The fundamental determinants of financial integration in the European Union



(1b) Capital controls preserve monetary autonomy

Monetary autonomy refers to the extent to which the central bank is in a position to control domestic interest
rates, that is, to conduct monetary policy independently of the rest of the world.14 The degree of monetary
autonomy is determined by three factors: (1) exchange rate variability, (2) the substitutability of domestic
and foreign assets and (3) the effectiveness of capital controls. The substitutability of domestic and foreign
assets is partly dependent on exchange rate uncertainty, and the first factor can, therefore, be seen as an
important aspect of the second. Capital controls that entirely preclude interest-sensitive capital movements
result in complete autonomy -- irrespective of the exchange rate regime. Effective capital controls impose
further restrictions on the substitutability of domestic and foreign assets. Capital controls or the threat of
capital controls may result in significant country premia as described by Aliber (1973). This country premium
is exploitable to achieve monetary independence. With no restrictions on capital movements, on the other
hand, the substitutability of domestic and foreign assets needs to be imperfect, for some monetary autonomy
to exist. The OECD (1990a, p. 25) argues: "In integrated financial markets monetary policy cannot control
interest rates and exchange rates simultaneously, without the use of another instrument -- capital controls,
for example.15 The imposition of capital controls allows the government to pursue "inconsistent" monetary
policies for a while.16 The OECD (1990a, p. 23) argues: "Thus, exchange controls have been often viewed
as a means whereby the authorities may seek to insulate, at least temporarily, domestic credit expansion
from monetary developments abroad and increase the autonomy with which the supply of money can be
steered to influence domestic objectives. With fixed exchange rates, the freedom of capital movements
opens greater possibilities for low-risk interest arbitrage when interest rates differ across countries. In the
limiting case -- with perfect capital mobility -- movements of capital should theoretically induce interest
rates to be maintained at complete parity across countries. This means that, for example, a reduction of
domestic interest rates resulting from an expansionary monetary policy stance would induce capital to flow
out of the country, thereby offsetting the monetary expansion and provoking a rise in domestic interest
rates back to the parity level. Indeed, any significant deviation of domestic interest rates from parity levels
across countries would result in capital flows leading eventually to restoration of interest rate parity."

The incentive of the government to impose capital controls should, then, depend on the degree of control
the government has over monetary policy. The control the government acquires over monetary policy by
imposing capital controls depends (among other things) on the degree of independence of the central bank.
We hypothesise this control to be tighter, the less independent the central bank (see also Alesina, Grilli
and Milesi-Ferretti, 1994 and Milesi-Ferretti, 1995). We employ the Eijffinger-Schaling index (ES) of central
bank independence, since it is available for all EU countries considered (see Appendix B).17 For the
Eijffinger-Schaling index, the following rule applies: the higher the score ranging from 1 to 5, the more
independent the central bank. Figure 2 plots the Eijffinger-Schaling index of central bank independence
against the intensity of capital controls. Clearly, countries with less independent central banks maintain
capital export restrictions, while countries with highly independent central banks maintain capital import
restrictions. It may be argued that the Eijffinger-Schaling index of central bank independence points at long
run monetary policy independence, which means that countries may opt for different rates of steady-state
inflation. Consequently, high levels of inflation (INF) may also indicate the increased presence of capital
export controls. The plot for the relationship between INF and CC is contained in Appendix D. Only plots

14 Policymakers attempt to insulate the economy from external disturbances.

15 See also the discussion in articles of Eichengreen, Tobin and Wyplosz (1995, pp. 162-172), Garber and Taylor (1995, pp. 173-180)
and Kenen (1995, pp. 181-192) of the January 1995 Economic Journal Policy Forum on Sand in the Wheels of International Finance.
Other policy instruments are the imposition of a transaction tax (Tobin Tax) on purchases and sales of foreign currency or a non-
interest-bearing deposit requirement on loans in domestic currency to non-residents.

16 The argument for capital controls to pursue "inconsistent" fiscal policies follows later.

17 Cukierman’s legal index (LVAU) of central bank independence which is also available for all EU countries in our sample gives
similar results. The Grilli, Masciandaro and Tabellini (1991) total (economic and political) index of central bank independence
also gives similar results. However, this index is not available for all EU countries. The same holds for the Alesina (1988, 1989)
and the Bade-Parkin (1988) legal indices of central bank independence.



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