The Distorting Impact of Capital Controls Makram El-Shagi Halle Institute for Economic Research (IWH), Department of Macroeconomics Abstract. This paper uses panel data to show that capital controls have a significant impact on international interest rate differentials. Various types of controls can be distinguished within the data. The analysis shows that the aforementioned effects of capital controls on interest rates are especially strong in the case of capital import controls on portfolio capital; the implementation of these controls has been suggested in the wake of the Asian Crisis to prevent further crises. The results presented herein contradict the hypothesis that capital controls can achieve a restructuring of the maturity of capital inflows without a distortion in international capital allocation. JEL classification: E43, F33, G15. Keywords: Interest rate differentials; capital controls. 1. INTRODUCTION The present paper investigates the question of whether capital controls, used by roughly two-thirds of the IMF members, distort the international allocation of capital. To consider the effects on allocation, we examine the impact of capital controls on real interest rates. The major contributions of the paper are as follows. First, we use new, more detailed data that account for the different effects of inflow and outflow controls; these effects have not been considered in prior, similar studies. Second, the paper provides broad-panel data useful in answering a question, whereas the existing body of literature is almost exclusively limited to time-series data or to very narrow country panels. Third, we use recently developed econometric techniques that allow for an unbiased estimate of the impact of slowly changing variables (such as capital controls), despite the presence of unobservable country-specific effects. This circumstance has been a major obstacle to previous empirical work on capital controls. The question of whether capital controls cause international real interest rate differentials has two distinct aspects. First, are capital controls effective in isolating national capital markets from international competition, or are market participants generally able to evade the regulations? Second, do (and should) politicians intend to affect real interest rates via capital controls? If effective capital controls are implemented to allow for an autonomous monetary policy, then there will be a clear impact on real interest rates. 1 However, if capital controls are meant to affect the structure of capital flows (i.e., to increase the average maturity of capital inflows) in the spirit of Tobin (1978), then risk-adjusted real interest rates should not deviate systematically between countries. Thus, by gathering evidence that capital controls (mostly inflow controls, which are usually officially implemented with the latter reasoning) increase real interest 1. Based on a dynamic model, Herrera and Valde ´s (2001) further argue that even controls targeted toward the creation of interest rate differentials do not necessarily succeed in this attempt. r 2011 The Author German Economic Review r 2011 Verein fu ¨r Socialpolitik. Published by Blackwell Published Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA. German Economic Review ( ): 1– 5 1 13 4 5