Capital Controls: Theory and Evidence

Abstract

This paper synthesizes recent advances in the theoretical and empirical literature on capital controls. We start by observing that international capital flows have both benefits and costs, but some of these are not internalized by individual actors and thus constitute externalities. The theoretical literature has identified pecuniary externalities and aggregate demand externalities that respectively contribute to financial instability and recessions. These externalities provide a natural rationale for countercyclical capital controls that lean against boom and bust cycles in international capital flows. The empirical literature has developed several measures of capital controls to capture different aspects of capital account openness. We evaluate the strengths and weaknesses of different measures and provide an overview of the empirical findings on the effectiveness of capital controls in addressing the externalities identified by the theory literature, that is, in reducing financial fragility and enhancing macroeconomic stability. We also discuss strategies to deal with the endogeneity of capital controls in such statistical exercises. We conclude by providing an overview of the historical and current debates on the role of capital controls in macroeconomic management and their relationship to the academic literature. (JEL D62, F32, F33, F38, F44)

Analysing sectoral capital flows

“…This may arise as policymakers may tighten capital controls in response to high capital inflows/outflows. This would lead to downward biases estimates and could lead to coefficients going in the opposite direction (capital controls leading to increasing flows) as well discussed in Erten et al (2019). This concern is addressed by following Ahnert et al (2020), Auerbach and Gorodnichenko (2013) and Furceri et al (2018)'s methodology to estimate seemingly "exogenous" policy shocks, thereby removing the potential for endogenous adjustments.…”

Sectoral capital flows: Covariates, co-movements, and controls

“…25 We first estimate Equation (3) using pooled OLS for the baseline results as the significance of capital controls might be dampened by the country fixed effects. 26 Next, we estimate Equation ( 3) controlling for potential endogeneity in capital controls regressions, well explained in Erten et al (2019). 27 To address this concern, we follow Ahnert et al (2020), Auerbach and Gorodnichenko (2013) and Furceri et al (2018) method of estimating seemingly "exogenous" policy shocks, thereby removing the potential for endogenous adjustments.…”

The “exorbitant privilege” and “exorbitant duty” of the United States in the international monetary system: implications for developing countries

“…The debate on financial globalization often juxtaposes the expected advantages and risks of capital flows (e.g. Akyüz, 2017;Erten et al, 2019;Gallagher, 2015;Ghosh et al, 2017). However, persistent capital flows also increase the size and alter the composition of the stocks of foreign assets and liabilities, and there is a lack of evidence on the pattern of associated income streams and valuation effects.…”