Economic Effects and Structural Determinants of Capital Controls

Economic Effects and Structural Determinants of
Capital Controls by Vittorio Grilli and Gian Maria Milesi-Ferretti

This paper examines capital controls from a long-term perspective, it
analyzes theoretically and empirically their determinants and their economic
effects. With regard to the determinants of capital controls, the paper
investigates whether certain political and structural features of an economy
make the imposition or removal of capital controls more likely. With regard
to the effects of foreign exchange restrictions, it investigates whether
limitations on capital mobility, together with other economic, political,
and institutional features, help explain the behavior of key macroeconomic
variables, such as inflation, real interest rates, and growth.

The theoretical part of the paper presents a simple and widely used
overlapping generations model. Although no formal test of propositions
derived from the model is performed, the theoretical framework helps to
identify some of the key issues examined in the empirical analysis. The
empirical part of the paper is based on a panel of 61 developing and
developed countries. Dummy variables are constructed from the IMF's Annual
Report on Exchange Arrangements and Exchange Restrictions as proxies for
capital controls. These proxies include restrictions on payments for
current and capital account transactions and multiple currency practices.

Several interesting empirical regularities are identified in the paper.
Capital controls are more likely to be in place when income is low, the
share of government in economic activity is large, the exchange rate is
managed, and the government has a relatively free hand in monetary policy
because the central bank is not very independent. As for the economic
impact of capital controls, restrictions on capital account transactions
tend to be associated with higher inflation, a higher share of seigniorage
revenue in total revenue, and lower interest rates. This study finds no
robust impact of capital controls on the rate of growth, although there is
evidence that countries with large black-market premiums (themselves
correlated with foreign exchange restrictions) grow more slowly.