EPRU Working Paper Series

Are countries with unregulated capital flows more vulnerable to currency crises? Efforts to answer this question properly must control for “self selection” bias since countries with liberalized capital accounts may also have more sound economic policies and institutions that make them less likely to experience crises. We employ a matching and propensity score methodology to address this issue in a panel analysis of developing countries. Our results suggest that, after controlling for sample selection bias, countries with liberalized capital accounts experience a lower likelihood of currency crises. That is, when two countries have the same likelihood of allowing free movement of capital (based on historical evidence and a very similar set of identical economic and political characteristics at a point in time)—and one country imposes controls and the other does not-the country without controls has a lower likelihood of experiencing a currency crisis. This result is at odds with the conventional wisdom and suggests that the benefits of capital market liberalization for external stability are substantial. The views presented in this paper are those of the authors alone and do not necessarily reflect those of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. Please address correspondence to Hutchison at [email protected].