CAPITAL FLOWS AND INSTITUTIONAL QUALITY: A SYSTEMATIC LITERATURE REVIEW

Abstract

The understanding of what drives capital flows is continually evolving. Earlier theories provided support for the role of macroeconomic factors, however, the drivers expanded to include non-macroeconomic factors following the Lucas (1990) paradox, which spurred interest towards examining the role of institutional quality and, in more recent years, capital market frictions. While other reviews of capital flow literature have concentrated on macroeconomic drivers, this review focuses on institutional factors and frictions and delves into three types of flows, as drivers can vary by type of flow. The literature is vast on drivers of foreign direct investment (FDI) while drivers of other types of capital flows have been less studied, and evidence remains scant. There is evidence of institutional quality helping to explain the Lucas paradox. Based on the literature reviewed in this paper, many institutional factors are important for FDI. Law and order and military in politics are notably important for both FDI and portfolio debt. Findings for portfolio equity are limited. On capital market frictions, the empirical evidence shows that distance; economic ties; and having a common language, border, and colonial past help explain capital flows; with distance driving all three types of capital flows. This review will help inform further research and policies aimed at attracting and retaining foreign capital, especially in developing economies that need such flows for economic development and poverty alleviation.