Essays on international capital flows to developing countries

This thesis investigates international capital flows to developing countries for the period 1970-2006. The first chapter introduces the theoretical and empirical framework of the thesis, motivates it, overviews its building blocks (i.e. the following chapters) and clarifies its approach to the balance of payments. The second chapter reviews the data and shows the overall trends and developments in capital flows to the developing world by focusing on the geographical regions and income groups. The core of the thesis explores the empirical puzzle that although one would expect international capital to flow to capital scarce countries where returns are higher, observation shows that capital flows to richer rather than to poorer countries (the Lucas paradox). To explore this total capital is measured as the sum of foreign direct investment and portfolio equity flows. The third chapter addresses the argument, based on cross-section evidence (Alfaro et al, Rev. Econ. Stats), that including the quality of institutions accounts for the paradox (because richer countries have better institutions they attract more capital) and finds that this only holds if developed countries are included; within developing countries, institutions do not account for the paradox. The fourth chapter extends this by including institutional quality indicators among determinants of capital inflows and employs a variety of panel data estimators; the quality of institutions does not resolve the Lucas paradox, although certain types of institutions are important. The persistence in the paradox and implied non-convergence could be ascribed to the detrimental impacts of negative shocks and volatility in global financial markets or to a Linder-type home bias in international finance. The fifth chapter analyzes volatility, comovement (or contagion risk) and sudden stop (reversibility) of capital flows (foreign direct investment (FDI), foreign portfolio equity investment, long-term and short-term debt flows) using time series econometric techniques for twelve emerging market economies over 1970-2006. This is informative on the pattern and relationship between capital inflows, with implications for accommodating macroeconomic policies in countries receiving inflows. The chapter also addresses the predictions of conventional theory, that differences are associated with the maturity of the capital (long-term vs. short-term), with the information-based trade-off model of Goldstein and Razin (2006), that differences are associated with the structure of the capital (equity vs. debt). In line with the latter, equity flows (FDI and portfolio) are less volatile, more persistent, more predictable and less susceptible to sudden stops than debt flows. Contrary to conventional theory, short-term flows are not more volatile, but there is evidence that correlations and risks of contagion are stronger within the pairs of long-term and equity capital flows than within the short-term capital flows