Capital Account Liberalization, Institutions and Financial Development

Capital Account Liberalization, Institutions

and Financial Development:

Cross Country Evidence

by

Menzie D. Chinn*

UC Santa Cruz and NBER

and

Hiro Ito**

UC Santa Cruz

May 5, 2002

Acknowledgements: Helpful comments were received from Joshua Aizenman, Michael

Hutchison, Carl Walsh, Frank Warnock, participants at the UCSC brown bag, the USC

development seminar and, on an earlier version of the paper, the ANU-IMF East Asia Office

conference on “Regional Financial Markets” (Sydney, November 2001). We also thank Ashok

Mody and Dennis Quinn for providing data. Financial support of faculty research funds of UC

Santa Cruz are gratefully acknowledged.

* Menzie D. Chinn, Department of Economics, Social Sciences 1, University of California, Santa Cruz, CA 95064.

Tel/Fax: (831) 459-2079/5900 Email: chinn@cats.ucsc.edu .

** Hiro Ito, Department of Economics, Social Sciences 1, University of California, Santa Cruz, CA 95064. Email:

hiroito@cats.ucsc.edu .

Capital Account Liberalization, Institutions and Financial Development

Cross Country Evidence

Abstract

The empirical relationship between capital controls and the financial development of credit and

equity markets is examined. We extend the literature on this subject along a number of

dimensions. Specifically, we (1) investigate a substantially broader set of proxy measures of

financial development; (2) create and utilize a new index based on the IMF measures of exchange

restrictions that incorporates a measure of the intensity of capital controls; and (3) extend the

previous literature by systematically examining the implications of institutional (legal) factors.

The 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 development. These

results also suggest that only in an...