Bank of Lithuania

Evolution of bilateral capital flows to developing countries at intensive and extensive margins


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Motivated by the rise in capital flows to low-income countries (LICs), we examine the nature of these flows and the factors affecting foreign investors’ decision. Recognizing the presence of fixed investment costs, we analyze capital flows at both intensive and extensive margins. To fix ideas, we resort to the gravity literature for the estimating relationships which we embed into a two-tier econometric framework with cross-sectional dependence. Our main finding is that market entry costs are statistically and economically very detrimental to LICs. We also obtain the gravity-type relationship for the destination income unconditionally but not after conditioning on relevant variables, as well as establish labor productivity as a robust attractor of capital inflows.

JEL Codes: C33, C34, F21, F62, O16.

The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

Bilateral capital flows, foreign direct investment, portfolio flows, low-income countries, extensive and intensive margins, Cross-sectional dependence