Capital flows to Brazil : the endogeneity of capital controls

This paper investigates the determinants of capital flows to Brazil and constructs an index of capital controls that includes restrictions on both outflows and inflows. Using monthly capital flows data from the Central Bank of Brazil, the paper finds that foreign interest rates and contagion effects are important in explaining capital flows to Brazil, confirming previous results in the literature. It also shows that these factors affect mostly equity and debt flows, but not net direct investment. The paper explicitly takes into account the endogeneity of capital controls through a government reaction function that sets controls in line with capital flows. Using instrumental variables, the paper shows that the government reacts strongly to capital flows by increasing controls in booms and relaxing them in moments of distress. The paper estimates a vector autoregression (VAR) with monthly capital flows, controls, and interest differentials. It shows that controls have been temporarily effective in altering the level and composition of capital flows within a 6-month period and have been responsible for up to 30 percent of the forecasted variance of capital flows, but have had no sustained long-run effects. The results are robust to using different data sets (monthly flows from Brazil.s central bank and monthly primary flows from Loanware and Bondware) and different frequencies (quarterly capital flows from the International Monetary Fund.s International Financial Statistics).