ABSTRACT
This chapter expresses that capital markets should be substantially and progressively liberalized from the beginning rather than waiting until goods market liberalization is well advanced. Though capital controls' effects on aggregate investment are debatable, they likely cause avoidable and potentially serious misallocation of limited capital across competing projects. The chapter discusses how financial markets generate information that firms can use in setting hurdle rates to evaluate projects. Government restrictions on domestic residents' capital outflows undermine the credibility of promises of free repatriation of capital and accumulations for foreigners. The chapter also discusses how asset markets price securities in terms of risk and expected return. A good investment is one where the expected rate of return is greater than the rate of return required on risk grounds. Financial markets provide information needed for appropriate intertemporal resource allocation, by allowing the observer to infer which risk factors are priced and the size of the risk premia for these factors.
