The fear of globalizing capital markets

Abstract

It is generally accepted that free flow of goods benefits both economies without serious risks. The situation with the free flow of capital is different. Many policy makers and economists are skeptical not only about the benefits of free flow of capital, but also see uncontrolled capital flows as risky and destabilizing. Other economists, however, firmly believe that free capital flows will lead to a more efficient allocation of resources and greater economic growth. Nevertheless, the debate has little empirical evidence to rely on. We hope to fill that gap in this paper. We study the benefits and risks associated with capital flows by examining the experience of emerging economies around the time that foreign investment in stock markets was allowed. We investigate the impact of capital flows on stock returns, stock market efficiency, inflation, and exchange rates. We also examine the effect on different kinds of volatility that might arise as a consequence of capital flows: volatility of stock returns, volatility of inflation rates, and volatility of exchange rates. We find no evidence of an increase in inflation or an appreciation of exchange rates. Stock returns reflect a lower cost of capital after liberalization. There is no increase in stock market volatility and the volatility of inflation and exchange rates actually decreases. Stock markets become more efficient as determined by testing the random walk hypothesis.