Opening Up: Capital Flows and Financial Sector Dynamics in Low-Income Developing Countries

Abstract

Over the past two decades, many low-income developing countries have substantially increased openness towards external financing and have received large capital inflows. Using bank-level micro data, this paper finds that capital inflows have been associated with financial deepening through increases in bank loans, deposits, and wholesale funding. Domestic banks increase loans more than foreign banks. There are only modest signs of a build-up in financial vulnerabilities. Causality is examined through an instrumental variable approach and an augmented inverse-probability weighting estimator. These approaches indicate only limited evidence for global push effects, pointing towards the importance of domestic pull factors.