Flow-Specific Capital Controls for China

Working Paper 900

Abstract

This paper examines how flow-specific capital controls affect business cycle fluctuations and welfare in China. We develop an asymmetric two-country model to provide an emerging market perspective and introduce both inflow and outflow capital controls. The results indicate that both flow-specific capital controls effectively manage their respective capital flows, mitigate the effects of foreign interest rate shocks on business cycle fluctuations, and enhance welfare through the balance sheet channel and the collateral constraint channel. Imposing controls on the real sector significantly impact the dynamics of home and foreign credits and the real economy. In contrast, when controls are imposed on financial intermediaries, they have minimal effects on the dynamics of other financial and real variables. Lastly, flow-specific capital controls are effective in stabilizing capital flows with relatively low costs in terms of the volatility of output.