Inequality and the Structure of Countries’ External Liabilities

IMF Working Papers, July 8, 2022

Source details

Canonical URL: Inequality and the Structure of Countries’ External Liabilities

Higher income inequality is associated with a greater equity share in countries' external liabilities.
The paper develops a theoretical model to explain this empirical observation in the context of a small open economy with traded and nontraded goods.
Entry barriers in nontraded industries depress entrepreneurial activity, raise income inequality, create space for foreign firms in the domestic market, and reduce external borrowing.
The model suggests that barriers to entrepreneurial activity could be conducive to attract equity-type capital inflows.
The authors' empirical results lend some support to this conjecture.

Observed association: higher income inequality → greater equity share in external liabilities.
Empirical results provide supportive evidence for the model's conjecture linking entry barriers, entrepreneurship, inequality, and the composition of external liabilities.

Environment: small open economy featuring traded and nontraded goods.
Mechanism:
- Entry barriers depress entrepreneurial activity in nontraded industries.
- Reduced domestic nontraded-goods firm entry raises income inequality.
- Fewer domestic nontraded-goods firms leave room for foreign firms to operate domestically.
- Presence of foreign firms and fewer domestic borrowers reduce external borrowing, increasing the equity share of external liabilities.
Implication: barriers to entrepreneurial activity can be conducive to attracting equity-type capital inflows.

Barriers to entrepreneurial activity affect both income distribution and the structure of external liabilities.
Policies that lower entry barriers may influence the composition of external liabilities by altering domestic entrepreneurial activity and the scope for foreign firm entry.
The link between inequality and external liability composition suggests that reforms targeting entrepreneurship and market entry could have cross-cutting effects on external finance composition.