The fundamental determinants of financial integration in the European Union

which represent the institutional and political variables are contained in the main text.

Figure 2 - The intensity of capital controls: The Eijffinger-Schaling index of central bank independence

CC = - 2.63^** + 0.66^** ES

(0.55) (0.18)

Netheriands

I⁰-⁵

-2.5
0             1             2             3             4             5             6

Eijffinger-SchaliQf index of central bank independence

Capital controls may also follow from the need to prevent the loss of foreign exchange reserves of the central
bank in case of a speculative attack or inconsistent monetary policies. The OECD (1990a, p. 27) argues:
"Countries pursuing exchange rate targets may feel concern with the adequacy of their currency reserves
in relation to real or potential flows of capital at the given exchange rate." In the EMS -- characterized
by periodic realignments -- anticipation of a realignment may give rise to speculative attacks against the
reserves of the central banks. The central bank may try to offset the impact of undesirable capital movements
on domestic monetary aggregates through sterilisation. In addition, a country that expands its rate of money
growth to reduce its interest rate, capital controls will prevent the outflow of capital seeking yields abroad.
Consequently, a useful indicator of the inconsistencies in monetary policy is the ratio of broad money over
GDP (M2). With a monetary expansion, capital export restrictions are needed, while a monetary contraction
dictates capital import restrictions. The variable M2 was not included in previous research of Alesina, Grilli
and Milesi-Ferretti (1994) and related papers.

(1c) Capital controls limit exchange rate volatility under flexible exchange rates

Although flexible exchange rates free the national monetary authorities from balance of payments
constraints¹⁸ and thus from the need to impose capital controls, capital controls still are frequently defended
as a stabilization policy instrument under flexible exchange rates. The case for limiting capital mobility
under flexible exchange rates relies on the differential speed of adjustment between the financial and the
real sector (Dornbusch, 1976). This differential speed of adjustment, together with "excess volatility" in
financial markets, may induce excess exchange rate volatility with negative effects on trade (Bini-Smaghi,
1991, Alesina, Grilli and Milesi-Ferretti, 1994, p. 294). The argument is closely related to the previous
argument, since it may also hold during periods with exchange rate realignments, and for exchange rate
movements within a band. Controls on capital inflows are intended to keep a strong currency from becoming
stronger. Controls on capital outflows are intended to support a weak currency. We expect exchange rate
depreciation (appreciation) to be a major driving force for capital outflows (inflows). Therefore, we construct
a proxy for the expected exchange rate depreciation (DEP). We apply the assumption of rational expectations
to proxy exchange rate expectations by their realized values. The proxy for Germany is based on the bilateral
exchange rate expressed in DM per US $, for the other European countries the proxy is expressed in national

Exchange rate depreciation is regularly defended to restore the loss of competitiveness (see also argument 2b).

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