Impact of capital controls on banking crises and economic growth

Abstract

This study examines the expected impact of capital control tools on financial stability. We demonstrate that capital controls lower the probability of a banking crisis (positive effect) and simultaneously reduce economic growth (negative effect). We apply a dynamic panel logit model with fixed effects on a sample of countries composed of emerging and advanced economies for the period 2000–2020. Moreover, we use an impulse response function analysis to assess the net effect of capital controls. The results show that while regulation of capital flows directly stabilizes the economy, it also indirectly destabilizes it by impeding economic growth. Furthermore, we found that the positive impact of lowering the probability of a crisis dominates the adverse effect on economic growth. These impacts are different across the subgroups of emerging market economies and advanced countries. However, in both subgroups the effect of capital controls is independent of capital controls tightening. These results have significant implications for policymakers, who must adjust the capital flows regulatory policy according to economic growth and financial stability objectives.