The fundamental determinants of financial integration in the European Union

of banks to lend abroad (see Giavazzi and Giovannini, 1989). Capital controls should (temporarily) prevent
c.q. discourage speculative capital flows (see Wyplosz, 1988, p. 95). For example, when the markets expect
a realignment, the holding of weak currencies becomes more risky (i.e. the degree of substitutability between
weak and strong currencies diminishes). If the authorities of weak currency countries wish to avoid or delay
the realignment they will be obliged to raise domestic interest rates to make investors indifferent to the
choice between holding domestic and foreign assets. This interest rate variability is particularly damaging
in countries where the government has a large proportion of short-term debt, or when longer-term debt
instruments are indexed to short-term interest rates, as is the case in Italy (Alesina, Grilli and Milesi-Ferretti,
1994, p. 294). Similarly, currency pegging with concomitant high short-term domestic interest rates also
harm households and firms with large proportions of short-term debt. On the other hand, restrictions on
capital export may (temporarily) sustain the pressure for the domestic interest rate to rise. Foreigners engaged
in speculative transactions move to the offshore markets causing large offshore-onshore interest rate
differentials. For example, during the EMS exchange crisis of September 1992 Ireland, Portugal and Spain
defended their exchange rate by creating large offshore-onshore interest rate differentials through the
reintroduction of measures penalizing speculative transactions by non-residents.

We hypothesise that countries participating in less flexible exchange rate arrangements are more inclined
to use capital import and export controls. To that end, we construct an index variable (EXR) of exchange
rate flexibility taking the value of 2 during periods of minimal flexibility (i.e. the exchange rate flexibility
is limited in terms of a cooperative arrangement under mutual intervention arrangements (the "snake" or
EMS), 1 during period of intermediate flexibility (i.e. the exchange rate is maintained within relatively
narrow margins in terms of a single currency (DM or US dollar) or a composite of currencies (ECU)) and
the value of 0 during periods of maximum flexibility (i.e. more flexible arrangements) (see Appendix B
for data sources). Our index variable EXR differs from the dummy variable EXR constructed by Alesina,
Grilli and Milesi-Ferretti (1994) where periods of minimal and intermediate flexibility take the value 1
and periods with maximum flexibility take the value 0. Figure 1 plots the classification of the exchange
rate arrangement (EXR) against the average deviation of the price measure representing the intensity of
capital controls (CC) over the period 1973-1993. In addition, we report a bivariate cross-section regression
with variables averaged over the period 1973-1993 to investigate the relationship between exchange rate
flexibility and the intensity of capital controls. One asterisk indicates that the coefficient is significantly
different from zero at the 95 % confidence interval, while two asterisks indicate that the coefficient is
significantly different from zero at the 99 % confidence interval. Standard errors are indicated between
parentheses. Furthermore, we report the adjusted coefficient of determination (R²).

Figure 1 - The intensity of capital controls: The classification of the exchange rate arrangement

CC = - 1.67 + 0.05 EXR           R² = 0.01

(0.91) (0.05)
1-,---------------------------------------------------------------------------------------------------------

_                                                            Denmark _x

t,                                                                           4

a os-                                         Austria                                ∣

i                                         '                                  1

'£                                                                    Germany

⅛j ŋ ^-                                                                          Netherlands   "

.1
i-°'^s- United Kingdom                                                 Belriom  ■

S                            Spain                                        France

f                              -                          _b Italy

3 2-                                 _a Sweden

ɑ                                               Finland

■2-5 -∣------------------1-------------------1------------------1-------------------1------------------1-------------------1------------------1-------------------1------------------1-------------------1------------------1-------------------1------------------1-------------------1------------------1-------------------1------------------1-------------------1------------------1-------------------1------------------1------------------

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44

Classificaticii exchange rate arrangeront: total

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