Capital controls as restrictions on capital flows are a tool proposed as a cure to the destabilizing market movements of the 1970s (i.e., Tobin, 1978) despite the criticism that they have received (Edwards, 1999). Capital controls resurfaced during the European Financial Crisis and the restrictions imposed on capital flows in Cyprus and Greece. These were the first instances of capital control implementation in the European Union’s history and had various effects on firms’ financial positions. By using a sample of EU countries and distinguishing between austerity and capital controls periods, we assess the effects of capital controls on the stock liquidity of firms. All of the sample countries have a common financial reporting framework (International Financial Reporting Standards -IFRS), and some of them implemented a range of different measures from less intensive, such as increases in tax rates, to more intensive, such as the enforcement of capital controls, in their effort to stabilize their economies. For the task at hand, we specifically engage two accounting determinants of information asymmetry, namely, conditional conservatism and the level of earnings management. Our results show that financial reporting quality as measured by higher conditional conservatism and lower earnings management is beneficial for liquidity. However, during the capital controls period, the relation between conditional conservatism and liquidity becomes negative, and this negative relation relates to less risky firms. Thus, the negative relation between conditional conservatism and liquidity is likely due to investors keeping more conservative firms in their portfolios as a measure against the crisis.

Introduction

The European Financial Crisis, which started as a debt crisis and continued as a generalized financial crisis, had a significantly more adverse impact on a number of South-European countries in relation to the rest of the Eurozone countries. The inability of these countries to borrow money through the markets due to escalating interest rates led to a number of measures that were targeted at limiting the negative effects of the crisis. These measures ranged from increases in tax rates or decreases in wages and pensions to restrictions of capital flows (Cyprus in 2013 and Greece in 2015). These circumstances were the first in which an extreme measure such as capital controls was used in the European Union, which certainly had an impact on the capital flows of the firms domiciled in the affected countries. The present study attempts to examine how such regulations on capital flows may help an economy to break free from the crisis downward spiral. To this extent, we emphasize the usefulness of financial reporting quality as a protecting mechanism against the crisis and underline the presence of the “flight to quality” phenomenon. Capital controls were devised as a measure of fiscal policy to limit market turbulence. For example, Tobin (1978) proposed the use of an international uniform tax on foreign exchange transactions (Edwards, 1999). These measures were particularly common until the 70s (Johnson and Mitton, 2003). However, due to the continuous effort by institutions such as the IMF for more liberalized emerging markets, the use of capital controls was reduced until the Asian Crisis (Bhagwati, 1998). Therefore, despite the controversy around the usefulness of capital controls (Edwards, 1999), there is a tendency of using these measures as a final solution during a financial crisis from a macroeconomic perspective (Krugman, 1998). For example, during the Asian Crisis, Malaysia used capital controls as a measure of reducing the effects of the crisis (Johnson and Mitton, 2003). Moreover, in the European Union, the financial crisis that affected the countries of the South and in particular, Cyprus and Greece, also led to the implementation of capital control measures to limit the drain of their banking systems.