6 - Financial integration and capital formation, foreign debt and the real exchange rate

Summary

A further question to be addressed is the effect of financial integration on macroeconomic structure, particularly on domestic capital formation, the current account and the real exchange rate. This question is topical because the policy debate in a number of east Asian economies, including Korea (Dornbusch and Park 1994; Kim 1994); Park 1994), Malaysia, Taiwan and Thailand (Nijathaworn and Dejthamrong 1994) is concerned that the nominal and real exchange rate will appreciate and hence international competitiveness be eroded when the capital account is fully liberalised. Should this factor be a concern for policy?

A view from the literature

The traditional Mundell–Fleming model neither links financial flows to the formation of capital (Makin 1994: 63) nor explores the evolution of the real exchange rate in the process of financial opening, and so is not a useful device with which to analyse the effects of liberalisation on economic structure. Surprisingly, these matters have received little attention so far in dynamic, intertemporal optimising models. The predictions from two-period, two-country and two-good models are generally straightforward. Van Wijnbergen (1990) argues that the elimination of capital controls reduces the current interest rate and so is equivalent to reducing a tax on current consumption. He predicts that it boosts demand for the home good and induces a real appreciation in the current period, but reduces demand for the home good and induces a real depreciation in the next period. Edwards (1989) reaches similar conclusions.