Liberalization and capital flight

Abstract

A two-period trade theoretic model is used to analyse the effects of liberalisation programmes in a financially repressed economy (where official bank loan and deposit rates are artificially low). Financial repression creates incentives for households to overcome the capital controls and invest abroad (capital flight). It is shown that capital controls, financial regulation and trade policies are intimately related in the sense that some financial repression and capital controls are optimal if imports are subject to tariffs, and tariffs are optimal if there is financial repression. Hence, sequential liberalisation programmes may lead to a deterioration of welfare. It is shown that the presence of capital flight improves the possibilities that financial deregulation may succeed even when trade has not been completely liberalised.