Does Capital Account Liberalization Discipline Budget Deficit?

Abstract

Abstract The paper investigates whether free capital mobility leads a government to tighten its budget deficit for fear of being penalized from the international capital market. The author tests the hypothesis using three‐stage least squares (3SLS), which can control for the endogenous nature of capital account liberalization. Even the conservative measure shows that, if capital account liberalization were exogenously imposed, ceteris paribus, government budget deficit would be reduced by 2.275% of GDP. Furthermore, 3SLS results show that this disciplinary effect is stronger for countries under a fixed exchange rate regime or for countries with weak central bank independence. The disciplinary effect is also found to be stronger in more recent periods—the 1990s—during which capital market integration has been most prevalent.

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