1.1 Background of the Study

Capital controls were widely used to prevent the free flow of funds between countries until the late 1970s. A cautious relaxation of such controls during the 1980s proved consistent with greater economic integration among advanced countries and strengthened the case for capital market opening more generally. By the early 1990s, capital controls appeared to be finished as a serious policy tool for relatively open economies. The conventional view about international financial integration is that it should enable capital to flow from high income countries, with relatively high capital labor ratios, to low income countries with lower capital labor ratios. If investment in poor countries is constrained by the low level of domestic saving, access to foreign capital should boost their growth and it would also allow residents of richer countries to get higher returns on their savings invested abroad. Openness to capital flows can expose a country’s financial sector to competition, spur improvements in domestic corporate governance as foreign investors demand the same standards locally that they are used to at home, and impose discipline on macroeconomic policies and the government more generally. So, even if foreign capital is not needed for financing, financial openness, to both inflows and outflows, may create ‘collateral benefits’ such as domestic financial sector development which could enhance growth in total factor productivity[1]. Capital account liberalization in financially repressed economies often leads to a period of rapid capital inflows followed by financial crises with international financial integration and policy agenda for further liberalization of capital inflows. Concern has also been expressed as to whether the costs of increased vulnerability to financial fragility might not outweigh the gains from financial integration. But most of the countries continue to progress in dismantling capital controls to integrate their financial markets with the rest of the world.

1.2 Justification and Relevance of the Study

Economic growth is thought to be a function of investment and other factors. The conventional belief is that foreign capital inflows bring new investible funds and foreign exchange with which the recipient country can achieve higher rates of investment and therefore growth. The role of foreign capital in economic growth is an issue that has provoked continuous debate. Foreign capital augments the total resource availability in a country, but its impact on investment and economic growth is controversial. If judiciously used, it could have favorable effects on economic growth through higher investment and other positive effects. But it is also possible that foreign capital investment might not yield any net benefit to the host country. Economic liberalization and globalization have resulted in rapid mobility of resources between nations as to reap the comparative advantage of the respective country. The 1990s saw a number of capital account crises in emerging market economies. The crises, which were precipitated by a sudden reversal of capital inflows, occurred against the background of financial market deregulation, capital account liberalization, and financial sector opening.