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. 22 ©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 in- ward 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. 23 ©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,