Faculty of Economics and Business Administration Publications Database

Financial Liberalizations and Capital Flow Reversals: Optimal Policy for Short and Long Term Debt Management

Eicher, Theo S.
Turnovsky, Stephen J.
Volume: 52
Number: 4
Pages: 300 - 314
Year: 2001
Abstract: The recent crisis in Asia has focused economists'' interests on capital flows and their determinants. This paper examines three possible economic fundamentals that are likely to have contributed to the capital flow reversals. First, as in Eicher, Turnovsky and Walz (2000), financial market liberalizations alone turn out to be sufficient to generate capital flow reversals if the decentralization of the financial sector is not accompanied by the correct taxes. These taxes are shown to represent incentives for domestic capital accumulation and disincentives to excessive foreign borrowing. Second we extend the analysis to show that the term structure also matters for capital flow reversals. The share of debt held in long and short term assets, is shown to be a determinant of the optimal tax during financial liberalization. The greater the share of international debt held in short term assets, the greater the optimal tax on foreign borrowing and the greater the subsidies to domestic capital accumulation, to reduce the international debt exposure and minimize the effects of a crisis. The crisis itself is aggravated by exchange rate movements, as shown in the extension of the model, which proves to be consistent with the data presented in the paper.