Capital Controls

Modigliani and Miller (1958) show that under certain conditions, including frictionless capital

markets, firms should face the same cost for internal and external finance. As a result, a firm’s

liquidity and capital structure should not affect its investment decisions. Since this seminal

article, however, there has been an extensive theoretical literature explaining why informational

asymmetries and incentive problems can make external financing more expensive than internal

financing, as well as an extensive empirical literature testing these propositions.19 Although

results vary somewhat across studies, the majority of evidence suggests that firms predicted to

have greater asymmetric information and incentive problems, and therefore be more financially

constrained, tend to have a greater sensitivity of investment to fluctuations in internal funds.

Most closely related to this paper, studies of both developed countries and emerging

markets have found extensive evidence that smaller firms tend to be more financially constrained

than larger firms.20 Other studies, such as Love (2001) and Laeven (2002), provide cross-country

evidence that firms tend to be less financially constrained in countries with more developed or

liberalized financial markets. Harrison, Love and McMillan (2001) is the only study which

directly considers the impact of capital controls on firm-financing constraints, although this is

only a short extension of their more detailed analysis of capital flows and financing constraints.

They use an Euler-equation model and find that “restrictions on payments for capital account

18 Gallego and Loayza (2000) find evidence, however, that firms eligible for investment in pension funds

(PFMC-grade firms) were less financially constrained than non PFMC-grade firms before 1990. Since

PFMC-grade firms tend to be larger than the average Chilean firm, this suggests that smaller firms may

have been more financially...