Capital controls and the global financial cycle

Capital flows into emerging markets are volatile and risky, which sparked interest in active capital flow management. We first revisit the use of capital controls and discover a new stylized fact: emerging markets, which actively revaluate their capital flow restrictions, increase capital inflow controls during episodes of major international financial distress when investors are very risk averse and markets volatile. We then explore this finding theoretically. We argue that heightened international financial volatility and investor risk aversion incentivize regulators to reduce the amount of risky emerging market debt to cope with elevated risk premiums. This rationale can be decentralized via capital inflow restrictions during periods of major financial distress, consistent with the empirical findings. The paper hence provides an alternative to the familiar macroprudential motivation for capital controls.