Do Financial Regulation and Deregulation Work Symmetrically?

Abstract

The paper compares the effects of financial deregulation and regulation in emerging market economies. The findings imply that, in contrast to common belief, financial regulation and deregulation do not work symmetrically. The related mechanisms differ in the way they affect domestic interest rates as well as borrowing and investment decisions. Two main reasons support this hypothesis. First of all, it has to be considered that domestic firms, in the initial situation, have already determined a specific size of enterprise. Since it is usually easier to expand operational activities than to reverse them, at least in the short-run, a change in domestic capital mobility would then have different effects on domestic investment contingent on whether restrictions are removed or introduced. Secondly, though capital controls do affect the financing decisions of domestic firms, they are not expected to reduce the aggregate market capitalization of emerging market economies. Market-based capital-inflow controls are rather likely to shift short-term inflows to longer term inflows without declining the overall volume of inflows. This in turn may stimulate long-term investment with higher risk-adjusted yields. Consequently, the impact of capital controls on investment and thus on growth opportunities in emerging markets has to be considered and analyzed individually and independently from the effects of financial liberalization.