Fiscal rules, capital controls, and cross-border financial integration

Abstract

This paper shows that adopting fiscal rules (FRs) decreases the use of capital controls and increases cross-border financial integration. This result is robust to alternative measures of fiscal rules, capital controls, and international financial integration — it is also robust to alternative econometric approaches. It also shows that the adoption of fiscal rules increases financial integration. This paper innovatively employs a formal instrumental variables (IV) approach to tackle the endogeneity of the decision to adopt fiscal rules. The adoption of FRs is instrumented using the age dependency ratio (ADR). This strategy is particularly effective because adopting FRs is more likely when the ADR is relatively low, a finding well established in the empirical literature. Governments impose capital controls to channel domestic savings into the public sector, finance their excessive fiscal deficits, and reduce their borrowing costs. However, the uncertainty over the government's future fiscal policies may lead to capital flight. FRs ‘tie the hands’ of governments and induce them to commit themselves to fiscal discipline. Moreover, FRs can also reduce the government's borrowing costs. These effects of FRs render capital controls less necessary and lead policymakers to lift capital controls, resulting in higher cross-border financial integration.