1 Introduction
Globalization has reduced the distances between countries and has sped up the integration of capital markets. In response to capital market integration, countries have started liberalizing/deregulating financial markets. Both the liberalization and deregulation have led to rapid growth in capital flows across countries. The growth of capital flows changes not only the volumes and the frequencies of flows but also their nature and the composition, which could then affect the fundamentals of an economy and have raised many concerns. Thus, the issues related to capital flows have attracted broad attention and discussion, especially in emerging markets.
Capital flows An increase in capital flows, on one hand, could integrate capital markets across countries and reduce the frictions of financial markets. On the other hand, the associated contagion effects, also called spill-over effects, could shake the stability of the banking system and the financial markets and hence expose the economy to international credit risks and ultimately lead the economy to overseas- originated financial crises. While enjoying the benefits brought by increasing capital flows, the countries, especially emerging economies, are motivated to manage increasing capital flows to prevent contagion effects as well as overseas-originated crises. Amongst all management on capital flows, capital controls are the most popular and controversial policies. Their effectiveness as well as their pros and cons have been under debate for several decades since the 1970s. The results of the debates are inconclusive. The inconclusive results from this debate and the mixed results from decades of research also reflect in reality that while some countries move from free flows to capital controls, other countries move from capital controls to free flows through the liberalization of capital controls and/or accounts. In general, capital controls were adopted widely before the 1970s but were removed gradually to promote free flows after the 1970s. Controls became popular and were implemented once again in the 1990s. During 1990–1997, prior to the Asian Financial Crisis, the implemented capital controls were mainly on inflows [Edwards (2009a, 2009b), Johnson et al (2007)], such as in Thailand, Malaysia, Philippines, Indonesia, Czech Republic, Colombia and Brazil.
