Capital Controls and Risk Misallocation: Evidence From a Natural Experiment

74 Pages Posted: 16 Jan 2018 Last revised: 12 Aug 2020

Date Written: September 1, 2019

Abstract

Foreign currency debt has led to many crises in emerging markets. However, in the past decade, firms in emerging economies have drastically increased their foreign currency borrowing, making them significantly exposed to depreciation shocks. To reduce their exposure to external shocks, central banks have increased their use of capital controls. In this paper I study whether capital controls can have the unintended consequence of inducing firms to borrow more in foreign currency. I exploit heterogeneity in the strictness of capital controls across Peruvian banks to provide novel causal evidence of the effect of capital controls on local firms' dollar borrowing from banks. Using a unique dataset that includes all foreign exchange transactions and loans given by Peruvian banks, I find that capital controls encourage firms to take more foreign currency loans. I describe a new mechanism to explain these findings, in which capital controls induce local banks to shift exchange rate exposure away from foreigners and onto domestic firms. This is worrisome as the literature shows that depreciation shocks have led to significant reductions in investment and employment for these firms.

Keywords: capital controls, macroprudential policies, emerging markets, carry trade

JEL Classification: E44, F31, F32, F41, G15

Suggested Citation

Keller, Lorena, Capital Controls and Risk Misallocation: Evidence From a Natural Experiment (September 1, 2019). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=3099680 or http://dx.doi.org/10.2139/ssrn.3099680
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