Journal Issue

Economic Effects and Structural Determinants of Capital Controls

International Monetary Fund. Research Dept.
Published Date:
January 1995
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The turbulence on foreign exchange markets that led to the demise of the “hard EMS,” and the Mexican crisis of late 1994 and its contagion effects have once again sparked a debate on the opportunity to impose restrictions on international capital flows.1 The economics literature on foreign exchange restrictions is extensive, and has analyzed important issues such as the rationale for the imposition of capital controls, their implications for monetary and fiscal policy conduct, their effectiveness in segmenting domestic and foreign financial markets, and the optimal sequencing in a process of trade and financial liberalization. This paper examines capital controls from a long-term perspective, and analyzes theoretically and empirically their determinants and their economic effects. The novel element in the paper is the empirical investigation of the link between foreign exchange restrictions and economic, political, and institutional features of an economy in a wide sample of countries.2

On the determinants of capital controls, we investigate whether certain political and structural features of an economy affect the imposition or removal of capital controls. Since effective capital controls can have significant macroeconomic and distributional consequences, we believe this investigation is a logical starting point. For example, capital controls may allow a country to pursue an independent monetary policy for a given period of time. The government’s incentive to impose capital controls for this reason would then depend on the degree of control the government has over monetary policy, which is inversely related to the independence of the central bank. As for distributional considerations, capital controls may allow the government to tax capital more easily, provided they are effective in curtailing capital flight. With regard to the effects of foreign exchange restrictions, we investigate whether limitations on the degree of capital mobility, together with other economic, political, and institutional features, help explain the behavior of key macroeconomic variables, such as inflation, real interest rates, and growth. Our analysis is therefore part of the growing body of literature on endogenous macroeconomic policy formation that links economic policy choices to the various structural, institutional, and political features of an economy.3

The theoretical part of the paper discusses the rationale for introducing capital controls.4 The empirical part of the paper is based on a data panel of 61 developing and developed countries and extends a previous study (Alesina, Grilli, and Milesi-Ferretti (1994)) that focused solely on OECD countries. Although the data have many shortcomings, discussed in Section III, we identify several interesting empirical regularities. Overall, our results are consistent with the view that capital controls are a complement to financial repression measures that allow the government to extract seigniorage revenue more effectively and to reduce domestic debt service through lower real interest rates. We find that capital controls are more likely to be in place when income is low, the share of government in economic activity is large, the exchange rate is managed, and the government has a relatively free hand on monetary policy because the central bank is not very independent. As for the economic impact of capital controls, we find that restrictions on capital account transactions tend to be associated with higher inflation, a higher share of seigniorage revenue in total revenue, and lower interest rates. We do not find any significant impact of capital controls on economic growth, although there is evidence that countries with large black market premiums (correlated with foreign exchange restrictions) grow more slowly.

I. Why Capital Controls?5

A recent study by Mathieson and Rojas-Suarez (1993) provides a useful classification of the main rationales for imposing restrictions on capital account transactions:

  • Limiting volatile short-term capital flows (avoiding balance of payments crises, exchange rate volatility, etc.);

  • Retention of domestic savings;

  • Sustainability of stabilization and structural reform programs; and

  • Maintenance of the domestic tax base.

Before discussing these motivations, we should point out that their relevance depends on the government’s ability to impose effective capital controls. This ability has probably weakened over time, for two reasons. The first is the endogenous erosion of existing barriers, as agents find ways to circumvent official restrictions. The second has to do with structural change and technological progress in financial markets, which facilitate international capital movements and make them harder to monitor. The nature of our data makes it impossible to account for these factors; they should be taken into account, however, when weighing the arguments for or against financial liberalization. Indeed, empirical work suggests that the effective degree of capital mobility in developing countries may be quite high (Haque and Montiel (1991)).

Limiting Volatile Short-Term Capital Flows

Foreign exchange markets are very liquid and react very quickly to shocks. Because of factors such as price and wage rigidities and investment irreversibility, the real economy has a slower speed of adjustment. Authors such as Tobin (1978) and Dornbusch (1986) argue that this differential speed of adjustment, together with exogenous excess volatility in financial markets, may induce excess exchange rate volatility (overshooting, bubbles, etc.), with negative effects on real economic activity. Tobin proposed “throwing sand in the wheels” of short-run capital flows by imposing a uniform tax on all foreign exchange transactions, thereby discouraging very short-term capital flows, but with negligible effects on long-run ones.6Dornbusch (1986) suggests the adoption of measures such as dual exchange rate systems, which are able to shield, at least partially, the real economy from the vagaries of short-term financial market behavior. Tornell (1990) presents a model in which Tobin taxes can help increase real investment by reducing the volatility of returns on financial investment, resulting from rumors unrelated to economic fundamentals. Since real investment is assumed to be irreversible, it is discouraged by high volatility of returns.

With pegged exchange rates, unrestricted short-term capital flows may cause large variations in foreign exchange reserves, the collapse of the peg, or high interest rate variability. The turbulence experienced in late 1992 and in 1993 in countries belonging to the European Monetary System and in countries that unilaterally pegged their rate to the ECU or the deutsche mark, and the more recent developments in Mexico prove this point very effectively. According to their proponents, effective capital controls can at least mitigate these undesirable effects in the short run. Obviously crises can occur because fundamentals are out of line, as is the case when two macroeconomic policy objectives (say, domestic credit expansion and fixed exchange rates) are mutually inconsistent, as shown in the literature on speculative attacks and balance of payments crises.7 In the absence of capital controls, sustainability of an adjustable-peg mechanism requires large interest rate changes before realignments, to compensate asset holders for capital losses. This interest rate variability is particularly damaging in countries where the government has a large short-term public debt, or when longer-term debt instruments are indexed to short-term interest rates.8 In order to justify the imposition of controls, one would need to find arguments in support of the adoption of policy measures that are inconsistent with the exchange rate peg in the long run.

However, the possibility of self-fulfilling speculative attacks against a fixed exchange rate, not motivated by market fundamentals, would provide an additional justification for the imposition of capital controls: the exchange rate peg can collapse even when current fundamentals are consistent with the peg (Obstfeld (1986 and 1988)). This line of argument has been adopted recently by Eichengreen and Wyplosz (1993). Overall, the analysis suggests that governments with stronger credibility problems would be more likely targets of speculative attacks and would therefore be more likely to impose capital controls.9

Retention of Domestic Savings

If the private return from holding domestic instruments is below the social return, for example because of the existence of positive externalities from domestically invested capital, there is a rationale for limiting capital outflows and/or encouraging capital inflows. As observed by Mathieson and Rojas-Suarez (1993), however, restricting domestic residents’ ownership of foreign assets implies reduced portfolio diversification and increased vulnerability to domestic macroeconomic shocks.

A related argument is that a government may be willing to adopt measures that stimulate savings if savings are prevented from flowing abroad by low capital mobility or by capital controls. For example, a panel study of OECD countries by Jappelli and Pagano (1994) finds that savings are higher in countries with restrictions on household borrowing. To be effective in raising domestic savings, these restrictions also require the presence of capital controls (Pagano (1994)).

Finally, capital inflows, especially in the form of foreign direct investment, may be discouraged by countries that wish to limit foreign ownership of domestic factors of production, for political or ideological reasons.

Help for Stabilization and Structural Reform Programs

There is an extensive literature on the optimal sequencing of external sector liberalization. Authors such as Frenkel (1982), Edwards (1984, 1989), and van Wijnbergen (1990) have stressed the effects of liberalizing the capital account on the real exchange rate. In the context of an inflation stabilization plan accompanied by trade liberalization, an early opening of the capital account can cause a real appreciation, because of the high interest rates typically associated with a stabilization plan, and increased real exchange rate volatility. Both these effects would make trade liberalization more problematic.

The credibility of the stabilization plan plays a key role in determining the consequences of free capital mobility. Lack of credibility of the stabilization plan may cause capital flight and a balance of payments crisis, making the plan failure more likely. If the plan is credible, the high real interest rates typically associated with a stabilization program may cause temporary large capital inflows. If these inflows are sterilized, domestic interest rates would remain high, thereby encouraging further inflows, and the central bank would incur a quasi-fiscal cost, because the return on foreign exchange reserves would be below the return on assets denominated in domestic currency.10 If no sterilization occurs, the increase in the money supply could jeopardize the control of inflation. Finally, letting the nominal exchange rate appreciate may hamper a trade reform aiming at lower barriers to imports.11

The appropriate response to a surge in capital inflows cannot be determined without a close examination of the causes of the inflow, and may differ depending on the composition of inflows. Clearly, portfolio investment is more reversible than foreign direct investment. Indeed, proponents of foreign exchange restrictions tend to propose measures that hamper short-term flows, rather than long-term ones (see previous subsection). From a political economy point of view, one should consider the relation between political stability, government preferences, and credibility. Again, governments with lower initial credibility may be those with stronger incentives to introduce capital controls (see above). Overall, this motivation for the introduction of capital controls may be more applicable to developing countries.

Maintenance of the Domestic Tax Base and Distributional Issues

Restrictions on foreign currency holdings reduce the ability of domestic agents to avoid the inflation tax. The government can impose measures such as high reserve requirements that raise the demand for money and, therefore, the inflation tax base. As stressed by Drazen (1989), these measures can have negative long-run effects, because they may discourage capital accumulation by raising the interest rates that banks charge on loans.12 In order to maintain seigniorage revenue after the dismantling of barriers to trade and capital flows, Brock (1984) argues, the central bank can impose a reserve requirement on foreign capital inflows and a prior import deposit.

More generally, foreign exchange restrictions are often accompanied by various types of financial market restrictions, such as controls on interest rates, constraints on banks’ portfolios, and credit controls. These measures can be used by the government to reduce the cost of domestic borrowing. Giovannini and de Melo (1993) compare the domestic and foreign costs of borrowing for a sample of developing countries, and show that this source of revenue can be substantial. Even in the absence of financial repression, effective controls on capital outflows may allow the government to reduce the cost of financing its debt by lowering real interest rates. Aizenman and Guidotti (1994) present a second-best argument in favor of this policy choice when tax distortions are high and domestic debt is large.13

The links between financial development and economic performance, highlighted in the work of Goldsmith (1969) and McKinnon (1973), among others, have been recently re-examined by Roubini and Sala-i-Martin (1992 and 1995) and King and Levine (1993). These authors underline that an underdeveloped and repressed financial system allows the government to finance public expenditure more easily when the tax system is inefficient, but it may be an obstacle to growth.

Giovannini (1988) and Razin and Sadka (1991) argue that taxation of domestic capital can induce capital flight when it is difficult to tax foreign-source income, thus making a case for controls on capital outflows. According to Giovannini, the distortions introduced by capital controls may be less than those implied by the inability to tax foreign-source income. Razin and Sadka show that when taxing foreign-source income is impossible, it may be optimal to impose a restriction on capital exports in order to generate overinvestment domestically.

Alesina and Tabellini (1989) examine the distributional aspects of tax policy and capital controls when economic agents are heterogeneous. The authors view capital controls as a form of limiting holdings of foreign assets that are nontaxable. Individuals would accumulate foreign assets to avoid the risk of future domestic taxation. In their model, there are two social groups—“workers” and “capitalists”—and two parties that represent them. The workers’ source of income is labor (they cannot own domestic capital), while the capitalists’ income comes from capital holdings. Under reasonable assumptions about initial endowments and distribution it is shown that fear of a future workers’ government may induce capitalists to export capital. Among other things, the paper shows that once homogeneity between private agents is removed, distributional factors become important in the evaluation of foreign exchange restrictions.14Epstein and Schor (1992) use a Keynesian framework to argue that capital controls enhance monetary policy autonomy, and that an expansionary monetary policy in the presence of controls can raise employment and capacity utilization by reducing interest rates, thus favoring workers and damaging financial sector interests.

II. The Data on Capital Controls

The data on restrictions to international capital flows adopted in this study come from the International Monetary Fund’s Annual Report on Exchange Arrangements and Exchange Restrictions. The report has been issued since 1950, and provides a description of the exchange rate system and exchange rate restrictions in each IMF member country. Since the 1967 issue (covering 1966) the Report has also included a summary table specifying whether given forms of exchange arrangements and restrictions have been adopted by member countries. The data presented in this table were used to construct dummy variables, taking the value of one when a restriction was in place for a given year in a given country, and zero otherwise.

This study focuses on three forms of exchange restrictions. The first is “restrictions on payments for capital transactions.” This restriction refers exclusively to resident-owned funds. The second restriction is “separate exchange rate(s) for some or all capital transactions and/or some or all invisibles.” This restriction mainly reflects multiple currency practices, as well as the use of a unitary rate for transactions with a certain group of countries and another, different, unitary rate for transactions with other countries. Both these restrictions can broadly be interpreted as a form of control on capital flows. The third restriction—”restriction on payments for current transactions”—refers to limitations on current account transactions. It has been included in the study because current account transactions can be used to (partially) evade restrictions on capital transactions through practices such as leads and lags in export billing, overinvoicing of imports, and underinvoicing of exports.

The problem with the use of these dummy variables to measure restrictions on international capital flows is that they provide no measure of the intensity of controls. Although there have been attempts to construct indices of the degree of capital controls, it is difficult to find a measure that is comparable across countries and that is available for a sufficiently long period of time. To some degree, the current account restrictions dummy variable can proxy for the intensity of controls, as pointed out above.

Alternative measures of the degree of intensity of capital controls have been adopted in previous studies. Among these, one can cite onshore-offshore interest differentials (see, for example, Giavazzi and Pagano (1988)); the size of the black market premium; and deviations from covered interest rate parity (Dooley and Isard (1980), Ito (1983)). These measures are more suited to empirical analysis that uses higher frequency data. A comparison of findings using different measures of controls would be a topic for future research.

Examination of the dummy variables for the sample of countries under examination reveals several interesting regularities, summarized in Table 1.15 The most common form of restriction among the countries in our sample is the first (capital controls). Of the 61 countries in our sample, 34 had capital controls in place throughout the period, while 5 never had them. Also, while the number of industrial countries with capital account restrictions decreased over time, the number of developing countries with them increased.

Table 1.Foreign Exchange Restrictions
Number of countries586161
Type of restrictions
(1)Restrictions on capital account transactions444345
(2)Restrictions on current account transactions322730
(3)Multiple currency practices111514

Current account restrictions were in place throughout the period in 19 countries, while they were never in place in 15 countries. Interestingly, the countries that had restrictions on current account transactions also had capital account restrictions (compare line (2) with line (1) + (2)). Once again, the number of countries with current account restriction fell among industrial countries and rose among developing countries.

Multiple currency practices were the least common form of restriction. Only 4 countries had them in place throughout the period, while they were never in place in 27 countries.16 Also, most countries using separate exchange rates for capital transactions had restrictions on capital and current account transactions as well (line (1) + (2) + (3)).

Before turning to the empirical evidence, it is important to point out its limitations. Given the nature of our measures of foreign exchange restrictions, our analysis focuses on medium- and long-run aspects, and is not suitable for studying the interaction between foreign exchange market instability, speculative attacks, and capital controls.17 The second limitation is that the imposition and removal of capital account restrictions is typically undertaken together with other macroeconomic and structural reform measures. For example, capital controls may be a complement to measures of financial repression designed to facilitate the financing of government spending when the tax system is relatively inefficient. This makes it more difficult to evaluate the consequences of measures such as capital account liberalization per se.

III. Empirical Evidence on the Effects of Exchange Controls

This section examines the effects of capital controls and current account restrictions on inflation, real interest rates, and economic growth. In addition to the data on capital controls described in the previous section, we use data on macroeconomic, political, and institutional variables. These are taken from various sources: the economic variables from International Financial Statistics, Summers and Heston (1991), and Barro and Lee (1994); and the political and institutional variables from Banks (various issues), Cukierman (1992), and Taylor and Jodice (1983). Appendix II describes the sources in more detail.

Capital Controls and Inflation

The discussion in Section I and the theoretical literature provide ambiguous predictions of the impact of capital controls on the rate of inflation. According to the optimal taxation literature, inflation is a tax that is chosen optimally together with other tax instruments: tax rates are set at values that equalize the marginal distortions of the different tax instruments, weighted by the size of the respective tax bases. By limiting the scope for portfolio diversification and facilitating the imposition of financial repression measures, capital controls can enlarge the inflation tax base. As a result, the optimal rate of inflation may rise or fall, while seigniorage revenue would unambiguously rise (for given distortions).18

In other work, inflation is viewed as a residual form of taxation, given other taxes and bond financing. In the latter view, financial liberalization may reduce the tax base for the inflation tax, implying that the same financing gap would have to be covered by a higher rate of inflation for a given amount of bond financing. This effect would be enhanced by the necessity to raise revenue to finance the higher interest payments on government debt.19

In this section we present results of regressions in which the dependent variable is the rate of inflation. The results are qualitatively similar to those that obtain when the share of seigniorage over total GDP or over total tax revenue is used (results are available from the authors).

In order to proxy, albeit roughly, for the intensity of capital controls, we included restrictions to current account transactions among the regressors, with the idea that current account restrictions may make it more difficult to evade capital controls through leads and lags in import and export billing. We also included among the regressors two measures of central bank independence, taken from Cukierman (1992). The first variable, LEGAL, measures the legal independence of the central bank: higher numbers imply a more independent central bank. According to Cukierman (1992), this is a good measure of central bank independence for industrial countries. The second variable, TURNOVER, measures the turnover in central bankers, which is considered to be negatively correlated with the degree of independence of the central bank. According to Cukierman (1992), this is a good measure of central bank independence for developing countries. Both measures change every ten years for most countries, and are constant across time for the rest. We expect inflation to be lower in countries with a more independent central bank, because central bank independence is associated with the choice of central bankers that are more inflation averse than is the government.

We introduce three time-varying political variables. The first variable, LEFT, captures the political orientation of the government: it takes the value of one when a democratic left-wing government is in power, and zero otherwise. “Partisan” models of monetary policy (Alesina (1987)) predict that inflation should be higher under left-wing governments, which are more concerned about output and employment performance than about inflation. The second variable, COAL, takes the value of one when a coalition government is in power and zero otherwise. Coalition governments may find it more difficult to reach agreement on tax increases and may therefore rely more heavily on seigniorage. The third political dummy, NODEM, takes the value of one when the country is not a democracy, and zero otherwise. There is no a priori presumption about its effect on inflation.

We also introduce two political variables that are country specific but time invariant. The first, TCHANGE, equals the total number of government changes in the period 1950–82.20 The second, COUP, gives the total number of successful coups in the same period. Both variables are proxies for the degree of political instability. As several studies have shown, inflation and political instability are strongly correlated, although the issue of causality is not firmly resolved (see Cukierman, Edwards, and Tabellini (1992); and Roubini and Ozler (1994)).

Finally, we include among the regressors three macroeconomic variables. The first is the (log of) initial level of income, GDP1966. The expected sign on this variable is a priori ambiguous: on the one hand, countries with lower income have a less efficient tax system and may therefore rely more heavily on the inflation tax; on the other hand, the degree of monetization of the economy is lower in poorer countries. The second variable is the lagged share of the budget balance to GDP (negative numbers indicate a deficit). We expect inflation to be higher in countries with large budget deficits. The third variable is the degree of openness of the economy, OPEN, measured as the ratio of exports plus imports to GDP. According to Romer (1993), countries that are more open to international trade have lower incentives to use unexpected inflation to stimulate economic activity, because of the negative effects of real depreciation.21 We therefore expect to find a negative correlation between inflation and openness. The last explanatory variable is a dummy variable identifying the type of exchange rate regime, EXR. It takes the value of one when the exchange rate is fixed or managed, and zero when it is floating. We expect inflation to be lower in countries that peg or manage their exchange rate, because of the constraints that such a regime imposes on monetary policy.

The inflation equations were estimated using three different specifications. The regressions were first run on the pooled cross-sectional time-series data, using ordinary least squares (OLS) (column (1) in Table 2). The residuals from this regression were then used to calculate appropriate weights, and the subsequent regressions were run using weighted least squares (WLS). This procedure was used given the difference in the variance of inflation across the countries in our sample. The second column in Table 2 reports results from the WLS regressions using a dummy variable for each year in the sample. Time dummies help control for the effects of omitted variables that are time varying but have the same effect across countries. Finally, the third column reports results from WLS regressions that include country-specific dummies as well as time dummies. These country dummies are introduced in order to control for omitted variables that are country specific but constant through time. It should be noted that introducing country-specific fixed effects implies that it is impossible to identify the coefficient on variables that are country specific and time invariant, such as the initial level of income and the TCHANGE and COUP variables.22

Table 2.Determinants of Inflation, 1966–89
Whole SampleInduslrial CountriesDeveloping Countries
DEFY (1)-0.250.02(0.67)-0.05(-1.24)-0.17(-2.36)-0.08(-1.43)0.01(-0.12)-0.23(-1.74)-0.10(-0.73)-0.07(-1.26)
Number of observations1.0611.0611.061468468468607607607
Note: t-statislics are in parentheses. Regression (1) is ordinary least squares. Regression (2) is weighted least squares, time dummies. Regression (3) is weighted least squares, time + country dummies.
Note: t-statislics are in parentheses. Regression (1) is ordinary least squares. Regression (2) is weighted least squares, time dummies. Regression (3) is weighted least squares, time + country dummies.

In order to avoid capturing the effects of outliers, the observations on the dependent variable were restricted to inflation rates below 80 percent.23 Results for the inflation regressions are presented in Table 2, with the first three columns reporting results using the entire sample. They show that capital controls, current account restrictions, and multiple exchange rate practices are associated with higher rates of inflation. Regressions (1) and (2) also suggest that inflation is higher in countries that have a high turnover of central bankers and a lower degree of legal independence. The coefficients on the central bank independence variables are not significant in the regressions that include fixed country effects (regression (3)). The reason is that the estimate captures only the effects of the time-series variation in the degree of independence, which is very small in the data (for all countries, the index of independence changes only three times or less in the sample). The political variables LEFT and NODEM have a positive sign and are significant in regressions (1) and (2), but not in the regression with country-specific effects. The coefficient on the initial level of income is positive and significant—this result is consistent with the monetization effect outweighing the impact of a less efficient tax system. The coefficient on the lagged budget deficit is significant with the expected sign only in the OLS regression. This result is not too surprising, given the known difficulty in finding an empirically robust correlation between inflation and fiscal imbalances. With regard to external sector variabies, the results show that inflation is significantly lower in countries that are more open and that manage their exchange rate, in accordance to the theory.

We subsequently divided the sample into industrialized and developing countries (see list of countries in Appendix I). For industrialized countries we again find evidence that inflation is higher in countries with capital controls and current account restrictions, while the coefficient on multiple currency practices is not statistically significant. As predicted, inflation tends to be higher under left-wing and coalition governments, as well as when the central bank is less independent. Inflation is lower in countries that manage the exchange rate, but there is no evidence here that openness is associated with lower inflation.

Results for developing countries are presented in the last three columns of Table 2. Not surprisingly, the overall fit of the regressions is worse than for industrial countries. We find that the coefficient on the MULTER dummy variable is positive and significant in all the panel regressions. Also, the capital controls variable is statistically significant in the regressions with country effects. Countries with more turnover of central bankers and with capital controls in place have experienced higher inflation; furthermore, inflation tends to be higher in nondemocratic regimes. Our measures of political instability (COUP, TCHANGE, and COAL) do not provide evidence in favor of a positive link with inflation. Interestingly, developing countries with higher initial income per capita in 1966 have experienced higher inflation (after controlling for the effects of the other explanatory variables). A possible explanation is that poorer developing countries are not fully monetized, and that this effect dominates the seigniorage effect that works through the impact of a less developed tax system on the choice of revenue instruments. The coefficient on external sector variables are significant and with the expected sign in all regressions: countries that are more open and that manage the exchange rate tend to have lower inflation rates.

A similar set of regressions was run using nonoverlapping five-year averages, instead of annual values, for all variables. This procedure reduces the serial correlation problems. The results, not presented for reasons of space, are consistent with those presented in Table 2.

Capital Controls and Real Interest Rates

In the theoretical model, capital controls drive a wedge between domestic and world interest rates. In principle, capital controls may be used either by a country that wants to maintain interest rates that are lower those prevailing on world markets without experiencing capital outflows or by a country that seeks to maintain higher interest rates without experiencing capital inflows. We therefore first considered whether real interest rates differ systematically between countries that impose capital controls and countries that do not. Our sample includes three interest rate measures: interest rates on government bonds, loan rates, and deposit rates, all taken from the IMF’s International Financial Statistics. For reasons of space, we report only the results of regressions that use government bond yields as the dependent variable. Real (ex-post) rates are calculated by subtracting the rate of inflation from the nominal interest rate. Since data on interest rates are not available in a consistent and uniform fashion for the developing countries in our sample, we focus exclusively on industrialized countries.

Among the explanatory variables we include the three measures of controls—CAPCON, CURRCON, and MULTER. The degree of central bank independence, measured by the variable LEGAL, and the political variables LEFT, COAL, and TCHANGE are also included. The first set of regressions comprises data from 1960 to 1989, and therefore excludes MULTER (for which data are available only from 1966). These regressions include the lagged budget balance as an explanatory variable. Ideally, one would want to include the stock of public debt: however, data on public debt for the 1960s are not consistently available for the countries in our sample.

The results, presented in Table 3, show that countries with capital account and current account restrictions have lower real interest rates. One interpretation of the latter finding is that other forms of restrictions on foreign exchange transactions proxy for the intensity of capital controls, and more intensive controls are associated with lower real interest rates. Another, possibly complementary, explanation is that exchange restrictions are capturing the degree of government-imposed distortions, such as financial repression. The coefficient on the degree of central bank independence is positive and significant; countries with a more independent central bank have higher real interest rates. The evidence on political variables is less strong, but there is some evidence that real interest rates tend to be higher under left-wing governments.

Table 3.Determinants of Real Interest Rates in Industrial Countries. 1960–89
Number of observations541541541
Number of observations356356356
Note: t-statistics in parentheses. Regression (1) is OLS. Regression (2) is weighted least squares, time dummies. Regression (3) is weighted least squares, time + country dummies.
Note: t-statistics in parentheses. Regression (1) is OLS. Regression (2) is weighted least squares, time dummies. Regression (3) is weighted least squares, time + country dummies.

The second set of regressions in Table 2 refers to the period 1970–89, and includes the (lagged) ratio of domestic government debt to GDP (DEBTGY{1}) as an explanatory variable. Results are similar to those for the period 1960–89: capital controls, current account restrictions, and multiple currency practices are associated with lower real interest rates. The debt variable is significant and with the expected positive sign in regressions (1) and (2), but is insignificant and with the wrong sign once we control for country-specific effects. Results are qualitatively similar if we use different real interest rate measures, such as real loan or deposit rates. Overall, the results are in line with those obtained by Cukierman and others (1993), who regress average real interest rates on the degree of central bank independence for a sample of industrial and developing countries. For both samples they find that real rates are significantly higher when the central bank is more independent.

It should be noted that these results do not have implications about the effectiveness of capital controls. Financial repression measures are widespread in some countries with capital controls, so that the interest rates we are measuring are not the relevant ones in determining the effective degree of arbitrage between domestic and foreign financial markets.

Capital Controls and Growth

Once again, theory does not provide unambiguous predictions for the effects of capital controls on growth. On the one hand, capital controls may stimulate capital accumulation and (temporarily) raise the growth rate by lowering real interest rates. On the other hand, in an endogenous growth framework lower real interest rates imply a lower rate of growth. The empirical literature on economic growth is immense.24 A number of empirical studies have examined the relation between growth in real income per capita and political and financial repression variables. For example, Alesina and Perotti (1992) document the relationship between growth and political instability, democracy, and income distribution. Roubini and Sala-i-Martin (1992) find that countries with a more distorted trade and financial system tend to grow more slowly. Cukierman and others (1993) find that central bank independence is positively correlated with growth rates in developing countries.

The empirical growth literature uses mainly cross-sectional estimates or panel estimates that use five- or ten-year averages. Here we present the results of panel regressions that use five-year nonoverlapping averages of all variables. In addition to our data, we use the Barro and Lee (1994) data set, which contains data on schooling and educational attainment that are shown to be correlated with economic growth.

The dependent variable is the rate of growth of real income per capita, taken from Summers and Heston (1991). The independent variables are the three exchange restrictions dummies (CAPCON, CURRCON, and MULTER); the two measures of central bank independence (LEGAL and TURNOVER); the political dummy (NODEM); the average size of the black market premium on foreign exchange (BMP); and the degree of openness of the economy (OPEN). In line with the empirical growth literature, we also include (the log of) initial income (GDP) and the initial level of education (SYRM) among the regressors. The latter is measured using years of secondary schooling of the male population, which is found to be systematically correlated with growth in Barro and Lee (1994). The convergence hypothesis implies that countries with a lower initial level of income should—ceteris paribus—grow faster than richer countries. Finally, we use two measures of government consumption, GCONS and GOVSH. The first one measures the share over real GDP of real government consumption net of spending on defense and education, but is not available for 1985–89. This is the measure used in Barro and Lee (1994), which is found to be negatively correlated with growth. The second, GOVSH, measures the share of real government consumption over real GDP, and is available for the whole sample.

The growth regressions were run using instrumental variable estimation. We use own lagged values as instruments for OPEN and GCONS (GOVSH), while the other variables are their own instruments. Time dummies were also included. Results for the whole sample are presented in Table 4. Regressions (1) and (3) ((2) and (4)) present results without (with) regional dummies. Regressions (3) and (4) also exclude the two measures of central bank independence, TURNOVER and LEGAL. The initial level of income enters significantly in the regression, lending support to the conditional convergence hypothesis. The coefficient on the black market premium is also significant and negative: countries with a more distorted foreign exchange system tend to grow more slowly. The evidence on other determinants of growth in our sample is weaker. For example, the openness variable is significant and with the expected positive sign only in regressions (3) and (4). The coefficient on the capital controls variable is positive in all regressions, but its significance declines once we introduce continental dummies. The coefficient on current account restrictions is negative and significant in regressions (3) and (4), but is insignificant in the others. It should be noted, however, that the black market premium (BMP) is positively correlated with our foreign exchange restrictions dummies, and in particular with CURRCON. Omitting BMP tends to raise the significance of the current account dummy.

Table 4.Determinants of Growth, 1966–89(Whole sample, five-year averages)
Number of observations181181238238
Note: t-statistics, calculated using White’s heteroscedasticity-consistent standard errors, are in parentheses.
Note: t-statistics, calculated using White’s heteroscedasticity-consistent standard errors, are in parentheses.

IV. Determinants of Capital Controls25

So far we have treated capital controls as exogenous variables. However, the discussion of the theoretical literature in Section 1 broadly suggests several potential determinants for capital controls.

  • Tax system and size of government: In a country with an underdeveloped tax system and a narrow tax base for income taxation, capital controls may facilitate the taxation of domestic capital, as well as the collection of revenue through the inflation tax. Taxing domestic assets only would lead to capital flight and a reduction in the domestic capital stock. A related argument is that the incentive to impose controls for fiscal reasons is likely to be larger, the larger the share of government.

  • Distributional considerations: Governments attempting to redistribute resources from capital to labor may want to impose capital controls in order to avoid capital flight. It should also be noted that the distributive implications of controls may differ in the short and in the long run: higher taxes on capital will discourage capital accumulation and may therefore reduce productive capacity and wages in the long run.

  • Independence of monetary policy: When monetary policy is not a choice variable for the government because of the independence of the central bank, the incentive to increase seigniorage revenue by raising money demand is reduced, because monetary policy is decided autonomously.26 Furthermore, an independent central bank may reduce the credibility problems that make the imposition of controls more likely.

  • External sector and exchange rate management: Capital controls can make it easier—ceteris paribus—to manage the exchange rate, and may be imposed in order to limit the loss of foreign currency when the current account is in deficit.

With regard to general public finance motivations, countries with an inefficient tax system may be more likely to impose capital controls and current account restrictions in order to facilitate the taxation of imports and exports, tax capital, and extract revenue through financial repression (see Section II). The sophistication of the tax system is positively correlated with the level of development; we therefore introduce the level of income per capita (GDP) as an explanatory variable for the presence of capital controls.27 The need to raise revenue is enhanced when the size of the government is large: we therefore include among the regressors the share of government consumption over GDP (GCONS).

The power that the government acquires over monetary policy by imposing controls depends, among other things, on the degree of independence of the central bank. We therefore included among our regressors the two variables measuring the independence of the central bank, TURNOVER and LEGAL, taken from Cukierman and others (1992). As mentioned above, a more independent central bank can imply more credibility of the government’s monetary policy stance and therefore make speculative attacks less likely. This would lessen the need for capital controls.

With regard to distributional motivations, capital controls may facilitate the taxation of domestic capital by hampering or preventing capital flight. Alesina and Tabellini (1989) argue that in the presence of distributional conflict between labor and capital, capital controls are likely to be imposed by left-wing governments, which are traditionally closer to labor. In order to capture the impact of the political leaning of the government on the decision whether to introduce or to remove capital controls, we use two dummy variables, LEFT and NODEM. We expect the coefficient on the former variable to be positive, while there is no a priori presumption on the coefficient of the second. We also introduce two measures of political stability: the dummy variable MAJ, taking the value of one when a democratic majority government is in power and zero otherwise, and the country-specific variable TCHANGE, which equals the number of government changes during the sample period. These measures would also be linked to overall policy credibility.

Finally, three external sector variables are included among the determinants of controls. The first is a dummy variable (EXR), taking the value of one when the exchange rate is fixed or managed, and zero during periods of freely floating exchange rates. The second variable is the (lagged) value of the ratio of the current account balance to GDP (CAY). We expect countries that experienced current account difficulties to be more likely to impose controls. The third variable is the degree of openness of the economy (OPEN). The sign on this variable is a priori ambiguous. On the one hand, monitoring capital flows is more difficult in a very open economy, suggesting that the expected sign should be negative. On the other hand, the effects of external shocks on the domestic economy are larger, the more open is the economy, so that the incentive to insulate the economy from foreign shocks through foreign exchange restrictions or a flexible exchange rate regime is stronger. All three external sector variables raise the issue of the direction of causality: it can be argued that the size of current account imbalances and the degree of openness of the economy are themselves affected by foreign exchange restrictions. We therefore use lagged values of both CAY and OPEN.

In Table 5 we present results of a logit model for the whole sample, as well as for industrial and developing countries separately. The model is based on annual data, and relates the capital controls dummy to the set of explanatory variables discussed earlier. We also used a probit model specification, with analogous results.28 The first regression (column 1) refers to the whole sample, with pooled cross-sectional time-series data and time dummies. The second and third columns show results for the subperiods 1970–79 and 1980–89.

Table 5.Determinants of Capital Controls, 1966–89(Annual data estimation by logit)
Whole SampleIndustrial CountriesDeveloping Countries
Usable observations1171509481630463733
Degree of frequency1131469442586430696
Cases correct941410396550403610
Average likelihood0.6620.6790.7010.7750.7690.713
Notes: t-statistics are in parentheses. Time dummies are included among the explanatory variables.
Notes: t-statistics are in parentheses. Time dummies are included among the explanatory variables.

The results suggest that capital controls are less likely to be in place in countries where the central bank enjoys a higher degree of legal independence and where the turnover of central bankers is low.29 We also find that controls are more likely to be in place in countries with lower income per capita and a higher ratio of government consumption to GDP, consistent with fiscal motivations for the imposition of controls. There is also evidence of partisan political effects on the likelihood of the imposition of controls: these are more frequent under left-wing governments, consistent with theories of income distribution that emphasize how capital controls facilitate the taxation of domestic capital and, more generally, wealth. However, we find no clear evidence of a link between controls and political stability—the coefficients on the majority (MAJ) and coup (TCOUP) dummies are not statistically significant, although there is some evidence that countries with frequent government changes are more likely to impose controls. The absence of a statistically significant correlation between controls and political stability may also be due to the binary nature of our controls measure, which does not capture changes in the intensity of controls.

Results also show that countries with a flexible exchange rate and without current account imbalances are less likely to have capital controls in place. The sign of the coefficient on the openness variable (OPEN), uncertain a priori, is negative and significant; more generally, the coefficients on all three external sector variables are statistically significant at the 5 percent confidence level. As can be seen from columns 2 and 3, the results are generally robust across subperiods. In particular, the results for the 1980s are consistent with the theory.

It is interesting to examine whether there are systematic differences in the determinants of controls between industrial and developing countries. For this purpose, the last three columns in Table 5 present results for industrial and developing countries separately. For industrial countries, macroeconomic variables and the degree of legal independence of the central bank seem the most robust determinants of controls, while the evidence on political variables is less clear cut. Not surprisingly, the model performs better (in terms of average likelihood) than the whole sample, given the greater homogeneity among countries. For developing countries, the coefficients on the level of output and the exchange rate regime dummy are statistically insignificant, while the other determinants are analogous to those for industrial countries. Regional dummies are statistically significant: after controlling for the other explanatory variables, we find that controls were less likely to be in place in Latin America and more likely to be in place in Africa.

As discussed in Section II, our measure of controls has high persistence. In order to reduce serial correlation problems and smooth out the effects of temporary shocks, we calculated five-year nonoverlapping averages of each variable, and studied the determinants of controls using simple regression analysis. For reasons of space, we report here only the results for the determinants of capital controls, which are the most frequent form of restriction in our sample; further evidence on the determinants of current account restrictions and multiple exchange rate practices is presented in Milesi-Ferretti (1995). Among the explanatory variables, the only variable that is not an average is the (log of) the level of income (GDP), which is the level of income at the beginning of each five-year period (1965–1985). The results of these regressions are presented in Table 6 for the whole sample only, for the periods 1965–89 and 1970–89.30 For each period, the first regressions control for fixed time effects, while the second control for both time and country effects. The low (or zero) time variability of the central bank independence data implies that the coefficients on LEGAL and TURNOVER are less likely to be statistically significant in regressions including fixed country effects.

The results show that the share of government, the degree of openness, and the level of income per capita are the most significant determinants of controls. Furthermore, the TURNOVER variable is statistically significant and with the expected sign, while the legal independence variable becomes insignificant in the regressions including country effects. The large increase in explanatory power with the inclusion of fixed country effects is not surprising, given the nature of our dependent variable.

Table 6.Determinants of Capital Controls, 1966–89(Five-year averages, OLS)

Time dummies

Fixed effects

Time dummies

Fixed effects
Usable observations220220184184
Degree of frequency202153167118
Mean of dependent variable0.7220.7220.7350.735
Standard error of dependent variable0.4300.4300.4220.422
Note: t-statistics, calculated using White’s heteroscedasticity-consistent standard errors, are in parentheses.
Note: t-statistics, calculated using White’s heteroscedasticity-consistent standard errors, are in parentheses.

The analysis in this section has treated capital controls and other foreign exchange restrictions as endogenous variables. This suggests that the results in the previous section, where capital controls are used as explanatory variables for macroeconomic variables such as inflation, interest rates, and growth, may be plagued by endogeneity problems. In order to check for potential endogeneity, we conducted a Hausman-type test (for a similar procedure, see Dowrick and Nguyen (1989)). This test was conducted by adding to the inflation and growth regressions the residual from the regressions of the variable suspected of endogeneity on a set of independent variables (see Table 5). The residuals turned out to be insignificant: for example, the t-statistics for the endogeneity tests for CAPCON, CURRCON, and MULTER in the inflation equations (5-year averages) were 0.84, 0.85, and 0.94 respectively. More generally, however, future empirical analysis should focus on a simultaneous equation framework with a dynamic structure in order to check the robustness of the basic correlations highlighted in this paper.

V. Concluding Remarks

The study of effects and determinants of capital controls reveals several interesting empirical regularities. Capital controls, current account restrictions, and multiple currency practices are in general associated with higher rates of inflation, a higher share of seigniorage in total taxes, and lower real interest rates. We do not find any robust correlation of current and capital account restrictions with economic growth. We find, however, that countries with large black market premiums (themselves correlated with foreign exchange restrictions) grow more slowly. Capital controls are more likely to be imposed in countries in which monetary policy is more firmly under the government’s control, because the central bank is not independent. Also, they are more likely to be imposed in poorer countries, which have a less developed tax system. An explanation for the latter finding is that capital controls appear to have strong fiscal implications, working through their impact on the use of seigniorage as a source of revenue and through their effects on the real return on domestic government debt. Furthermore, capital controls are more likely to be in place in countries with a larger share of government and a more closed economy.


List of Countries

  • United States*

  • United Kingdom*

  • Austria*

  • Belgium*

  • Denmark*

  • France*

  • Germany*

  • Italy*

  • Netherlands*

  • Norway*

  • Sweden*

  • Canada*

  • Japan*

  • Finland*

  • Greece*

  • Iceland*

  • Ireland*

  • Malta

  • Portugal*

  • Spain*

  • Turkey

  • Yugoslavia

  • Australia*

  • New Zealand*

  • South Africa

  • Argentina

  • Bolivia

  • Brazil

  • Chile

  • Colombia

  • Costa Rica

  • Honduras

  • Mexico

  • Nicaragua

  • Panama

  • Peru

  • Uruguay

  • Venezuela

  • Bahamas

  • Barbados

  • Israel

  • Egypt

  • India

  • Indonesia

  • Malaysia

  • Nepal

  • Pakistan

  • Philippines

  • Singapore

  • Thailand

  • Botswana

  • Zaire

  • Ethiopia

  • Ghana

  • Kenya

  • Morocco

  • Nigeria

  • Tanzania

  • Uganda

  • Zambia

  • Western Samoa


Variables: Sources and Definitions

CAPCON: dummy variable taking the value of one when capital controls are in place, and zero otherwise. Controls defined as “restrictions on payments on capital transactions.”

CURRCON: dummy variable taking the value of one when restrictions on current account transactions are in place, and zero otherwise. Current account restrictions defined as “restrictions on payments for current transactions.”

MULTER: dummy variable taking the value of one when multiple exchange rate practices are in place, and zero otherwise. Multiple exchange rate practices defined as “separate exchange rate(s) for some or all capital transactions and/or some or all invisibles.”

EXR: dummy variable taking the value of one during periods of fixed or managed exchange rates and zero during periods of freely floating exchange rates.

Source: Elaborations on IMF Annual Report on Exchange Rate Arrangements and Exchange Restrictions, various issues.

INFLATION RATE: annual rate of change of the Consumer Price Index.

REAL INTEREST RATE: long-term nominal interest rate on government debt minus actual inflation.

CAY: ratio of current account deficit to GDP.

DEFY: ratio of government budget deficit to GDP.

DEBTGY: ratio of public debt to GDP.

Sources: IMF International Financial Statistics, various issues; and national sources.

GROWTH: growth rate of real GDP per capita.

LRGDP: log of real GDP per capita.

GCONS: ratio of government consumption to GDP.

OPEN: ratio of the sum of imports and exports to GDP.

Source: Summers and Heston (1991); and PWT 5.5 update.

GOVSH: ratio of real government consumption to GDP, net of spending on defense and education (5-year average).

SYRM: average years of secondary schooling in the male population over age 25.

BMP: 1 + log of the black market premium on foreign exchange.

Source: Barro and Lee (1994).

LEGAL: index of legal central bank independence. Higher numbers correspond to more central bank independence.

TURNOVER: actual turnover of central bankers per year.

Source: Cukierman and others (1992).

LEFT: dummy variable taking the value of one when a democratic left-wing government is in power, and zero otherwise.

COAL: dummy variable taking the value of one when a coalition government is in power, and zero otherwise.

MAJ: dummy variable taking the value of one when a majority government is in power, and zero in the case of a coalition or minority government.

NODEM: dummy variable taking the value of one when a totalitarian government is in power, and zero otherwise.

Source: Elaborations on Banks, various issues.

TCHANGE: total number of government changes for a given country, 1950–82.

TCOUP: total number of successful coups in a given country, 1950–82.

Source: Taylor and Jodice (1983).


Vittorio Grilli is head of the Debt Management and Privatization Department at the Italian Treasury. He received his undergraduate degree from Università Bocconi in Milan and his Ph.D, from the University of Rochester. He has taught at Yale University and Birkbeck College. Part of this work was undertaken while he was visiting the Research Department. Gian Maria Milesi-Ferretti is an Economist in the IMF’s Research Department. He received his undergraduate degree from Università di Roma and his Ph.D, from Harvard University. The authors are grateful to Alex Hoffmaister, Manmohan Kumar, Norman Loayza, Donald Mathieson, Sunil Sharma, and especially to José De Gregorio and Paul Cashin for very useful comments and suggestions. Luisa Lambertini and Brooks Dana Calvo provided tireless research assistance.

See, for example, Eichengreen and Wyplosz (1993), Eichengreen, Rose, and Wyplosz (1994), and Policy Forum (1995). The original argument was formulated by Tobin (1978).

In a previous study (Alesina, Grilli, and Milesi-Ferretti (1994)) we focused only on OECD countries. See also Epstein and Schor (1992).

The earlier version of this study (Grilli and Milesi-Ferretti (1995)) also presents an overlapping generations model, following Diamond (1965), Persson (1985), and Giovannini (1988), that identifies some of the key issues subsequently examined in the empirical analysis.

This section draws largely from Alesina, Grilli, and Milesi-Ferretti (1994).

To be effective, this type of measure would need to be adopted by all countries, in order to avoid capital flows to tax haven countries. Of course, this raises serious coordination problems.

This was the case in Italy. Giavazzi and Giovannini (1989) underline the asymmetry between strong- and weak-currency countries: as long as the burden of adjustment falls on the weak-currency countries, the other countries are insulated from the effects of interest-rate variability. Giavazzi and Pagano (1990) relate the likelihood of a confidence crisis to public debt management.

Since effective capital controls allow the government to pursue inconsistent policies in the short run (for example, expansionary monetary policy with a fixed exchange rate), their imposition may be perceived by private agents imperfectly informed about government preferences as a signal that the government will indeed behave inconsistently, implying a worsening of credibility rather than an improvement. Lane and Rojas-Suarez (1992) analyze the impact of capital controls on the credibility of a commitment to keep the exchange rate within pre-specified bands. Delias and Stockman (1993) show that self-fulfilling speculative attacks can occur under a fixed exchange rate regime because agents expect that capital controls will be imposed in the future. On the signaling role of capital account liberalization, see Bartolini and Drazen (1994).

For an illustration of the “perils of sterilization,” see Calvo (1991).

For an analysis of policy response to capital inflows following stabilization, see for example Calvo, Leiderman, and Reinhart (1993), Among the policy responses they discuss are fiscal restraint, the removal of restrictions on capital outflows, and the imposition of Tobin taxes on short-run capital inflows.

On the relation between reserve requirements and the inflation tax, see also Brock (1989).

Using an overlapping-generarions framework, Sussman (1991) also suggests that capital controls (in the form of a tax on interest-bearing foreign assets, accompanied by a tax on domestic assets) reduce debt service and increase the demand for money.

Capital flight may be induced by expectations of future capital controls and capital levies.

A similar table for a larger sample of countries but not including current account restrictions is presented in Mathicson and Rojas-Suarez (1993).

The only industrial country with separate exchange rates in 1989 was Belgium. Several industrial countries, among them Belgium and Italy, dismantled their remaining foreign exchange restrictions in 1990.

See, for example, Roubini and Sala-i-Martin (1995) for a model in which the optimal inflation rate rises with financial repression.

See, for example, Giovannini (1988).

This is the time period covered in the Taylor and Jodice (1983) study. The use of an average value over a long time period can be interpreted as a measure of the average probability of the event occurring in a given year.

Cukierman, Edwards, and Tabellini (1992) and Romer (1993) present cross-sectional evidence of a negative relation between inflation and openness.

We also tried instrumental variable estimation, in order to control for the possible endogeneity of capital controls. The instruments for the capital control variables are their own lagged value and the share of government consumption to GDP, which is highly correlated with capital controls but not with inflation rates. The results, not reported, are in line with those presented in the text.

The only countries in the sample with sustained high inflation episodes (more than 3–4 years) are Argentina and Brazil.

For recent papers see Barro and Lee (1994) and the December 1993 issue of the Journal of Monetary Economics. Barro and Sala-i-Martin (1994) summarize the theoretical and empirical growth literature.

Milesi-Ferretti (1995) contains a more comprehensive analysis of the determinants of other restrictions on capital mobility.

Epstein and Schor (1992) argue that central bank independence reflects the power of financial sector interests, which oppose limitations to capital mobility.

There is of course an endogeneity problem in using real income as an explanatory variable. Furthermore, this variable can capture other factors, such as the degree of development of the financial system. However, measures of the development of the tax system were not available for most countries during our sample period. Results are similar when the level of income in 1966 is used as an explanatory variable instead of current income.

The whole sample covers the years 1966–89, because the data on restrictions to capital account transactions for developing countries are available only after that date.

Note that a high turnover of central bankers indicates less independence. One needs to take into account the possibility that the inverse correlation between the capital control dummy and the degree of central bank independence captures reverse causality (when capital controls are in place, the government is less likely to want an independent central bank). Given the fact that central bank statutes are changed very infrequently, we tend to favor the first interpretation.

For the foreign exchange restrictions variables, data for 1965 are unavailable. For the five-year period 1965–69 we therefore use the average value for the period 1966–89. The results for the period 1970–89 are presented because for four developing countries the observations on capital controls start only between 1968 and 1971.

Countries are ordered according to their IFS code. Those marked with an asterisk were classified as industrial countries in the regressions of Sections III and IV.

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