Time-Varying Risk Premia and Capital Flows to Developing Countries

One of the most well-known puzzles in international economics is the Lucas paradox: Why doesn't capital flow from rich to poor countries? Given the low capital-output ratios in developing countries, the difference in unconditional expected returns from investing there rather than in developed markets is too high to compensate for risk alone. Hence, the Lucas paradox shares key features with well-known asset-pricing puzzles. In this paper, we study whether pricing kernels, as in Bansal and Yaron (2004), that can rationalize the equity-premium puzzle can also account for the Lucas paradox. Bansal and Yaron (2004) show that time-varying uncertainty associated with long-run trend growth shapes asset valuations. In addition, Aguiar and Gopinath (2007) find that shocks to trend growth are the primary source of fluctuations in emerging markets. Finally, Borri and Verdelhan (2012) argue that there exists a strong positive correlation between the macroeconomic conditions in developing and developed countries. The last two facts suggest that time-varying risk premia are potentially a key ingredient necessary to account for the lack of capital flows to developing countries.