Capital market liberalization entails stripping away the regulations intended to control the flow of hot money in and out of the country-short term loans and contracts that are usually no more than bets on the exchange rate movements. This speculative money cannot be used to build factories or create jobs-companies don't make long-term investments using money that can be pulled out on a moments notice-and indeed, the risk that such hot money brings with it makes long-term investments in a developing country even less attractive. The adverse effects on growth are even greater. To manage the risks associated with these volatile capital flows, countries are routinely advised to set aside their reserves an amount equal to their short-term foreign-denominated loans.
To see what this implies, assume that a firm in a small developing country accepts a short-term loan for $100 million loan from an American bank, paying 18 percent interest. Prudential policy on the part of the country would require that it would ass $100 million to it's reserves. Typically reserves are hel in U.S. Treasury bills, which today pay around four percent. In effect, the country is simultaneously borrowing from the United States at 18 percent and lending to the United States at four percent. The country as a whole has no more resources available for investing. American banks may make a tidy profit and the United States as a whole gains $14 million a year in intrest. But it is hard to see how this allows the developing country to grow faster. Put this way, it clearly makes no sense. There is a further problem: a mismatch of incentives. With capital market liberalization, it is firms in a country's private sector that et to decide whether to borrow short-term funds from the American banks, but it is the government that must accomodate itself, adding to it's reserves if it wishes to maintain its prudential standing.