Financial Repression and Capital Mobility: Why Capital Flows and Covered Interest Rate Differentials Fail to Measure Capital Market Integration

Required reserves on banks' deposit liabilities have been utilized by both industrial and developing countries to discourage and sterilize international capital flows. In this paper, we utilize an open economy macro model incorporating bank credit to evaluate this policy. The model suggests that high levels of reserve requirements are a perverse policy tool in that they amplify the effects of foreign monetary shocks, but changes in reserve requirements can insulate a repressed financial market from international financial shocks. The model also suggests that traditional measures of capital mobility such as interest parity conditions or the scale of gross private capital flows are of no value in assessing the openness of repressed financial systems.