Liberalization and capital flight

A two period trade theoretic model is used to analyze the effects of liberalization programmes in a financially repressed economy (where official bank loan and deposit rates are very low). Financial repression creates incentives for households to overcome the capital controls and invest abroad (capital flight). It is shown that capital controls, financial regulation and trade policies are intimately related in the sense that some financial repression and capital controls are optimal if imports are subject to tariffs, and tariffs are optimal, if there is financial repression. Hence, sequential liberalization programmes may lead to a deterioration of welfare. It is shown, though, that the existence of capital flight improves the possibilities that financial deregulation succeeds even when trade has not been completely liberalized.