Volatile capital flows: Interactions between de jure and de facto financial liberalization

Utilizing a panel data set for 13 developed economies, this paper examines the volatility of capital flows following the liberalization of financial markets. The paper focuses on the response of foreign direct investment, portfolio flows, and other debt flows to both financial liberalization and increased capital flows. The regression analysis examines how capital volatility is affected by the interaction between de jure financial liberalization (an index of liberalization) and de facto liberalization (the volume of capital flows). At average and high volumes of capital, financial liberalization is found to increase capital volatility as expected. At lower volumes of capital, financial liberalization reduces capital volatility, particularly for foreign direct investment and other flows, indicating there may be a threshold level of capital flows below which financial liberalization reduces volatility.