RWP 21-08, September 2021; updated December 2021
Capital flows into emerging markets are volatile and associated with risks, which renewed interest in capital controls as a policy tool. This paper documents that emerging markets increase capital inflow restrictions during episodes of major international financial distress, like the Global Financial Crisis or the Dot-Com Bubble. We develop a model in which this behavior arises from a desire to manipulate the risk premium. When investors are more risk-averse or markets are volatile, investors require a high marginal compensation to hold risky emerging market debt, thus incentivizing regulators to limit capital inflows. However, these interventions are only optimal from the perspective of the individual emerging market and reduce global welfare, adding a cautious note on the desirability of capital controls.
JEL classification: F36, F38, F41
Lovchikova, Marina, and Johannes Matschke. 2021. “Capital Controls and the Global Financial Cycle.” Federal Reserve Bank of Kansas City, Research Working Paper no. 21-08, September. Available at External Linkhttps://doi.org/10.18651/RWP2021-08