Capital inflows to emerging markets in recent years have generated opportunities for economic development and problems for economic management. The exchange market crisis in Mexico and the lingering negative impact on the Mexican economy have led to renewed calls for greater official participation and control of international capital movements. In fact, many developing countries have imposed controls designed to reduce or alter the composition of capital inflows. In this paper we review familiar arguments about capital controls and attempt to evaluate a ‘new’ distortion that might justify government interventions in international capital markets. The idea is straightforward. Emerging markets inherited distorted domestic credit markets from a model of economic development that placed the state in the centre of financial intermediation. Liberalization of these domestic markets is proceeding but far from complete. During the transition, incentives can emerge that make capital inflows welfare reducing. Free deposit insurance is an obvious distortion. But less obvious chains of implicit ‘insurance’ can also cause problems. We argue that fixed exchange rates and solvency can be a deadly combination for governments with a history of heavy involvement with domestic financial markets.
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