A new approach to capital flows: Theory and evidence

This paper examines how an open economy determines its financial openness and deals with volatile capital flows when deciding to utilize them for output growth. We find that higher economic instability is an inevitable price paid for faster growth if a country permits wider openness without reversing its financial vulnerability. We prove that the country can leave its capital market wider open to achieve higher growth and lower instability if its financial system has been strengthened substantially. We show why some financially advanced countries request reluctant developing countries to liberalize their immature markets and how the conflict of interest between the two parties is formulated. The paper also presents a large sample of cross-country experiences with tradeoffs between growth and instability, with the observed evidence supporting our theoretical predictions.

Research Highlights► Capital flows can be utilized for growth but coupled with instability. ► High instability could be traded for high growth under financial weakness. ► High growth may come with low instability if with strong financial systems. ► Financial efficiency must be raised before capital markets are left wide open. ► Cross-country evidence shows a negative association of growth with instability.