Institutional Quality and Capital Inflows: Theory and Evidence

45 Pages Posted: 19 Jan 2018 Last revised: 22 Jan 2019

See all articles by Edouard Challe

Edouard Challe

Ecole Polytechnique

Jose Ignacio Lopez

Universidad de los Andes, Colombia - Department of Economics

Eric Mengus

HEC Paris - Economics & Decision Sciences

Date Written: January 21, 2019

Abstract

This paper analyzes, both theoretically and empirically, the link between capital inflows and the quality of economic institutions. To this purpose, we construct a small-open economy model of the “soft budget constraint” syndrome wherein persistently cheap funding from abroad (i) raises the prevalence of extractive projects and (ii) expands their support by the (benevolent) government ex post. While the government may in principle limit the prevalence of extractive projects ex ante, the incentives to do so is limited when foreign borrowing is cheap. Using a large sample of countries, and controlling for reverse causality and omitted variable bias, we confirm empirically that capital inflows are followed by a decline in the quality of domestic economic institutions. Our model and empirical analysis help explain the divergence between southern European countries (Spain, Portugal, Italy and Greece) and the rest of OECD countries since the mid-1990s.

Keywords: Institutions, current account

JEL Classification: F33, G15, E02

Suggested Citation

Challe, Edouard and Lopez, Jose Ignacio and Mengus, Eric, Institutional Quality and Capital Inflows: Theory and Evidence (January 21, 2019). HEC Paris Research Paper No. ECO/SCD-2018-1247. Available at SSRN: https://ssrn.com/abstract=3105296 or http://dx.doi.org/10.2139/ssrn.3105296

Edouard Challe (Contact Author)

Ecole Polytechnique ( email )

Ecole Polytechnique
Department of Economics
Paris, 75005
France

Jose Ignacio Lopez

Universidad de los Andes, Colombia - Department of Economics ( email )

Carrera 1a No. 18A-10
Santafe de Bogota, AA4976
Colombia
5713394949 (Phone)

HOME PAGE: http://joseignaciolopez..com

Eric Mengus

HEC Paris - Economics & Decision Sciences ( email )

Paris
France

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