Financial Development and International Capital Flows

Haiping Zhang () and Juergen von Hagen ()

No 16-2007, Working Papers from Singapore Management University, School of Economics

Abstract: We develop a general equilibrium model with financial frictions in which internal capital (equity capital) and external capital (bank loans) have dierent 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.

Keywords: Capital account liberalization; Capital controls; Financial frictions; Foreign direct investment; Internal capital; External capital (search for similar items in EconPapers)
JEL-codes: E32 E44 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac
Date: 2007-09
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Published in SMU Economics and Statistics Working Paper Series

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