Working Paper: CEPR ID: DP7664
Authors: Korolai Kirabaeva; Assaf Razin
Abstract: In this survey, we focus on key mechanisms through which liquidity and financial shocks affect major types of capital flows. We focus on a few models that examine the role of asymmetric information, liquidity preferences, limited enforcement, and incomplete markets on the composition of capital flows. We show that the information asymmetry between foreign and domestic investors leads to inefficient investment allocation and borrowing in a country that finances its domestic investment through foreign debt or foreign equity. In the presence of asymmetric information between sellers and buyers in the capital market, foreign direct investment is associated with higher liquidation costs due to the adverse selection. The exposure to liquidity shocks can explain the composition of equity flows (FDI vs. FPI) between developed and emerging countries, as well as FDI flow patterns during financial crisis. In each section we also discuss the empirical relevance of the models in view of the empirical evidence.
Keywords: asymmetric information; capital flows; liquidity crisis
JEL Codes: F21; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| asymmetric information between domestic and foreign investors (F21) | inefficient investment allocation (G11) |
| asymmetric information leads to domestic oversaving and foreign underinvestment (F21) | marginal productivity of capital at home relative to the cost of importing capital (F21) |
| liquidity shocks (E44) | higher ratio of foreign portfolio investment (FPI) to foreign direct investment (FDI) (F21) |
| financial crises (G01) | capital outflows in the form of FPI while simultaneously attracting FDI (F21) |
| liquidity constraints (E41) | resale FDI phenomenon (F23) |