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Stopping "Hot Money" or Signaling Bad Policy? Capital Controls and the Onset of Currency Crises

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Reuven Glick
Michael Hutchison

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Abstract

Restrictions on international capital transactions and other payments are usually designed to limit volatile short-term capital flows (“hot money”) and stabilize the exchange rate. Their imposition, however, may have the opposite effect by inadvertently signaling the continuation of macroeconomic imbalances and inconsistent (“bad”) future policy (Bartolini and Drazen, 1997a,b). This paper investigates these alternative hypotheses by testing the impact of restrictions on international capital flows and other payments controls on the likelihood of currency crises. We employ a comprehensive sample of 90 developing and emerging-market economies over the 1975-1997 period, identifying 160 currency crises. Restrictions on international capital flows, current accounts, and international payments are associated with a higher probability of the onset of a speculative attack on the currency. This finding is robust to alternative measures of liberalization on international payments and the exchange rate regime, controlling for macroeconomic determinants of currency instability, and taking into account instability emanating from the banking sector. There may be some individual exceptions but the weight of the evidence suggests that countries imposing capital restrictions are sending a “bad signal” to markets, in turn increasing the likelihood of a net capital outflow and a currency crisis.

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Paper provided by Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics in its series EPRU Working Paper Series with number 00-14.

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Handle: RePEc:kud:epruwp:00-14

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Allan Drazen, 1997. "Policy Signaling in the Open Economy: A Re-Examination," NBER Working Papers 5892, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Bartolini, Leonardo & Drazen, Allan, 1997. "When liberal policies reflect external shocks, what do we learn?," Journal of International Economics, Elsevier, vol. 42(3-4), pages 249-273, May. [Downloadable!] (restricted)
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  3. Caprio, Gerard Jr. & Klingebiel, Daniela, 1996. "Bank insolvencies : cross-country experience," Policy Research Working Paper Series 1620, The World Bank. [Downloadable!]
  4. Sebastian Edwards, 1999. "How Effective Are Capital Controls?," Journal of Economic Perspectives, American Economic Association, vol. 13(4), pages 65-84, Fall. [Downloadable!] (restricted)
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  5. Hali J. Edison & Carmen M. Reinhart, 2000. "Capital controls during financial crises: the case of Malaysia and Thailand," International Finance Discussion Papers 662, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  6. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May. [Downloadable!] (restricted)
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  7. Frankel, Jeffrey A. & Rose, Andrew K., 1996. "Currency crashes in emerging markets: An empirical treatment," Journal of International Economics, Elsevier, vol. 41(3-4), pages 351-366, November. [Downloadable!] (restricted)
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  8. Barry Eichengreen & Andrew K. Rose, 1998. "Staying Afloat When the Wind Shifts: External Factors and Emerging-Market Banking Crises," NBER Working Papers 6370, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Sebastian Edwards, 1999. "Crisis Prevention: Lessons from Mexico and East Asia," NBER Working Papers 7233, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  10. Leonardo Bartolini & Allan Drazen, 1997. "Capital Account Liberalization as a Signal," NBER Working Papers 5725, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  11. Dooley, Michael P & Isard, Peter, 1980. "Capital Controls, Political Risk, and Deviations from Interest-Rate Parity," Journal of Political Economy, University of Chicago Press, vol. 88(2), pages 370-84, April. [Downloadable!] (restricted)
  12. Barry Eichengreen & Charles Wyplosz, 1993. "The Unstable EMS," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24(1993-1), pages 51-144. [Downloadable!]
  13. Jason Furman & Joseph E. Stiglitz, 1998. "Economic Crises: Evidence and Insights from East Asia," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(1998-2), pages 1-136. [Downloadable!]
  14. Sebastian Edwards & Francisco Gil Diaz & Arminio Fraga, 1999. "Capital Flows to Latin America," NBER Chapters, in: International Capital Flows, pages 5-56 National Bureau of Economic Research, Inc. [Downloadable!]
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Forbes, Kristin J., 2004. "Capital Controls: Mud in the Wheels of Market Discipline," Working papers 4454-03, Massachusetts Institute of Technology (MIT), Sloan School of Management. [Downloadable!]
    Other versions:
  2. Toprak, Metin, 2001. "Yükselen Piyasalarda Finansal Kriz
    [Financial Crises in Emerging Markets]    ," MPRA Paper 9092, University Library of Munich, Germany, revised 2001. [Downloadable!]
  3. Wolfgang Eggert & Martin Kolmar, . "Contests with Size Effects," EPRU Working Paper Series 02-04, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics. [Downloadable!]
    Other versions:
  4. Isriya Nitithanprapas & Thomas D. Willett, 2002. "Classifying Exchange Rate Regimes," Claremont Colleges Working Papers 2002-22, Claremont Colleges. [Downloadable!]
  5. Barry Eichengreen & David Leblang, 2003. "Capital account liberalization and growth: was Mr. Mahathir right?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 8(3), pages 205-224. [Downloadable!]
    Other versions:
  6. Henry, Peter B., 2007. "Capital Account Liberalization: Theory, Evidence, and Speculation," Research Papers 1974, Stanford University, Graduate School of Business. [Downloadable!]
    Other versions:
  7. Wolfgang Eggert & Laszlo Goerke, . "Fiscal Policy, Economic Integration and Unemployment," EPRU Working Paper Series 02-05, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics. [Downloadable!]
    Other versions:
  8. James L. Butkiewicz & Halit Yanikkaya, 2003. "Capital Account Openness, International Trade, and Economic Growth: A Cross-Country Empirical Investigation," Working Papers 03-06, University of Delaware, Department of Economics. [Downloadable!]
    Other versions:
  9. Wolfgang Eggert & Martin Kolmar, . "Information Sharing, Multiple Nash Equilibria, and Asymmetric Capital-Tax Competition," EPRU Working Paper Series 02-01, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics. [Downloadable!]
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