Developing country governments have historically imposed controls on capital movements, the international activities of domestic financial institutions, and the entry of foreign ones. In the last decade, however, a growing number of developing countries have opened their financial systems by liberalizing capital flows and the rules governing the international operations of financial intermediaries; Table 1 provides a typology of these liberalization efforts. This chapter seeks to explain both the general trend toward what we call “financial internationalization” as well as variations in the pace and scope of these reform efforts across countries.

The rush to liberalize capital movements and open domestic financial systems to foreign competition is puzzling on several accounts. A growing economic literature on the sequencing of economic reforms has underlined a number of preconditions required to make capital account liberalization an optimal policy. There are well-documented cases of premature and ill-conceived liberalization efforts that had extremely high costs, including the Southern Cone experiments of the late 1970s in Chile, Argentina, and Uruguay and, more recently, Mexico (Bisat, Johnston and Sundarajan 1992; Corbo and de Melo 1985, 1987; Edwards 1984, 1995; McKinnon 1991). It is revealing that the advanced industrial states are only now completing the internationalization of their own financial markets (Goodman and Pauly 1993; Pauly 1988; Rosenbluth 1989).

Even if there were a strong economic case for the liberalization of capital flows, a number of political questions would remain.