Can enforcement constraints explain the patterns of capital flows after financial liberalizations?
A standard, small open economy model would have problems accounting for the pattern of capital flows into capital-poor economies that open to the rest of the world: such types of models would predict extremely large and very sudden capital flows, putting these predictions at odds with the data. While the bulk of the literature has focused on the role of inputs frictions to produce slower capital flows, this article presents an exploration into the role of financial frictions (in particular, enforcement constraints) to produce endogenously slow capital flows. We are left with three main findings. First, enforcement constraints are helpful frictions for producing slow capital flows. However, these flows do not exhibit the degree of persistence observed in the data. Finally, when we extend our model to mimic declining values of financial autarky, the model is able to produce more persistent capital inflows that are more in line with the data. Although these deficits revert into surpluses more quickly than in the data, we are left with a finding that leads to a promising line of research: models that include endogenously increasing costs of defaulting are better suited to reproduce the patterns of capital flows into opening economies.
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