Currency Risk Under Capital Controls

Abstract

Currencies in emerging markets with stricter capital controls exhibit lower average returns, unexplained by standard currency risk factors. This relation is pronounced in debtor countries with high foreign currency liability shares. Capital controls mitigate currency risk by preventing depreciation during market turmoil. We propose an intermediary asset pricing model incorporating an occasionally binding credit constraint for borrowing countries. Capital controls lower crises probability and reduce currency crashes. The model replicates the empirical findings and quantifies the financial impact of pecuniary externality. Based on the model, currency risk premia serve as a tool for policy evaluation.

Keywords: Capital control, Currency risk, Risk premia, Emerging markets

JEL Classification: F31, F38, G15