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

Abstract

IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. This paper is part of a research project on macroeconomic policy in low-income countries supported by the U.K.'s Foreign, Commonwealth and Development Office (FCDO). The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, its management, or the FCDO. 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. participants at LMU's macro research seminar, as well as a seminar at the Japan International Cooperation Agency (JICA) and seminars at the RES and SPR Departments of the IMF, and IMF colleagues who conducted internal review, for helpful comments and thoughtful discussions. This paper is part of a research project on macroeconomic policy in low-income countries (IATI Identifier: GB-1-202960) supported by the U.K.'s Foreign, Commonwealth and Development Office (FCDO). The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, its management, or the FCDO. We are responsible for any remaining errors.