Capital Controls and Financial Crises

Abstract

The purpose of this paper is to explain the reluctance of developing countries to open up their capital market to foreigners, and the conditions inducing an emerging market economy to switch its policies. We consider an economy characterized initially by a one-sided openness to the capital market where domestic agents can borrow internationally, but foreign agents cannot hold domestic equity. We identify conditions under which the emerging market's capitalists would oppose financial reform. This would be the case if green-field investment by multinationals would bid up real wages, reducing thereby the rents of domestic capitalists. A financial crisis that raises the domestic interest rate may induce the emerging market's capitalists to support opening up the economy to FDI. This attitude switch is more likely to occur the greater the debt overhang, and the lower the borrowing constraint. Even in these circumstances, the emerging market's capitalists would prefer a partial reform to a comprehensive one -- they would prefer to maintain the restrictions on green-field FDI. If the attitude of capitalists is the obstacle to a comprehensive reform, a side payment from labor to the capitalists may be needed to induce a reform.