We develop a two-country overlapping generations model with financial frictions and address two empirical puzzles. First, capital has been recently flowing “uphill” from poor to rich countries, (Prasad, Rajan, and Subramanian 2006, 2007). Second, two-way capital flows, i.e., emerging economies have constantly accumulated large stocks of US treasury bills and received large inflows of foreign direct investment (FDI) and portfolio investment at the same time, (Ju and Wei 2007).Most theoretical models on international capital flows only investigate the flow of financial capital and neglect FDI flows. As a few exceptions, Ju and Wei (2006, 2007) develop a static two-country model and show that cross-country difference in financial development, corporate governance, and property right protection give rise to two-way capital flows, i.e., households in the less developed economy may benefit from investing their funds in the financial sector of the more developed ones which are then transformed into FDI in the less developed economy. As a result, net capital inflows into developing economy are much smaller than the gross flows. In contrast, our model shows that cross-country difference in financial development alone is enough to generate two-way capital flows and the less developed economy witnesses net capital outflow instead of net inflow, in line with the empirical evidence in Prasad, Rajan, and Subramanian (2006, 2007).
Our model is closely related to Matsuyama (2004) and Boyd and Smith (1997). In their models, only a fraction of agents actually invest, while the rest act as lenders. The dynamics and the steady state of the closed-economy model are independent of financial development, due to the perfect inelastic credit supply. They focus on financial capital flows and exclude FDI. As one major difference, we assume that some agents are more productive than the others. In the financially underdeveloped economy, due to borrowing constraints, the effective credit demand of those more productive agents is inefficiently low and so is the loan rate. Thus, some unproductive projects are financed and the steady-state capital stock is lower than in the country with more developed financial sector. This assumption helps generate an upward-sloping credit supply curve as well as the spread between the equity rate and the loan rate. We analyze how financial development affects the model dynamics, how it affects the two interest rates, and how cross-country difference in financial development results in the two-way flows of financial capital and FDI between emerging and developed economies.
We show that financial capital and FDI flows affect aggregate investment and output differently. The unequal or even opposite welfare effects exist within as well as across the generations. It may explain why capital account liberalization encounters support and opposition in the developing economy. The short-run and long-run gains and losses in the intra- and inter-generational dimensions may play an important role in determining the policy sequence of capital account liberalization in the developing economies.