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Effects of capital controls on foreign exchange liquidity

Carlos Cantú

Journal of International Money and Finance, 2019, vol. 93, issue C, 201-222

Abstract: This paper investigates from a theoretical and empirical perspective the effects of capital controls on cost-based measures of foreign exchange (FX) market liquidity. First, we propose a market microstructure model of the exchange rate where capital controls reduce the trades of constrained dealers. The effect is a tightening of the effective spread, which increases market liquidity. Then, we propose a new measure of capital account restrictiveness that, in contrast to other traditional measures, can account for intensive changes in capital controls policies. Using this measure in a panel of emerging market economies, we provide empirical evidence showing that capital controls can reduce the implicit cost component of FX market liquidity.

Keywords: Capital flow management policies; Foreign exchange market; Market liquidity; Effective spread; FX liquidity measures (search for similar items in EconPapers)
JEL-codes: F31 F38 G11 G15 (search for similar items in EconPapers)
Date: 2019
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:93:y:2019:i:c:p:201-222

DOI: 10.1016/j.jimonfin.2019.01.006

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