The Lucas Paradox and Institutional Quality: Evidence from Emerging Markets

Abstract

The neoclassical theory illustrates that the capital will flow from the capital-rich economies towards the capital-poor states. However, it is generally observed that the capital does not move from high-income to low-income economies. This contradictory behavior of global capital flows is called the Lucas paradox. According to Alfaro, Kalemli-Ozcan, & Volosovych (AKV) model, the Lucas paradox can be entirely explained by the institutional quality. In the light of AKV notion, this paper examines the role of institutional quality in explaining the Lucas paradox. The empirical analysis involves 17 major emerging economies of the world by using panel data for the period 1999-2018. The GMM estimation reveals that the Lucas paradox is explained by the institutional quality in case of FDI flows only. However, institutional quality indicators generally remain unable to explain the paradox in case of portfolio equity capital flows. Moreover, financial development is found to be a significant determinant of portfolio equity flows in the emerging markets. Finally, we suggest that the financial flows to the emerging markets are sensitive to the nature of the capital flows.