Imperfect Competition in Financial Markets and Capital Controls: A Model and a Test

This paper explores the implications of financial repression, specifically, imperfect competition in the financial sector and capital controls for equilibrium interest rates and current account imbalances; and the implications of liberalization. I find that (1) interest differentials between home and foreign markets exist and are higher the fewer the number of domestic financial institutions (2) liberalization of the domestic financial sector - i.e. increasing the number of players - exacerbates current account imbalances in growing economies and reduces revenues from repression (3) revenues from financial repression decline when capital controls become porous (which may be a consequnce of trade liberalization), making liberalization of domestic financial sector more palatable to the domestic governments. An empirical exercise validates several predictions of the model.