Journal of International Money and Finance 28 (2009) 367391

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Journal of International Money and Finance

journal homepage: www.elsevier.com/locate/jimf

Institutions and the external capital structure of countriesq

Andre Faria a, Paolo Mauro b, *
a b

Barclays Global Investors, London, United Kingdom International Monetary Fund, United States

a b s t r a c t
JEL classication: F21 F34 F36 Keywords: Foreign direct investment Portfolio equity External debt External liabilities

A widespread view holds that countries that nance themselves through foreign direct investment and portfolio equity, rather than bonds and loans, are less prone to crises. But what determines countries external capital structures? In a cross-section of advanced economies, emerging markets, and developing countries, we nd that equity-like liabilities as a share of countries total external liabilities are positively and signicantly associated with indicators of educational attainment, openness, natural resource abundance and, especially, institutional quality. These relationships are robust to attempts to control for possible endogeneity, suggesting that better institutional quality may help improve countries external capital structures. 2008 Andre Faria. Published by Elsevier Ltd. All rights reserved.

1. Introduction A widespread view holds that the external capital structure of countries (that is, the relative shares of items such as foreign direct investment, portfolio equity, and external debt in a countrys external nance) is an important determinant of economic performance and propensity to crises. Indeed, this view has been reinforced by a number of recent emerging market crises, and some authors have argued that it would be desirable for emerging market countries to reduce their reliance on debt and increase the role of equity in their external capital structures (Rogoff, 1999). Equity nance makes it possible for domestic producers to share risk with foreign investors, thereby helping stabilize domestic consumption and improving domestic producers ability to undertake projects with high risk and high

q The paper was written while both authors were at the IMF. * Corresponding author. Barclays Global Investors, United States. E-mail addresses: alfaria@alumni.uchicago.edu, andre.faria@barclaysglobal.com (A. Faria), pmauro@imf.org (P. Mauro).
0261-5606/$ see front matter 2008 Andre Faria. Published by Elsevier Ltd. All rights reserved. doi:10.1016/j.jimonn.2008.08.014

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expected return. Moreover, liquidity crises have often been triggered by sudden stops in debt ows, but are unlikely to be generated by sudden stops in equity ows. In addition, one form of equity-like nance, namely, foreign direct investment is often viewed as especially desirable because it is associated with technological transfer (Borensztein et al., 1998). However, for policies aimed at improving capital structures to be formulated, or even for the effects of capital structures to be accurately estimated, it is rst necessary to understand the factors underlying countries existing capital structures: this is the objective of the present paper. Many previous studies have sought to identify the determinants of either total capital ows or FDI ows only. Previous work on the composition of countries capital ows has been more limited. And only recently have new data sets made it possible for researchers to begin analyzing the composition of the stocks of countries liabilities. We restrict our analysis to external liabilities, rather than the whole balance sheet. This makes for a simpler analysis and cleaner parallels with the corporate nance literature, which considers the composition of rms liabilities. In our study, we devote substantial attention to the role of institutional quality (e.g., the absence of corruption, red tape, or political violence) as a potential determinant of capital structures.1 This is consistent with increased emphasis on institutional variables in explaining economic development and, more specically, capital owsdsee, for example, Alfaro et al. (2008), and Lothian (2006). Indeed, an additional motivation for our analysis is the recently identied association between weak institutional quality and severe crises (Acemoglu et al., 2004). The mechanism underlying such association has not yet been uncovered. If institutional quality turns out to be associated with a more crisis-prone external capital structure, this might be a plausible channel through which weak institutions lead to higher frequency and severity of crises. A number ofdoccasionally conictingdhypotheses have been put forward regarding the impact of institutions on the composition of capital structures. We conjecture, for example, that weak institutions may have an especially deleterious impact on FDI: investors considering foreign direct investment may be particularly concerned about the likely exposure to requests for bribes and the need to work through red tape. Similarly, weak institutions in a recipient country (including lack of transparency in the corporate sector and weak corporate governance)2 may deter international investors from acquiring portfolio equity stakes there. Wei (2001) suggests that weak institutions may reduce the relative importance of FDI in total liabilities: foreign banks are more likely than foreign direct investors to be bailed out in the context of a crisis, and are therefore more willing to invest in corrupt countries; thus, as countries with weak institutions are usually crisis-prone, they will tend to have a smaller share of FDI. Albuquerques model (2003) implies that better institutions lead to a greater share of FDI in total liabilities after controlling for a countrys international nancial constraints. In contrast, a formal theory by Razin et al. (1998) suggests that informational asymmetries would be associated with a higher share of FDI, and a lower share of portfolio equity, in total external liabilities. The role of institutional quality has been somewhat under explored in previous empirical studies of the determinants of external capital structures. Indeed, pioneering work by Lane and Milesi-Ferretti (2001a,b) on the composition of the stocks of countries external liabilities analyzed a limited number of potential correlates (namely, openness, economic size, and per capita GDP).3 Other authors have analyzed the impact of institutional variables on total capital ows; the composition of capital ows, rather than stocks; and specic subcomponents of the stock of liabilities drawn from different data sources. In a cross-section of about 40 advanced and developing countries, Alfaro et al. (2008) nd that institutional quality is a key determinant of total capital ows. In a panel of advanced and developing countries, Albuquerque (2003) nds the share of FDI in total ows to be negatively and signicantly

1 A recent wave of studies has empirically analyzed the relationship between indicators of institutional quality and economic variables such as investment and growth (Knack and Keefer, 1995; Mauro, 1995); foreign direct investment (Benassy-Quere et al., 2005; Wei, 2000a,b); development outcomes (Kaufmann et al., 1999); economic and political instability (Acemoglu et al., 2003); and the severity of crises (Johnson et al., 2000). 2 As reported by Acemoglu and Johnson (2003), corporate governance and political governance are highly correlated, so that it is difcult to disentangle their individual effects. 3 Lane (2004) empirically analyzes the determinants of long-term external debt levels, including the role of institutions.

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associated with good credit risk ratings, but unrelated to indicators of institutional quality.4 In a cross section of advanced and developing countries, Hausmann and Fernandez-Arias (2000) consider the determinants of the share of FDI ows in total ows, using averages for 199698, and nd no relationship with institutional quality.5 In a gravity model of bilateral FDI stocks (drawn from OECD data) and bank loan stocks (drawn from BIS data) applied to a common sample of about 10 source countries and 20 recipient countries, Wei (2001) nds that weaker institutions are associated with less FDI and more bank loans. In this paper, we take the same approach as Lane and Milesi-Ferretti (2001a,b) by focusing on crosscountry variation and, more important, working with stocks, rather than ows. Stocks are the object of capital structure theories in the corporate nance literature, and empirical studies of the determinants of corporate structures typically rely on cross-sectional data on liability stocks at the rm level. Moreover, as Lane and Milesi-Ferretti (2001b) put it, [the] stock position is the relevant state variable in a macroeconomic model, and capital ows arise to close the gap between desired and actual stock positions.6 Consistent with our focus on the composition of liability stocks, and our interest in the fundamental, slow-moving, determinants of cross-country differences, our empirical analysis is based upon cross-country regressions of time-series means from 1996 to 2004.7 To measure institutional quality, we rely on subjective indicators.8 In an attempt to reduce potential endogeneity bias, we use instrumental variables, following a strategy used by previous studies.9 We nd that the key determinants of countries external capital structures include institutional quality and, to a lesser extent, educational attainment, openness, and the availability of natural resources. Holding other factors constant, better institutions tilt countries capital structures signicantly toward equity and away from debt. Our main results are conrmed by a host of robustness exercises. Here we list a few examplesdmore are included in an extensive robustness tests section. First, we show robustness to changes in the sample of countries, data sets, and estimation technique (including robust regressions; bounded dependent variable estimation; and FamaMacbeth regressions). Second, we document robustness to the introduction of additional or alternative explanatory variables, such as domestic stock market capitalization, international nancing constraints, and capital controls or equity market liberalization. The rest of the paper is organized as follows. Section 2 surveys some of the existing hypotheses regarding the potential determinants of countries external capital structures. Section 3 describes the data, presents the empirical strategy, and reports the main results and the robustness tests. Section 4 concludes. 2. Existing theories and hypotheses A generally accepted theory of the external capital structure of countries has not yet been developed, though several studies have sought to draw lessons for international nance from the corporate

Albuquerques (2003) empirical analysis abstracts from country xed effects. Of these studies, only Alfaro et al. (2008) use instrumental variables to address possible endogeneity issues. 6 In a related vein, Wei (2001) sketches a model in which a multinational allocates FDI stocks among countries. 7 Our baseline cross-country regression of time-series means is equivalent to a between estimator regression. We obtain essentially identical results in regressions where the dependent variables are based on stock measures for any single year during the sample period; or when using FamaMacBeth regressions (see below). 8 Some authors have questioned the validity of an approach based on subjective indicators of institutional quality combined with instrumental variables, and have argued in favor of objective measures of institutional quality (Glaeser et al., 2004; Przeworski, 2004). We agree that developing better objective measures of institutional quality compared with the existing ones is a high priority task for further research. Nevertheless, our view is that subjective indicators are preferable, because they capture de facto institutional quality: countries may have excellent legislation on their books, but what matters is whether such legislation is applied and enforced in practice. 9 The consultants who produce such subjective indicators of institutional quality might be inuenced in their judgment by the structure of a countrys liabilities, or by other factors that are correlated with the structure of liabilities. The instruments we work with include settler mortality and population density in the 1500s from Acemoglu et al. (2003), ethnolinguistic fractionalization from Mauro (1995), and British legal origin from La Porta et al. (1998).
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nance literature, which has extensively analyzed capital structures at the rm level.10 In this section, we provide a brief review of full-edged theories and less formal hypotheses regarding external capital structures. A rst theory, by Albuquerque (2003), focuses on the problems of expropriation and imperfect enforcement of international nancial contracts.11 The theory assumes that FDI is less subject to expropriation than are other liabilities, though the validity of this assumption may depend on the specic economic sector in which FDI is undertaken. On the whole, Albuquerque (2003) suggests that much of FDI is of an intangible nature (technology, brand names) and thus difcult to expropriate. Under this view, the optimal contract between international investors and nancially constrained countries, which are unable to pre-commit not to expropriate, will usually take the form of FDI. Therefore this theory predicts that countries with tighter nancial constraints will nance themselves primarily through FDI. The theory may also be interpreted to predict thatdfor given nancial constraintsdworse institutions (greater ease of expropriation of FDI) will lead to a lower share of FDI in total external liabilities.12 A second theory, by Razin et al. (1998) focuses on the role of informational asymmetries, and foresees a pecking-order in countries external capital structures, as in the corporate nance literature. Firms would nance themselves rst through FDI (a parallel to retained earnings and, therefore, internal equity), then debt, and then portfolio equity (external equity). In fact, to circumvent informational barriers, foreign multinationals would favor placing their own managers in the recipient country and thus investing abroad through FDI. To the extent that weak institutional quality (such as a poorly regulated stock market) may be taken to proxy for more severe informational asymmetries, it would be associated with a larger share of FDI, and a lower share of portfolio equity, in total external liabilities.13 As mentioned in Section 1, early empirical tests of the relationship between indicators of institutional quality and variables related to countries capital structures have reached a variety of results. In a cross-section of countries (including advanced economies), Hausmann and Fernandez-Arias (2000) document no relationship or a negative relationship between the ratio of FDI inows to total private capital inows and institutional quality. In contrast, Wei (2000a,b, 2001) and Wei and Wu (2002) nd that weak institutions tilt capital inows toward bank loans and away from FDI, consistent with their hypothesis that foreign direct investors are less likely to be bailed out than are foreign banks in the event of a crisis. Other studies have identied a number of additional factors that may affect countries capital structures, with special attention to FDI.14 Such factors include human capital, natural resources, economic size, and openness. Human capital may act as a stronger pull factor for FDI (Borensztein et al., 1998) than other forms of capital such as portfolio equity or debt. Natural resources may also attract FDI to a greater extent than they do other types of capital, as suggested by Hausmann and

10 While corporate nance reasoning cannot be trivially applied to the international setting, the literature on sovereign debt (Eaton and Gersovitz, 1981, 1984; Cole and English, 1991, 1992; Cole and Kehoe, 1995; Bulow and Rogoff, 1989) may be interpreted as being in a broadly similar vein. Hart and Moores (1994) analysis of default and renegotiation when one of the sides to a nancial contract cannot commit to the contract has particular resonance in international nance. Attempts to extend corporate nance reasoning to the international nance setting are reviewed in Borensztein et al. (2004). A broader survey of theories of capital structures in the domestic corporate context is Myers (2001). Rajan and Zingales (1995) and Booth et al. (2001) have analyzed the effects of government policies, laws, and regulations on the domestic capital structures of the G-7 countries, and developing countries, respectively. Using rm level evidence for a cross-section of 39 developed and developing countries, Fan et al. (2006) nd that rms operating in more corrupt countries tend to have capital structures with less equity. 11 Albuquerques (2003) main interest is in why FDI ows are less volatile than other capital ows, and he focuses on nancial constraintsdempirically proxied by credit risk ratings. For an alternative theoretical analysis on related issues, see Schnitzer (2002). 12 This is our interpretation of Albuquerques (2003) model, though it is not emphasized by the author. It is based upon the authors simulations in Table 2, p. 370, and interpreting the parameter q as the ease with which FDI may be expropriated. (Other types of capital can always be fully expropriated in the model.) 13 There is a conceptual difference between informational asymmetries and institutional weaknesses, and this interpretation may not have been intended by the authors. 14 Lim (2001) reviews the literature on the determinants of FDI.

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Fernandez-Arias (2000) and Lane and Milesi-Ferretti (2001b). Indeed, in many cases natural resources might lie unexploited or even undiscovered without the crucial expertise provided by multinationals (Markusen, 1997). However, the tangible nature of FDI aimed at extracting natural resources might make it especially vulnerable to expropriation once it is in place. Larger economic size (proxied by measures such as total GDP) also attracts FDI, which provides an opportunity to better serve the local market (possibly circumventing trade barriers). Finally, openness may reduce the need for tariffhopping FDI, though the ease with which products can be exported increases a countrys appeal as a destination for FDI. With a variety of existing theoretical hypotheses, the relationship between countries external capital structures and variables such as institutions is ultimately an empirical question. Early empirical tests have not reached denitive conclusions, largely owing to data constraints. In the next section, we provide new empirical evidence on this question, drawing on data sets which have become available recently and which provide far greater country coverage and better cross-country consistency than was the case in the past. 3. Empirical analysis This section briey describes the data, presents the empirical strategy, and reports the results. Appendix 1 describes the data sources and variable denitions in greater detail. 3.1. Data sources and variables used The data on our dependent variabledexternal liabilities and their subcomponentsdwere assembled by Lane and Milesi-Ferretti (2006), updating and extending their initial exercise (Lane and MilesiFerretti, 2001a,b) from 67 to 145 countries. In the Lane and Milesi-Ferretti (2006) classication, external liabilities comprise FDI, portfolio equity, debt (consisting of portfolio debt, loans, currency, and deposits), and nancial derivatives. Lane and Milesi-Ferrettis new database improves on alternative sources, notably the International Investment Position (IIP) reported in the International Monetary Funds International Financial Statistics, in terms of both country coverage and appropriate correction for valuation effects.15 In the robustness section, we show that our main results are similar using the IIP data set. More generally, evidence of robustness to changes in data source is provided by the observation that the working paper version (Faria and Mauro, 2004), where we obtained very similar results, was entirely based upon a previous vintage of the IIP. Potential explanatory variables include the size of the economy (total GDP in U.S. trillions of dollars at constant 2000 prices); the level of economic development (GDP per capita in U.S. thousands of dollars at constant 2000 prices); openness (sum of imports and exports over GDP); the relative importance of natural resources (share of exports of fuels, metals, and ores as a ratio of GDP); human capital (percentage of population over 25 that has attended some secondary schooling); nancial development (private credit to GDP)16; a dummy variable for transition economies; and an index of institutional quality. This last variable is the simple average of six institutional indicators drawn from

15 The maximum number of countries covered by IIP for the period 19962004 is 106 for some categories of external liabilities. (A thorough description of the IIP data is provided in IMF, 2002a.) While the IIP reports FDI at market value for some countries and at book value for others, Lane and Milesi-Ferrettis database provides portfolio equity at market value and FDI at book value consistently for all countries. Unfortunately, neither data set distinguishes between public and private liabilities, or between bank loans and non-bank nance. While a public/private decomposition would be interesting, in practice it may not be too informative, because many loans originally extended to private entities are assumed by the sovereign borrower when repayment difculties emerge. 16 Our baseline measure of nancial development, private credit to GDP, is recommended by Levine et al. (2000) as the preferred indicator of nancial development, because it proxies for higher levels of nancial services and therefore greater nancial intermediary development, even though it does not directly measure the amelioration of information and transaction costs. Another advantage is the large country coverage in the data. In the robustness section, we look at alternative measures of nancial development.

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Kaufmann et al. (2006)17: voice and accountability, political stability and absence of violence, government effectiveness, regulatory quality, rule of law, and control of corruption.18 In the full country sample of Kaufmann et al. (2006), each index ranges between 2 and 2 for the vast majority of countries, with a mean of 0 and a standard deviation of 1.19 We focus our analysis on two groups of countries: the whole sample, including countries at all levels of economic development, and a sample of developing and emerging market countries only. The reason for looking at both samples separately is twofold. First, while advanced economies have substantial gross assets and liabilities, emerging markets and developing countries have traditionally had limited external gross assets.20 Second, while we do control for GDP per capita, we are not only interested in the heterogeneity between advanced countries, on the one hand, and developing and emerging market countries, on the other, but also in the heterogeneity within developing and emerging market countries; indeed, as mentioned in motivating our study, developing countries and emerging markets may deserve special attention because they are more crisis-prone than are advanced economies. Our baseline sample consists of the 94 countriesd22 advanced and 72 emerging/developing, listed in Appendix 1dfor which all of our key explanatory variables are available (at least for 1 year of the years between 1996 and 2004 for each country).21 We regress the time-series mean of the dependent variable for the available years on the time-series means of the explanatory variables. For the typical country in the sample (that is, the cross-country average of time-series means in the sample of 94 countries used in the baseline regressions), FDI is 27 percent of total liabilities, portfolio equity 6 percent, and debt 67 percent. Throughout the paper we report the results for total equity (dened as the sum of FDI and portfolio equity).22 Table 1 reports the descriptive statistics for the variables used in this study.

17 Instead of simple averaging of the six subcomponents, one could consider extracting a common component (for example, the rst principal component obtained by applying principal components analysis to the six series). This yields essentially the same resultsdnot only in this paper but also in the broader literature on institutional quality. 18 In our view, the indices compiled by Kaufmann et al. (2006), now known as World Bank Governance Indicators (WGI), are the state of the art among indicators of institutional quality, in the sense that they are a summary measure of the largest set available of such indicators. These indices are based on several hundred individual variables measuring perceptions of governance, drawn from 31 separate data sources constructed by 25 different organizations, ranging from think-tanks to governments, multilateral organizations and commercial rms (for example, Freedom House, Heritage Foundation, World Economic Forum, U.S. State Department, European Bank for Reconstruction and Development, Economist Intelligence Unit, and Political Risk Services). They report values every other year beginning in 1996, and annually beginning in 2002. 19 The range for the institutional quality index is narrower because we exclude countries without adequate data coverage for other variables, and because of the averaging of the six governance indicators. 20 Blonigen and Wang (2005) argue against pooling advanced economies together with emerging markets and developing countries in empirical studies of FDI, on the grounds that advanced economies experience large two-way FDI ows, whereas emerging markets and developing countries have traditionally been almost exclusively recipients of FDI. 21 Our baseline sample size is smaller than that of Lane and Milesi-Ferretti (2006) primarily owing to constraints on the availability of data on educational attainment. We eliminate offshore nancial centers from the sample (13 countries in total, of which six are non-high income countries). However, the main result of the paperdthe positive and signicant correlation between institutional quality and the share of equity-like components in total liabilitiesdstill holds at the 1 percent signi` cance level when offshore nancial centers are included; the only change vis-a-vis the baseline regressions refers to the increase in the coefcient and statistical importance of economic size in explaining cross-country shares of total equity in total liabilities for the sample of non-high income countries. Results not reported for the sake of brevity. 22 Whether FDI and portfolio equity should be treated separatelydas emphasized in some of the literaturedis an open question: FDIs conceptually distinctive feature compared with portfolio equity is the existence of a long-term relationship between the direct investor and the enterprise, and a signicant degree of inuence on the management of the enterprise. At a practical level, the balance-of-payments statistics usually dene FDI on the basis of whether the direct investor has at least 10 percent of the ordinary shares or voting power (for an incorporated enterprise) or the equivalent (for an unincorporated enterprise); but several countries have chosen to permit qualications from that criterion when a direct investor owns less than 10 percent of an enterprise but has an effective voice in management, or when the investor owns more than 10 percent but does not have an effective voice in management. In this paper, we focus on the aggregate, FDI plus portfolio equity, total equity. In the robustness section, we explore the differential impact of the independent variables on the subcomponents of equity. In the working paper version, using a different data set and period coverage, we look into these disaggregated components in more detail.

A. Faria, P. Mauro / Journal of International Money and Finance 28 (2009) 367391 Table 1 Descriptive statistics: averages 19962004. Variable Whole sample Total equity Institutional quality index GDP (constant 2000 US$ trillions) GDP per capita (constant 2000 US$ thousands) Financial development Natural resources Openness Human capital Transition Non-high income countries Total equity Institutional quality index GDP (constant 2000 US$ trillions) GDP per capita (constant 2000 US$ thousands) Financial development Natural resources Openness Human capital Transition Minimum 0.03 1.56 0.001 0.12 0.04 0.00 0.21 0.03 0 0.04 1.56 0.001 0.12 0.04 0.00 0.24 0.03 0 Maximum 0.84 1.84 9.55 36.90 2.04 0.97 2.08 0.90 1 0.84 1.09 1.24 10.92 1.80 0.97 2.08 0.77 1 Mean 0.33 0.11 0.31 6.80 0.48 0.21 0.75 0.40 0.16 0.33 0.28 0.08 2.01 0.32 0.23 0.76 0.33 0.19 Median 0.30 0.16 0.02 2.04 0.30 0.10 0.66 0.39 0 0.30 0.32 0.01 1.42 0.25 0.11 0.65 0.25 0 Standard deviation 0.16 0.87 1.12 9.64 0.43 0.24 0.38 0.23 0.37 0.17 0.54 0.19 2.04 0.31 0.25 0.39 0.21 0.40

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Coefcient of variation 0.50 8.17 3.61 1.42 0.90 1.16 0.51 0.58 2.31 0.52 n.a. 2.24 1.01 0.95 1.08 0.52 0.63 2.05

Sources and notes: The whole sample consists of 94 observations and the non-high income countries sample consists of 72 observations; the classication of countries according to the income level follows the Global Development Network Growth Database. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI, and is expressed as a share of total international liabilities. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. GDP (U.S. trillions of dollars at constant 2000 prices) and GDP per capita (U.S. thousands of dollars at constant 2000 prices) are from the World Banks World Development Indicators (WDI). Financial development is measured by private credit divided by GDP, from the WDI. Natural resources are the percentage of ore, metals and fuels in total exports, built using data from the WDI. Openness is the sum of exports and imports divided by GDP, built using data from the WDI. Human capital is the share of population over 25 that attended at least some level of secondary schooling, from the World Banks Education Indicators, EDSTATS (Education Attainment in the Adult Populationdfollowing Barro and Lee, 2001). Transition is a dummy variable that indicates whether a country belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries, from the Global Development Network Growth Database. Variables are time-series means for the available years during the period 19962004. Appendix 1 provides further details on sources and variable denitions.

The list of potential explanatory variables we consider in our baseline specications is relatively parsimoniousdnot an unnatural choice in light of the limited number of countries for which data are available and the need to attain a sufcient number of degrees of freedom in the estimation. Several of these potential explanatory variables are correlated with each other (Table 2), highlighting the importance of using multivariate regressions. Nevertheless, as mentioned in Section 1 and explained in detail in an extensive robustness tests section presented below, our results are conrmed when we introduce additional explanatory variables. 3.2. Results Considering the univariate correlations between the shares of equity in total liabilities and factors potentially associated with liability composition, a number of signicant correlations emerge (Table 3). For the whole sample, total equity as a share of total liabilities is signicantly and positively correlated with institutional quality, nancial development, openness, and human capital; across the sample of non-high income countries, total equity is signicantly correlated with the variables mentioned above (though the correlations have a different order of magnitude), as well as with country size and level of economic development. Not surprisingly (given that the shares of the various components of liabilities need to sum to 1), the remaining component of total

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Table 2 Pairwise correlations (independent variables): averages 19962004. Institutional quality index Whole sample Institutional quality index GDP GDP per capita Financial development Natural resources Openness Human capital Transition Non-high income countries Institutional quality index GDP GDP per capita Financial development Natural resources Openness Human capital Transition 1 0.30*** 0.84*** 0.70*** 0.33*** 0.15 0.68*** 0.01 1 0.10 0.68*** 0.44*** 0.36*** 0.37*** 0.48*** 0.31*** GDP GDP per capita Financial development Natural resources Openness Human capital Transition

1 0.51*** 0.54*** 0.15 0.25** 0.33** 0.10

1 0.71*** 0.13 0.03 0.65*** 0.16

1 0.27*** 0.07 0.53*** 0.23**

1 0.12 0.03 0.01

1 0.29*** 0.40***

1 0.42***

1 0.30*** 0.35*** 0.10 0.25** 0.13 0.09

1 0.33*** 0.06 0.18 0.55*** 0.22*

1 0.20* 0.30*** 0.27** 0.12

1 0.16 0.04 0.03

1 0.47*** 0.42***

1 0.70***

Sources and notes: ***signicant at 1%; **signicant at 5%; *signicant at 10%. The whole sample consists of 94 observations and the non-high income countries sample consist of 72 observations; the classication of countries according to the income level follows the Global Development Network Growth Database. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. GDP (U.S. trillions of dollars at constant 2000 prices) and GDP per capita (U.S. thousands of dollars at constant 2000 prices) are from the World Banks World Development Indicators (WDI). Financial development is measured by private credit divided by GDP from the WDI. Natural resources are the percentage of ore, metals and fuels in total exports, built using data from the WDI. Openness is the sum of exports and imports divided by GDP, built using data from the WDI. Human capital is the share of population over 25 that attended at least some level of secondary schooling, from the World Banks Education Indicators, EDSTATS (Education Attainment in the Adult Populationdfollowing Barro and Lee, 2001). Transition is a dummy variable that indicates whether a country belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries, from the Global Development Network Growth Database. Variables are time-series means for the available years during the period 1996 2004. Appendix 1 provides further details on sources and variable denitions. Table 3 Pairwise correlations of total equity with each independent variable: averages 19962004. Institutional quality index Whole sample 0.29*** Non-high income countries 0.56*** GDP GDP per capita 0.04 0.48*** Financial development 0.24** 0.43*** Natural resources 0.08 0.03 Openness Human capital 0.29*** 0.37*** Transition

0.07 0.24**

0.32*** 0.37***

0.04 0.04

Sources and notes: ***signicant at 1%; **signicant at 5%; *signicant at 10%. The whole sample consists of 94 observations and the non-high income countries sample consists of 72 observations; the classication of countries according to the income level follows the Global Development Network Growth Database. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI, and is expressed as a share of total international liabilities. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. GDP (U.S. trillions of dollars at constant 2000 prices) and GDP per capita (U.S. thousands of dollars at constant 2000 prices) are from the World Banks World Development Indicators (WDI). Financial development is measured by private credit divided by GDP from the WDI. Natural resources are the percentage of ore, metals and fuels in total exports, built using data from the WDI. Openness is the sum of exports and imports divided by GDP, built using data from the WDI. Human capital is the share of population over 25 that attended at least some level of secondary schooling, from the World Banks Education Indicators, EDSTATS (Education Attainment in the Adult Populationdfollowing Barro and Lee, 2001). Transition is a dummy variable that indicates whether a country belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries, from the Global Development Network Growth Database. Variables are time-series means for the available years during the period 19962004. Appendix 1 provides further details on sources and variable denitions.

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liabilities (unreported) bears relationships with all these variables with opposite signs to those of total equity. Turning to multivariate regressions, we begin by focusing on the determinants of the share of total equity in total liabilities in the whole sample (Table 4). Our main, and most robust, nding is that institutional quality is positively and signicantly associated with total equity in essentially all specications and samples, and controlling for a variety of other explanatory variables. The magnitude of the coefcient is economically signicant: for example, a one-digit improvement in the institutional quality index is associated with an 18 percentage point increase in the ratio of total equity to total liabilities controlling for economic size and economic development in the whole sample (column 2).23 That magnitude is also reasonably robust to changes in the set of controls and sample considered. Other variables seem to play a role, too, with a statistically and economically signicant impact in a number of specications. Total equity is positively correlated with economic size (perhaps because market size tends to attract foreign investors), butdwhen institutional quality is included as a regressordnegatively with the level of economic development (in the whole sample but not in the sample that excludes advanced economies). The ratio of private credit to GDP, a proxy for domestic nancial development, is positively associated with the share of total equity in total liabilities in most specication, and occasionally signicant. Openness, natural resource abundance, and indicators of educational attainment are positively, signicantly, and fairly robustly associated with the share of total equity in total liabilities. Transition countries have a signicantly lower share of total equity controlling for the other baseline explanatory variables. The overall ability of these independent variables to t the cross-sectional variation in the total equity share is considerable: the adjusted R2 coefcient is 0.37 in the whole sample, and 0.46 in the non-high income sample; the adjusted R2 coefcient in the univariate regressions using institutional quality alone is 0.07 in the whole sample, and 0.31 in the non-high income sample. 3.3. Robustness tests In this section, we outline a number of potential concerns regarding our main estimates, explain our approach in seeking to address them, and report the related ndings, as follows. Some results are not shown to conserve space. 3.3.1. Changes in the sample The results are robust to other alternative samples, including the following: an enlarged sample that uses all available data for each specication (i.e., no longer restricted to those countries for which all explanatory variables are available)dsee Table 5; and a narrower sample consisting of the countries that have observations for all dependent and explanatory variables in all years between 1996 and 2004.24

23 In the institutional quality scale, one digit is approximately equal to one standard deviation within the full country sample of Kaufmann et al. (2006): taking the index at face value, this would be equivalent, for example, to improving the institutions of Jamaica to the level of those of Chile, or improving the institutions of Peru to the level of Slovenia. Of course, these comparisons between pairs of countries are only for illustration purposes. Our view is that the institutional quality index is useful in identifying broad cross-country correlations, but measurement error is often too large for comparisons between pairs of countries to be taken too seriously (see Kaufmann and Kraay, 2004). 24 Human capital and the institutional quality index only have information available for some of the years (for human capital we only have information, at best, for 1990, 1995, and 2000). Given the sluggishness of these variables, wherever data for a given year are not available, we use the data for the most recent available year. Narrowing the sample to those years for which data on institutional quality are available (1996, 1998, 2000, 2002-04) does not change the results. Narrowing the sample to the set of countries that have recent data for education (1995 and 2000) does not change the results either. We describe in detail the construction of these variables in Appendix 1.

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Table 4 Total equity as a share of total international liabilities: averages 19962004. A. Faria, P. Mauro / Journal of International Money and Finance 28 (2009) 367391 Whole sample (1) Institutional quality index GDP GDP per capita Financial development Natural resources Openness Human capital Transition Constant Observations Adjusted R-squared 0.05*** (0.02) (2) 0.18*** (0.03) 0.03*** (0.01) 0.01*** (0.003) (3) 0.16*** (0.03) 0.02*** (0.01) 0.01*** (0.003) 0.08 (0.05) (4) 0.17*** (0.03) 0.04***(0.01) 0.02*** (0.003) 0.07 (0.05) 0.15** (0.07) 0.10** (0.05) (5) 0.17*** (0.04) 0.04*** (0.01) 0.02*** (0.003) 0.01 (0.06) 0.10 (0.08) 0.12** (0.05) 0.34*** (0.13) 0.19*** (0.07) 0.23*** (0.05) 94 0.37 Non-high income countries (6) 0.18*** (0.02) (7) 0.15*** (0.04) 0.14 (0.12) 0.01 (0.02) (8) 0.12*** (0.04) 0.09 (0.11) 0.01 (0.02) 0.11*** (0.04) (9) 0.15*** (0.05) 0.21** (0.09) 0.002 (0.01) 0.06 (0.06) 0.16** (0.07) 0.11** (0.06) (10) 0.18*** (0.05) 0.24** (0.10) 0.004 (0.02) 0.03 (0.06) 0.16** (0.07) 0.16*** (0.06) 0.18 (0.16) 0.18** (0.08) 0.20*** (0.06) 72 0.46

0.32*** (0.02) 94 0.07

0.40*** (0.02) 94 0.22

0.37*** (0.03) 94 0.23

0.27*** (0.04) 94 0.29

0.38*** (0.02) 72 0.31

0.34*** (0.04) 72 0.33

0.30*** (0.05) 72 0.34

0.21*** (0.06) 72 0.41

Sources and notes: robust standard errors in parentheses. Ordinary least squares regressions. ***Signicant at 1%; **signicant at 5%; *signicant at 10%. The classication of countries according to the income level follows the Global Development Network Growth Database. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI, and is expressed as a share of total international liabilities. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. GDP (U.S. trillions of dollars at constant 2000 prices) and GDP per capita (U.S. thousands of dollars at constant 2000 prices) are from the World Banks World Development Indicators (WDI). Financial development is measured by private credit divided by GDP from the WDI. Natural resources are the percentage of ore, metals and fuels in total exports, built using data from the WDI. Openness is the sum of exports and imports divided by GDP, built using data from the WDI. Human capital is the share of population over 25 that attended at least some level of secondary schooling, from the World Banks Education Indicators, EDSTATS (Education Attainment in the Adult Populationdfollowing Barro and Lee, 2001). Transition is a dummy variable that indicates whether a country belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries, from the Global Development Network Growth Database. Dependent and independent variables are time-series means for the available years during the period 19962004. Appendix 1 provides further details on sources and variable denitions.

Table 5 Robustness tests: enlarging sample size. Whole sample (1) Institutional quality index GDP GDP per capita Financial development Natural resources Openness Human capital Transition Constant Observations Adjusted R-squared (2) (3) 0.11*** (0.03) (4) 0.16*** (0.03) (5) 0.18*** (0.03) Non-high income countries (6) 0.13*** (0.03) (7) 0.10*** (0.04) 0.14 (0.11) 0.01 (0.01) (8) 0.07* (0.04) 0.09 (0.10) 0.01 (0.01) 0.10** (0.04) (9) (10)

A. Faria, P. Mauro / Journal of International Money and Finance 28 (2009) 367391

0.05*** (0.02) 0.13*** (0.03)

0.15*** (0.03) 0.18*** (0.04) 0.28** (0.07) 0.01 (0.01) 0.01 (0.01) 0.25*** (0.09) 0.004 (0.02) 0.04 (0.07)

0.03*** (0.01) 0.02* (0.01) 0.04*** (0.01) 0.05*** (0.02) 0.01*** (0.003) 0.01*** (0.003) 0.02*** (0.003) 0.02*** (0.003) 0.08* (0.05) 0.09 (0.05) 0.02 (0.003) 0.16** (0.06) 0.11** (0.04) 0.12 (0.07) 0.13*** (0.04) 0.32*** (0.12) 0.18*** (0.06) 0.23*** (0.04) 94 0.38

0.32*** (0.01) 129 0.06

0.38*** (0.02) 126 0.13

0.35*** (0.03) 124 0.13

0.24*** (0.04) 117 0.29

0.17*** (0.06) 0.18*** (0.07) 0.16*** (0.05) 0.18*** (0.05) 0.16 (0.16) 0.17** (0.08) 0.38*** (0.02) 0.32*** (0.03) 0.29*** (0.04) 0.18*** (0.04) 0.19*** (0.05) 105 103 101 94 72 0.19 0.21 0.21 0.39 0.49

Sources and notes: robust standard errors in parentheses. Ordinary least squares regressions. ***Signicant at 1%; **signicant at 5%; *signicant at 10%. The classication of countries according to the income level follows the Global Development Network Growth Database. The dependent variable is total equity as a share of total international liabilities. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. GDP (U.S. trillions of dollars at constant 2000 prices) and GDP per capita (U.S. thousands of dollars at constant 2000 prices) are from the World Banks World Development Indicators (WDI). Financial development is measured by private credit divided by GDP from the WDI. Natural resources are the percentage of ore, metals and fuels in total exports, built using data from the WDI. Openness is the sum of exports and imports divided by GDP, built using data from the WDI. Human capital is the share of population over 25 that attended at least some level of secondary schooling from the World Banks Education Indicators, EDSTATS (Education Attainment in the Adult Populationdfollowing Barro and Lee, 2001). Transition is a dummy variable that indicates whether a country belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries, from the Global Development Network Growth Database. Dependent and independent variables are time-series means for the available years during the period 19962004. Appendix 1 provides further details on sources and variable denitions.

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3.3.2. Dropping potentially inuential observations To show that our results are robust to changes in the sample of countries, we run the key regressions routinely dropping one country at a time, and nd that no individual country has excessive inuence on the results.25 3.3.3. Robust regressions From the partial correlation plots, we identify a potential outlier (Fiji), and four possible inuential observations (Botswana, Chile, Tajikistan, and Trinidad and Tobago, for the whole sample; and Botswana, Chile, Namibia, Tajikistan, and South Korea, for the non-high income sample).26 Therefore we run robust regressions that take these cases into account by weighting the observations inversely to their residuals so that observations with smaller residuals have more weight after dropping inuential observations (it is a form of weighted least squares regression). Results for the institutional quality index are unchanged for our preferred specications (columns 4 and 5, for the whole sample, and columns 9 and 10 for the non-high income countries sample). One result that appears to be somewhat fragile is the (conditional) relationship between openness and total equity for the non-high income countries sample (Table 6).27 3.3.4. FamaMacBeth procedure The results hold when we adopt the Fama and MacBeth (1973) approach, widely used in nance, as an alternative estimation procedure to explore both time-series and cross-section information. In the rst step, this involves running cross-section regressions for each year. In the second step, the timeseries averages of the cross-sectional regression point estimates are used as point estimates for the coefcients of interest, and the standard deviations of the cross-sectional estimates are used to generate the standard errors for the estimates. The point estimates for all estimated coefcients are very similar to those reported in our baseline regressions, and all main results retain their high degree of statistical signicance. 3.3.5. Bounded nature of the dependent variables To take into account that the shares of total equity by denition cannot lie outside the 01 range, we run the key regressions using a quasi-maximum likelihood procedure, as proposed by Papke and Wooldridge (1996), and obtain broadly similar results (not shown) to those reported above. 3.3.6. Shares of GDP Although we are mostly interested in the determinants of the composition of external liabilities, we also checked whether the same explanatory variables are associated with the size of total equity (and its subcomponents, FDI and portfolio equity) expressed as a share of GDP. The ndings are similar: institutional quality, openness, and, for the non-high income countries sample, natural resources are

25 By dropping one country at a time for specications (4) and (5) for the whole sample, and (9) and (10) for the non-high income countries sample (Table 4), the institutional quality index coefcient remains signicant at the 1 percent level, the only exception being when we drop South Korea from the non-high income countries sample for specication (9), which makes the coefcient signicant only at the 5 percent level and slightly smaller (0.11). By dropping Fiji, the results are strengthened; however, we keep Fiji in the sample as its inclusion goes against the main result of the paper. 26 An extreme version of this procedure would be to drop all observations we think are outliers or inuential observations. First, we adopt a conservative approach and drop only the inuential observations. For the regressions in the whole sample, the signicance level for the institutional quality index remains at the 1 percent level, though the magnitude of the coefcient is lower (1213 percentage points). For the regressions in the non-high income countries, for specication (10), the magnitude of the coefcient falls to 9 percentage points, and is signicant only at the 10 percent level (for specication 9, the coefcient is only 4 percent and we cannot reject it is different from zero). By dropping Fiji (the outlier), institutional quality is again signicant in all specications, even when the inuential observations are dropped. 27 For specications (7) and (8), Fiji obtains zero weight and China is dropped from the regressions (technically, its Cooks D value is larger than one, so an inuential observation). The institutional quality index coefcient remains signicant at the 5 percent level but its magnitude is smaller. For specication (5), the United States is dropped from the regressions because its Cooks D value is larger than one.

Table 6 Robustness tests: accounting for outliers and inuential observations. A. Faria, P. Mauro / Journal of International Money and Finance 28 (2009) 367391 Whole sample (1) Institutional quality index GDP GDP per capita Financial development Natural resources Openness Human capital Transition Constant Observations Adjusted R-squared 0.06*** (0.02) (2) 0.18*** (0.03) 0.03* (0.02) 0.01*** (0.003) (3) 0.16*** (0.03) 0.02 (0.02) 0.01*** (0.003) 0.08 (0.05) (4) 0.18*** (0.04) 0.03** (0.02) 0.02*** (0.003) 0.07 (0.05) 0.18*** (0.07) 0.07* (0.04) (5) 0.20*** (0.04) 0.10*** (0.04) 0.02*** (0.01) 0.05 (0.06) 0.15** (0.07) 0.13*** (0.04) 0.33*** (0.12) 0.20*** (0.06) 0.22*** (0.05) 93 0.38 Non-high income countries (6) 0.18*** (0.03) (7) 0.12*** (0.04) 0.04 (0.14) 0.03** (0.01) (8) 0.09** (0.04) 0.05 (0.14) 0.03*** (0.01) 0.10* (0.06) (9) 0.16*** (0.05) 0.22** (0.10) 0.002 (0.01) 0.09 (0.06) 0.20*** (0.07) 0.06 (0.04) (10) 0.18*** (0.05) 0.23** (0.10) 0.002 (0.01) 0.01 (0.07) 0.18*** (0.07) 0.12** (0.05) 0.14 (0.14) 0.14** (0.06) 0.20*** (0.05) 72 0.50

0.31*** (0.02) 94 0.10

0.38*** (0.02) 94 0.24

0.35*** (0.03) 94 0.25

0.27*** (0.04) 94 0.30

0.37*** (0.02) 72 0.33

0.30*** (0.03) 71 0.39

0.25*** (0.04) 71 0.46

0.22*** (0.05) 72 0.45

Sources and notes: standard errors in parentheses. Robust regressions. ***Signicant at 1%; **signicant at 5%; *signicant at 10%. The classication of countries according to the income level follows the Global Development Network Growth Database. The dependent variable is total equity as a share of total international liabilities. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006) also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. GDP (U.S. trillions of dollars at constant 2000 prices) and GDP per capita (U.S. thousands of dollars at constant 2000 prices) are from the World Banks World Development Indicators (WDI). Financial development is measured by private credit divided by GDP from the WDI. Natural resources are the percentage of ore, metals and fuels in total exports, built using data from the WDI. Openness is the sum of exports and imports divided by GDP, built using data from the WDI. Human capital is the share of population over 25 that attended at least some level of secondary schooling, from the World Banks Education Indicators, EDSTATS (Education Attainment in the Adult Populationdfollowing Barro and Lee, 2001). Transition is a dummy variable that indicates whether a country belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries, from the Global Development Network Growth Database. Dependent and independent variables are time-series means for the available years during the period 19962004. Appendix 1 provides further details on sources and variable denitions.

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Table 7 Robustness tests: validity of the results for the IMFs International Investment Position data set. A. Faria, P. Mauro / Journal of International Money and Finance 28 (2009) 367391 Whole sample (1) Institutional quality index GDP GDP per capita Financial development Natural resources Openness Human capital Transition Constant Observations Adjusted R-squared 0.04* (0.02) (2) 0.17*** (0.04) (3) 0.15*** (0.04) (4) 0.16*** (0.04) (5) 0.14*** (0.04) Non-high income countries (6) 0.19*** (0.03) (7) 0.16*** (0.05) (8) 0.13*** (0.05) (9) 0.16*** (0.05) (10) 0.20*** (0.05)

0.04*** (0.01) 0.03** (0.01) 0.04*** (0.01) 0.04** (0.01) 0.01*** (0.003) 0.01*** (0.004) 0.02*** (0.003) 0.02*** (0.003) 0.10 (0.06) 0.09 (0.07) 0.01 (0.07) 0.18* (0.11) 0.10** (0.05) 0.10 (0.12) 0.11** (0.05) 0.53*** (0.12) 0.21*** (0.06) 0.16*** (0.06) 70 0.39

0.24*** (0.04) 0.19*** (0.04) 0.01 (0.01) 0.01 (0.01) 0.11** (0.05)

0.27*** (0.04) 0.28*** (0.04) 0.01 (0.01) 0.01 (0.01) 0.07 (0.07) 0.05 (0.07) 0.30*** (0.07) 0.28*** (0.08) 0.11* (0.06) 0.14*** (0.05) 0.43*** (0.16) 0.22*** (0.07) 0.11* (0.06) 48 0.67

0.32*** (0.02) 0.38*** (0.03) 70 70 0.03 0.19

0.35*** (0.03) 70 0.21

0.24*** (0.06) 70 0.26

0.37*** (0.02) 0.31*** (0.04) 48 48 0.29 0.46

0.27*** (0.05) 0.14** (0.06) 48 48 0.48 0.59

Sources and notes: robust standard errors in parentheses. Ordinary least squares regressions. ***Signicant at 1%; **signicant at 5%; *signicant at 10%. The classication of countries according to the income level follows the Global Development Network Growth Database. The dependent variable is total equity as a share of liabilities. Total equity consists of portfolio equity plus FDI. International liabilities and their components are from countries International Investment Position in the IMFs International Financial Statistics (IFS). The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. GDP (U.S. trillions of dollars at constant 2000 prices) and GDP per capita (U.S. thousands of dollars at constant 2000 prices) are from the World Banks World Development Indicators (WDI). Financial development is measured by private credit divided by GDP from the WDI. Natural resources are the percentage of ore, metals and fuels in total exports, built using data from the WDI. Openness is the sum of exports and imports divided by GDP, built using data from the WDI. Human capital is the share of population over 25 that attended at least some level of secondary schooling from the World Banks Education Indicators, EDSTATS (Education Attainment in the Adult Populationdfollowing Barro and Lee, 2001). Transition is a dummy variable that indicates whether a country belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries, from the Global Development Network Growth Database. Dependent and independent variables are time-series means for the available years during the period 19962004. Appendix 1 provides further details on sources and variable denitions.

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estimated to play a role using that alternative dependent variable. The working paper version (Faria and Mauro, 2004) reports a host of tables analyzing this issue. 3.3.7. Validity of the results for the IMFs International Investment Position data set We replicate the main regressions (as in Table 4) involving the share of total equity in total liabilities, with IIP data (Table 7).28 Reassuringly, despite using a different data set that covers different sets of countries, the main result of the paper remains unchanged: the institutional quality index coefcient is positively and signicantly correlated with total equity at conventional levels (and the magnitude of the coefcients is close to the ones obtained with the Lane and Milesi-Ferretti data set). It is also worth recalling that the working paper version (Faria and Mauro, 2004), which had obtained very similar results, had been entirely based on a previous vintage of the IIP data set. Compared with that previous version of this study, one result that changes with the new Lane and Milesi-Ferretti (2006) data is that the ratio of portfolio equity to FDI no longer bears a clear-cut and robust relationship to institutional quality when other controls enter in the regression. 3.3.8. Possible special role of individual subcomponents of the institutional quality index Now beginning again from our baseline sample and data set, one might be interested in nding out whether a particular subcomponent of the institutional quality index is especially important in driving the results. We thus regress our dependent variables on each subcomponent of the institutional quality index, one at a time. In all regressions, we include our baseline controls (GDP, GDP per capita, nancial development, natural resources, openness, human capital, and a transition dummy) (Table 8).29 (We do not report coefcients and p-values for the controls.) There is no clear pattern of a particular subcomponent being more important than others. (Indeed, theory suggests that various aspects of poor institutional quality would tend to go togetherdsee Mauro, 2004.) The coefcients of the different institutional subcomponents, whenever signicant, have the same sign.30 3.3.9. Subcomponents of equity In an effort to disentangle the exact mechanisms whereby various factors may affect the composition of countries external liabilities, we run multivariate regressions of debt and each subcomponent of equity (FDI and portfolio equity) on the same set of potential determinants. This allows us to ask questions such as the following: when the institutional quality index improves by one digit, by how many percentage points of total liabilities do the shares of debt, FDI, and portfolio equity change, respectively? By identity, the sum of the changes in the shares of FDI, portfolio equity, and debt has to equal to 0. We nd that institutional quality is positively and signicantly associated with total equity, and, in particular, with FDI as a share of total liabilities. As countries institutional quality improves, the composition of external liabilities tilts in favor of FDI over debt. FDI may thus be especially vulnerable to institutional weaknesses such as red tape hurdles or expropriation through bribes. A one-digit improvement in the institutional quality index is associated with a 3 percentage point increase in the share of portfolio equity in total liabilities (though not statistically different from 0); a 14 percentage point increase in the FDI share; and a 17 percentage point decline in the share of debt (which includes portfolio debt, loans, currency, and deposits). Consistent with previous studies, a number of pull factors, such as openness, natural resources, and human capital are positively and signicantly associated with the share of FDI in total liabilities and thus seem to play a role in attracting FDI. In some specications, nancial development, though not signicantly associated with total equity as a share of total liabilities, is positively and signicantly associated with portfolio equity as a share of total liabilities.31

28 We show regressions for the averages in the period 19962004 for the sake of comparability with the baseline regressions that use Lane and Milesi-Ferrettis (2006) data set. Including 2005 in the IIP averages does not change the results. 29 As noted above, the six subcomponents that form the institutional quality index are: voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. 30 The few instances in which a subcomponent is not signicant are due to the inclusion of Fiji in the sample. Dropping Fiji makes all subcomponents signicant and increases or maintains the magnitude in almost all of them. 31 These results are strengthened when running robust regressions.

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Table 8 Robustness tests: role of individual subcomponents of institutional quality. Whole sample Institutional quality index Voice and accountability Government effectiveness Political stability Regulatory quality Rule of law Control of corruption 0.17*** 0.08*** 0.14*** 0.12*** 0.11*** 0.09** 0.13*** (0.04) (0.03) (0.04) (0.03) (0.04) (0.04) (0.03) Non-high income countries 0.18*** 0.07** 0.13*** 0.11*** 0.08 0.08 0.17*** (0.05) (0.03) (0.05) (0.03) (0.05) (0.05) (0.04)

Sources and notes: robust standard errors in parentheses. Ordinary least squares regressions. ***Signicant at 1%; **signicant at 5%; *signicant at 10%. The dependent variable is total equity as a share of liabilities. Each line of the table represents a regression. In each regression, the controls are GDP, GDP per capita, nancial development, natural resources, openness, human capital, and a transition dummy. The whole sample includes 94 observations and the non-high income countries sample include 72 observations; the classication of countries according to the income level follows the Global Development Network Growth Database. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. GDP (U.S. trillions of dollars at constant 2000 prices) and GDP per capita (U.S. thousands of dollars at constant 2000 prices) are from the World Banks World Development Indicators (WDI). Financial development is measured by private credit divided by GDP from the WDI. Natural resources are the percentage of ore, metals and fuels in total exports, built using data from the WDI. Openness is the sum of exports and imports divided by GDP, built using data from the WDI. Human capital is the share of population over 25 that attended at least some level of secondary schooling, from the World Banks Education Indicators, EDSTATS (Education Attainment in the Adult Populationdfollowing Barro and Lee, 2001). Transition is a dummy variable that indicates whether a country belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries, from the Global Development Network Growth Database. Dependent and independent variables are time-series means for the available years during the period 1996 2004. Appendix 1 provides further details on sources and variable denitions.

3.3.10. Controlling for international nancial constraints We now turn to changes in the list of explanatory variables. To relate our results to one of the propositions put forward by Albuquerque (2003), we add a control for international nancial constraints. As a proxy, we use the number of years a country was in default between 1970 and 2001.32 We nd that institutional quality is still positively and signicantly associated with the share of equity in total liabilities and the ratio of FDI to total liabilities (Table 9). Financing constraints are positively and signicantly associated with the share of equity in total liabilities, in particular FDI, as predicted by Albuquerque (2003). 3.3.11. Domestic stock market development instead of domestic credit The baseline regressions reported in the previous section have included the ratio of domestic credit to GDP as an explanatory variable. The results are robust to using instead alternative measures of domestic nancial development, notably proxies for domestic stock market development, which may help attract not only portfolio equity, but also foreign direct investment, because multinational rms often tap domestic markets to nance local investments. Although domestic stock market capitalization is signicant in a number of specications, institutional quality remains highly signicant in most specications (Table 10). These results are robust to using the number of listed rms as an alternative proxy for domestic stock market development. 3.3.12. Controlling for international equity liberalization This is of course potentially most important for portfolio equity, and is also related to the previous point, as both portfolio equity ows and domestic stock market capitalization have become gradually more important in recent years. We run the regressions controlling for a dummy variable indicating whether a country had liberalized international access to its equity markets by 1995 (Bekaert et al.,

32 We thank a referee for suggesting this measure, whichdas suggested by Reinhart et al. (2003)dmay be viewed as more exogenous than credit ratings.

Table 9 Robustness tests: including international nancing constraints. Whole sample (1) Institutional quality index Financing Constraints GDP GDP per capita Financial development Natural resources Openness Human capital Transition Constant Adjusted R-squared (2) (3) 0.16*** (0.03) 0.005*** (0.002) (4) 0.17*** (0.03) 0.006*** (0.002) (5) 0.17*** (0.03) 0.004* (0.002) Non-high income countries (6) 0.18*** (0.02) (7) 0.16*** (0.04) (8) 0.13*** (0.04) (9) 0.15*** (0.05) (10) 0.18*** (0.05) A. Faria, P. Mauro / Journal of International Money and Finance 28 (2009) 367391

0.06*** (0.02) 0.18*** (0.02) 0.006*** (0.002) 0.005*** (0.002)

0.003* (0.002) 0.002 (0.002) 0.002 (0.002) 0.004* (0.002) 0.001 (0.003) 0.14 (0.12) 0.01 (0.02) 0.09 (0.11) 0.01 (0.02) 0.11*** (0.04) 0.22** (0.10) 0.002 (0.01) 0.05 (0.05) 0.15** (0.07) 0.14** (0.07) 0.24** (0.10) 0.004 (0.02) 0.03 (0.07) 0.16** (0.07) 0.17*** (0.06) 0.17 (0.18) 0.17* (0.09) 0.19*** (0.06) 0.46

0.03*** (0.01) 0.02*** (0.01) 0.04*** (0.01) 0.04*** (0.01) 0.01*** (0.003) 0.01*** (0.003) 0.01*** (0.003) 0.02*** (0.004) 0.07 (0.05) 0.06 (0.06) 0.01 (0.06) 0.13* (0.07) 0.12*** (0.05) 0.10 (0.07) 0.13*** (0.05) 0.29** (0.15) 0.17** (0.08) 0.21*** (0.05) 0.37

0.30*** (0.02) 0.38*** (0.03) 0.11 0.25

0.35*** (0.03) 0.25

0.23*** (0.04) 0.33

0.37*** (0.02) 0.31

0.34*** (0.04) 0.30*** (0.04) 0.19*** (0.06) 0.32 0.34 0.42

Sources and notes: robust standard errors in parentheses. Ordinary least squares regressions. ***Signicant at 1%; **signicant at 5%; *signicant at 10%. The whole sample includes 94 observations and the non-high income countries sample include 72 observations; the classication of countries according to the income level follows the Global Development Network Growth Database. The dependent variable is total equity as a share of liabilities. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. Financing constraints are measured by the number of years a country has been in default between 1970 and 2001. GDP (U.S. trillions of dollars at constant 2000 prices) and GDP per capita (U.S. thousands of dollars at constant 2000 prices) are from the World Banks World Development Indicators (WDI). Financial development is measured by private credit divided by GDP from the WDI. Natural resources are the percentage of ore, metals and fuels in total exports, built using data from the WDI. Openness is the sum of exports and imports divided by GDP, built using data from the WDI. Human capital is the share of population over 25 that attended at least some level of secondary schooling, from the World Banks Education Indicators, EDSTATS (Education Attainment in the Adult Populationdfollowing Barro and Lee, 2001). Transition is a dummy variable that indicates whether a country belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries, from the Global Development Network Growth Database. Dependent and independent variables are time-series means for the available years during the period 19962004. Appendix 1 provides further details on sources and variable denitions.

383

384

Table 10 Robustness tests: alternative measure of nancial development. Whole sample (1) Institutional quality index GDP GDP per capita Market capitalization Natural resources Openness Human capital Transition Constant Adjusted R-squared 0.16*** (0.03) 0.03*** (0.01) 0.01*** (0.003) (2) 0.14*** (0.03) 0.03** (0.01) 0.01*** (0.003) 0.08* (0.05) (3) 0.16*** (0.04) 0.05*** (0.01) 0.02*** (0.003) 0.16* (0.09) 0.13*** (0.04) 0.32** (0.14) 0.18*** (0.06) 0.21*** (0.09) 0.33 (4) 0.17*** (0.04) 0.05*** (0.01) 0.02*** (0.004) 0.03 (0.06) 0.16* (0.09) 0.13*** (0.05) 0.34** (0.16) 0.19*** (0.07) 0.21*** (0.06) 0.32 Non-high income countries (5) 0.15*** (0.05) 0.13 (0.12) 0.01 (0.02) (6) 0.14*** (0.05) 0.12 (0.13) 0.005 (0.02) 0.07 (0.05) (7) 0.17*** (0.05) 0.24** (0.09) 0.01 (0.02) 0.26*** (0.08) 0.18*** (0.05) 0.16 (0.18) 0.15** (0.07) 0.16** (0.07) 0.43 (8) 0.19*** (0.05) 0.26*** (0.09) 0.01 (0.02) 0.1 (0.1) 0.28*** (0.09) 0.20*** (0.06) 0.25 (0.21) 0.21** (0.09) 0.16** (0.07) 0.44

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0.41*** (0.02) 0.16

0.39*** (0.03) 0.18

0.36*** (0.05) 0.23

0.34*** (0.05) 0.23

Sources and notes: robust standard errors in parentheses. Ordinary least squares regressions. ***Signicant at 1%; **signicant at 5%; *signicant at 10%. The whole sample includes 78 observations and the non-high income countries sample include 56 observations; the classication of countries according to the income level follows the Global Development Network Growth Database. The dependent variable is total equity as a share of liabilities. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. GDP (U.S. trillions of dollars at constant 2000 prices) and GDP per capita (U.S. thousands of dollars at constant 2000 prices) are from the World Banks World Development Indicators (WDI). Market capitalization is the ratio of stock market capitalization divided by GDP, from the WDI. Natural resources are the percentage of ore, metals and fuels in total exports, built using data from the WDI. Openness is the sum of exports and imports divided by GDP, built using data from the WDI. Human capital is the share of population over 25 that attended at least some level of secondary schooling from the World Banks Education Indicators, EDSTATS (Education Attainment in the Adult Populationdfollowing Barro and Lee, 2001). Transition is a dummy variable that indicates whether a country belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries, from the Global Development Network Growth Database. Dependent and independent variables are time-series means for the available years during the period 19962004. Appendix 1 provides further details on sources and variable denitions.

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2005). About one-third of the countries in our sample had not liberalized by that time, whereas several emerging markets had already liberalized by the early 1990s.33 The impact of institutional quality on external capital structures is essentially the same as in the main tables. We also run these same regressions using a nancial liberalization reform index created by Detragiache et al. (unpublished): the institutional quality index remains signicant at the 1 percent level and the nancial development index is only signicant (at the 10 percent level) when the only regressors are nancial development, institutional quality, size, and level economic development. 3.3.13. Adding capital controls to the list of independent variables Our main results hold when we introduce standard measures of capital controls as an additional regressor.34 In all of our main regressions, the coefcient on institutional quality is essentially unchanged and always remains signicant, whereas capital controls are never statistically signicant. Capital controls are always positively (and signicantly, in some specications) associated with the share of total equity in total liabilities. The impact of capital controls on total equity comes from its positive (and sometimes signicant) association with the share of FDI in total liabilities. Specically, to proxy for capital controls, we use the sum of four dummy variables that take the value of one if the country has (a) multiple exchange rates; (b) current account restrictions; (c) capital account restrictions; and (d) export proceeds surrender requirements. (Thus, in each year, the summary measure takes integer values between 0 and 4.) For each country, we use the 19901995 average of this sum. The dummy variables are all drawn from the International Monetary Funds Annual Report on Exchange Arrangements and Exchange Restrictions (AREAR).35 3.3.14. Possible endogeneity of the institutional quality index We run regressions of liability components (as a share of total liabilities) on institutional quality using a variety of instruments such as settler mortality. The F-statistic in the rst-stage regression conrms that the instruments are not weak, and that 2SLS estimation is thus warranted. The identifying assumption is that settler mortality (and/or the other instruments) affects institutional quality, and institutional quality in turn affects the composition of countries external liabilities, with no other links between liability structures and the instruments. In particular, for the identifying assumption to hold, there must be no direct channel from the instruments to liability structures. This leads us to use univariate regressions combined with a broad interpretation of institutions (Table 11). For example, column (2) reports the results of the share of total equity in total liabilities on an index of institutional quality, using settler mortality and population density in the 1500s as instruments (as in Acemoglu et al., 2001). This specication may be of interest to those who believe that settler mortality and population density in the 1500s affected institutions in the broad sense (the institutional quality index would then proxy for many aspects of institutions, perhaps even including educational attainment); and institutions in turn affected our dependent variable, with no direct channel from the instruments to liability structures. Column (4) reports the results using instead ethnolinguistic fractionalization (as in Mauro, 1995) and British legal origin (as in La Porta et al., 1998) as instruments. In all

33 The samples for which the data are available consist of 2544 countries (depending on the specication). Institutional quality is signicant at the 1 percent level in all specications (except one in which it is signicant at the 5 percent level); in such limited samples, the equity market liberalization dummy is never signicant. Moreover, Bekaert et al. (2005) use an index of institutional quality as an instrument for equity market liberalization, suggesting that they view equity market liberalization as endogenous to institutional quality. Equity market liberalization appears with the expected (positive) sign and signicant when the dependent variable is the share of portfolio equity in total liabilities: a country that liberalized its equity market before 1995 has a share of portfolio equity in total liabilities 23 percentage points larger than a country that did not liberalize. (For comparison, the sample mean share of portfolio equity in total liabilities is 7 percent.) 34 Ideally, in our set up, one would wish to control for restrictions on certain types of capital ows (such as FDI, or short-term ows). Unfortunately, reliable cross-country measures of capital controls by type of ow are not yet available. 35 In 1996, the format of the AREAR changed to more detailed dummies with no simple mapping to the previous system. In our view, and in light of the persistence of many aspects of capital controls, this is the best compromise measure in terms of precision of the capital controls measure, relevance for the questions we address, and availability for a broad cross-section of countries.

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Table 11 Robustness tests: two stage least squares regressions. (1) OLS Institutional quality index Constant Observations R-squared in OLS First stage for institutional quality index Settler mortality Population density in 1500 Ethnolinguistic fractionalization British legal origin Constant R-squared in rst stage F-statistic Hansens J statistic (p-value) 0.12*** (0.02) 0.35*** (0.02) 51 0.35 (2) IV 0.13*** (0.03) 0.35*** (0.02) 51 n.a. 0.26*** (0.08) 0.23*** (0.04) 1.16*** (0.37) 0.58 38.05 0.19 (3) OLS 0.06*** (0.02) 0.30*** (0.02) 85 0.15 (4) IV 0.08*** (0.03) 0.29*** (0.02) 85 n.a.

0.02*** (0.003) 0.45** (0.19) 0.72*** (0.16) 0.22 18.62 0.14

Sources and notes: robust standard errors in parentheses. ***Signicant at 1%; **signicant at 5%; *signicant at 10%. The dependent variable (in the second stage) is total equity as a share of liabilities. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. Settler mortality is the logarithm of settler mortality for former colonies; and population density in the 1500s is the logarithm of population density in the 1500s for former colonies; both from Acemoglu et al. (2001). Ethnolinguistic fractionalization is the probability that two randomly selected persons from a given country will not belong to the same ethnolinguistic group from Mauro (1995). British legal origin is a dummy variable that attributes one to countries with English law or former British colonies or protectorates, from La Porta et al. (1998). Appendix 1 provides further details on sources and variable denitions.

cases, the coefcient on institutional quality rises compared with the ordinary least squares estimation. (To emphasize this point, we report the OLS results obtained with the same sample of countries as is available for instrumental variable estimation.) 4. Conclusion Previous studies have emphasized the importance of countries external capital structures for economic performance: reliance on equity-like instruments (FDI and portfolio equity) improves an economys ability to share risks with international investors; moreover, FDI is usually considered to be a vehicle for technological transfer. This study has shown that equity-like components in countries external capital structures are signicantly associated with indicators of institutional quality, as well as educational attainment, and natural resources. This nding may help shed light on the mechanism underlying the observed correlation between weak institutional quality and severe crises (Acemoglu et al., 2004): weak institutions may tend to increase countries reliance on crisis-prone forms of nancing, thereby increasing the frequency and severity of crises. Our interpretation of the results is that improving institutionsdobviously no easy task, and typically requiring a long timedmay help to promote a shift toward more desirable external liability structures. Moreover, measures aimed at improving countries external capital structures in a more direct manner should be evaluated carefully, because their effectiveness might be undermined by countries weak institutional quality. Acknowledgements We thank Geert Bekaert, Eduardo Borensztein, Simon Johnson, Gian Maria Milesi-Ferretti, Elias Papaioannou, Alan Taylor, Shang-Jin Wei, participants in seminars at the International Monetary Fund and the InterAmerican Development Bank, the CEPR conference on Institutions, Policies, and Economic Growth, the Annual Congress of the European Economic Association, and the Annual Meeting of the Latin American and Caribbean Economic Association, and two anonymous referees for insightful suggestions; and Priyanka Malhotra and Martin Minnoni for able research assistance. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.

Appendix 1. Sources and description of the variables

Table A1 FamaMacBeth regressions. Whole sample (1) Institutional quality index GDP GDP per capita Financial development Natural resources Openness Human capital Transition Constant Observations Number of time periods Adjusted R-squared (2) (3) 0.14*** (0.01) (4) 0.16*** (0.01) (5) 0.14*** (0.01) 0.03*** (0.002) 0.02*** (0.0004) 0.03* (0.01) 0.13*** (0.01) 0.08*** (0.02) 0.31*** (0.03) 0.13*** (0.01) 0.22*** (0.01) 0.37*** (0.02) 0.33*** (0.01) 737 545 545 9 9 9 0.40 0.30 0.37 Non-high income countries (6) 0.17*** (0.01) (7) 0.14*** (0.01) (8) 0.11*** (0.01) (9) 0.14*** (0.01) (10) 0.15*** (0.01) 0.22*** (0.01) 0.002*** (0.002) 0.03* (0.002) 0.18*** (0.01)

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0.05*** (0.01) 0.16*** (0.01)

0.03*** (0.001) 0.02*** (0.001) 0.03*** (0.001) 0.01*** 0.01*** 0.01*** (0.0005) (0.0003) (0.0003) 0.07*** (0.01) 0.07*** (0.01) 0.17*** (0.01) 0.07** (0.02)

0.16*** (0.01) 0.11*** (0.01) 0.21*** (0.01) 0.01*** (0.002) 0.01*** (0.002) 0.003*** (0.002) 0.11*** (0.01) 0.09*** (0.01) 0.19*** (0.01)

0.32*** (0.02) 0.39*** (0.02) 737 737 9 9 0.09 0.24

0.36*** (0.02) 737 9 0.26

0.27*** (0.01) 737 9 0.34

0.29*** (0.01) 545 9 0.41

0.08*** (0.02) 0.10*** (0.01) 0.12*** (0.02) 0.09*** (0.02) 0.21*** (0.01) 0.20*** (0.01) 545 545 9 9 0.49 0.51

Sources and notes: robust standard errors in parentheses. ***Signicant at 1%; **signicant at 5%; *signicant at 10%. The classication of countries according to the income level follows the Global Development Network Growth Database. The dependent variable (in the second stage) is total equity as a share of liabilities. International liabilities and their components are from Lane and Milesi-Ferretti (2006). Total equity consists of portfolio equity plus FDI. The institutional quality index is the simple average of six governance indicators from Kaufmann et al. (2006), also known as World Bank Governance Indicators (WGI): voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption. Settler mortality is the logarithm of settler mortality for former colonies; and population density in the 1500s is the logarithm of population density in the 1500s for former colonies; both from Acemoglu et al. (2001). Ethnolinguistic fractionalization is the probability that two randomly selected persons from a given country will not belong to the same ethnolinguistic group from Mauro (1995). British legal origin is a dummy variable that attributes one to countries with English law or former British colonies or protectorates from La Porta et al. (1998). Appendix 1 provides further details on sources and variable denitions.

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Dependent variables The source for countries total external liabilities and their components in the baseline regressions (FDI, portfolio equity and debt) is the data set developed by Lane and Milesi-Ferretti (2006). All variables are in millions of U.S. dollars. Data are available at http://www.imf.org/external/pubs/ft/wp/ 2006/data/wp0669.zip. An alternative source for countries total external liabilities and their components (FDI, portfolio equity, portfolio debt, and other instruments) is the International Investment Position reported in the IMFs International Financial Statistics. All variables are in millions of U.S. dollars. A thorough description of the methodology is available at http://www.imf.org/external/np/sta/iip/guide/index.htm. The dependent variables are expressed as ratios to total liabilities. The dependent variables used in the baseline regressions and in most specications are, unless otherwise noted, a time-series mean of the variables of interest between 1996 and 2004, whenever available. Independent variables Institutional quality index Simple average of six institutional indicators (voice and accountability, political stability and absence of violence, government effectiveness, regulatory quality, rule of law, control of corruption), drawn from Kaufmann et al. (2006), for all available years between 1996 and 2004 (available for 1996, 1998, 2000, and annually from 2002 on). The institutional quality index in a given year is formed only for countries that have information for all governance indicators in that year. Each institutional indicator is modeled by the authors as a standard normal distribution (zero mean, and standard deviation one), http://info.worldbank.org/governance/wgi2007/resources.htm. Gross domestic product Constant 2000 U.S. dollars for all available years between 1996 and 2004. Rescaled to trillions in the regressions to make results more legible. Source: World Development Indicators, World Bank, http:// devdata.worldbank.org/dataonline/. GDP per capita Constant U.S. dollars in 2000 for all available years between 1996 and 2004. Rescaled to thousands in the regressions to make results more legible. Source: World Development Indicators, World Bank. Financial development Private credit divided by total GDP for all available years between 1996 and 2004. Source: World Development Indicators, World Bank. Natural resources Percentage of ore, metals and fuels in total exports for all available years between 1996 and 2004. Source: World Development Indicators, World Bank. Openness Sum of imports and exports divided by total GDP for all available years between 1996 and 2004. Source: World Development Indicators, World Bank.

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Human capital Percentage of total population over 25 that attended at least some secondary schooling. Sources: Barro and Lee (2001) available from World Bank Education Indicators (EDSTATS), http://devdata.worldbank.org/edstats/td10.asp. Data refer to 1995 and 2000 for a vast majority of countries and to 1990 for a smaller set of countries (values for the U.S.S.R. attributed to Russia). Transition Countries that belonged to the former Soviet Union, former Yugoslavia, or ex-communist countries. Source: Global Development Network Growth Database, http://www.nyu.edu/fas/ institute/dri/dataset/Social%20Indicators%20Fixed%20Factors_7_2005.xls. Market capitalization as a share to GDP All available years between 1996 and 2004. Source: World Development Indicators, World Bank. Financing constraints Number of years in default between 1970 and 2001. A country is in default if any of the following sources considers it in default. Detragiache and Spilimbergo (2001), Manasse and Roubini (2005), and Reinhart et al. (2003). The independent variables used in the baseline regressions and in most specications are, unless otherwise noted, a time-series mean of the variables of interest between 1996 and 2004, whenever available. Time-series means of variables are only formed using data for the years for which observations for the dependent variable are available. To enlarge the number of years available, for the years 1997, 1999, and 2001 we attribute to a given countrys institutional quality index the value for that same country in the previous year (1996, 1998, and 2000, respectively). In the baseline regressions, we restrict the sample to the set of countries for which we have information for all key variables in at least one year between 1996 and 2004. Instruments Logarithm of settler mortality: for former colonies. Source: Acemoglu et al. (2001). Logarithm of population density in the 1500s: for former colonies. Source: Acemoglu et al. (2001). Ethnolinguistic fractionalization: Probability that two randomly selected persons from a given country will not belong to the same ethnolinguistic group. Source: Mauro (1995). Countries The baseline sample used in the regressions consists of the following 94 countries: Algeria, Argentina, Australia*, Austria*, Bangladesh, Belgium*, Benin, Bolivia, Botswana, Brazil, BulgariaT, Cameroon, Canada*, Chile, China, Colombia, CroatiaT, Czech RepublicT, Denmark*, Dominican Republic, Ecuador, Egypt, El Salvador, EstoniaT, Ethiopia, Fiji, Finland*, France*, Germany*, Ghana, Greece*, Guatemala, Haiti, Honduras, HungaryT, Iceland*, India, Indonesia, Iran, Ireland*, Italy*, Jamaica, Japan*, Jordan, KazakhstanT, Kenya, Kuwait*, LatviaT, LithuaniaT, Malawi, Malaysia, Mali, Mexico, MoldovaT, Mozambique, Namibia, Nepal, New Zealand*, Nicaragua, Niger, Norway*, Pakistan, Papua New Guinea, Paraguay, Peru, PolandT, Portugal*, Romania, Russia, Rwanda, Senegal, Slovak Republic T, SloveniaT*, South Africa, South Korea*, Spain*, Sri Lanka, Sudan, Swaziland, Sweden*, Syria, TajikistanT, Thailand, Togo, Trinidad and Tobago, Tunisia, Turkey, Uganda, United Kingdom*, United States*, Venezuela, Vietnam, Zambia, Zimbabwe.

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The full sample (129 economies) includes the 94 countries listed above plus the following: AlbaniaT, Angola, ArmeniaT, AzerbaijanT, BelarusT, Bosnia and HerzegovinaT, Burkina Faso, Cam bodia, Chad, Democratic Republic of Congo, Republic of Congo, Cote dIvoire, Equatorial Guinea, Gabon, GeorgiaT, Guinea, Kyrgyz RepublicT, Lao, Libya, MacedoniaT, Madagascar, Morocco, Myanmar, Nigeria, Oman, Qatar*, Saudi Arabia, Taiwan (Province of China), Tanzania, Turkmenistan, UkraineT, United Arab Emirates*, UzbekistanT, Yemen, YugoslaviaT. Countries marked with * are excluded from the non-high income sample. Countries marked with T are transition countries. The classication of countries according to the income level and transition from communism follows the Global Development Network Growth Database. We exclude from the sample all countries considered offshore nancial centers (as listed in Table 1 of International Monetary Fund (2002b): Bahrain*, Costa Rica, Cyprus, Hong Kong (S.A.R. of China)*, Israel*, Malta*, Mauritius, Netherlands*, Panama, Philippines, Singapore*, Switzerland*, and Uruguay. In some specications, we follow a more stringent interpretation of the table and also exclude Ireland, Japan, Malaysia, Portugal, Thailand, United Kingdom, and United Statesdthese countries either have banking facilities or parts of their territory in which offshore activities are allowed. References
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