Impact of capital account liberalization on stock market crashes

This paper examines the effect of capital account liberalization on the frequency of stock market crashes. We use de jure and de facto measures of capital account liberalization and employ a negative binomial random effect model to analyse the relationship. Using a sample of 65 countries for 1973-2016, we show that with restricted capital account liberalization, an increase in capital flows leads to a decrease in stock market crashes. With a more liberalized capital account convertibility, higher capital flows lead to a rise in stock market crashes. The main key finding supports the notion that free and unregulated capital flows induce more volatility in the stock market, and crashes in these markets are more likely to happen. These results are also robust to different sub-samples comprising of high-income OECD countries and non-OECD countries. Our results are also robust to change in the specification of stock market crashes and changes in capital flows' specification.