While global financial integration has been progressing well, financial deepening is not. Only a handful of emerging market economies are benefiting from large capital inflows in the form of FDI. In countries like Kenya where the capital account is open and foreign bank entry has long been allowed, capital market remains shallow and real interest rate remains high, hindering the private sector development.
Why is there a weak association between financial openness and financial deepening in the poor countries? In a November conference, Professors Ju and Wei seemed to have provided an answer. In their paper "A Solution to Two Paradoxes of International Capital Flows", they provide a framework to study the role of financial and property right institutions in determining patterns of capital flows. Their two-sector model features differentiating returns to financial investment and physical investment, as financial investors have to share the return to capital with entrepreneurs. The more developed a financial system is, the greater the slice that goes to the financial investors. As an implication, a poor country with an inefficient financial sector may experience a large outflow of financial capital, but together with inward FDI, resulting in a small net inflow. The model also incorporates property rights protection as another institution. Countries with poor property rights protection may well experience an outflow of financial capital without a compensating inflow of FDI.
First, the quality of the financial system and expropriation risk play crucial roles in the patterns of capital flows. Second, financial capital flows and FDI can move in either the same or the opposite directions. And last, in a world of frictionless capital markets and identical expropriation risks, the less developed financial system is completely bypassed, and that is, all capital owned by the country with the less developed financial system will leave the country in the form of financial capital outflows, but physical capital (and projects) re-enters the country in the form of FDI. That implies, the less developed financial system serves no financial intermediation at all in the equilibrium.
This and other crucial issues will be discussed in WBI's Global Senior Policy Seminar on "Capital Flows, Financial Integration and Stability" to be held on April 23-26, Paris France. For information and registration, please click here.