The information content of capital controls

Capital controls, policy measures used by governments to regulate cross-country financial flows, have became standard policy options in many emerging market economies. This paper will focus on what capital controls convey about the state of the economy and the implications of such revelation for policy efficacy. Empirically, this paper finds that capital controls convey important information market participants use to improve their understanding of economic fundamentals. Using a small open economy model with a collateral constraint and over-borrowing relative to the social optimum, I incorporate a representative agent’s Bayesian updating of information in response to change in policy and show that the efficacy of capital controls to correct over-borrowing and mitigate the negative impact of financial crises could be undermined if the agent rationally learns from policy. This paper highlights the need for policymakers to take into account the unintended consequences of information revelation in the design of capital flow management policies.