The Compatability of Capital COntrols and Financial Development: A Selective Survey and Empirical Evidence

This paper examines the relationship between capital controls and financial development, with an emphasis on the empirical aspects of the linkage. Financial development is interpreted broadly as increasing the efficiency of allocating financial resources and monitoring capital projects. In empirical terms, this translates into an increasing volume of bank intermediation and an increasing role for equity capital. Hence, this paper investigates a substantially broader set of proxy measures of financial development than has heretofore been analysed. Moreover, in addition to the IMF’s measures of exchange restrictions, the Quinn (1997) index of financial openness is used as a measure of capital controls. The econometric results suggest that the rate of financial development, as measured by private credit creation and stock market activity, is linked to the existence of capital controls. However, the strength of this relationship varies with the empirical measure used and the level of economic development. Equity market activity appears to be linked to capital controls in both the full sample and in a restricted sample of developing countries. The possibilities for work at a more disaggregate level on banking and equity markets are also discussed. The results pertaining to equity market development are particularly important, as recent work suggests that new technologies may not be effectively supported by bank-directed finance.