Effects of Capital Controls on Foreign Exchange Liquidity

45 Pages Posted: 7 Sep 2017

See all articles by Carlos Cantú

Carlos Cantú

Bank for International Settlements (BIS) - Representative Office for the Americas

Date Written: August 2017

Abstract

The literature on capital controls has focused on their use as tools to manage capital and improve macroeconomic and financial stability. However, there is a lack of analysis of their effect on foreign exchange (FX) market liquidity. In particular, technological and regulatory changes in FX markets over the past decade have had an influence on the effect of capital controls on alternative indicators of FX liquidity.

In this paper, we introduce a theoretical model showing that, if capital controls are modelled as entry costs, then fewer investors will enter an economy. This will reduce the market's ability to accommodate large order flows without a significant change in the exchange rate (a market depth measure of liquidity). On the other hand, if capital controls are modelled as transaction costs, they can reduce the effective spread (a cost-based measure of liquidity). Using a panel of 20 emerging market economies and a novel measure of capital account restrictiveness, we provide empirical evidence showing that capital controls can reduce cost-based measures of FX market liquidity. The results imply that capital controls are effective in reducing the implicit cost component of FX market liquidity but can also have a negative structural effect on the FX market by making it more vulnerable to order flow imbalances.

Keywords: capital flow management policies, foreign exchange market, market liquidity, market depth

JEL Classification: F31, F38, G11, G15

Suggested Citation

Cantú García, Carlos, Effects of Capital Controls on Foreign Exchange Liquidity (August 2017). BIS Working Paper No. 659. Available at SSRN: https://ssrn.com/abstract=3030102

Carlos Cantú García (Contact Author)

Bank for International Settlements (BIS) - Representative Office for the Americas ( email )

Switzerland

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