange rate targets were supported by foreign travel allowances had also been eased consid- stability-oriented policies, the exchange rate could erably. In May 1986, after a last major general re- be forcefully tested by the markets. In particular, a alignment of EMS currencies in which the French willingness to increase interest rates and tighten franc was devalued by 6 percent vis-a-vis the monetary conditions to support official interventions deutsche mark, the devises-titres market, reintro- proved to be crucial. Eventually, the French franc duced in 1981, was abolished, and restrictions on for- joined the EMU on January 1, 1999 at the parity ward foreign exchange operations were eased. Very originally set in January 1987. shortly thereafter, the safeguard clause, which France had applied since 1968 with respect to the EEC liber- Evaluation alization obligations, was abolished. The liberalization process then gained considerable momentum: in The severe exchange crises from 1981 until 1983 the same year, bank lending in French francs to non- and general disillusionment regarding the effective- residents (largely prohibited since 1974) was par- ness of capital controls provided the political back- tially liberalized; and toward the end of the year, ad- drop for a turnaround in French policies. The primary ministrative control of import and export settlements goals of exchange control—maintenance of the ex- (the "domiciliation" regime) was abolished. Under ternal value of the currency and the preservation of that regime, the French commercial banks had been official exchange reserves—had not been realized. required to match trade and financial data, thus The tightening of restrictions had only provided avoiding evasion of the controls by taking advantage short-term relief and had undermined public confi- of leads and lags in current account transactions or by dence. In particular, the unpopular carnet de change, channeling flows through uncontrolled capital ac- which had resulted in a decrease in tourist expendi- count items. The regulations became extremely bur- tures abroad by 13 percent in 1983, was regarded as a densome and put the French banks at a disadvantage fairly drastic measure that shook public opinion.40 compared with banks in other countries. A large part of the success of the capital account Although in early January 1987, unrest in the for- liberalization process undertaken in France over six eign exchange markets led to a relatively limited re- years must be ascribed to the complementary alignment (the French franc was devalued by 3 per- process of domestic deregulation and macroeco- cent vis-a-vis the deutsche mark), the liberalization nomic stabilization. Great care was taken to efforts were not interrupted. In 1987, the remaining strengthen the domestic economy before liberalizing limits on tourist travel allowances were eliminated, the more volatile items in the capital account. A and from June 1988, domestic enterprises were per- basic reform of industrial policy was carried out: mitted to operate foreign currency accounts and to subsidies to inefficient firms were discontinued; freely borrow abroad. The considerably strengthened quantitative credit controls were abolished; and fi- credibility of the hard-currency policy, supported by nancial markets were deregulated. Macroeconomic the Basel/Nyborg operational procedures (described policies were aimed at decreasing inflation and in Section II), ensured that the exchange rate was restoring balance of payments equilibrium. This stabilized in the face of considerably increased capi- made it possible to actively pursue a hard-currency tal mobility. The last liberalizing steps were taken in policy that restored confidence in the financialmar - 1989, freeing bank lending in French francs to non- kets. In these circumstances, the removal of capital residents and allowing residents to open foreign ex- controls may actually have reduced intra-EMS exchange accounts (though initially only ECU (Euro- change rate tensions by increasing the substitutabil- pean currency unit)-denominated accounts were ity of assets denominated in French francs and allowed). On January 1, 1990, six months ahead of deutsche mark. Previously, portfolio shifts triggered schedule, all remaining exchange control regulations by expectations of an appreciation of the deutsche were abolished. The overall liberalization process mark vis-a-vis the U.S. dollar had invariably trig- took approximately six years, and this time it was gered intra-EMS tensions, since capital controls hin- not marred by backtracking, despite realignments dered flows into French franc assets.41 during 1986-87 and sizable increases in portfolio flows (Figure 4.5). Although the French franc came under severe 40See Galy (1988). downward pressure in the 1992-93 EMS crises, 41Grilli and Roubini argue, in an article included in Conti and Hamaui (1993), that the removal of capital controls in Europe which led to decisive interest rate hikes, heavy inter- may have reduced asymmetric intra-EMS exchange rate re- ventions, and a broadening of the EMS fluctuation sponses to movements in the U.S. dollar rate by increasing asset margins, the central rate of the French franc was not substitutability.

Figure 4.5. France: Portfolio Flows, 1975-95 (Percent of GDP)

Source: IMF, International Financial Statistics (Washington), various issues.

Liberalization was initially made conditional on ence also illustrates the importance of ongoing struc- stronger monetary cooperation in Europe, particu- tural reform during the liberalization process (Box larly through a strengthening of the EMS. But pro- 4.1). In all three countries, external pressure (multi- gressively, the French authorities wished to liberal- lateral on France and Italy and bilateral, from the ize in France's own interest and to attune their United States, on Japan) played an important role in policies to those of the vast majority of larger indus- stimulating liberalization. trial countries. Although the exchange rate had to be Although a variety of sequencing approaches have devalued repeatedly under a tight exchange control been adopted by advanced countries making slow system, the period of gradual liberalization saw the transitions, allowing changes to be seen as part of a eventual restoration of exchange rate stability. When coherent, clear plan and reducing the incentives to capital flows were fully liberalized, periods of ex- delay progress appear to be helpful. The Japanese change rate tension occurred as financial markets experience indicates that attempts to shield the do- tested the determination of the authorities to main- mestic financial sector from the impact of liberaliza- tain exchange rate stability. These episodes were tion are unlikely to be successful and may actually countered by decisive action by the monetary au- increase the risk of ensuing problems. For France, thorities, however. All in all, the French experience the prospect of further European economic and mon- shows that full capital mobility can go hand in hand etary integration was a major factor in maintaining with exchange rate stability, provided the authorities confidence in the liberalization process. Neverthe- are prepared to adopt supporting policies. less, when there were doubts about the prospects of monetary integration (for example, after Denmark rejected the Maastricht Treaty and the United King- General Lessons dom and Italy withdrew from the EMS in 1992), the French franc came under severe downward pressure. The experiences of Japan and France in gradually Firm action, particularly the raising of domestic in- liberalizing capital controls show that deregulation terest rates, was needed to demonstrate the authori- in one area can create momentum for further change. ties' commitment to the exchange rate target. They also illustrate that a gradual process does not In European countries, net capital inflows followed necessarily eliminate the risk of financial crises or liberalization and deregulation when the reforms transition costs (including pressures in foreign ex- were perceived as signs of strength. While inflows change markets as participants test the determination may help maintain the momentum to lift capital con- of the authorities). These risks appear to be mini- trols on outflows, they may also diminish the disci- mized, however, when an integrated approach to re- plinary effect on macroeconomic policies. When the form is taken involving macroeconomic stabilization authorities are seen as backtracking on macroeco- and institutional strengthening. The Italian experi- nomic stabilization efforts, the liberalized environ-

Box 4.1. Gradual Liberalization in Italy

Although proposals for reform of Italy's extensive just ahead of the deadline of July 1, 1990 imposed by exchange control system were circulated from the be- the EEC directive. ginning of the 1980s, and parliament had been offered After the signing of the Maastricht Treaty and estab- draft laws designed to implement a positive control sys- lishment of the EMU, financial market participants tem, the precarious economic situation, characterized came to view the EMS as already having evolved into a by high inflation and a fragile balance of payments, quasi-monetary union in which the exchange rates no substantially delayed the reform. The traditional fear longer needed to be adjusted. The Italian lira had that lifting controls would lead to tax evasion (with traded at the upper end of the fluctuation margin since funds flowing especially to Switzerland) also played a 1990. This sentiment reversed abruptly when Denmark role, and Italy was one of the few industrial countries rejected the treaty in a June 1992 referendum. Markets that (from 1976) treated violations of exchange control took a fresh look at the EMU process and noted that regulations as criminal offenses. At the same time, the Italy was far from being in conformity with the Maas- need to ease restrictive domestic regulations and in- tricht criteria for joining the EMU. In particular, fiscal crease the efficiency of the domestic financial markets deficits remained high. Strong pressures developed, was urgently felt. Finally, the safeguard measures, and despite substantial interventions, the lira was de- under which derogation from EEC obligations had been valued on September 14, 1992. This devaluation, how- allowed since 1981, were lifted in 1987. ever, was followed by further attacks. On Black After the EEC liberalization directive of 1988 had Wednesday (September 16), the ERM memberships of been adopted, Italy introduced a positive system of the pound sterling and the lira were suspended. Appar- capital controls while maintaining restrictions on ently Italy, in a fundamentally weaker economic posi- short-term transactions. This change was viewed in tion than France, was not able to maintain exchange the financial markets as a sign of strength and led to rate stability in the face of full capital mobility. The substantial inflows, which were also attracted by the changed external circumstances, casting doubt on the country's high interest rate differential vis-a-vis Ger- ability of Italy to fulfill the Maastricht criteria for join- many. Temporary measures were taken to dampen in- ing the EMU, eventually exerted pressure on Italy to flows by reintroducing a reserve requirement on incre- tighten fiscal policy. The policy adjustments helped mental foreign exchange deposits to discourage stabilize the exchange rate, and the lira eventually reborrowing in foreign currencies. In an atmosphere of turned to the ERM with a central parity approximately much-improved confidence, all controls were lifted 20 percent lower than the previous parity.

merit allows any reversal of investor sentiment to be capital movements. When Germany and France had quickly translated into capital outflows. This may both agreed to fully liberalize capital movements and have been the case for countries such as Italy in the enact supporting legislation to that effect, a strong po- run-up to the 1992-93 EMS crisis. Large inflows litical incentive to follow suit was provided to other of capital, based on market perceptions of a quasi- countries that were initially reluctant to liberalize. monetary union, may have given the Italian authori- This suggests that pressure from regional or interna- ties a false sense of security regarding the need for tional organizations, such as the European Union or ongoing stabilization and reform efforts. Spain and the OECD, may be more effective once there is mo- Portugal were also severely hit by that crisis. mentum toward liberalization from a number of coun- In the European case, peer pressure has been an im- tries and when the number of similar countries that portant factor in encouraging countries to liberalize have liberalized exceeds some threshold.