Institutional drivers of capital flows

This paper empirically analyzes the role of institutional factors in shaping the dynamics of gross capital flows. We build an institutional quality index and test its relevance for both gross capital inflows and outflows using a panel of 56 countries, differentiating between high-income and low-income economies, over the period 1996-2012. We find that institutional quality is a significant factor affecting the behavior of both foreign and domestic investors. Countries with better governance and public sector credibility tend to attract more flows. Causality is confirmed through IV estimates for a sub-sample of 25 countries. In addition, we show that some governance features matter more than others. Specifically, the most relevant institutional indicators are Government Effectiveness and Regulatory Quality, which capture the government’s ability to implement adequate, sound and credible policies. Finally, we assess the role of institutional quality during periods of financial stress. The analysis suggests that domestic investors in countries with a sound institutional framework tend to retrench more capital, mitigating the negative effects of declining gross capital inflows. Therefore, sound institutions incentivize the build-up of external assets in high-income countries by promoting larger outflows in normal times. They also facilitate the repatriation of such assets during crises.