Productivity Growth and Capital Flows: The Dynamics of Reforms
Why doesn't capital flow into fast-growing countries? This paper provides a model incorporating heterogeneous producers and underdeveloped domestic financial markets to study the joint dynamics of total factor productivity (TFP) and capital flows. When a large-scale reform eliminates idiosyncratic distortions and liberalizes capital flows, the TFP of our model economy rises gradually and capital flows out of it. The rise in TFP reflects efficient reallocation of capital and entrepreneurial talent, a process drawn out by frictions in domestic financial markets. The capital outflows reflect a surge in saving - driven not only by initial interest rate differentials but also by strong self-financing motives of entrepreneurs - and a stagnation in investment following the reform, the latter being another ramification of the domestic financial frictions. Our welfare analysis finds that most individuals in the economy, except for entrepreneurs and the wealthy, are worse off with capital account liberalization.
Presented at the CFSP & MFI 2009 Finance and Development Conference.