Capital Account Liberalization, Institutional Quality and Economic Growth: Theory and Evidence

Abstract

This paper shows that the effects of capital account liberalization on growth depend upon the environment in which that policy change occurs. A theoretical model demonstrates how the institutional quality of a country, reflecting the extent to which its capital is protected from expropriation, affects the responsiveness of growth to capital account liberalization. In particular, this model predicts a non-monotonic, inverted-U shaped relationship between the amount of time during which the capital account is liberalized and economic growth. A specification drawn from this model is tested by considering the determinants of economic growth over the period 1976 - 1995 for a panel of 71 countries. The estimates of this model strongly support a non-monotonic interaction between capital account liberalization and institutional quality, with 20 percent of the countries, those with better (but not the best) institutions exhibiting a significant relationship between capital account openness and economic growth.