The Role of Institutions on the Direction of International Capital Flows

Abstract

This paper studies the effect of different domestic institutions (property rights, corporate governance, and financial efficiency) on the net direction of different international capital flows (FDI and financial capital) in an empirical setting by taking the theoretical framework designed in Ju and Wei (2010) as a basis. Using a panel dataset for 123 countries covering the period 2006-2014 the results confirm the two-way direction of different international capital flows. The strength of property rights protection is found to have a statistically significant negative lagged effect on net FDI leading to a net outflow of FDI at relatively higher levels of property rights protection. Better corporate governance and financial efficiency is found to have a statistically significant positive effect on net financial capital leading to a net inflow of financial capital at relatively higher levels of financial system efficiency. The relationships holds for different specifications of the model although property rights becomes insignificant once the model has been corrected for potential autocorrelation and heteroskedasticity. Furthermore, there is potential reverse causality between institutions and capital flows that needs to be addressed using a proper time-variant instrument.