Capital controls, political risk premium and capital flows

Choon-Shan Lai, Purdue University


This dissertation includes three studies on the use of capital controls in Malaysia. The first two studies focus on empirical investigations of the effectiveness of capital controls. The last study focuses on modeling the determinants of political risk premium associated with potential capital controls on outflows. The first study constructs a capital control index and estimates the effectiveness of capital controls using a vector autoregressive (VAR) framework. This framework takes into consideration the dynamic interaction among interest differentials, capital flows and capital controls. The second study addresses skepticism on the effectiveness of capital controls in Malaysia. Skeptics of this move argue that capital controls by Malaysia were at best redundant, if not counterproductive given that its counterparts in the region, such as Korea and Thailand, also recovered markedly at almost the same time. To address this issue, this study uses a time-shifted difference-and-differences method similar to Kaplan and Rodrik (2001)'s. The third study constructs a macroeconomic model of political risk premium based on a modified version of the money equilibrium model by Dooley et al (1997). This study intends to estimate the political risk premium, given the prospect of future capital controls on outflows. Combining the results of a variety of estimation frameworks in the first two studies, I conclude that capital controls in Malaysia in 1998 were effective in reducing domestic interest rates relatively to foreign interest rates and increasing net capital flows. In the third study, the model explains the variation in political risk premium that measures the risk of future capital controls by incorporating macroeconomic variables that characterize international shocks and sterilization intervention policies.




Carlson, Purdue University.

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