Rationale

Alongside trade and payments liberalization, the rapid integration of financial markets in the 1990s has hastened the process of globalization in international trade and finance. Total capital flows to the developing world soared to US$ 303 billion in 1996 from US$ 237 billion in the previous year—thanks to a sharp rise in private flows to a record US$ 234 billion (up from US$ 160 billion in 1995). And nowhere was this phenomenon of increased access to international capital markets been more notable than in the rapidly growing economies of East Asia. In Sri Lanka, foreign capital inflows to bolster investment and, hence, the rate of growth is regarded as imperative in the context of a low rate of savings in the country. As Sri Lanka endeavours to achieve a higher rate of growth, the East Asian development experience is often regarded as a model to emulate. However, if Sri Lanka is to imitate the East Asian model and succeed, then policy makers must critically examine the underlying causal factors that combined to produce the East Asian financial crisis.

Objectives

Is a free and open capital account desirable in the light of the East Asian experience? Do policymakers have the necessary manoeuverability and the flexibility to fine-tune economic policy to deal with the macroeconomic consequences of large and sustained capital inflows? And, even if Sri Lanka were to adopt an open capital account regime, would it necessarily lead to an increase in foreign capital inflows? And if so, what type of inflows are we likely to see? Or are we more likely to experience an outflow of capital?

This paper examines the underlying causal factors that combined to produce the East Asian financial crisis and attempts to draw useful lessons for Sri Lanka. The paper discusses the changing trends in foreign capital flows in the 1990s that underlay the emergence of instability in capital movements across borders, and the measures open to governments to deal with a surge in foreign capital flows. It also looks in some detail at the financial crises that gripped East Asia during 1997-98, paying particular attention on the role of the financial sector. The paper also examines Sri Lanka’s past experience in dealing with a surge in capital inflows.