Patterns of International Capital Flows and Their Implications for Developing Countries

According to standard economic theory, capital should flow from rich to poor countries. However, a reverse pattern has prevailed in the world economy. This is the so-called Lucas paradox. In addition, it has been shown that, counterintuitively, there is a negative correlation between capital inflow and productivity growth across developing countries. This is the so-called allocation puzzle. This review sheds light on the following questions: “What are the patterns of international capital flows in the world economy?”, “What are the most plausible explanations for these patterns?”, and “What are the possible implications of these developments for developing countries?” In addition, the current period is compared with the first era of financial globalization (1870-1914). The review finds that heterogeneity in financial development is central in explaining why capital tends to flow from poor to rich countries; that the net capital flow between poor and rich countries has been dominated by the reserve accumulation by central banks in emerging market and developing economies; and that capital controls have prevented private flows from offsetting the effect of reserve accumulation. These findings suggest that the Lucas paradox is not a paradox after all and that there is no allocation puzzle in private capital