openness might be linked to income growth via the domestic financial system. In this
view, lifting capital account restrictions promotes faster development of the domestic
financial intermediation leading to a greater volume of credit being available to
finance profitable projects as well as higher efficiency in the allocation of resources8.
The central message of this literature is that financial openness positively correlates
with per-capita income (and with the rate of economic growth). Hence, the
implication is that if a country maintains capital account restrictions and limits the
degree of international integration of its financial markets, then it will experience a
widening gap in per-capita income relative to a partner which is more financially
open. That is, for a given level of financial openness of the partner country, the
income gap between the partner country and the domestic country will be greater the
lower the degree of financial openness of the domestic country.
However, this prediction does not go unchallenged. Several models emphasise
possible counter-effects of financial openness on income which might, in turn,
complicate the relationship between financial openness and income catching-up. If
domestic institutions are weak, increasing financial openness will lead to a capital
flight (even if the country is capital-scarce). This will hamper investment and hence
long term growth prospects. Similarly, since the capital account is a channel of
contagion in financial crises, its liberalization will make the country more vulnerable
to speculative attacks, sudden stops and capital reversal, which are in turn all likely to
have large negative output effects. Finally, informational asymmetries and/or pre-
existing distortions (such as trade restrictions) might well imply that foreign capitals
will be allocated inefficiently, for instance going to sectors where the country has a
comparative disadvantage9. All of these counter-arguments thus point to the
possibility that an increase in financial openness might in fact have perverse effects
on the income gap of the domestic country relative to richer partners.
8 Bailliu (2000) proposes a simple formalization of several links between financial openness and
growth within an AK setting. Bekaert and Lundbland (2001) and Henry (2003) discuss the effect of
financial openness on the cost of capital. Obstfeld (1994) shows that financial openness, when resulting
in capital market integration, supports risk-taking. Bartolini and Drazen (1997) examine the argument
that capital account liberalization can work as a signal.
9 See Boyd and Smith (1992) for a critics of the perverse effects of financial openness when domestic
institutions are inefficient. A sceptical view of capital account liberalization based on various
arguments is put forward by Rodrik (1998). The empirical literature also provides mixed evidence on
the growth-effects of financial liberalization. For a broad assessment see Eichengreen (2001).