Capital Flows with Debt- and Equity-Financed Investment-Equilibrium Structure and Efficiency Implications

IMF Working Papers, November 1, 1998

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Canonical URL: Capital Flows with Debt- and Equity-Financed Investment-Equilibrium Structure and Efficiency Implications

Authors: Assaf Razin, Chi-Wa Yuen, Efraim Sadka
Date: November 1, 1998
Core focus: Distinguishes between debt and equity flows in the presence of information asymmetry between the firm’s “insiders” and “outsiders” in a small open economy.
Key conclusion: Capital investment is inadequate because its scope is too narrow and the investment each firm makes is too little.
Policy proposal: An unconventional policy tool is proposed to correct the market failure: lump-sum subsidies to firms that choose to equity-finance their investments.
Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Differentiation of capital flows:
- Distinguishes debt-financed flows and equity-financed flows under information asymmetry between insiders and outsiders.
Market failure characterization:
- Investment inadequacy arises from two dimensions: the scope of capital investment is too narrow and individual firm investment levels are too low.
Efficiency implications:
- The inefficiencies identified stem from information asymmetries affecting financing choice and consequently aggregate investment.

Proposed corrective instrument:
- Lump-sum subsidies to firms that choose to equity-finance their investments.
Intended effect:
- Correct market failure caused by information asymmetry and encourage equity financing to expand investment scope and level.