Currency Risk Under Capital Controls

Currencies of emerging markets with stricter capital controls have lower average returns. These return spreads cannot be explained by traditional currency risk factors. The effect of capital controls is concentrated in debtor countries and is not present in currencies of advanced economies. The high-capital-control currencies depreciate less in times of high global risk, measured by VIX or currency implied volatility. This evidence is consistent with the macroprudential view of capital controls. We propose an equilibrium intermediary-based asset pricing model where a country borrows subject to an occasionally binding credit constraint. Capital controls can reduce the crises probability and mitigate the currency crashes in crisis times. The model quantitatively accounts for the empirical findings. The model quantifies the financial impact of non-pecuniary externality and the effect of capital control policies to restore efficiency.