Can a liberalization of capital outflows increase net capital inflows?

Facing massive capital inflows that put downward pressure on the real exchange rate, some policymakers and analysts have recommended a liberalization of capital outflows. Empirically, however, the removal of capital outflow controls has apparently stimulated a net inflow of capital in several experiences, such as Britain since 1979, Italy, New Zealand and Spain in the mid to late 1980s, and Colombia, Egypt and Mexico in the 1990s. Numerous measures to liberalize capital outflows in Chile during the 1990s have not had a noticeable effect in offseting a surge of net capital inflows. How can we explain the apparent paradox that reducing controls on capital outflows can actually increase net capital inflows? Our theoretical model provides one such explanation. A liberalization of capital outflows, understood here as a reduction in the minimum capital repatriation period for foreign investment, reduces the degree of 'irreversibility' of the decision to invest in a given country. This, in turn, lowers the option value of waiting until uncertainty about a possible change in the rules of the game that affect investment in domestic assets is resolved, because in this event foreigners investing at home will be stuck with the low-return asset for a shorter period of time. Thus, a reduction in the minimum repatriation period is likely to increase-not decrease-net capital inflows. This result has an important policy implication. Liberalizing capital outflows may have significant benefits on its own. But it may not be the appropriate policy to defend the real exchange rate in the presence of massive capital inflows, because it is likely to strengthen those very capital inflows. (C) 1997 Elsevier Science Ltd.