Barriers to Global Capital Allocation

Abstract

Observed patterns of international investment are difficult to reconcile with frictionless capital markets. In this paper, we provide a quantitative theory of international capital allocation: a multi-country dynamic general equilibrium model with rationally-inattentive investors, where cross-border investment is subject to both information and policy frictions. These frictions result in a persistent misallocation of capital across countries. We estimate model parameters using nationality-based, bilateral investment data, and measures of geographic, linguistic and cultural distance, which capture information frictions. Our unified theoretical-empirical framework can account for several stylized facts: the gravity structure of investment flows, home bias, persistent global imbalances and capital return differentials across countries, as well as the paucity of net flows from developed to emerging economies. Finally, we perform counterfactual exercises: we find that information and policy barriers to international investment greatly amplify the capital gap between rich and poor countries, and result in a large reduction in world output.

Keywords: Capital Flows, Foreign Investment, Culture, Institutions, Geography, Gravity, Interna- tional Macroeconomics, International Finance, Open Economy

JEL Classification: E22, E44, F2, F3, F4, G15, O4