Development Strategy and International Capital Flows

ABSTRACT Although the “Lucas Paradox” has sparked extensive literature on the determinants of international capital flows between developed countries and developing countries, few papers have captured substantial private capital inflows to emerging economies with good economic performance. In this paper, we develop a model where countries differ in their factor endowments and governments' development strategies. If the government in a labour‐abundant country, influenced by inappropriate development ideas, employs policy interventions to favour the development of the capital‐intensive sector, the economic performance will be poor and capital return will be repressed. As a result, capital outflow will occur. We test the theory using comprehensive data with a novel measure of distortions caused by development strategy. Our results show that a reduction in strategy distortions significantly increases capital inflows. In addition, the Lucas Paradox arises only when developing countries implement highly distorted development strategies, and the threshold above which GDP per capita is significantly positively correlated with capital inflows is close to the average extent of policy distortions in some faster‐growing developing countries since the 1990s.