Theoretical and empirical analysis: practical lessons

analysis in various ways and tackling the issues from various angles to get a better picture of the real impacts of capital controls before implementing/liberalizing capital controls.

The effectiveness of capital controls

Depending on the goals one wishes to achieve, there are many definitions of the effectiveness of capital controls. In general, according to Edwards (2001, 2007a, 2007b), the goals of capital controls can be summarized as (1) restricting the volumes and compositions of flows, (2) gaining monetary autonomy and (3) reducing fluctuations and preventing crises. Empirically, the findings regarding the effectiveness of capital controls are mixed in several ways.

One example regards the effects of controls on capital flows. Forbes and Warnock (2012) find that capital controls have little association with foreign-driven capital flows. However, El-Shagi (2010) discovers that capital controls can restructure capital flows without distortion but does not specify whether the capital flows to be restructured by controls are limited to foreign- or domestic-driven flows. Without the specification of foreign-/domestic driven flows, it is difficult to conclude whether the two results are inconsistent. Another example regards general versus specific patterns of flow. Forbes and Warnock (2012) focus on general patterns of flow waves during specific periods. Meanwhile, El-Shagi (2010) focuses on the panel data of specific countries. If the patterns found in specific countries differ from Forbes and Warnock (2012), should the results be considered as inconsistent? Note that patterns may depend on the datasets and the methodology adopted for the empirical studies. Various datasets may have different definitions and measurements both within and across countries and across time. While using the term “capital flows”, some studies analyse gross flows; some use net flows; some did not mention whether it is gross or net flows. Therefore, it has been challenging to compare various empirical studies related to capital flows and controls.

In order to overcome the challenges of empirical studies, Eichengreen (2004, p 51) takes the first step by exploring the problems and limitations of the measures based on statute, on actual flows and on asset prices. He concludes that with various measures, the results of studying the effectiveness of capital account liberalization are various and inconsistent, and that the consistency depends crucially on the measures and the data. Therefore, although it is challenging to unify the definitions and measures of datasets, especially for historical datasets, it is important and crucial to take steps to clarify specific issues of debates and to understand better various empirical studies on capital flows.

Note that the challenges mentioned earlier have not accounted for the policy shifts between various capital controls as well as on and off controls from time to time. Even though some challenges may be overcome by further developments in empirical methodology and measurements, some challenges require a structured theoretical analysis to clear the road for the next step or directions. These challenges explain why Magud and Reinhart (2007) call for the development of a unified theoretical framework to resolve the existing apple-to-orange problems

in empirical studies on the effectiveness of capital controls. Through a theoretical framework, specific complications can be simplified, and some challenges faced by empirical studies can be overcome. By connecting flows with financial markets and banking systems in a theoretical framework, we can analyse the circumstances in which contagion effects are more likely to occur and in which the banking system would be more fragile. With the assistance of theoretical analysis, we can then identify the real impacts of capital flows and controls on the financial markets, the banking system and the economy and find mechanisms with which to prevent contagion effects associated with flows. Based on the analysis, we may find those factors that are the causes of inconsistent results in empirical findings.

Theoretical frameworks

In macroeconomics, there are theoretical frameworks that can be the candidates for analysing the increasing role of banks and the linkages to capital flows. Acemoglu (2009, chapter 19) extends an infinite-horizon model of trade to analyse the direction of flows and to show how flows depend on the returns of the capital–labour ratio. Bencivenga and Smith (1991) adopt an overlapping-generations model to analyse the roles of financial intermediation on growth. Diamond and Dybvig (1983, 1986) extend an overlapping-generations model to address bank runs and demonstrate the fragility of the banking system. Following Diamond and Dybvig (1983), the overlapping-generations model has been widely extended to discuss various circumstances of bank runs and the fragility of the banking system. The recent work of Gertler and Kiyotaki (2015) opens the door for an infinite-horizon model to incorporate banking systems to discuss the possibility of bank runs.

Infinite-horizon and overlapping-generations models have their own advantages and disadvantages. Depending on the features to incorporate and the purposes of the analysis, one type of model can be more appropriate than the other. In this book, I extend the overlapping-generations framework for its key feature to incorporate the dynamics of the decisions made by different generations. The feature will provide the space to analyse the amount of periods it will take to affect the banking system and the economy, as some effects may take time to surface, including the effects of flows. Depending on the topics, the models of each chapter would incorporate the specific features of capital flows, the banking system and the financial markets. Moreover, while an overlapping-generations framework has been adopted to analyse bank runs and financial assets, it also suits the purposes of the chapters to analyse the stability of banking systems and the financial markets. Therefore, the overlapping-generations framework is adopted here to analyse various issues related to capital flows and controls and banking crises.

In this book, an open-economy, three-period-lived overlapping-generations model is constructed to incorporate the features of capital flows, the financial markets and the banking system. There are agents of different types as well as financial markets and the banking system. The banks, also called financial intermediaries, are assumed to serve primarily as middlemen and as portfolio managers in the analysis which focuses on capital flows and growth. The assumption is then relaxed, and the banks are assumed to maximize their own profits in the

analysis which then focuses on the fluctuations of capital flows, capital controls and bank governance. The decisions made (and expected to be made) by the agents of different generations would affect the decision of the banks, which would have impacts on the situations of the financial markets and capital flows and hence the economy and the decision making of the agents of different generations. The realized as well as the expected outcome would then affect the decisions of the agents in the following period and affect the economic outcome. The dynamics across various agents and sectors need not be unidirectional. The features of overlapping-generations frameworks provide the space to peel away the interactions of various sectors carefully before and after incidences period by period. This allows us to identify when specific crucial factors take place underneath and when the effects would surface and show the impacts.

The rest of the book is organized in the following order. Chapters 2 and 3 are both on growth aspects. While Chapter 2 focuses on long-term foreign direct investment flows, Chapter 3 focuses on short-term flows, portfolios and other investment. Chapter 4 discusses the change of capital flows and their relations to the stability of the financial markets and the banking system. Chapter 5 concentrates on the banking system to analyse the effectiveness of the facilities used to prevent the runs. Combining what has been learned in Chapters 4 and 5 on capital flows and the stability of the banking system, I introduce capital controls in Chapter 6 to analyse whether such implementation can make a difference in preventing banking crises. This is followed by Chapter 7, in which I combine current studies in various literatures to look at the missing pieces and the possible steps in both theories and empirics to further understand the flows and related policies as well as their impacts. The conclusion is provided in Chapter 8.

To be more specific, as long-term capital flows, foreign direct investment has been considered as the steady component of capital flows. Based on the existing theory analysing various types of foreign direct investment projects, FDI flows should have positive effects on both home and host countries’ growth. However, the empirical studies have found mixed and inconsistent results even for the same countries as well as for the countries at similar development stages. Chapter 2 develops a model incorporating the key features of FDI projects and analyses both the short-term and the long-term impacts on the banks’ role as a portfolio manager and hence economic growth.

The short-term capital flows often refer to portfolio and other investments. The short-term flows are sensitive to economic conditions and shocks. The economic conditions are the conditions of all countries involved in the investors’ investment portfolios, not limited to those of the host countries. Thus, the shortterm capital flows tend to fluctuate more frequently than long-term flows and are considered as one main cause of “sudden stops”. Extending the theoretical model of Chapter 2, Chapter 3 analyses how the short-term flows might affect the portfolios of the financial intermediaries and hence economic growth of both the home and the host countries. This is followed by discussion on how economic growth might affect portfolio capital flows in return.

One argument on capital flows benefitting both home and host countries is based on deepening financial development. Chapter 4 looks into the channels

of how capital flows affect the financial markets and the ability of capital flows to shake the stability of the banking system. To do so, this chapter analyses the financial markets and the stability of banking systems in both home and host countries with and without capital flows as well as the consequences of sudden stops.

Banking crises have occurred more frequently after deregulations in financial markets, which may and may not be related to capital flows. In response to banking crises, short-term lending facilities have been considered as the elixir to rescue banks from crises. Thus, such lending facilities have been provided by central banks and international organizations. Unfortunately, banking crises do not stop occurring. The banking crises in the Global Financial Crisis in 2008 were the most recent examples. Do lending facilities fail to prevent banking crises? Or are there problems in the banking system which prevent lending facilities from being effective? Chapter 5 examines the limitations of lending facilities in preventing banking crises and asks whether there exists an alternative way to improve the effectiveness of lending facilities in preventing banking crises without capital flows. Focusing on the banking system without capital flows allows us to deepen our understanding of the issues existing in the banking system when capital flows have not yet taken place.

Since the 1990s, capital controls have been implemented to prevent contagion effects via financial liberalizations and hence to prevent the countries from experiencing banking crises. Have capital controls been effective in achieving the goal of preventing banking crises? There are various types of capital controls. Some countries control either inflows or outflows, and some control both flows. Are controls in one specific direction more effective in preventing the crises? Is one specific control more suitable for certain countries than other controls? Chapter 6 examines the effectiveness of various types of capital controls in preventing banking crises. The chapter also evaluates the cost and the benefits of implementing capital controls.

The issues of capital flows and their connections to the stability of banking systems and crises have been challenges to empirical studies. The challenges include data limitation, issues of measurement and methodology adopted. Thus, empirical findings related to capital flows are sensitive to the datasets, the methodology and the countries. The sensitive findings in empirical work have led to inconsistency and generate various debates on capital flows, financial liberalizations and the stability of banking systems. Chapter 7 summarizes the findings of current empirical studies related to capital flows and financial markets. Then, connecting what has been learned in theoretical analyses in the previous chapters, this chapter discusses what can be done in empirical studies to narrow the gap and to contribute to the current debate. Moreover, this chapter takes a step further to discuss policy implications, especially on the policies related to capital flows, the financial de(regulations) and the stability of banking systems. This is followed by the conclusion in Chapter 8.

Chapter 8 summarizes the key features and conclusions of each chapter and highlights the main policy implications as well as possible extensions for further theoretical and empirical studies.