Why doesn't capital flow from rich to poor countries?

Yet another study where institutions appear to matter for economic development. A new NBER Working Paper (No. 11901), Why Doesn't Capital Flow from Rich to Poor Countries? An Empirical Investigation, finds that low institutional quality is the leading explananation of the 'Lucas Paradox' - the lack of flows of capital from rich to poor countries. Authors Laura Alfaro, Sebnem Kalemli-Ozcan and Vadym Volosovych analyse empirically the role of different theoretical explanations, including fundamentals and capital market imperfections, behind the Paradox for a base sample of 58 countries over three decades.

The theoretical explanations include differences in fundamentals across countries and capital market imperfections. We show that during 1970-2000 low institutional quality is the leading explanation. For example, improving Peru's institutional quality to Australia's level, implies a quadrupling of foreign investment. Recent studies emphasize the role of institutions for achieving higher levels of income, but remain silent on the specific mechanisms. Our results indicate that foreign investment might be a channel through which institutions affect long-run development.

Their paper also point to some specific institutional mechanisms to focus on:

Our results suggest that policies aimed at strengthening the protection of property rights, reducing corruption, increasing government stability, bureaucratic quality and law and order should be at the top of the list of policy makers seeking to increase capital infows to poor countries. 

A free November 2005 version of the paper is available here (PDF).

Comments

[Emmanuel]

Sho' nuff. Investors seek where there's a semblance of order. Otherwise, capital flight occurs. Not only do foreign investors avoid uncertainty like a plague, but those locals who can also transfer their money out do so, especially in Africa.

Governance is the hardest nut to crack, and I don't think moral suasion will do the trick. I think that when an incentive structure that rewards good governance with foreign investment exists, things will begin to fall in order. Describing the problem is straightforward enough; fixing it is another matter altogether.

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