Capital controls, capital flows, and banking crises

Abstract

Capital controls have been adopted by emerging economies to change the volume and the composition of capital flows and to protect the economy from sudden stops. The effectiveness measured by empirical studies has remained inconclusive, due to the limitation of the available data. This paper adopts a theoretical model to examine whether capital controls could achieve these goals effectively. Consequently, this paper finds that capital controls on outflows and inflows may not achieve the goals on changing the volume and the composition of capital flows and on protecting the economy from banking crises and sudden stops. To be more specific, controls on capital outflows and inflows could change the volume of capital flows at the time when the controls are imposed. However, the ability of capital controls on changing composition of capital flows and to protect the country from banking crises and sudden stops is limited, regardless of symmetric or asymmetric controls across countries. It is concluded that capital controls may not be the way to protect the economy from sudden stops. It is overcoming the liquidity problems and offering affordable rates, rather than competitive rates, that are crucial to protect the economy from crises and sudden stops.