Capital flows and institutions

Summary

Focus

Do foreign investors improve the quality of domestic institutions? This question is crucial to understanding how a country's capital inflows can spur or hinder economic growth.

Contribution

To answer this question, existing studies have used aggregate data to examine if institutional reforms take place when capital inflows are high. However, this can establish only simple correlations. This paper solves this problem by using granular industry data. It also distinguishes across country groups and between different types of capital inflows. The paper applies a difference-in-difference methodology to 22 industries in 89 countries between 1985 and 2014. The aim is to understand how industries that depend on "good institutions" fare relative to their counterparts when a greater volume of foreign capital flows into the country. Good institutions mean effective contract enforcement and low corruption.

Findings

Industries that depend on good institutions grow more when more foreign capital comes into the country. We call this "the institutional quality channel" of capital flows. But this channel does not work when capital flows into the official sector instead of the private sector. Further, the channel does not work if the institutional quality in the recipient country is very low. Countries should implement certain structural reforms before opening their economy to foreign investors. 

Abstract

Does foreign capital improve the quality of domestic institutions? Consistent with an institutional quality channel of capital flows, we show that industries that are more dependent on "good" institutions to operate grow more than others after foreign capital flows into the private sector. The effects are stronger in countries that are further away from the institutional frontier (e.g., emerging markets), but they disappear and even turn negative in countries with very low initial institutional quality, suggesting that foreign capital inflows can exacerbate the ex-ante institutional deficit. We also find that institution-dependent industries grow less when capital flows to the official sector. Our findings support the view that foreign investors can be, under certain conditions, a catalyst for institutional reform and that the relaxation of government budget constraints generally weakens structural reform incentives.

JEL classification: F33, F60, G15, E02, O43.

Keywords: capital flows, institutions, manufacturing, institutional dependence.