Project Director: Kathryn Dominguez
The project examines the global financial system in the post-crisis era to establish whether the capital market reforms of the 1990s were maintained and whether the resultant patterns of capital flows provide new lessons on the value of these reforms.
Theory tells us that, for recipient countries, foreign capital put to good use can finance investment and stimulate economic growth. Opening to global financial markets should stimulate the flow of capital from capital-rich to capital-poor countries and reduce the cost of capital in markets where capital is scarce. Capital flow can increase the efficiency of the financial sector and facilitate the transfer of technology. A second-order effect is to help diversify risk, by reducing local investors' exposure to country-specific risk.
Experience, however, tells us that capital flows in practice often do not fit theory. International capital markets are dominated by flows between industrialized countries. Further, the financial crises of the 1990s suggest that even when capital does flow to poorer countries, the results are not always positive. Lucas (AER 1990) has argued that the paucity of capital flows to poor countries must be rooted in fundamental economic forces, such as externalities in human capital formation favoring further investment in already capital rich countries. Others have argued that credit risk is the main culprit; the record of default for poorer countries simply makes them less attractive to potential investors.
Understanding what drives international capital flows, why they differ so markedly from what theory suggests, how they impact recipient country investment and growth, and why they often prove temporary are all important topics that are currently being studied in both policy and academic circles. Our proposal is to take historical patterns of capital flows as given, and examine what changes have occurred in the post-financial crisis era. Numerous (micro and macro) reforms were put in place by developing countries prior to the crisis to attract capital flows. We propose to examine whether these reforms were maintained, and whether the resultant patterns of capital flows provide new lessons on the value of these reforms.