An empirical analysis on government capital controls and international capital flows in Korea

Abstract

The present paper analyses government controls of international capital flows using Korean data. First, indexes of liberalizations are constructed on controls of capital inflows and outflows based on documented policy changes made by the Korean government. Second, VAR models are estimated that include the constructed capital liberalization indexes, capital flows, and other macroeconomic variables. It is found that capital inflows increase persistently after shocks to liberalization policy while capital outflows increase temporally. It is also found that shocks to liberalization of capital outflows attract capital inflows, a result explicable by two competing theories - that liberalization of capital outflows: (1) removes investment irreversibility; and (2) signals more friendly government policy in the future. Examination of the effects of separate capital liberalization measures concerning only Korean residents and those concerning only nonresidents confirms the importance of the ‘signal effect’.