Capital Controls, Liberalizations, and Foreign Direct Investment

Multinational firms circumvent capital controls by distorting their reported trade patterns, profitability, and dividend repatriations. The changed patterns of reported profits in response to capital controls are comparable to the effects of a 24% difference in corporate tax rates. The costliness of these acts of evasion combined with the significantly higher interest rates faced by multinationals firms operating in capital control environments significantly reduce the level of foreign direct investment in countries imposing capital controls. Multinational affiliates borrowing in countries with capital controls face 5.4 percent higher interest rates than affiliates of the same parent in other countries. The higher costs and lower returns associated with capital controls together encourage American firms to reduce the size of their affiliates by 13-16 percent thereby reducing total foreign direct investment. These patterns reverse upon liberalization of those capital account restrictions. JEL Classifications: F21, F23, G15, H87, G18, G38. Mihir A. Desai C. Fritz Foley James R. Hines Jr. Harvard Business School University of Michigan University of Michigan Morgan 363 Business School Business School Soldiers Field 701 Tappan Street 701 Tappan Street Boston, MA 02163 Ann Arbor, MI 48109-1234 Ann Arbor, MI 48109-1234 [email protected] [email protected] [email protected]