International Equity and Debt Flows to Emerging Market Economies: Composition, Crises, and Controls

Abstract

Standard models of capital flows to emerging market economies focus on debt flows and a pecuniary externality. However, by offering better risk sharing, international equity flows can render such externality unimportant, yet many economies fail to attract equity investment in a large quantity. We propose a theory of endogenous composition of capital flows that highlights two asymmetries. In our model, poor institutional quality leads to an inefficiently low share of equity financing as well as an inefficiently high volume of total inflows. Somewhat surprisingly, a social planner would often impose taxes on both equity and debt inflows. Our story differs in important ways from an alternative narrative focusing on collateral constraint.