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A Risk-Based Rationale for Two-way Capital Flows: Why Do Capital Flights and Inward Foreign Direct Investments Co-exist?

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  • Arnab K. Basu

    ()
    (Department of Economics, College of William and Mary)

  • Nancy H. Chau

    ()
    (Department of Applied Economics and Management, Cornell University)

Abstract

This paper develops a positive theory of two-way capital flows -- the simultaneous outward flight of capital assets, and the inflow of foreign direct investment that acquires ownership of local production units. The basic model exploits insights from entrepreneurial decision making under uncertainty in a general equilibrium setting, and traces out the relationship between (i) entrepreneurial incentives to exploit higher expected profits from risky production activities at the firm level and (ii) the resulting competitive rewards to capital in general equilibrium. The model shows that contrary to expectation, relatively liquid capital assets tend to flow from capital-poor to capital-rich economies, while foreign direct investment aimed at acquiring ownership of production units follows the reversed pattern. We also examine the optimal investment policies for both host and origin countries, and show the rationale behind the inherent conflict of interests between developing and developed economies in the context of capital market liberalization.

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Bibliographic Info

Paper provided by Department of Economics, College of William and Mary in its series Working Papers with number 04.

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Length: 33 pages
Date of creation: 10 Sep 2004
Date of revision:
Handle: RePEc:cwm:wpaper:4

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Keywords: Affirmative Action; Discrimination; Public Policy; Education; Asymmetric Information;

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References

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  1. Claessens, Stijn & Naude, David, 1993. "Recent estimates of capital flight," Policy Research Working Paper Series 1186, The World Bank.
  2. Miklós Koren, 2003. "Financial Globalization, Portfolio Diversification, and the Pattern of International Trade," IMF Working Papers 03/233, International Monetary Fund.
  3. Jagdish Bhagwati & Arvind Panagariya & T. N. Srinivasan, 2004. "The Muddles over Outsourcing," International Trade 0408004, EconWPA.
  4. Helpman, Elhanan & Razin, Assaf, 1978. "A theory of international trade under uncertainty," MPRA Paper 22112, University Library of Munich, Germany.
  5. Marianne Baxter & Mario J. Crucini, 1994. "Business Cycles and the Asset Structure of Foreign Trade," NBER Working Papers 4975, National Bureau of Economic Research, Inc.
  6. James R. Markusen, 1995. "The Boundaries of Multinational Enterprises and the Theory of International Trade," Journal of Economic Perspectives, American Economic Association, vol. 9(2), pages 169-189, Spring.
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  8. Batra, Raveendra N & Ramachandran, Rama, 1980. "Multinational Firms and the Theory of International Trade and Investment," American Economic Review, American Economic Association, vol. 70(3), pages 278-90, June.
  9. Pomery, John, 1983. "Restricted stock markets in simple general equilibrium models with production uncertainty," Journal of International Economics, Elsevier, vol. 15(3-4), pages 253-276, November.
  10. Jones, Ronald W. & Neary, J. Peter & Ruane, Frances P., 1983. "Two-way capital flows : Cross-hauling in a model of foreign investment," Journal of International Economics, Elsevier, vol. 14(3-4), pages 357-366, May.
  11. James R. Markusen & Anthony J. Venables, 1997. "Foreign Direct Investment as a Catalyst for Industrial Development," NBER Working Papers 6241, National Bureau of Economic Research, Inc.
  12. S. Lael Brainard, 1993. "An Empirical Assessment of the Proximity-Concentration Tradeoff between Multinational Sales and Trade," NBER Working Papers 4580, National Bureau of Economic Research, Inc.
  13. Sakai, Yasuhiro, 1978. "A simple general equilibrium model of production: Comparative statics with price uncertainty," Journal of Economic Theory, Elsevier, vol. 19(2), pages 287-306, December.
  14. Stiglitz, Joseph E, 1969. "Behavior Towards Risk with Many Commodities," Econometrica, Econometric Society, vol. 37(4), pages 660-67, October.
  15. Jones, Ronald W & Dei, Fumio, 1983. "International Trade and Foreign Investment: A Simple Model," Economic Inquiry, Western Economic Association International, vol. 21(4), pages 449-64, October.
  16. Kihlstrom, Richard E & Mirman, Leonard J, 1981. "Constant, Increasing and Decreasing Risk Aversion with Many Commodities," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 271-80, April.
  17. Michael Dooley & William Helkie & Ralph Tryon & John Underwood, 1983. "An analysis of external debt positions of eight developing countries through 1990," International Finance Discussion Papers 227, Board of Governors of the Federal Reserve System (U.S.).
  18. Joseph E. Stiglitz, 1969. "A Note on Behavior towards Risk with Many Commodities," Cowles Foundation Discussion Papers 262, Cowles Foundation for Research in Economics, Yale University.
  19. Cole, Harold, 1988. "Financial Structure and International Trade," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 29(2), pages 237-59, May.
  20. Chau, Nancy H, 1998. "Dynamic Stability and International Trade under Uncertainty," Economica, London School of Economics and Political Science, vol. 65(259), pages 381-99, August.
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Cited by:
  1. Dinuk Jayasuriya, 2011. "Improvements in the World Bank's Ease of Doing Business Rankings: Do they translate into greater foreign direct investment inflows?," Development Policy Centre Discussion Papers 1108, Development Policy Centre, Crawford School of Public Policy, The Australian National University.

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