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The Effect of Capital Controls on Interest Rate Differentials

Author

Listed:
  • Herrera, L.O.
  • Valdes, R.

Abstract

In this paper we present a model of international interest rate arbitrage under conditions of entry and exit costs to and from the domestic capital market. We seek to measure the maximum potential effect of capital controls, such as non-interest paying reserve requirements, on interest rate differentials. We quantify the effect of such taxes using a dynamic optimization model with uncertainty and transaction costs. An optimal (S,s) rule gives the limits for interest rate differentials that trigger massive capital inflows and outflows. We also calculate maximum sustainable interest rate differentials for various maturities and study the effect of parameter changes. Using parameters estimated for the Chilean economy, the model shows that the effect of capital controls on interest rate differentials is considerably smaller than what static calculations suggest.

Suggested Citation

  • Herrera, L.O. & Valdes, R., 1999. "The Effect of Capital Controls on Interest Rate Differentials," Papers 50, Cambridge - Risk, Information & Quantity Signals.
    • Handle: RePEc:fth:cambri:50
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    Cited by:

    1. El-Shagi Makram, 2012. "The Distorting Impact of Capital Controls," German Economic Review, De Gruyter, vol. 13(1), pages 41-55, February.
    2. Francisco A. Gallego & F. Leonardo Hernández, 2003. "Microeconomic effects of capital controls: The chilean experience during the 1990s," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 8(3), pages 225-253.
    3. Straetmans, Stefan T.M. & Versteeg, Roald J. & Wolff, Christian C.P., 2013. "Are capital controls in the foreign exchange market effective?," Journal of International Money and Finance, Elsevier, vol. 35(C), pages 36-53.
    4. Leonardo Hernández & Klaus Schmidt-Hebbel, 2002. "Banking, Financial Integration, and International Crises: An Overview," Central Banking, Analysis, and Economic Policies Book Series, in: Leonardo Hernández & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.),Banking, Financial Integration, and International Crises, edition 1, volume 3, chapter 1, pages 001-030, Central Bank of Chile.
    5. Ayele, Gashaw Tsegaye, 2011. "Challenges to Monetary Policy Transmission to Consumer Prices in Ethiopia," MPRA Paper 118058, University Library of Munich, Germany.
    6. Tsekrekos, Andrianos E., 2010. "The effect of mean reversion on entry and exit decisions under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 34(4), pages 725-742, April.
    7. Michele Fratianni, 2004. "Borders and the Constraints on Globalization," Working Papers 2004-05, Indiana University, Kelley School of Business, Department of Business Economics and Public Policy.
    8. Schmukler, Sergio L. & Serven, Luis, 2002. "Pricing currency risk : facts and puzzles from currency boards," Policy Research Working Paper Series 2815, The World Bank.
    9. Francisco Gallego & Leonardo Hernández & Klaus Schmidt-Hebbel, 2002. "Capital Controls in Chile: Were They Effective?," Central Banking, Analysis, and Economic Policies Book Series, in: Leonardo Hernández & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.),Banking, Financial Integration, and International Crises, edition 1, volume 3, chapter 12, pages 361-412, Central Bank of Chile.
    10. De Gregorio, Jose & Edwards, Sebastian & Valdes, Rodrigo O., 2000. "Controls on capital inflows: do they work?," Journal of Development Economics, Elsevier, vol. 63(1), pages 59-83, October.
    11. Vithessonthi, Chaiporn & Tongurai, Jittima, 2013. "Unremunerated reserve requirements, exchange rate volatility, and firm value," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 23(C), pages 358-378.
    12. Kevin Cowan L. & Erwin Hansen S. & Luis Óscar Herrera B., 2005. "Currency Mismatches in Non-Financial Firms in Chile," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 8(2), pages 57-82, August.
    13. Herrera, Luis Oscar & Valdes, Rodrigo O., 2001. "The effect of capital controls on interest rate differentials," Journal of International Economics, Elsevier, vol. 53(2), pages 385-398, April.
    14. Caputo, Rodrigo & Pedersen, Michael, 2020. "The changing nature of the real exchange rate: The role of central bank preferences," Economic Modelling, Elsevier, vol. 90(C), pages 445-464.
    15. Kevin Cowan & Erwin Hansen & Luis Oscar Herrera, 2005. "Currency Mismatches, Balance Sheet Effects and Hedging in Chilean non-Financial Corporations," Working Papers Central Bank of Chile 346, Central Bank of Chile.
    16. Taro Esaka & Shinji Takagi, 2013. "Testing the Effectiveness of Market-Based Controls: Evidence From the Experience of Japan With Short-Term Capital Flows in the 1970s," International Finance, Wiley Blackwell, vol. 16(1), pages 45-69, February.
    17. Kevin Cowan & Erwin Hansen & Luis Oscar Herrera, 2005. "Descalces cambiarios, repercusiones en el balance general y protección contra el riesgo en empresas no financieras chilenas," Research Department Publications 4388, Inter-American Development Bank, Research Department.
    18. Hu, Jiafei & Yuan, Haishan, 2021. "Interest arbitrage under capital controls: Evidence from reported entrepôt trades," Journal of Banking & Finance, Elsevier, vol. 127(C).

    More about this item

    Keywords

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    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F30 - International Economics - - International Finance - - - General

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