"Rethinking the Balassa Samuelson Effect: Capital Controls and Real Exchange Rate Misalignment"
Abstract: The Balassa-Samuelson effect suggests that a poorer country should have a lower price level – or a more depreciated real exchange rate, and that a country with faster productivity growth should experience an appreciation of its real exchange rate. This paper documents large and persistent real exchange rate deviations from the Balassa-Samuelson effect based on a country level panel dataset that covers 154 countries from 1970 to 2011. This paper argues that with capital controls, less capital flows into countries with faster economic growth, and there is a slower appreciation of the real exchange rate. My results show that capital controls help explain the existence of countries’ large and persistent real exchange rate misalignment including both real exchange rate overvaluation and undervaluation. Moreover, this paper finds that capital control policy is effective at undervaluing the real exchange rate. I use propensity score matching to solve the potential endogeneity and selection bias problems. The results are robust to different forms of Balassa-Samuelson estimations as well as different measures of capital controls. In addition, the results are robust to other factors that can cause real exchange rate misalignment. For a sub-sample analysis focusing on countries with faster economic growth that would have more pressure on real exchange rate appreciation suggested by the Balassa-Samuelson effect, this paper finds that fixing the nominal exchange rate alone does not slow down the real appreciation. However, capital control policy is effective at keeping the real exchange rate largely undervalued and slowing down the speed of real exchange rate convergence, and allow countries to stay substantially undervalued for a considerable period of time. These results also contribute to explaining the Purchasing Power Parity (PPP) puzzle.
"Capital Controls and Capital Flows: Do Controls Reduce the Size of Flows?"
Abstract: This paper examines the effectiveness of capital outflow controls on reducing the size of capital outflows based on a large panel data that covers 98 countries from 1995 to 2015. Results in this paper show that imposing capital controls comprehensively that putting restrictions on almost all the asset is the necessary condition to reduce the size of outflows. In addition, comprehensive capital controls can also be imposed episodically on reducing outflows even though the country had a fairly open capital account in the past. This provides a policy rationale for using capital controls as a temporary tool on targeting outflows. Last, on targeting a particular type of asset flows, this paper finds that countries are able to reduce banking flows by closing assets channels that affect banking flows only. In contrast, it is not effective to reduce either equity or debt flows by only closing assets channels that affects these two types of flows respectively.
"Optimal Monetary Regime on Consumption Growth Volatility"
Abstract: After the collapse of Bretton-Woods international monetary system, countries faced their own choices of exchange rate regime and degree of financial openness. This paper explores the relationship between monetary regime combinations of exchange rate flexibility and degree of financial openness and consumption growth volatility in the post Bretton Woods era. In theory, a flexible exchange rate allows countries to have monetary autonomy that can counteract shocks and stabilize consumption, and a flexible exchange rate itself also acts as real external shock absorber. Financial integration allows a country to pool its idiosyncratic consumption risk through international borrowing. Thus, countries with highly opened financial markets and a floating exchange rate (open-float regime) should have the smallest consumption growth volatility relative to other regime combinations. Empirical results found in this paper support the theoretical prediction for rich (High income) countries. In contrast, for non-rich countries, several regime combinations, such the semiopen-softpeg regime, are associated with smaller consumption growth volatility compared with the open-float regime, which is different from the theoretical prediction. In addition, this paper also explores the policy benefits tradeoff between having independent monetary policy and international consumption risk sharing on reducing consumption growth volatility, by comparing the close-peg regime with open-peg regime. The results show that for rich countries, having international risk sharing contributes to lower consumption growth volatility.