Capital Flow Management Policies and Riskiness of External Liability Structures: the Role of Local Financial Markets

This paper investigates the role domestic financial systems play in the effectiveness of capital flow management policies (CFMs) on the risk of over-reliance on debt. Using data from 44 emerging market countries over the period 1995—2008, we investigate the relationship between financial development, CFMs, and the share of debt in external liabilities as the measure of financial stability risks. We find that financial sector development is an important channel for the effectiveness of CFMs, and enhances the impact of different policy measures on the reduction of external debt liabilities. Our results show that CFMs are significantly more effective in curbing debt inflows in a bank-based economy but, to a lesser extent, in a market-based economy. Our findings remain robust to alternative measures of external liability structures, CFMs and financial development, and consideration of potential endogeneity.