Exchange and Capital Controls as Barriers to TradeWP/98/81-EAWP/98/81 The significance of the link between exchange and capital controls and trade is a fundamental key to the smooth functioning of the international economic and financial system. During the past several decades, most countries have liberalized controls on current payments and transfers, and the focus of economic policy is increasingly shifting toward liberalizing controls over capital account transactions. Generally, however, the theoretical effect of exchange and capital controls on trade is somewhat ambiguous, and the systematic empirical evidence remains limited. This paper examines the effect of exchange and capital controls on trade for 1996 in the empirical gravity-equation framework, in which bilateral exports depend on the distance between countries, the countries. size and wealth, tariff barriers, and exchange and capital controls. The extent of exchange and capital controls is measured by unique indices, which aggregate information on 142 individual types of control from the IMF.s Annual Report on Exchange Arrangements and Exchange Restrictions. Overall, exchange and capital controls represent a noticeable barrier to trade. The specific impact of exchange and capital controls on trade, however, varies depending on the level of development of a country and the type of control. Controls on current payments and transfers are a minor impediment to trade, while capital controls significantly reduce exports into developing and transition economies, but not into industrial countries. These findings may reflect the extent to which controls on current payments and transfers have been liberalized worldwide, while the liberalization of capital controls has so far focused largely on industrial countries. An implication of the study is that further liberalization of exchange and capital controls can discernibly foster trade. |