Can Capital Account Liberalization Lessen Capital Volatility in a Country with 'Original Sin'?

Abstract

Over the last three decades the volatility in international capital flows has shown an increasing trend in both emerging economies and advanced countries. This study investigates how capital account liberalization affects capital flow volatility using 34 country panel data. Overall, we find that the level of financial openness increases capital volatility. However, after we divide our panel data based on whether or not a country can borrow abroad in its own currency, namely 'original sin', the effect of financial openness appears differently in each group. While in original sin free groups capital openness has no significant effect on capital volatility, it increases the volatility significantly in original sin groups. Also when the sample is limited to countries which established good quality in their institutions, the difference remains between the two groups. It means that the different effects of capital openness on the volatility should be attributed to differences in international status of currencies rather than in institutional quality. This finding suggests that emerging economies whose currencies are not internationalized should be more cautious of capital account liberalization.