The Impact of Trade Payment Restrictions and Capital Controls on External Sector Balances

Models of external balances rely on economic fundamentals, structural indicators, cyclical variables, and policy factors. However, existing models may not fully capture the effects of restrictions on trade payments and capital controls. In this paper, we include two new policy variables in a standard empirical model of the current account to address this gap: the Measure of Aggregate Trade Restrictions (MATR) and the FinOpen index. The results indicate that tighter restrictions on trade payments of one standard deviation are associated with increases in the current account balance of about one percentage point and an appreciation of the real effective exchange rate (REER). These effects primarily operate through suppressing import demand and reducing domestic absorption. Tightening capital inflow restrictions by one standard deviation increases the current account balance by about 1.4 percentage points and depreciates the REER. Outflow restrictions operate in the opposite direction. These effects are primarily due to a wedge between domestic and global real interest rates, which in turn affect saving and investment decisions. Updating these models to assess how trade payment and capital controls affect current account balances helps support more actionable policy recommendations.