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

  • Reuven Glick
  • Michael Hutchison

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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  1. Leonardo Bartolini & Allan Drazen, 1996. "Capital Account Liberalization as a Signal," NBER Working Papers 5725, National Bureau of Economic Research, Inc.
  2. Glick, Reuven & Rose, Andrew K, 1998. "Contagion and Trade: Why are Currency Crises Regional," CEPR Discussion Papers 1947, C.E.P.R. Discussion Papers.
  3. Sebastian Edwards, 1999. "How Effective are Capital Controls?," NBER Working Papers 7413, National Bureau of Economic Research, Inc.
  4. Reinhart, Carmen & Kaminsky, Graciela, 1999. "The twin crises: The causes of banking and balance of payments problems," MPRA Paper 14081, University Library of Munich, Germany.
  5. 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.
  6. Andrew Berg & Catherine Pattillo, 1999. "Are Currency Crises Predictable? A Test," IMF Staff Papers, Palgrave Macmillan, vol. 46(2), pages 1.
  7. Takatoshi Ito, 1999. "Capital Flows in Asia," NBER Working Papers 7134, National Bureau of Economic Research, Inc.
    • Takatoshi Ito, 2000. "Capital Flows in Asia," NBER Chapters, in: Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies, pages 255-296 National Bureau of Economic Research, Inc.
  8. Calvo, Guillermo A. & Mendoza, Enrique G., 1996. "Mexico's balance-of-payments crisis: a chronicle of a death foretold," Journal of International Economics, Elsevier, vol. 41(3-4), pages 235-264, November.
  9. 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.
  10. Takatoshi Ito & Kathryn M. Dominguez & Moeen Qureshi & Zhang Shengman & Masaru Yoshitomi, 1999. "Capital Flows to East Asia," NBER Chapters, in: International Capital Flows, pages 111-190 National Bureau of Economic Research, Inc.
  11. Vittorio Grilli & Gian Maria Milesi-Ferretti, 1995. "Economic Effects and Structural Determinants of Capital Controls," IMF Staff Papers, Palgrave Macmillan, vol. 42(3), pages 517-551, September.
  12. James Tobin, 1978. "A Proposal for International Monetary Reform," Cowles Foundation Discussion Papers 506, Cowles Foundation for Research in Economics, Yale University.
  13. Eichengreen, Barry & Rose, Andrew K, 1998. "Staying Afloat When the Wind Shifts: External Factors and Emerging-Market Banking Crises," CEPR Discussion Papers 1828, C.E.P.R. Discussion Papers.
  14. Jose De Gregorio & Sebastian Edwards & Rodrigo O. Valdes, 2000. "Controls on Capital Inflows: Do they Work?," NBER Working Papers 7645, National Bureau of Economic Research, Inc.
  15. Dani Rodrik & Andres Velasco, 1999. "Short-Term Capital Flows," NBER Working Papers 7364, National Bureau of Economic Research, Inc.
  16. Allan Drazen, 1997. "Policy Signaling in the Open Economy: A Re-Examination," NBER Working Papers 5892, National Bureau of Economic Research, Inc.
  17. Sebastian Edwards, 1999. "Crisis Prevention: Lessons from Mexico and East Asia," NBER Working Papers 7233, National Bureau of Economic Research, Inc.
  18. 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.
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