Working Paper: CEPR ID: DP9174
Authors: Alberto Martin; Jaume Ventura
Abstract: As a result of debt enforcement problems, many high-productivity firms in emerging economies are unable to pledge enough future profits to their creditors and this constrains the financing they can raise. Many have argued that, by relaxing these credit constraints, reforms that strengthen enforcement institutions would increase capital flows to emerging economies. This argument is based on a partial equilibrium intuition though, which does not take into account the origin of any additional resources that flow to high-productivity firms after the reforms. We show that some of these resources do not come from abroad, but instead from domestic low-productivity firms that are driven out of business as a result of the reforms. Indeed, the resources released by these low-productivity firms could exceed those absorbed by high-productivity ones so that capital flows to emerging economies might actually decrease following successful reforms. This result provides a new perspective on some recent patterns of capital flows in industrial and emerging economies.
Keywords: capital flows; economic growth; financial globalization; financial reforms; productivity
JEL Codes: F34; F36; G15; O19; O43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial reforms that relax credit constraints (G28) | high-productivity firms expand investments (D25) |
| high-productivity firms expand investments (D25) | increase capital inflows (F21) |
| high-productivity firms expand investments (D25) | crowding out of low-productivity firms' investments (D25) |
| crowding out of low-productivity firms' investments (D25) | potential capital outflows (F21) |
| financial reforms (G28) | net effect on capital flows depends on distribution of firm productivities (F16) |
| distribution of firm productivities (many low-productivity firms) (D39) | overall increase in capital outflows (F32) |
| distribution of firm productivities (few low-productivity firms) (D39) | increased capital inflows (F32) |
| successful reforms in raising quality of investments (O16) | future wages increase (J31) |
| future wages increase (J31) | reduction in return to all types of investments (G11) |
| reduction in return to all types of investments (G11) | low-productivity firms cease operations (D21) |
| low-productivity firms cease operations (D21) | freeing up domestic savings for high-productivity firms (O16) |