Financial Flows, Composition of Capital, and Growth

This paper investigates the extent to which financial integration promotes growth by improving the quality of a country’s capital stock. To that end, it derives a capital composition index, where the share of a particular type of capital in the total capital stock is determined by its embodied efficiency. The paper constructs its empirical counterpart using capital production and trade data. Using five-year averaged data between 1976 and 2001 for 60 countries, it provides evidence on the positive effects of financial flows on the capital stock’s quality, with the largest impact coming from equity inflows. It also shows that when the capital composition is accounted for, the direct effect of financial flows on TFP diminishes. Although financial flows do not directly affect growth, they raise it indirectly by improving the composition of a country’s capital stock. All else constant, financial flows explain a growth difference of 1.10 percentage points between the countries with total liabilities equal to the first quartile and the third quartile. Finally, the paper finds that the effect of financial flows on the composition of capital and therefore GDP growth is larger for less developed countries, and smaller and insignificant for countries with less developed financial markets.