Does Foreign Capital Go Where the Returns Are? Financial Integration and Capital Allocation Efficiency

Katja Mann*

*Corresponding author for this work

Research output: Contribution to journalJournal articleResearchpeer-review

Abstract

This paper asks whether financial integration leads to a more efficient allocation of capital within economies. I build a model of a small economy with an investment and a consumption goods sector. Financial frictions impede capital from allocating optimally between the two sectors. Capital account opening has positive allocation effects if the economy is financially less developed than the rest of the world, but negative effects otherwise. I test the model predictions on a sample of 113 countries, using the relative price of consumption and investment goods as a measure of allocation efficiency. I find that international capital flows indeed have adverse effects in highly developed countries, whereas there is less evidence of positive effects in low-development countries. Overall, financial integration leads to more similar capital allocations across countries.
Original languageEnglish
JournalInternational Journal of Finance and Economics
Number of pages27
ISSN1947-2757
DOIs
Publication statusPublished - 12 Aug 2020

Bibliographical note

Epub ahead of print. Published online: 12. August 2020

Keywords

  • Capital allocation
  • Financial development
  • Financial integration
  • International investment
  • Relative prices

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