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Mix of Capital Control Regimes

Countries’ control over capital inflows and outflows vary across the world, from capital openness to tight capital control. Capital controls create stability by preventing the flow of real and financial assets as recorded in the capital account in the balance of payments. Such controls can take the form of taxes, quantity or price controls on capital inflows or outflows, or restrictions on trade in assets abroad. These were first used on a larger scale by the belligerents beginning during World War I, restricting capital outflows, in order to keep capital in the domestic economy for taxation purposes (Neely 1999).

Although throughout the 1990s, financial openness was encouraged, studies have shown that financial openness has mixed effects. After the Asian financial crisis, China was lauded for maintaining capital controls, which helped the country to evade accelerating capital reversals, and capital controls once again were back in vogue. Later research, such as that of Chinn and Ito (2005), finds that financial openness is beneficial only in countries above a particular level of institutional development. Indeed, the Great Recession has shown that capital controls may be applicable to countries with an even higher level of institutional development, since without capital controls, contagion of declining assets can quickly spread to foreign-investing countries.

Edwards (2005) creates an index of capital controls to determine countries’ vulnerability to and depth of financial crises, looking at crises that manifest themselves in sudden stops of capital inflows and current account reversals. He finds that openness may worsen a financial crisis once it has begun. Other authors, such as Chang and Velasco (1998) and Williamson and Mahar (1998), find that financial openness may also increase vulnerability to crises.

 
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