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Abstract:
This paper deals with three highly controversial aspects in the international finance literature: the degree of international financial integration, the economic impact of capital mobility, and the potential role of capital controls in the emerging international financial architecture.
Regarding the first aspect, many observers have been influenced by the recent hype about "globalisation" and in fact take it for granted that capital markets have become almost fully integrated into a world financial marketplace. This paper, reviews evidence that challenges this conventional wisdom, though confirming that the degree of international financial integration is rising.
With respect to the second aspect, it is demonstrated that there are circumstances under which the free flow of international capital could negatively impact upon economic performance and/or otherwise welfare-enhancing domestic policies. This finding conflicts with traditional theory and provides an economic rationale for the judicious introduction of capital controls.
With this assertion in mind, the final aspect, the role of capital controls, is investigated. The specific question explored is how far restrictions on international capital flows are able to avert a costly economic imbalance arising from fluctuations in the balance of payments. Although the international consensus seems to have shifted in recent years towards promoting Chilean-style capital controls as a potential new building block in the international financial landscape, this paper cautions against such a generalisation of the Chilean experience. Rather, a review of the empirical literature suggests that much of Chile's economic success story in the last decade can be explained by factors other than its control regime.
The rising degree of international financial integration enhances the need for small countries to resolve their dilemma of being dependent on external funding and, at the same time, most vulnerable to sudden reversals of international capital flows. Yet, simple solutions of how to counterbalance the potential threats of capital mobility in a second-best equilibrium, are not found to be easily forthcoming. In particular, this paper argues that capital controls are no panacea - even less so, if they delay necessary macro- and microeconomic reforms.
A worrying feature of the international financial system, partly due to continued innovations in financial engineering, is that short-term capital flows appear to have become increasingly detached from economic fundamentals. As such, how much this trend will further curtail governments' unilateral efforts to withstand financial destabilisation, in spite of a healthy macro- and microeconomic economy is an important question for future research. Further, understanding whether or not this provides a case for greater international economic policy co-operation, is equally prudent.
Table of Contents:
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| 1. |
Introduction and Overview |
1
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| 2. |
The Degree of International Financial Integration |
3
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| 2.1. |
Saving-Investment Correlations |
3
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| 2.1.1. |
Non-Fundamental Causes |
5
|
|
Model-Specific Sources of Bias |
5
|
|
Sampling and Measurement Bias |
7
|
|
Evidence of Endogeneity |
8
|
|
Evidence of a Sampling Bias |
9
|
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Evidence of the Large-Country Effect |
11
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|
Interim Assessment |
12
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| 2.1.2. |
Fundamental Causes |
13
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Capital Controls |
13
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International Risk Diversification |
15
|
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Ultrarational Households |
15
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| 2.1.3. |
Summary |
16
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| 2.2. |
Arbitrage Tests |
18
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| 2.2.1. |
Concepts of Interest Parity |
18
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Uncovered Interest Parity |
18
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Covered Interest Parity |
18
|
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Real Interest Parity |
19
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| 2.2.2. |
Measurement |
21
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| 2.2.3. |
Empirical Evidence |
22
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| 2.2.4. |
Summary |
26
|
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Additional Comments |
26
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| 2.3. |
Portfolio Tests |
28
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| 2.3.1. |
Mean-Variance Analysis |
28
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| 2.3.2. |
The International Capital Asset Pricing Model |
29
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| 2.3.3. |
Alternative Measures Based on Portfolio Theory |
31
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| 2.3.4. |
Empirical Evidence |
33
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| 2.3.5. |
The Home Bias Revisited |
39
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Barriers to International Investment |
40
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Econometric Sources of Bias |
42
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Data Constraints |
42
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Market Failure |
43
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| 2.3.6. |
Summary |
44
|
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Additional Comments |
45
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| 2.4. |
Degree of Monetary Autonomy |
46
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| 2.4.1. |
Basic Outline |
46
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| 2.4.2. |
Measurement |
49
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| 2.4.3. |
Empirical Evidence |
50
|
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Additional Comments |
50
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| 2.5. |
Summary and Conclusions |
51
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| 3. |
The Economic Impact of Capital Mobility |
54
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| 3.1. |
Benefits from Capital Market Integration |
54
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| 3.1.1. |
The Traditional View |
54
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| 3.1.2. |
Endogenous Growth |
55
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| 3.1.3. |
International Risk Sharing |
56
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| 3.1.4. |
Summary |
57
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| 3.2. |
Risks of Capital Market Integration |
58
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| 3.2.1. |
Market Failure |
58
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Public Commercial Interventionism |
58
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Capital Account Liberalisation |
59
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Wage Rigidities and Unemployment |
61
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Inequality of Private and Social Returns |
61
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Policy Implications |
62
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| 3.2.2. |
Monetary and Fiscal Policy |
64
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The Basic Mundell-Fleming Model |
64
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Monetary and Fiscal Policy in a Fixed Exchange Rate Regime |
66
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Monetary and Fiscal Policy with Flexible Exchange Rates |
68
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Interim Assessment |
70
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The Mundell-Fleming Model with Sticky Prices |
70
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Taxation |
77
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Policy Implications |
77
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| 3.2.3. |
Balance of Payments Crises |
79
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Theories of Speculative Attacks |
80
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First-Generation Models |
81
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Second Generation Models |
88
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Third Generation Models |
93
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Policy Implications |
98
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| 3.3. |
Summary |
101
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| 4. |
Capital Controls: Theory and Evidence |
102
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| 4.1. |
Capital Controls in Modern Economic History |
103
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| 4.2. |
Types and Motivations of Capital Controls |
105
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| 4.3. |
The Effects of Capital Controls in Theory |
108
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| 4.3.1. |
The Traditional View |
108
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| 4.3.2. |
Changing the Volume and Composition of Capital Flows |
109
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| 4.3.3. |
Reducing Exchange Rate Volatility |
110
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Speculation versus Hedging Activities |
114
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| 4.3.4. |
Fending off a Speculative Attack |
115
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| 4.4. |
Measuring the Effectiveness of Capital Controls |
116
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| 4.5. |
Empirical Evidence |
119
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| 4.5.1. |
Inflow versus Outflow Controls: Some Stylised Facts |
120
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| 4.5.2. |
Controls on Capital Outflows |
120
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Restoring Policy Autonomy |
120
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Fending off Speculative Attacks |
122
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Recovering from a Speculative Attack |
125
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Interim Assessment |
126
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| 4.5.3. |
Controls on Capital Inflows |
127
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The Chilean Experience |
128
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Interest Rate Equivalence of the Chilean URR |
131
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The Effectiveness of Capital Controls in Chile |
135
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Methodological Issues |
135
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The Volume and Composition of Inflows |
136
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Domestic Interest Rates |
139
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Real Exchange Rates |
142
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Financial Stability |
145
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Summary |
148
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Selective Evidence from Other Countries |
151
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| 4.6. |
Conclusions |
152
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| 5. |
Summary and Policy Implications |
154
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| 6. |
Appendix |
159
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| 6.1. |
Purchasing Power Parity |
159
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| 6.1.1. |
The Law of One Price |
159
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| 6.1.2. |
Absolute Purchasing Power Parity |
160
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| 6.1.3. |
Relative Purchasing Power Parity |
160
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| 6.2. |
Concepts of the Real Exchange Rate |
162
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| 6.3. |
Exchange Rate Expectations |
165
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| 6.3.1. |
The Survey-Based Approach |
165
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| 6.3.2. |
The Rational Expectations Approach |
166
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| 6.4. |
Endogeneity of Regressors and Cointegration |
167
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References |
168 |
