1.

I n t r o d u c t i o n :

Capital account convertibility (CAC) means freedom to convert currency in terms of both

outflows and inflows for capital transactions at market-determined exchange rates. Simply,

CAC means that it allows anyone to convert local currency into foreign currency or vice versa

without any controls or restrictions. However, international movement of capital is not

always free. Controls are used by the countries to insulate the economy from erratic flows of

capital, which can lead to financial instability.

Liberalization in capital transactions is considered as an integral part of the overall liberalization

process in developing countries. External private capital is a very important source of funds

of investing in the developing economies. Fisher (1997) asserts that financial integration and

free capital mobility facilitate a more efficient global allocation of savings and help to channel

resources into the most productive uses, and therefore, increasing economic growth and welfare.

However, during the last three decades, a number of countries have opened-up their economies

for being integrated with world by loosening financial regulations to ensure capital movement

freely. While, number of countries have been much benefited by utilizing and managing the

flow of foreign capital successfully for their growth and development; on the other hand,

some countries had to face a severe financial crises due not to manage the flow of capital

efficiently. Experiences from both sides have put remarkable lessons for the countries like

Bangladesh.

Bangladesh has already been undertaken some measures in liberalizing capital flows together

with other reforms. Since 1990s, Bangladesh embarked on a path of stepped up reforms

for financial sector development and increasing openness with the global trade and

financial flows towards spurring investment and output growth. Adopting market based

1|Page
 interest rate system, significant trade and tariff liberalization, of IMF Article VIII

obligation for full convertibility of Taka for current external transactions, and adopting

market based exchange rate are the mentionable measures.

External capital account transactions have also been liberalized gradually to attract foreign

direct investment (FDI) and foreign portfolio investment (FPI) inflows. Bangladesh

permits full foreign ownership in enterprises. Foreign investors are free to invest in any

sector except the few reserve sectors. They are also allowed to buy and sell government

bonds, and shares and debentures through capital market activities.

The amount received from the sales of equity, profits, disinvestment proceeds and capital

gains on FDI and FPI are freely repatriable abroad. In addition, to the liberalization move

towards CAC, short-term borrowings from abroad by local corporate bodies have also been

allowed. However, restriction still remains on outward investment by Bangladeshi investors.

Given the importance of huge investment need to become an upper middle-income country

by 2030, greater inflows of foreign capital is imperative. Considering the need of capital

inflows for its growth path, it is likely that Bangladesh will be entering into greater liberalized

regime in future. However, before that some measures should be adopted, such as:

i) formation of a technical committee to prepare a road map for CAC regime,

ii) cutting down the budget deficits for fiscal consolidation,

iii) strengthening prudential banking regulations and standard of supervision,

iv) implementation of inflation targeting framework, and

v) widening the multi-financial intermediation process. It is imperative that CAC would

certainly benefit us and therefore, considering the above measures, Bangladesh

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 should move towards CAC regime gradually to achieve resilience and protect

vulnerability emanating from full CAC.

2. Major issues which the paper seeks to address:

Over the last two decades, many countries h a v e liberalized t h e i r capital accounts.

Industrial countries adopted capital convertibility almost universally in the 970s and 1980s,

building on a process of international economic integration that was already well advanced

in the area of trade in goods and services. The trend was facilitated by the Code of

Liberalization of Capital Movements of the Organization f o r Economic Cooperation and

Development (OECD), which was introduced in a limited way in 1961 and later extended

in stages to encompass the full range of capital account transactions by 1989. The adoption

in 1988 by the European Union (EU) of the Second Directive on Liberalization of capital

movements was also instrumental. Many developing countries have lifted controls on capital

movements, most relatively recently. A major among them retain such controls dejures

bur de facto the controls are less prevalent. The group maintaining controls may be

expected over time to seek the benefits of full of integration into global markets through

more open capital accounts, although the transition to a liberalized capital account raises

important issues, as discussed below.

2.1 Transition to an Open Capital Account

Moving to capital account convertibility requires careful consideration of the following:

(I) Whether a set of preconditions should be established before the capital account is

liberalized and how liberalization measures should be sequenced; (2) whether, in

view of the integration and development of international financial markets,

restrictions on capital flows can be effectively enforced; and (3) whether

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 difficulties might arise in the conduct of macroeconomic policies following

liberalization, and what they might be.

(II) In addition, separate issues arise when considering whether under particular

circumstances t he temporary re-imposition of controls, especially on capital

inflows, can be appropriate.

2.2 Preconditions and Sequencing

As described in Sections III and IV. recent experience tends to support the view that the

freeing of capital account transactions should be undertaken subsequent to. or at

broadly simultaneously with certain o t h e r reforms. The m o s t important among these

are domestic financial m a r k e t strengthened capacity to adapt fiscal policy to keep

resource pressures from arising when private demands mount. The centerpiece of

financial sector reform would be to ensure that interest rates arc competitive, thus

reducing pressures on the balance of payments and the exchange rate. "Strengthening

prudential r e g u l a t i o n s a n d requirements is also key to successful capital account

liberalization: when there is generous government deposit insurance, or when there. is

a presumption that large banks will not be permitted to fail, there may be incentives

for banks to take on excessive risk, and capital account liberalization could open up

further high-risk opportunities for depository institutions.

The type of exchange rate regime appears not to be a critical factor in successfully moving

to capital account convertibility. Notwithstanding a trend to- ward more flexible exchange

arrangements in developing countries.'' Experience to date shows that countries have

liberalized their capital accounts in the context of both flexible and fixed-rate regimes,

including currency board arrangements. What would appear to be paramount is, if necessary

4|Page
 initial adjustment of the exchange rate to a realistic level lowed by the pursuit of an

appropriate policy that avoids abrupt adjustment in either interest rates or exchange rates. In

particular, as noted above, fiscal policy should be sufficiently adaptable to sustainable

macroeconomic stability, most, but not all, countries liberalizing the capital account did so

in the context of a comprehensive stabilization package.

On issues of speed and sequencing of capital account liberalization in relation to other

reforms. clear-cut lessons arc difficult to draw. Liberalization in industrial countries tended

to follow the gradual and phased approach to economic reform suggested by the literature,

with capital account liberalization typically following relatively broad trade and

domestic financial reforms. Moreover. experience in the late 1970s and early 1980s,

especially in the Southern Cone countries, underlined the dangers of moving too rapidly

in opening the capital account without supporting policies. More recently, a number of

countries have successfully implemented complete reform packages over a relatively

short time. It could be argued that an advantage of early removal of capital controls would

be to limit the ability of vested interests adversely affected by the reforms to marshal

political resistance to those re- forms. Such an approach may also promote efficiency

in the domestic financial sector by injecting competition for funds, improve global

intermediation of resources from savers to investors, and allow enterprises and individuals

to diversify activities and portfolios abroad. However, rapid liberalization may leave little

lime for the adoption of complementary policies, including development of well-functioning

financial instruments and prudential arrangements. Several of the countries that have

liberalized rapidly experienced problems in the financial sector: In most cases, these

difficulties reflected underlying weak- nesses that were unrelated to the liberalization,

although in some cases the reforms may have exacerbated the existing problems. In the

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 context of a strong overall balance of pay-ments position, the authorities may wish to

minimize exchange rate or monetary pressures that could arise from foreign capital inflows

by liberalizing capital outflows before inflows. There could also be a desire to limit short-

term inflows that may be regarded as potentially re-destabilizing but to liberalize long-

term inflows, such as inward direct investment. That may be viewed as being more stable

and productive may, however, be difficult to achieve such fine-tuning, except temporarily;

liberalization of one component of the capital account may create pressures for deregulation

of all capital transactions; moreover. There is some evidence that long-term capital flows

are not necessarily more stable than flows through instruments with nominally short

maturities.

2.3 Effectiveness of Control Mechanisms

An important issue in the transition to an open capital account is whether the capital

regulations can be enforced to the extent that they play a significant role. There is by now

considerable evidence particularly with regard to controls on capital out flows, that suggests

only limited effectiveness. Notwithstanding the differentials created by capital controls

between domestic and international interest rates, the evidence accumulated now points to

the general inefficacy of such controls in maintaining an unsustainable exchange rate. In

situations where exchange rate pressures result from capital flight induced by poor policies,

there are considerable incentives to circumvent regulations through alternative

mechanisms. Thereby diminishing the effectiveness of controls. It has been argued that

measures to deter capital inflows have been more effective than those on out- flows, because

of the differing circumstances under which the two types of flows emerge as well as because

of the choice of alternatives available in each case. Recent experience suggests that.

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 Although controls or taxes on inflows should not be viewed as substitute for fundamental

policy measures. Especially in the area of fiscal policy, they might serve as temporary

supplementary tools that could provide policymakers with some additional times to react.

However, the experience relates yet to a relatively small and recent set of countries with

surges in inflows. Because quantitative restrictions on inflows are clearly less desirable than

those that retain an element of market incentives, in some countries a price-based approach

has been pursued to supplement more fundamental policy adjustments.

2.4 Constraints on Macroeconomic Policies

An open capital account places a particular premium on appropriate macroeconomic

policies. The risk of large capital reversals requires that monetary policy be managed so

that interest rates and exchange rates are broadly consistent with underlying fundamentals

and market conditions. Under fixed exchange rate arrangements, large movements in

interest rates may be required to stern outflows in situations where markets question the

sustainability of the exchange rate, possibly posing a conflict between domestic and

external objectives or policy. Similarly, sharp and costly movements in ex- change rates

could result if monetary policy is out of line with market expectations where the exchange

rate is managed flexibly.

Considerable discipline is accordingly also required of fiscal policy so as not to overburden

monetary policy. In recent years several developing countries that have liberalized their

capital accounts, many from a position of capital outflows, have experienced sizable

net capital inflows. While generally a welcome development, flows that are large relative

to the size of t h e economy can complicate macroeconomic management as well as the

7|Page
 task of ensuring that excessive risk taking does not undermine the health of the financial

s ys t e m . The nature of these macroeconomic a n d financial sector risks was detailed i n

a recent IMF p u b l i c a t i o n . The risks stem from the difficulties in containing

monetary and credit expansion in the context of large inflows, with potentially adverse

implications f o r inflation, the real exchange rate, and the external current account. The

threat of sudden reversal further underscores t h e need for careful adjustment t o such

inflows. Adjustment in fiscal policy is a key response that may dampen in- flows through

its effects on interest rates. In most countries, however, it is difficult to use fiscal policy

as a short-run response, and it may also exacerbate the problem of unsustainable inflows

if confidence in economic policy grows strongly.

3. Review of past and recent scenario, international comparison:

In the year 1990, capital accounts were, on average, partly repressed in all regions with the

exception of East Asia, where the capital accounts were already largely liberalized by then.

During the 1990s, all regions showed some liberalization, but the extent differed. The

following table shows the degree of Capital Account Liberalization of some selected

countries in 1990 and 2003.

Table 1. Degree of capital account liberalization in 1990 and 2003

Egypt PR L

Turkey LL LL

South Asia

Bangladesh PR PR

India PR LL

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 Pakistan PR LL
19 20
Sri-Lanka PR PR
Latin America 90 03
East Asia
Argentina PR LL
China R PR
Brazil PR LL
Hong Kong L L
Chili LL LL
Indonesia LL LL
Mexico LL LL
Korea PR LL
Peru PR L
Malaysia LL LL
Sub Saharan Africa
Singapore L L
Kenya LL LL
Thailand LL LL
Morocco PR LL

Nigeria PR LL

Uganda LL L

North Africa & Middle East

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 Note: Here PR: Partly repressed, R: Repressed, LL: Largely liberalized, L: Liberalized.

Source: IMF annual report on exchange arrangements and exchange restrictions, 1991 and 2003

According to IMF scores (which, of course, should be treated with caution), Latin America

went the furthest towards full capital account convertibility. Sub-Saharan Africa and North

Africa & Middle-East also undertook major liberalization steps. The smallest change was

observed in South Asia, a region that in 2003 was still classified as partly repressed. East Asia,

while already fairly liberalized by the early 1990s, undertook modest additional

liberalization.

3.1 Latin American Countries

In Latin America, Chile, Mexico and Venezuela were already largely liberalized at the

beginning of the 1990s, but that contrasted strongly with all other countries, which were partly

repressed, with Argentina and Peru being the most heavily repressed. This reflected the

historical tradition of closed capital accounts and the debt crisis of the 1980s.

a) Argentina: Argentina adopted capital account liberalization strategy in 1991. It liberalized

its capital account quite rapidly and intensively. In 1991, the adoption of the

convertibility plan created a currency board. This adoption of currency board was followed

by a marked increase in capital inflows in 1991-94. Foreign direct investment and

portfolio inflows reached 11% of GDP in 1993, compared with less than 1% in 1990.

Argentina’s access to capital market was substantially curtailed in early

10 | P a g e
 1995 and there was a large outflow of short-term capital. During the first half of 1995 the

central bank lost about one-third of its international reserves. The policy response to these

developments did not include an imposition of capital controls. Instead the authorities

adjusted macroeconomic policies including a marked tightening of fiscal policy

under an IMF program adopted in March 1995. By the end of August 1995, more than

half of the deposit outflows had been revised; and by December 1996 deposits had reached

their precise level.

b) Peru: Like Argentina, Peru adopted deep and fast liberalization of the capital account, from

an initial position of very restrictive controls. The exchange rate was unified and a free-

floating regime adopted, FDI received equivalent treatment to domestic investment, capital

could be freely repatriated, non-residents could acquire domestic securities, and residents

and non-residents could open foreign-currency denominated accounts, although with high

reserve requirements against such accounts (Ariyoshi et al., 2000).

c) Chile: Chile (which had already largely liberalized by 1990) has been a paradigmatic case

in the use of restrictions to reduce the volume of capital inflows and to influence their

composition. In the early 1990s, the country experienced excessive capital inflows. To

avoid excessive currency appreciation and other undesirable macroeconomic imbalances,

in June 1991 the country's authorities adopted an unremunerated reserve requirement

(URR) to reduce the volume of capital inflows and change their composition towards

flows with longer maturity. This created a simple, non-discretionary and prudential

mechanism, which penalized short-term foreign currency liabilities more heavily.

11 | P a g e
 3.2 East Asian Countries

East Asian countries experienced extensive liberalization in the 1990s. However, the standard

deviation in the region – IMF indicator of the degree of heterogeneity, or dispersion – both

for 1990 and 2001 is the largest among all regions. This means that the regional average

conceals sharp differences among the countries of the region. Four types of countries can be

found in East Asia.

A. China: During 1994-97, China’s international reserves increased sharply from 5.8 to

11 months of import, owing to a strong balance of payments and maintained stable

exchange rate of the currency against U.S dollar. China accepted the obligations of the

IMF‟s Article VIII in December 1996. While China was able to maintain the stability

of the currency throughout the Asian crisis, capital outflows became an increasing

problem in late 1997 and early 1998, driven by concerns of a devaluation of the

renminbi, the falling differential between domestic and foreign interest rates, and

increasing circumvention. The current account remained in surplus and foreign direct

investment remained strong, but the capital account deteriorated sharply. As a result

overall balance of payments surplus fell sharply, from $36 billion in 1997 to $6 billion

in 1998. In response to these developments, the authorities significantly intensified

enforcement of exchange and capital controls and moved to reduce circumvention.

These measures involved enhanced screening of capital account transactions and

increased documentation and verification requirements on current transactions. The

12 | P a g e
 measures were implemented with a view to safeguard illegal capital outflows and

ultimately maintaining a stable exchange rate. These steps improved the BOP situation

of China. Now in China FDI allowed but volume above $1 million requires signing

contract with government. There are ceilings and minimum holding periods. Effective

from April 2001, all controls on outward FDI were abolished. Nonresident may

purchase local shares subject to a minimum holding period. Residents are also permitted

to purchase portfolio securities from abroad. Credit operations are controlled.

B. South Korea: Korea is the country that, started from an initial fairly restrictive

position, undertook the largest capital account liberalization during the decade to

reach a fairly open stance by 2001. The country started out gradually, with residents

being permitted to issue securities in abroad and foreigners being allowed to invest

directly in the Korean stock market (though limits existed on the latter). From 1993 until

1997, the process was accelerated with the lifting of barriers on short-term borrowing

to different sorts of domestic activities previously restricted, investment by non-

residents in public bonds, and permission to issue equity-linked bonds and non-

guaranteed bonds by small and medium-sized firms, and non-guaranteed long-term

bonds by large firms.

Some restrictions were maintained, however, particularly on some forms of capital

inflows, due to concerns about surge of capital inflows, caused by interest rate

differentials. These were mainly in the form of ceilings on foreign investment in

domestic equity securities and borrowing from abroad by non-banks. However, the

exceptions to these, which proved harmful, included the liberalization of trade related

13 | P a g e
 short-term financing to domestic firms and short-term foreign currency borrowing by

domestic banks (Shin and Wang, 1999).

C. Malaysia: Malaysia has been relatively open for years, and experienced a massive

surge of capital inflows in the early 1990s. Until then, the limits on capital inflows

consisted mainly of ceilings on foreign currency borrowing, beyond which approval was

required. To further limit such flows, especially short-term ones, in 1994 the authorities

prohibited the selling by residents to non-residents of money market securities, and

commercial banks were forbidden to engage in swap and forward contracts with non-

residents. Ceilings were imposed on banks‟ net foreign exchange open positions, and

reserve requirements were decreed for foreign currency liabilities of commercial banks.

Most of these controls were subsequently lifted, with only the prudential ones remaining

in place. The assessment of Ariyoshi et al. (2000) is that such controls were effective

both in reducing the volume and changing the maturity of flows. During 1997 and early

1998 Malaysia suffered massive capital outflows. In response to that, in September 1998

the country‟s authorities adopted a number of restrictions on capital outflows. These

included: prohibition of using domestic currency in trade payments and offshore

trading, prohibition of credit facilities between residents and non-residents, and

repatriation of non-resident portfolio capital, which was blocked for 12 months

(Ariyoshi et al. 2000). Controls were later relaxed and then totally eliminated. Residents

are now permitted to obtain financial credit facilities in foreign currency up to the

equivalent of RM 5 million. But investment abroad exceeding RM 10000 in any form

requires approval.

14 | P a g e
 D. Thailand: Thailand’s liberalization w a s the most aggressive during the 1990s,

Particularly in the early 1990s with the creation of the Bangkok International Banking

Facility (BIBF), which through tax privileges greatly encouraged external flows,

especially short-term ones (Johnston et al., 1997). Outflow of capital exceeding $10

million a year required approval. Foreign capital may be brought into the country

without restriction. Because of rapid capital account liberalization, Thai baht came

under severe speculative pressure in May 1995. Therefore, in 1995, restrictions were

imposed to reduce the volume of (mainly short-term) capital inflows, which became

excessive in the first half of the 1990s. These restrictions included a 7 percent reserve

requirement on non-resident accounts with a maturity of less than one year and on short-

term borrowing of finance companies; limits for open short and long foreign currency

positions (with lower limits for short positions); and reporting requirements by banks

on risk control measures regarding foreign exchange and derivatives (Ariyoshi et al.,

2000). However, capital continued to flow in large amounts by taking different forms

(Siamwalla, Vajragupta and Vichyanond, 2003). In response to that, in1996 the reserve

requirements were extended to short-term borrowing by commercial and BIBF banks.

According to Ariyoshi et al. (2000), such controls on capital inflows succeeded in

reducing the volume of inflows, lengthening their maturity, reducing the short-term debt

to total debt ratio, and reducing the growth of non-resident baht accounts. However,

these developments were not sufficient to avoid the reversal of capital flows the country

experienced in 1997. Now in Thailand non-residents are allowed to purchase portfolio

capital locally, but purchase or issue abroad requires approval. Same rule apply for

money market instruments. Authorized banks are allowed to grant loans up to $10

15 | P a g e
 million.

E. Indonesia: Indonesia greatly encouraged capital flows, especially FDI, from the start

of the decade. Bank lending to the domestic corporate sector also became prominent

in the 1990s. In the mid-1990s, there was an effort to prioritize FDI over other types

of flows, with ceilings on foreign lending being used as an instrument, but with poor

effectiveness (Gottschalk and Griffith-Jones, 2003). Finally, Hong Kong and Singapore

are among the few developing countries with almost totally liberalized capital accounts

as early as 1990. Both countries remained open, though a few restrictions are in

place. For example, in Hong Kong, the disclosure and position limits on derivative

products are required, in addition to prudential limits on open foreign exchange

positions and on certain forms of capital outflows. In the case of Singapore, there

are upper limits for foreign lending from residents to non-residents in Singapore dollars,

and an obligation for non-residents to convert proceeds in Singapore dollars into foreign

currency. These measures are aimed at discouraging the international use of the

domestic currency. Also, there are certain prudential limits and restrictions on capital

outflows.

3.3 South Asian Countries

South Asian countries have adopted a cautious approach to capital account liberalization.

Liberalization of capital account transaction should be undertaken from a relatively strong

balance of payments position. As the balance of payment position of south Asian countries

are not so good, so they have taken cautious approach to capital account liberalization.

16 | P a g e
 A. India: Since the external crisis of 1991, India has undertaken economic reforms,

including partial capital account liberalization, to begin reversing several decades of

inward-looking and interventionist policies. FDI was liberalized first in India.

Portfolio equity flows were selectively liberalized during the 1990s, and the

liberalization of external borrowing was very limited. The country relied extensively

on quantitative and other controls. These included overall quantitative ceilings,

approvals on a case-by-case basis, different degrees of restrictions according to the

maturity of foreign liabilities, and end-use restrictions. Strong limits were imposed on

short-term debt. In June 1997 – thus just before the East Asian crisis broke out – the

Tarapore Committee recommended a timetable for further capital account

liberalization in India (Reserve Bank of India, 2000). The proposed liberalization

included both capital inflows and outflows; liberalization was to be progressive, in three

phases, over three years. However, these liberalization steps were conditional on the

country meeting certain pre-conditions. By 2001, India‟s capital account was still only

partially liberalized, with strong restrictions remaining in place, particularly on capital

outflows by residents. Apparently due to this more cautious approach, and to its high

level of foreign reserves, the country managed to escape the financial crises of the 1990s

and even to avoid contagion effects during the East Asian crisis. With the reorientation

of capital account policy toward non-debt-creating inflows and foreign direct

investment external indebtedness has declined markedly. However, there are indications

that India‟s wide-ranging capital and other economic controls may have reduced

17 | P a g e
 economic growth compared with other Asian economies with a more open economic

system.

B. Pakistan: Alongside India, Pakistan is the other South Asian country that pursued

significant liberalization steps during the 1990s. In fact, it went further than India, with

most types of capital inflow liberalized. Most of the remaining restrictions are on

capital outflows by residents, though lately some initial steps have been taken to

liberalize outflows.

C. Sri Lanka: Although having undertaken some liberalization steps, the capital account

in Sri Lanka remains quite repressed. These two countries have maintained capital

restrictions in the form of outright prohibitions (for example in the case of money

market instruments and derivatives) and central bank approval (for example for

long-term borrowing). Capital outflows by residents are still strongly restricted.

3.4 Sub Saharan Africa

A. Kenya: Kenya was another fast liberalizing country in the region. In a context of

shortage of foreign reserves and large fiscal deficit, in 1991 the country embarked on

a program of reforms that included rapid current and capital account liberalization.

The Capital Account liberalization included permission to hold foreign currency

certificates of deposit, which could be traded by residents and non-residents, used for

any foreign exchange transaction, and reclaimed at the Central Bank at face value. In

addition, some companies could hold foreign currency denominated bank accounts

abroad and domestically (Ayiroshyi et al, 2000). In 1994, the domestic currency became

18 | P a g e
 fully convertible, and in 1995 most of the remaining controls on foreign exchange

transactions were removed (including access by foreigners to shares and government

securities). Among the few exceptions, foreigners could hold portfolio equities up to

5% individually and 40% in aggregate. The overall result of capital account

liberalization in Kenya in the context of broader reforms was macroeconomic volatility

and increased capital flight (Ayiroshyi et al., 2000). As of June 1995, all industrial

countries had eliminated exchange controls on both capital inflows and outflows.

This follows the unique period in the history o f international financial relations after

the Second World War in which most countries maintained substantial restrictions

on capital movements in attempts to fend off destabilizing external financial

influences and to retain national savings for use in domestic reconstruction and

development. Canada, Switzerland, and the United States maintained a liberal

environment for most types of capital movement throughout the period, although

there were temporary exceptions. The evolution of capital account liberalization in

other industrial countries was relatively slow in t he early stages and did not gain

full momentum until the late 19805. Germany made an early start in 1958, when

it removed all controls on capital outflows. It continued to maintain tight controls

on capital inflows because balance of payments surpluses engendered pressures

toward an appreciation of the deursche mark and threatened its exchange rate parity

under the Bretton Woods sys- tem. Controls on inflows were removed in 1969 but

were subsequently reintroduced on two occasions before being removed again in

1981. Although the floating of exchange rates following the breakdown of the Bretton

Woods system in the early 1970s provided a degree of freedom to national monetary

19 | P a g e
 policies, this action did not by itself cause industrial countries 10 liberalize capital

controls immediately. The shift was instead largely infl uenced by the increasingly

g l o b a l nature o f financial markets and the changing political attitudes toward

controls on financial and capital markets. The controls were also removed in part as

a response to the pressure from corporations in the home countries to permit financing

of expansion of their production facilities abroad and from domestic banks

facing cornpeuuon from international financial markets. The development of

multinational corporations and international banks, in particular, increased the

opportunities for evasion of restrictions imposed by home governments and also for

exit from the home market. As the globalization p r o c e e d e d and the sophistication

of market techniques that sidestepped controls (e.g .•swaps) progressed, governments

increasingly recognized the ineffectiveness of the remaining controls and their costs

in terms of preventing domestic agents from participating fully in international

acriviries. The process of liberalization accelerated in the 1980s and early 1990s

throughout the group of industrial countries. A significant shift toward complete

liberalization was initiated with the rapid removal of capital controls by the United

Kingdom (1979) and the completion of liberalization by Japan (1980). Next came

the quick removal of all c apital controls by Australia (1983) and New Zealand

(1984) and extensive liberalizations by European countries. In the context of the

EU, where capital account liberalization was viewed as another step in the

eventual monetary integration of the area. a number of countries completed a first

round of decontrols: Netherlands (1986), Denmark (1988), France (1989), Belgium,

Ireland, Italy, and Luxembourg (1990). Several members of the European Free

20 | P a g e
 Trade Association (EFTA)-Sweden (1989). Austria, Finland, and Norway (1990)-

followed suit. The final set of liberalizations took place in those EU members for

whom more distant deadlines had been set; thus, Portugal and Spain liberalized on

January I, 1993 and Greece on July 1,1994. On January 1,1995. Iceland became the

last industrial country to adopt full capital convertibility.

4 Policies and programs to meet the challenges faced by Bangladesh:

Though it is difficult to assess the quantum and magnitude of capital flight for a country like

Bangladesh, the maintenance of low inflation and prudent financial sector management,

including institutional reforms, are necessary to combat the economic crimes that generated

huge illegal incomes, whether from the willful default of bank loans, corruption in tax

administration, leakage in public development expenditure, or illegal financial deals in the

running of state-owned enterprises.

The following policy measures may be considered as part of reform processes of the on-going

financial sector-strengthening project:

The existing tax laws may be changed. Tax holiday in investment declared by the government

should be curtailed. The rate of income tax and VAT should be reduced.

The tax officials should be honest with high moral integrity.

There should be provisions for heavy penalties, including jail sentence, for tax evasion by large

entrepreneurs, industries and corporations.

21 | P a g e
Good governance system should be established at every stage of administration. Administrative

and political transparency should be ensured. At the time of appointment the statement of wealth

and assets of the ministers, members of the Parliament, and others should be made public and on

the expiry of their assignment the final statement will need to be made for comparing the

activities of those people before and after their assignment.

The banking activities, which are involved in transaction of foreign currency, should be brought

under active surveillance of the central bank. Bank loan defaulters should not be allowed to

participate in the elections and issued passport to go outside the country. Bank loan defaulters

should be given 5-10 years of rigorous imprisonment through summary trial. The competent

authority should publish the list of the loan defaulters on a periodic basis in the national dailies.

The hidden wealth of the corrupt should be uncovered and invested in the industrial sectors.

Effective measures should be taken against corruption in both private and public sectors. An

independent enquiry commission like CBA of India should be established.

The scope of leakage in indenting commission should be checked.

Proper national policy should be adopted to stop the smuggling. The overall action of the law

enforcing agencies should be properly monitored. Strict maintenance of law and order situation

should be ensured.

Practical steps should be taken to increase the real interest rate, reduce large fiscal deficit, and

adjust the exchange rate of the currency at least to the neighboring country's level for reversing

capital flight from the country. For ensuring a stable macroeconomic environment in the country,

policies should be adopted to make exchange rate stable, keep the fiscal deficit at a tolerable

limit, and allow the interest rate to be determined by market forces.

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The government should pursue austerity measures at all levels of current purchase and

consumption to avoid unnecessary expenditure.

Developed with the availability of risk free instruments, which will induce domestic as well as

Along with the modernization of financial and capital markets, a bond market should be foreign

investors to invest their capital through diversifying their portfolio investment in the country.

To combat the money laundering activities through the financial channel, the Anti-Money

Laundering Department (AMLD) was established in the Bangladesh Bank in 2002. Some success

has already been achieved. To make this Department fully active and operative, the anti-money

laundering measures adopted should be strengthened in line with other countries’ experiences in

restraining the capital flight. Co-ordination among the Bangladesh Bank, commercial banks, non-

bank financial institutions, the Anti Corruption Commission, and law enforcement agencies is

very much crucial. A central data warehouse may also be set up in the Bangladesh Bank with all

information regarding money laundering and capital flight.

Necessary steps should be taken to amend the Bangladesh Bank's "Guidelines for Foreign

Exchange Transactions"i, to ease the present capital control measures, to raise the long run

economic efficiency, and to attract the domestic as well as foreign direct investment. Government

may actively consider gradual movement toward capital account convertibility. In this regard, a

timetable for convertibility may be fixed on suitability basis and necessary institutional and

financial reforms may be resumed.

Government should establish mechanisms of transparency and accountability in its decision

making process with regard to foreign borrowing and the management of borrowed funds. Since

in the absence of debt cancellation or repudiation, the burden of debt repayment ultimately lies

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with the population of the country, it is appropriate to provide full information to the public as

well as to the creditors, and to ensure public representation in the management of public debt.

This process will ensure greater accountability on the part of both borrowers and creditors and

prevent repeated cycles and inappropriate use of external borrowing and capital flight.

Specific Policy Suggestions for the Central Bank:

In order to combat the capital flight, the following policies may be considered by the central

bank:

1) Sound financial sector is an essential precondition in addition to strong macroeconomic

fundamentals for liberalization of capital account transactions. Bangladesh may embark

upon gradual shifting to capital account convertibility, which may have a positive impact

to arrest capital flight to some extent.

2) The effective operation of monetary policy by means of indirect instruments in a country

like Bangladesh requires a reasonably efficient payments system and transmission of

interest rate effects.

3) Adequate regulation and supervision are necessary for guiding the banking system to

work in a more efficient way. In this regard, Bangladesh Bank may consider transferring

banking surveillance or supervision responsibilities and functions to a separate and

independent agency to ensure transparency and uphold public confidence, keeping the

core monetary policy responsibility in the central bank itself.

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 4) Bangladesh Bank may also actively consider influencing the illegal foreign exchange

market or kerb market by purchasing huge amount of foreign exchange, thereby

downsizing the transactions in the Kerb market.

Recommendations:

For the strategies to harmonize the liberalization of external sector and financial system and

keeping in mind the present economic performance of Bangladesh, the following issues may

be considered:

1) There is no alternative way for Bangladesh but to open up the trade and financial

Sector. Therefore, before liberalizing the country must prepare her for the associated

opportunities and risks of openness. The authority should cross-examined, thoroughly,

the liberalization issues before taking further steps.

2) In moving towards capital account convertibility financial sector vulnerability is probably

the most serious concern for Bangladesh. Some prudential measures have been adopted

in recent days; however, only strict execution and application of the adopted policies

would provide accepted result.

3) Bangladesh’s tiny stock market and government bond market need a big push for

effective monetary policy operation. Moreover, it is crucial to have cooperation from

fiscal authorities in adopting effective monetary policy.

4) Based on experiences of other countries, it is now widely accepted that external financial

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 liberalization should follow internal financial liberalization (Choudhury and Raihan,

1999) and Bangladesh is no exception to it.

5) The aim of internal liberalization of Bangladesh is to attain higher growth and

stability on its macro-economic factors. The already fragile banking sector should

need further attention regarding solvency and non-performing assets.

6) Steps must be taken to attract more foreign investment by responding appropriately with

regard to the weakness of financial institutions, inadequate infrastructure facilities,

corruption and red-tapism in the bureaucratic systems, inadequate legal system and

political unrest in the country.

7) At present Bangladesh needs the type of FDI that will have significant impact on

incremental exports in order to offset rising payment liabilities overtime and to pull up

foreign exchange reserves.

8) Macroeconomic conditions of the country need to be improved to safeguard the

economy from plunging in to instability. Sufficient foreign exchange reserve should be

ensured, fiscal deficit should be brought down to a reasonable level, lower rate of inflation

should be maintained and ensuring political stability are required with regard to the non

performing advances of banks. The contractionary policy, (very high level of statutory

reserve requirements to limit the credit) may not be a good option in the presence of a

number of problem banks in the economy. With regard to the recovery drive of the

defaulted loan the result is impressive, but the speed is slower. More emphasis should be

given with regard to the recovery of the defaulted loan and the screening procedure should

be strengthened to sanction new loans.

9) Some sort of control over the capital mobility is necessary to safeguard financial crisis.

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 In this regard the country could manage the asset, liability and duration management

accordingly.

10) Making Taka convertible on capital account transactions does not necessarily mean

full removal of restrictions on capital mobility. The country should have some control

over capital mobility to protect the crisis.

11) If the government in able to develop their policies and implement them properly then the

real investors will come to Bangladesh, with capital and technology, and then actual

financial development will take place that will lead to overall economic growth.

5. Conclusions:

Opening of the trade and financial sector is becoming a compelling reality for the developing

countries. Opening of external sector is necessary for the countries that wish to take benefit

of the open world economic system by raising investment and foster economic growth.

Empirical study (Klein and Olivie, 99) shows that opening of financial sector increases the

growth and financial depth of a country. Convertibility of Taka in current account is a

necessary step in this openness process.

New reform measures have already been taken to boost export and attract foreign investment.

Foreign investors in Bangladesh are already got a package of facilities including tax holiday,

profit remittance, EPZ and other facilities. This reform resulted in higher foreign investment

and international trade. But the growth of foreign investment is not significant yet comparing

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 to the neighboring countries.

Bangladesh Taka is already awarded IMF Status of Article VIII in 1994. This is one of the

major financial reform measures country has taken so far. It effected positively to the

international trade also. Deregulation of exchange rate determination is another significant

reform measure taken by Bangladesh. Now the market forces determine the exchange rate of

Taka. This step is vital for improving the foreign exchange market in Bangladesh, especially

when the country is lagged behind the terms of well functioning money and capital market.

By deregulating the exchange rate, the country moved further towards financial liberalization.

Balance of payment (BOP) situation is one of the vital factors regarding a country’s

involvement in international trade. The BOP of Bangladesh showed, generally, a deficit

tendency in its trade and current account balances. A relatively weaker BOP may create

financial crisis if the country opens up its capital account. The Asian crisis in 1996 also

suggests that countries with BOP problems suffered most at that time. Thus before opening

the capital account, Bangladesh first is required to improve its macroeconomic accounts

especially BOP position.

Now a day’s one country cannot open its trade sector without going for convertibility.

Convertibility is positively related with country’s international trade and the financial deepness

(Klein and Olivei, 1999). Therefore, Bangladesh has to integrate trade and financial

liberalization measures effectively and orderly to achieve benefits from it.

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 The overall economy of Bangladesh suggested that the country has to improve its

macro-economic accounts further in order to make Taka convertible on capital account

transactions. Today FDI has contributed significantly less to net resource flow to Bangladesh

than that of the most of the developing countries of Asia and there is still substantial scope

to improve the sustainability of external financing in Bangladesh. It is very important in the

context of Bangladesh as its capital market is underdeveloped. FDI provides far more than

just capital, it provides benefits in the form of managerial know how and modern technology.

Moreover, at the current economic condition in Bangladesh, higher growth rate can be

achieved by supplementing the countries lower domestic saving by foreign capital inflows.

FDI has typically proven to be least volatile item and a strong resilience of FDI reduces the

risk of contagion. Therefore, the country should aim at higher level of FDI in external

financing which is clearly very low in Bangladesh.

However, experience suggests that capital outflow has to be permitted to increase the net

inflows in the long run, because controls on outflows effectively reduce inflows also.

Moreover, high inflow of capital has not always proved to be a positive factor in the economic

growth. Its destabilizing side effects in the form of rise in inflation, adverse effect on the

competitiveness of the export industries must be minimized by effective stabilization policy

to get the positive contribution of higher level of inflows. Thus, relaxing control on capital

outflows (permitting local institutions to make investments aboard, allowing on domestic

entity to issue local currency bonds in domestic market etc.) would be necessary to stabilize

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 capital inflows in near future in Bangladesh. However, the most important point to be noted

that, only removal of restrictions from outflow of capital would rather make the situation

worse if supportive measures are not ensured. Steps must be taken with regard to the

weakness of financial institutions, inadequate infrastructural facilities, and corruption in the

bureaucratic system, inadequate legal system and political confrontation that are very

important factors for the confidence of foreign investors.

6. References:

 Pande, G. C. and D. M. Mithani. Encyclopedic Dictionary of Economics, Vol. II (c),

Annual Publications, New Delhi, India 1990, P-28.

 Mcleod, Darryl. Capital Flight, (Internet Source). (Darryl Mcleod is an economics

professor at Fordham University in NewYork, USA).

 Fitzgerald, Valpy and Alex Cobham. 'Capital Flight: Causes, Effects, Magnitude and

Implications’ for the DFID White Paper. Eliminating World Poverty Making

Globalisation Work for the Poor, 2000, DFID.

 Loungani, Prakash and Paolo Mauro. Capital Flight from Russia. IMF Policy Discussion

Paper, Research Department, PDP/00/6, June 2000 International Monetary Fund.

 Ariyoshi, A.et al. (2000). Capital Controls: Country Experiences with Their Use

and Liberalization. IMF Occasional Paper No. 190.

 Bangladesh Bureau of Statistics, Foreign Trade Statistics . Dhaka, 1994-95 to 1998-99.

 Bangladesh Bureau of Statistics. Statistical Yearbook of Bangladesh, Dhaka . 1991-

92 to 1999-2000.

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  Chaudhuri, B. K. (1988). Finance of Foreign Trade And Foreign Exchange

Himalaya Publishing House, Bombay.

 Choudhury, T. A. (2002). Reading Materials on International Finance (Compiled).

BIBM, Dhaka.

 Choudhury, T. A., & A. Raihan. June, (1999). Implications of WTO on the Banking

and Financial Sector in Bangladesh. Bank Parikrama, BIBM, Volume XVIV, No. 1.

 Choudhury, T. A., & Mahmudul A. Masud. (2002). Reading Materials on International

Trade And Finance (Compiled). BIBM, Dhaka, 2002.

 Choudhury, T. A. (1993). Convertibility of Currency: Conceptual Framework

and Requirements. A Paper Presented in a Workshop Organized by Independent

University, Dhaka.

 Choudhury, Toufic Ahmad, & Ananya Raihan. Globalization and Finance for

Development. Published in Bangladesh Facing the Challenges of Globalization: A

Review of Bangladesh‟s Development 2001, The Centre for Policy Dialogue and The

University Press Limited, Dhaka,2002.

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