How Does Capital Control Spur Economic Growth?

Zongye Huang and Yu You

https://doi.org/10.1111/twec.12682

Abstract

This paper provides a conceptual and empirical framework for evaluating the effect of capital controls on long-term economic growth. In a small open economy which relies on successful investment projects to provide capital goods, taking out short-term loans has two contradictory impacts: 1) it reduces the interest costs of financing investment projects, 2) it also leads to larger asset losses in the scenario of short-term debt run. In this work, we hypothesize that private financing decisions made by domestic investors are distorted towards excessive risk-taking, leading to ineffective capital formation. Thus, capital control policies, particularly, regulations on short-term loans, can be socially beneficial as they alter the debt composition, promote capital formation, and achieve a higher output level. Using a panel dataset covering 77 countries from 1995 to 2009, we employ a system Generalized Method of Moments (GMM) estimator to sequentially test three hypotheses and find strong empirical evidence that supports our theory.

Keywords: Capital controls; capital flow composition; short-term debt run; economic growth

JEL Classification: F43; O24; O16