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Financial Development and International Capital Flows

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  • Haiping Zhang

    ()
    (School of Economics, Singapore Management University)

  • Jurgen von Hagen

    ()
    (Institut für Internationale Wirtschaftspolitik, University of Bonn)

Abstract

We develop a general equilibrium model with financial frictions in which internal capital (equity capital) and external capital (bank loans) have di erent rates of return. Financial development raises the rate of return on external capital but has a non-monotonic effect on the rate of return on internal capital. We then show in a two-country model that capital account liberalization leads to out ow of financial capital from the country with less developed financial system. However, the direction of foreign direct investment (FDI, henceforth) depends on the exact degrees of financial development in the two countries as well as the specific capital controls policy. Our model helps explain the Lucas Paradox (Lucas, 1990). Countries with least developed financial system have the out ows of both financial capital and FDI; countries with most developed financial system witness two-way capital fl ows, i.e., the in ow of financial capital and the out ow of FDI; countries with intermediate level of financial development have the out ow of financial capital and the in ow of FDI. It is consistent with the fact that FDI ows not to the poorest countries but to the middle-income countries.

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Bibliographic Info

Paper provided by Singapore Management University, School of Economics in its series Working Papers with number 16-2007.

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Length: 30 pages
Date of creation: Sep 2007
Date of revision:
Publication status: Published in SMU Economics and Statistics Working Paper Series
Handle: RePEc:siu:wpaper:16-2007

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Keywords: Capital account liberalization; Capital controls; Financial frictions; Foreign direct investment; Internal capital; External capital;

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  1. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 663-91, August.
  2. Shleifer, Andrei & McLiesh, Caralee & Hart, Oliver & Djankov, Simeon, 2008. "Debt Enforcement Around the World," Scholarly Articles 2961825, Harvard University Department of Economics.
  3. Jürgen von Hagen & Haiping Zhang, 2006. "Financial Liberalization in a Small Open Economy," CESifo Working Paper Series 1771, CESifo Group Munich.
  4. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
  5. Lucas, Robert E, Jr, 1990. "Why Doesn't Capital Flow from Rich to Poor Countries?," American Economic Review, American Economic Association, vol. 80(2), pages 92-96, May.
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  7. Rafael LaPorta & Florencio Lopez-de-Silanes & Andrei Shleifer & Robert W. Vishny, . "Law and Finance," Working Paper 19451, Harvard University OpenScholar.
  8. von Hagen, Jürgen & Zhang, Haiping, 2006. "A welfare analysis of capital account liberalization," ZEI Working Papers B 01-2006, ZEI - Center for European Integration Studies, University of Bonn.
  9. Kiminori Matsuyama, 2007. "Aggregate Implications of Credit Market Imperfections," NBER Working Papers 13209, National Bureau of Economic Research, Inc.
  10. Caprio,Gerard & Honohan,Patrick & Stiglitz,Joseph E. (ed.), 2006. "Financial Liberalization," Cambridge Books, Cambridge University Press, number 9780521030991, October.
  11. Ju, Jiandong & Wei, Shang-Jin, 2006. "A Solution to Two Paradoxes of International Capital Flows," CEPR Discussion Papers 5981, C.E.P.R. Discussion Papers.
  12. Steven Globerman & Daniel M Shapiro, 1999. "The Impact of Government Policies on Foreign Direct Investment: The Canadian Experience," Journal of International Business Studies, Palgrave Macmillan, vol. 30(3), pages 513-532, September.
  13. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  14. Kiminori Matsuyama, 2007. "Credit Traps and Credit Cycles," American Economic Review, American Economic Association, vol. 97(1), pages 503-516, March.
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