Abstract:-

This study examines the portfolio deflection effect of capital controls on portfolio inflows across 18 emerging market economies (EMEs) over the period 2001Q1–2022Q4. Using the Common Correlated Effects Mean Group (CCEMG) estimator, the study provides three main findings. First, both the wealth effect and the portfolio balance effect play a role in the reallocation of portfolio investments following the imposition of controls on portfolio inflows. Second, Latin American and Asian countries exhibit stronger portfolio deflection as well as greater cross-border withdrawal of portfolio investments to other countries than Central European and other EMEs. Third, portfolio deflection remains weak in several countries, which can be attributed to the infrequent use of inflow controls, more resilient domestic financial markets, and the circumvention of capital controls. These findings suggest that policymakers should pursue coordinated capital account policies to mitigate cross-border currency mismatch problems, the amplification of cross-border business cycles, cross-border macro-financial fragilities, and cross-country trilemma problems. In addition, strengthening macroeconomic fundamentals and domestic conditions, including financial sector depth and development, the quality of governance, and policy credibility, should be prioritized to complement capital inflow control measures.

Keywords: Capital controls on portfolio inflows; Capital deflection effect; In-degree centrality measures; Common correlated effects mean group estimator; Emerging market economies.