Credit market imperfection, lack of entrepreneurship and capital outflow from a developing economy

• Published date: 01 August 2023
• Author: Sugata Marjit,Suryaprakash Mishra
• Date: 01 August 2023
• DOI: http://doi.org/10.1111/rode.12984

REGULAR ARTICLE

Credit market imperfection, lack of

entrepreneurship and capital outflow from a

developing economy

Sugata Marjit

1,2,3,4†

| Suryaprakash Mishra

5

1

Indian Institute of Foreign Trade,

Calcutta, India

2

Centre for Training and Research in

Public Finance and Policy (at CSSSC),

Calcutta, India

3

CES-Ifo, Munich, Germany

4

GEP, Nottingham, UK

5

National Law School of India University,

Bengaluru, India

Correspondence

Suryaprakash Mishra, National Law

School of India University, Bengaluru,

India.

Email: misra.suryaprakash@gmail.com

Abstract

This paper explores the impact of credit market imper-

fection on lack of demand for capital, trade, and capital

flows in an economy with wealth heterogeneity. In par-

ticular, we look at the implications of wealth heteroge-

neity. We show that the low return of capital and lower

output of credit-intensive output in autarky may reflect

lack of entrepreneurship and demand for credit due to

wealth heterogeneity and eventually may lead to capi-

tal outflow from a capital-scarce country. This is a dif-

ferent way of echoing the sentiment of the well–known

Lucas paradox, which suggests that capital might flow

from the poor to the rich countries. We also show the

possibility of trade and capital flow being complements

and not substitutes, as is usual in standard trade

models driven by factor abundance.

KEYWORDS

capital flows, credit market imperfection, credit rationing,

entrepreneurs

JEL CLASSIFICATION

D63, F21, F36, G21

†

This paper has benefitted from seminar presentations at and/or academic visits to CSSSC, Indian Institute of

Management, Ahmedabad, IGIDR, Mumbai, Washington University, St. Louis, Australian National University,IMF,

Universities of Kobe and Tokyo. I am indebted to Rajat Acharyya, Subhayu Bandopadhyay, Aninda Chakraborty,

Marcel Thum, Heinrich Ursprung, Prasada Rao, Arye Hillman, Eden Eu, Lei Yang, Reza Oladi, and Hamid Beladi.

The usual disclaimer applies.

Received: 14 October 2022 Revised: 31 January 2023 Accepted: 7 February 2023

DOI: 10.1111/rode.12984

Rev Dev Econ. 2023;27:1855–1873. wileyonlinelibrary.com/journal/rode © 2023 John Wiley & Sons Ltd. 1855

1|INTRODUCTION

The purpose of this paper is to explore the impact of credit market imperfection on lack of demand

for capital, trade and capital flows in an economy with wealth heterogeneity. In particular, we look

at the implications of wealth heterogeneity. We show that the low return of capital and lower out-

put of credit-intensive output in autarky may reflect lack of demand for credit due to wealth hetero-

geneity and eventually may lead to capital outflow from a capital-scarce country. This is a different

way of echoing the sentiment of the well–known Lucas paradox, which suggests that capital might

flow from the poor to the rich countries. We also show the possibility of trade and capital flow being

complementsandnotsubstitutes,asisusualinstandard trade models driven by factor abundance.

Capital flows are among the important determinants of economic well-being of countries.

There is ample evidence that capital flight from developing countries is not a new phenomenon

(Varman-Schneider, 1991; Ndikumana & Boyce, 2011;2018;Ndikumanaetal.,2015;and

Reuter, 2012). In 2015, the net outflows of capital from the developing countries were well over

$600 billion –greater than a quarter of the inflows received during the preceding 6 years 2016

(Stiglitz & Rashid 2016). Heterogeneous financial development leads to capital outflows from

financially less developed countries to those with more developed financial systems (Ju &

Wei, 2006).

Capital outflow from the developing countries, when large in magnitudes, adversely affects the

real economy and hence their growth prospects. It can possibly lead to a host of adverse effects such

as drying up liquidity, increased borrowing rates, weakened currencies, reserve depletion and

decreased general asset prices. The literature analysing the role of financial frictions in determining

capital flows is voluminous. The main contributions are that of Gertler and Rogoff (1990), Boyd and

Bruce (1997), Shleifer and Wolfenzon (2002), Reinhart and Rogoff (2004), Kraay et al. (2005), Aoki

et al. (2010), Mendoza et al. (2009) and Caballero et al. (2008). Heterogeneous financial develop-

ment leads to capital outflows from financially less developed countries to those with more devel-

oped financial systems (Ju and Wei, 2006;AntrasandCaballero,2009; Von Hagen and

Zhang, 2014). Also, capital outflow from the developing countries is hugely underreported in coun-

triessuchasIndia(Marjitetal.,2000;2008; Biswas and Marjit, 2005) and China (Cheung et al.,

2016; Kar and Freitas, 2012; Kar and Spanjers, 2014;MaandMcCauley,2008;CheungandQian,

2009;Prasadetal.,2007;Biswasetal.,2019; Biswas, Von Hagen, and Sarkar, 2022).

In this paper, given the ample empirical evidence above, we bring forth a novel mechanism

through which capital flows out of a poor, capital-starved economy to the capital-rich ones. We

show that two countries that are exactly similar but have different wealth distribution can

engage in trade and capital flows. In our model among two otherwise similar countries (endo-

wed with same amount of capital), the one with more egalitarian distribution can drive capital

away due to lack of demand effect though the country may import capital intensive good. This

would happen as the stock of (productive) capital is spread over the entire population in com-

parison to the country where the distribution is skewed and the capital is concentrated in a few

hands. This paper contributes to the theoretical literature on trade and capital flows under

credit market imperfection, which itself is not voluminous.

Jones and Marjit (2001), Wynne (2005), Antras and Caballero (2009), Von Hagen and Zhang

(2014), Matsuyama (2007), Manova and Yu (2014), etc., discuss various aspects of the related prob-

lem. But none of them explores the role of wealth distribution in capital flows through our channel

whereby lack of demand for capital drives away capital from a capital-scarce country. Von Hagen

and Zhang (2014) in a macro setup discussed the possibility of ambiguous capital flows, but our

1856 MARJIT and MISHRA