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THE GLOBAL CAPITAL MARKET: Market Failures and the Policy Response 6

If more effective supervision proves impossible for a country, then there is a second-best case for limiting foreign capital inflows through taxes on capital imports, foreign deposit requirements, or similar measures. The possible moral hazard problem raised by fixed exchange rates suggests an argument for exchange-rate flexibility (Mishkin, 1996). By purposely leaving some scope for unexpected exchange rate movements and avoiding implicit exchange-rate guarantees, the authorities can induce domestic borrowers to internalize at least some of the costs of failing to hedge appropriately. Other steps that would reduce the scope for crises would be more foreign equity ownership in developing countries, and particularly ownership of developing-country financial institutions, coupled with greater representation in financial sectors of foreign-based intermediaries. These developments would have the side-benefit of reducing the perceived chance of government bailouts.

While private financial mismanagement and inadequate supervision bear much of the blame for recent developing-country capital-market crises, one should not conclude that international capital movements are necessarily stabilizing in the absence of underlying vulnerabilities. Calvo and Mendoza (1997) show that when international investors can allocate their wealth over many risky foreign investments and face a fixed cost of information about each country, it may pay for individuals to diversify widely without bothering to become informed. In this situation, capital flows can be volatile and subject to herding effects. Any mechanism for providing low-cost information to markets — for example, credible data on official foreign reserves, the maturity of foreign borrowing, and the quality of domestic investments — is a public good in this kind of model. In line with that conclusion, the IMF has been pressing countries to accelerate and broaden their disclosure of key economic data (although it is hard to verify the data that are disclosed, and harder still to believe that a government in difficulty would release damning figures). I conclude by taking up the Fund’s other major initiatives on capital markets, which have placed the organization at center stage as an advocate of open financial markets and as an international lender of last resort.