Does foreign capital go where the returns are? Financial integration and capital allocation efficiency1

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...

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Bibliographic Details
Published in:International journal of finance and economics 2021-07, Vol.26 (3), p.3945-3971
Main Author: Mann, Katja
Format: Article
Language:English
Subjects:
capital allocation
Consumption
Cost allocation
financial development
financial integration
international investment
relative prices
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Summary: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.
ISSN:1076-9307
1099-1158
DOI:10.1002/ijfe.1998