I am wondering What are some of the important steps that a country
should take before it liberalizes its capital account?  What types of
capital controls have been least costly (and most effective) for the
countries that imposed them?

Hi - thanks for the question.  
There are many important steps that a country must take before and
during capital account liberalization. Most economists agree that
liberalization can only succeed (if at all) when there is a reasonably
strong financial system in place and a strong political will. There
are some capital controls that have been empirically beneficial when
making this transition. Taiwan and Chile are two oft cited models. I
have outlined some excerpts on the important steps and empirically
successful capital controls below. The information is taken from a
Taiwanese economics organization and an excellent paper from the
National Bureau of Economic Research.
 
 
Steps to take before capital liberalization 
 
Taiwan is a good model for liberalization. Here are some of the steps
that were taken in Taiwan prior to full liberalization to facilitate a
smooth transition:
 
Adoption of a flexible exchange rate 
"Following the establishment of the Taipei foreign exchange market in
February 1979, a flexible exchange rate system was formally
implemented which allowed the exchange rate to be basically determined
by the market. However, the Central Bank intervenes when necessary to
counter disorderly conditions in the exchange market." Previously the
rate was pegged to the U.S. dollar.
Taipei.Org 
http://www.taipei.org/current/crisis4.htm 
 
Banking controls 
 
"In order to guard authorized banks against excessive exposure to
exchange rate risk, the Central Bank previously set ceilings for each
authorized bank's overbought and oversold positions in accordance with
the volume of its foreign exchange transactions." The ceiling has
since been lifted for authorized banks.
http://www.taipei.org/current/crisis4.htm 
 
Controls on forward foreign exchange transactions  
"In order to help reduce the foreign exchange rate risk, the Central
Bank began to deal in forward transactions with exporters and
importers through authorized banks in March 1972; and later, in May
1984, the forward foreign exchange market was established." These
controls have since been opened.
http://www.taipei.org/current/crisis4.htm 
 
Domestic financial deregulation 
"domestic financial deregulation should be implemented prior to
opening the financial sector to competition from foreign financial
institutions and the relaxation of foreign exchange controls."
"in July 1987, when all foreign exchange controls on trade-related
current account transactions were removed, the Central Bank further
stepped up relaxation of capital account transactions."
http://www.taipei.org/current/crisis4.htm 
 
 
Are capital controls necessary? 
 
"The first line of defense is prudential risk management of risks on
the part of banks and other financial institutions. This, in turn,
should be backstopped by domestic regulatory supervision that sets
limits on exposures, concentrated lending and so on. Only when the
first two lines of defense are inadequate should capital controls be
considered. Even then, it must be recognized that not all controls are
created equal, with some more market friendly (e.g. Chilean controls)
than others (e.g. Malaysian controls)."
National Bureau of Economic Research 
"Capital Controls and Crisis Management" John McHale, Harvard
University
The presentations were given by: Jagdish Bhagwati (Columbia
University) by videotape, Paul Krugman (MIT and NBER), Michael Dooley
(Federal Reserve System and NBER), Jeffery Frankel (Council of
Economic Advisors and NBER), Barry Eichengreen (UC, Berkeley and NBER)
and Michael Mussa (International Monetary Fund and NBER), Felipe
Larrain (Harvard University); Carmen Reinhart (University of
Maryland).
http://www.nber.org/crisis/capital_report.html?tools=printit 
 
 
"controls are hard to implement and enforce, they disrupt normal
trading relations, and they may impair confidence for a long time to
come."
http://www.nber.org/crisis/capital_report.html?tools=printit 
 
What Types of Capital Controls Are Effective? 
 
"there is the aim of discouraging the volume of inflows. These do seem
to be effective, if only because of their signalling effect to foreign
investors."
http://www.nber.org/crisis/capital_report.html?tools=printit 
 
"there is the aim of changing the composition of inflows. Frankel
reported evidence that short-term flows do increase the probability of
a crisis, so that restricting flows at the short end them could make
an economy less crisis prone."
http://www.nber.org/crisis/capital_report.html?tools=printit 
 
"Chile, a country that actually liberalized outflows during the 1990s
while simultaneously increasing controls on inflows. Somewhat
surprisingly, the liberalization of outflows led to larger net
inflows--a finding that is consistent with a number of other
episodes."
http://www.nber.org/crisis/capital_report.html?tools=printit 
 
"Chile has reduced its non-renumerated deposit requirement to zero to
attract inflows during the current difficult period, but the
instrument remains in place for future use. Reinhart's emphasized
that, given Paul Krugman's description of how little scope there was
for engaging in counter-cyclical policy by other means,
counter-cyclical controls on inflows could be a valuable instrument."
http://www.nber.org/crisis/capital_report.html?tools=printit 
 
 
Additional Links 
 
"Capital Account Liberalization and Poverty:  
Exploring the Linkages" 
Bretton Woods Project 
http://www.brettonwoodsproject.org/topic/financial/f23calwashington.htm
 
International Monetary Fund 
www.imf.org 
 
Destroy IMF 
www.destroyimf.org 
 
Jubilee (debt relief organization) 
www.jubilee.org 
 
 
Google Search Terms 
 
liberalized capital account 
://www.google.com/search?hl=en&lr=&ie=UTF8&oe=UTF8&q=liberalized+capital+account&spell=1

Try http://www.rbi.org.in/index.dll/21?OpenSection?fromdate=06/26/00&todate=06/26/00&s1secid=1001&s2secid=1001
for India's position. If you are starting from a state of capital
controls, then this is more relevant than advice to Malaysia and
others not to impose controls. It is important to first reduce
government deficits, move government borrowing to the market, and
introduce local trading in the bond markets first. You need a yield
curve that reflects multiple traders' opinions.

The East Asian freeing was done without thought to all this. India was
not affected by the contagion because it was controlled. It is a very
good idea to plan to get rid of controls, but the pre-requisites are
important if you want to avoid a big bang. However, even after big
bangs, a country can recover -- as Indonesia did. Indonesia also
managed to get rid of a dictator in the process, so there are some
positives in the big bang version. The problem is that the social cost
will be borne by the poor and middle class, so its better to use an
evolutionary approach.

I also consider it very important to have a thriving domestic marker,
and open foreign direct investment much earlier than the capital
account. That way there are many reasons why foreignors should want
the local currency, and it will get inherent strength from that. My
book addresses how to get out of an export-driven rut into a thriving
domestic economy. It is on Amazon and is called "Zen and the Art of
Funk Capitalism".