Capital Controls and the Global Financial Cycle

Abstract

Capital flows into emerging markets are volatile and associated with risks. A common prescription is to impose counter-cyclical capital controls that tighten during economic booms to mitigate future sudden-stop dynamics, but it has been challenging to document such patterns in the data. Instead, we show that emerging markets increase their capital controls in response to volatility in international financial markets and elevated risk aversion. We justify this behavior theoretically by a desire to manipulate the risk premium. When investors are more risk-averse or markets are volatile, investors require a high marginal compensation to hold risky emerging market debt. Regulators are able to exploit this tight link and raise capital inflow controls, thereby lowering the risk premium and reducing the overall debt burden. We emphasize that risk premium manipulations via capital controls are only rational from the perspective of the emerging market, but not from a global perspective. This adds a more cautious note on the use of capital controls in an international context.