DP7010 What Drives International Financial Flows? Politics, Institutions and Other Determinants

Author(s): Elias Papaioannou
Publication Date: October 2008
Keyword(s): banks, capital flows, institutions, international finance, law and finance, politics
JEL(s): F21, F34, G21, K00
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7010

This paper uses a large panel of financial flow data from banks to assess how institutions affect international lending. First, employing a time varying composite institutional quality index in a fixed-effects framework, the paper shows that institutional improvements are followed by significant increases in international finance. Second, cross-sectional models also show a strong effect of initial levels of institutional quality on future bank lending. Third, instrumental variable estimates further show that the historically predetermined component of institutional development is also a significant correlate of international bank inflows. The results thus suggest that institutional underdeveloped can explain a significant part of Lucas (1990) paradox of why doesn?t capital flow from rich to poor countries. The analysis also does a first-step towards understanding which exactly institutional features affect international banking.