Financial Development and the Effects of Capital Controls

This paper examines how the 1990s capital account liberalization policy trend affected international capital flows, and tests a new hypothesis that the depth and efficiency of the domestic financial system impacts the efficacy of capital account policy. The paper exploits a recently published IMF database on financial development that spans the period 1980–2014 and includes both developing and developed countries. The results confirm that policy on average does not have a statistically significant effect on accumulated gross capital flows, when controlling for other factors. I also find little effect on flows disaggregated by type and direction. However, interacting capital account policy and financial development, I do find that for financially developed countries, policy has the expected effect –policy openness leads to capital flows. Finally, I provide evidence that the impact of policy on a country’s share of global flows is also influenced by its level of financial development. These results are robust to using two alternative de jure policy measures. The implication is that the effectiveness of capital account liberalization requires developing the domestic financial system.