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International Capital Flows: Tradeoff at Optimum and Delay in Bargaining

This paper analyzes differing optimal tradeoffs between growth and volatility by both sides of capital flows on the basis of their different considerations of capital market openness and different levels of financial sector development. Since growth and volatility are negatively correlated, volatility must be kept low to derive high growth from capital flows if wanting to integrate deeply into the global market. The reason why one side’s push for capital market liberalization comes across the other side’s resistance to it is that the former may benefit from openness at the expense of the latter which is financially weak. This conflict of interest can be resolved via negotiations for compromise equilibrium at which each side’s optimal tradeoff is made internationally compatible. Given that strategic delay is used in bargaining as a signaling device for informational revelation, differing valuations of capital flows along with differing degrees of time preference may cause the Lucas paradox and bargaining delay. The paper shows that it does not pay an investing country to force host countries to liberalize their capital markets prematurely.