Economic policy, institutions, and capital flows: Portfolio and direct investment flows in developing countries

Scholars examining the cross-national mobility of capital have followed two distinct paths. Economists tend to focus on the determinants and economic effects of cross-country capital movements while political scientists largely concentrate on the political impact of capital mobility. This study fills an important gap in the literature by examining the effects of economic policy outcomes on capital inflows to developing countries, explicitly comparing the reactions of portfolio and direct investors. I find that portfolio investors are in fact sensitive to past government behavior and fiscal policy outcomes; portfolio investors reallocate funds as new information about government policy becomes available. Direct investors, on the other hand, are not sensitive to macrolevel economic policy outcomes but are concerned with political institutions. Countries with more stable and democratic political institutions attract more FDI. These findings have implications for developing country governments as they consider the sequence of market liberalizing reforms.