Does foreign capital go where the returns are? Financial integration and capital allocation efficiency¹

Abstract

This paper asks whether financial integration leads to a more efficient allocation of capital within economies. I build a model of a small economy with an investment and a consumption goods sector. Financial frictions impede capital from allocating optimally between the two sectors. Capital account opening has positive allocation effects if the economy is financially less developed than the rest of the world, but negative effects otherwise. I test the model predictions on a sample of 113 countries, using the relative price of consumption and investment goods as a measure of allocation efficiency. I find that international capital flows indeed have adverse effects in highly developed countries, whereas there is less evidence of positive effects in low‐development countries. Overall, financial integration leads to more similar capital allocations across countries.

The Spatial Effect of Financial Innovation on Intellectualized Transformational Upgrading of Manufacturing Industry: An Empirical Evidence from China

“…To realize the optimal allocation of capital is the basic function of the financial system. The improvement of capital allocation efficiency refers to the flow of capital from industries with a low marginal rate of return to industries with a high marginal rate of return, and finally to achieve Pareto optimization [43]. In this process, the development level of the financial market is one of the important factors.…”