Question

Under what circumstances Financial Liberalization can be beneficial for an economy?

Answer 1

Financial Liberalization of countries in emerging markets provides new opportunities for investors to increase their diversification and profit. Economic liberalization refers to a country "opening up" to the rest of the world with regards to trade, regulations, taxation and other areas that generally affect business in the country.1

As a general rule, you can determine to what degree a country is liberalized economically by how easy it is to invest and do business in the country. All developed (first world) countries have already gone through this liberalization process, whereas emerging countries need to undergo a series of changes.

· Removing Barriers to International Investing

Investing in emerging market countries can sometimes be an impossible task if the country you're investing in has several barriers to entry. These barriers can include tax laws, foreign investment restrictions, legal issues, and accounting regulations, all of which make it difficult or impossible to gain access to the country.

The economic liberalization process begins by relaxing these barriers and relinquishing some control over the direction of the economy to the private sector. This often involves some form of deregulation and privatization of companies.

· Unrestricted Flow of Capital

The primary goals of economic liberalization are the free flow of capital between nations and the efficient allocation of resources and competitive advantages. This is usually done by reducing protectionist policies such as tariffs, trade laws, and other trade barriers.2

One of the main effects of this increased flow of capital into the country is it makes it cheaper for companies to access capital from investors. A lower cost of capital allows companies to undertake profitable projects they may not have been able to with a higher cost of capital pre-liberalization, leading to higher growth rates.

· Stock Market Performance

In general, when a country becomes liberalized, stock market values also rise.3 Fund managers and investors are always on the lookout for new opportunities for profit. The situation is similar in nature to the anticipation and flow of money into an initial public offering (IPO).

A private company previously unavailable to investors that suddenly becomes available typically causes a similar valuation and cash flow pattern. However, like an IPO, the initial enthusiasm also eventually dies down and returns become more normal and more in line with fundamentals.

· Political Risks Reduced

Liberalization reduces the political risk to investors. For the government to continue to attract more foreign investment, areas beyond the ones mentioned earlier have to be strengthened as well. These are areas that support and foster a willingness to do business in the country, such as a strong legal foundation to settle disputes, fair and enforceable contract laws, property laws, and others that allow businesses and investors to operate with confidence.

As such, government bureaucracy is a common target to be streamlined and improved in the liberalization process. All these changes together lower the political risk for investors, and this lower level of risk is also part of the reason the stock market in the liberalized country rises once the barriers are gone.

· Diversification for Investors

Investors can benefit by being able to invest a portion of their portfolio into a diversifying asset class. In general, the correlation between developed countries such as the United States and undeveloped or emerging countries is relatively low. Although the overall risk of the emerging country by itself may be higher than average, adding a low correlation asset to your portfolio can reduce your portfolio's overall risk profile.

However, a distinction should be made that although the correlation may be low, when a country becomes liberalized, the correlation may actually rise over time. A high degree of integration can also lead to increased contagion risk, which is the risk that crises occurring in different countries cause crises in the domestic country.

This is exactly what happened in the financial crisis that started in 2008-2009. Weaker countries within the EU (such as Greece) began to develop severe financial problems that

quickly spread to other EU members.5

In this instance, investing in several different EU member countries would not have provided much of a diversification benefit as the high level of economic integration among the EU members had increased correlations and contagion risks for the investor.

· The Bottom Line

Economic liberalization is generally thought of as a beneficial and desirable process for emerging and developing countries. The underlying goal is to have unrestricted capital flowing into and out of the country to boost growth and efficiencies within the home country. The effects following liberalization are what should interest investors as they can provide new opportunities for diversification and profit.