Domestic Institutions and the Volatility of International Capital Flows

Assistant Professor of Finance, Fanhai International School of Finance, Fudan University.

Prof. Ma's CV: Upload/File/2019/2/20190225042834429.pdf

The existing literature emphasizes the existence of excessive borrowing from the international capital market by a typical emerging market economy due to an externality in the actions of individual borrowers. It does not explain how or why the inefficiency might evolve as the economy develops. We generalize the literature by allowing for multiple forms of cross border capital flows and embedding a role for institutions. In our model, poor domestic institutional quality leads to an inefficient external capital structure and thus excessive volatile capital flows. Therefore, optimal capital controls policy should depend on the quality of domestic institutions. We show that the policy includes a Pigovian tax on both external debt and equity and it decreases with domestic quality. We provide empirical evidence that is consistent with the theoretical model.