When Don’t Developing Countries Benefit from Capital Account Liberalization? The Role of Labor Market Institutions

Many developing countries do not seem to benefit from capital account liberalizations. We find that labor market frictions can be an important reason for this and develop a model to explain the relationship between unemployment and capital account openness. In our model, a developing country with a flexible labor market tends to attract more capital inflow after capital account liberalization and hence, employment and output go up. On the other hand, when a developing country has a rigid labor market, opening the capital account leads to greater capital outflow and both employment and output fall. Such a pattern becomes less obvious in advanced economies. Using cross-country data from 1980 to 2004, we provide empirical evidence to support the theoretical predictions. When calibrating our model to Peru, which has a rigid labor market and opened its capital account in the 1990s, we find that 40% of the increase in the unemployment rate in Peru in that period is due to the capital account liberalization. One policy insight from our analysis is that for developing countries labor market reforms and capital account liberalization are complements