March 1, 2005
Eva de Francisco
In the late 1980s and the early 1990s, many nations began implementing a wave of economic reforms. Among those reforms was capital-account liberalization. As a result, international financial markets are substantially more active today than 20 years ago, although there are still many countries with various sorts of capital controls. Economic theory predicts that a complete opening of all financial markets should be welfare-improving; intertemporal consumption smoothing, consumption insurance, and better allocation of investment across countries would presumably all contribute their share to this. However, it is not clear what effect partial liberalization (liberalization in the presence of other frictions that cannot be eliminated) would have. In this case Pareto improvements are not guaranteed and, at the very least, some groups may lose from liberalization while others gain. A complete account of the actual experience from past liberalizations is yet to be made; see, for example, the survey of empirical research by Das and Mohapatra (2003). The purpose of this paper, however, is theoretical, studying the effects of capital-account liberalization in conjunction with a particular friction: limited participation in the stock market. In other words, this paper studies whether the fact that some nationals do not have access to stock markets could limit the benefits of international liberalization, whether in size or in the differential impact across groups in society.