Institutional Quality and Capital Inflows: Theory and Evidence

Abstract

This paper analyzes, both theoretically and empirically, the link between capital inflows and the quality of economic institutions. To this purpose, we construct a small-open economy model of the “soft budget constraint” syndrome wherein persistently cheap funding from abroad (i) raises the prevalence of extractive projects and (ii) expands their support by the (benevolent) government ex post. While the government may in principle limit the prevalence of extractive projects ex ante, the incentives to do so is limited when foreign borrowing is cheap. Using a large sample of countries, and controlling for reverse causality and omitted variable bias, we confirm empirically that capital inflows are followed by a decline in the quality of domestic economic institutions. Our model and empirical analysis help explain the divergence between southern European countries (Spain, Portugal, Italy and Greece) and the rest of OECD countries since the mid-1990s.