Surviving Asymmetry in Capital Flows and the Business Cycles: The Role of Prudential Capital Controls

Abstract

Past literature of different strands has pointed to a potential asymmetry: while portfolio capital inflows are largely irrelevant to the economy, capital outflows can cause recession. In a model with a convex investment and portfolio balance adjustment cost, and endogenous credit‐in‐advance constraint, we find that investment is determined solely by opportunity cost of physical capital unrelated to portfolio capital inflows when the constraint is slack. However, once credit availability is tightened up by capital outflows, the negative liquidity constraint dominates the opportunity‐cost factor, causing an economic downturn. Financial fragility against capital outflows is an outcome of pecuniary externalities, which, however, can be moderated by prudential capital controls. Even when exchange rates float freely, capital controls ease the macro‐stabilizing burden of monetary policy, as they help shield the economy from financial instability. Prudential tax on foreign debt is most preferred, and works the best when the exchange rate float is managed.