The experience of some developing countries such as Mexico, Argentina and Turkey in the present decade has been a source of much concern. The question whether financial markets are dynamically stable in a context of deregulation and absence of capital controls has received particular attention. This paper investigates the linkages between domestic financial markets and the capital account regime in the case of developing countries. It first analyses some stylized facts which constitute 'anomalies' from the analytical perspective of the liberalization approach, but that are relevant to the explanation of the disequilibria and the instability in the interaction between the financial system and the capital account. Examples of such anomalies are the fall in national savings and mounting current-account deficits following the reform, financial crises and speculative attacks. The a simple analytical framework is developed, to show that the high level of uncertainty created by macroeconomic volatility and institutional flaws is the main cause of financial disintermediation and fragility. The issue of "dollarization" of the financial system is also analysed. We conclude that finance matters to development because of significant imperfections in the structure of financial markets in developing countries. The main implication for policy-making is that the objective should be to create markets which do not yet exist, and to strengthen existing ones. Therefore, it must be recognized that financial liberalization and the lifting of capital-account controls will foster financial deepening only to the extent that they contribute to removing uncertainty and to improving the institutional infrastructure. We argue that to ensure stability, some degree or market "friendly" financial repression might be necessary in the short run, even ii free financial markets are the ultimate objective. Capital controls to restrain capital inflows and to check the expansion of consumption credit during the boom which tends to follow the first stages of financial liberalization are two important examples.
