Explaining Capital Account Liberalization in Latin America: A Transitional Cost Approach

In the past three decades governments around the world have lowered barriers to international capital flows. This movement is widely attributed to the forces of globalization, as developed nations moved toward relative convergence on international financial openness. Yet developing nations with much to gain from openness to foreign investment moved only hesitantly and inconsistently in this direction. Analysis of two decades of capital account liberalization in Latin America and the OECD reveals that nations in Latin America with weaker domestic financial sectors face higher risks of transitional dislocations following liberalization and move less aggressively toward openness. In the OECD, by contrast, financial weakness is associated with greater movements toward capital account opening, as transitional costs are lower and governments are better equipped to ameliorate them. Examination of the transitional costs of liberalization thus helps to explain how market pressures may impede, rather than promote, market-oriented reform in Latin America.