Santa Cruz Center for International Economics

This paper investigates the link between capital account openness and the output cost associated with a currency crisis. Although the Malaysian experience during the Asian crisis of 1997-98 made many researchers and policy makers interested in the effectiveness of a policy restricting cross-border financial transactions to minimize the output cost, this association has not been exposed to a thorough empirical investigation. The probit analysis in this paper shows that the higher the level of financial openness is, the less likely countries are to experience a currency crisis among industrialized and less developed countries. It is found that a higher level of financial openness prior to a crisis helps to reduce output losses for industrialized countries, but not for less developed or emerging market countries. It is also shown that the duration of post-crisis output contraction can be shorter when an industrialized country has a high level of financial openness, but for the group of EMGs the duration of output contraction can be lengthened if a country has more open capital accounts. However, once the country encounters a currency crisis, the effect of capital account openness differs depending on the level of development. The post-crisis level of financial openness helps industrialized countries to reduce the magnitude of output losses while it increases post-crisis output losses for emerging market and less developed countries. A higher rate of financial liberalization is also found to be detrimental to less developed countries. When the dynamics of output gaps after a crisis are investigated, it is found that the negative effect of a higher level of capital account openness lasts for at least three years for emerging market countries. In general, I have found that institutional development such as corruption, law and order, and bureaucratic quality, rather than the level of openness in financial markets, is important in lowering the size of post-crisis output losses for the groups of less developed or emerging market countries. Only the group of IDCs appears to be able to reap the effect of capital account liberalization in terms of reducing the size of post-crisis output losses. Moreover, Mahathir’s type of capital restriction policy immediately after the breakout of a crisis does not appear to be effective.