While global cross border capital flows have risen to reach nearly $6 trillion in 2004, only a small fraction (about 10%) flows to developing countries. People cannot help but ask, Why doesn't capital flow from rich to poor countries? In a recent conference, Prof Enrique G. Mendoza and his co-authors seemed to have provided an answer. In their paper "Financial Integration, Financial Deepness and Global Imbalances", they argue that in the last decade, financial integration was a global phenomenon, but financial development was not. Capital market liberalization may lead to global imbalances when countries are vastly different (heterogeneous) in their levels of financial development.
Their model shows that first, countries with deeper financial markets have lower savings and accumulate net foreign liabilities. Conversely, countries with shallow financial markets may have higher savings (due to the lack of insurance, for example) but higher capital outflows (out of desire to seek more secure returns). Second, financial market differences also affect the composition of the international portfolio. Countries with deeper financial markets invest in high return assets. As a result, they may receive positive factor payments even if the net foreign asset (NFA) position is negative (e.g. the US). The authors conclude that this has some welfare implications to developing countries: Low income countries with low levels of financial development will be worse off in such an environment because their savings may bypass their domestic financial sector and flow to developed countries with highly sophisticated financial markets, at least in the short run. (Considering learning by doing, the long run effect may be different, in my view ).