Wednesday, January 05, 2005

Institutions and Hot Money

What determines the type of financing that a country gets? A new IMF paper attempts to answer the question. Institutions, it claims, account for much of the difference. More proof that the real question in macroeconomics is “what accounts for institutions?”

A widespread view holds that countries that finance themselves through foreign direct investment (FDI) and portfolio equity, rather than bonds and loans, are
less prone to rises. But what determines countries’ external capital structures? In a cross section of emerging markets and developing countries, we find that equity-like liabilities (FDI and, especially, portfolio equity) as a share of countries’ total external liabilities (or as a share of GDP) are positively and significantly associated with indicators of educational attainment, natural resource abundance, and especially, institutional quality. These relationships are robust to attempts to control for possible endogeneity, suggesting that better institutional quality may help improve countries’ capital structures. The results might also provide an explanation for the observed correlation between institutional quality and the frequency of crises.

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