Capital Account Liberalization and Financial Stability: An Application of the Finite Distributed Lag Model

Abstract

The recurrence of financial crises in recent years has sparked renewed interest in the controversy over the implications of financial openness for the stability of the financial system. This article examines the relationship between capital account liberalization and financial stability in 31 sub-Saharan African countries for the period 1996-2015. Firstly, the study uses the Exchange Market Pressure Index (EMP) as the indicator of the degree of financial risk. Then, to determine the timing and the nature of the effect of capital account liberalization on financial stability, a finite distributed lag model is used. The estimation of long-term structural coefficients is obtained by the Fully Modified Ordinary Least Squares (FMOLS) method in panel data. The results show that liberalization of the capital account negatively affects financial stability after two years in sub-Saharan African countries. These results suggest that sub-Saharan African countries should standardize their strategies for liberalizing capital accounts and engage reforms to promote long-term capital flows that are more stable and improve the macroeconomic and institutional environment.