Distance and Beyond. What Drives Financial Flows to Emerging Economies?

We build a model for the analysis of financial flows from advanced to emerging economies and introduce the quality dimension in cross-border asset trade. We reformulate the issue of transaction costs (Martin and Rey, 2004) in terms of a problem of trade in assets with different quality. The focus is on countries’ economic distance, as reflected in characteristics such as their institutional development, regulation of markets, enforceability of laws and political risk, and the impact on the expected inflows from the projects/assets. We further consider the spillover effects from the country of origin to the country of destination building on the idea that quality matters, but not always with the same intensity. We thus model “perceived” quality as depending on investors’ financial stress condition. We show that, besides the typical size effect, higher quality leads to higher asset demand and asset prices and, in particular, changes in “perceived” economic distance impact on the evolution of financial flows. We run econometric estimations for cross-border bank flows from advanced to emerging economies over the period 2005-2014 and analyze the interaction of market segmentation and global spillover effects in determining the changes occurred between the old and the new “normality”, as well as the heterogeneity across groups of countries.