EXPORT INSTABILITY AND LONG-TERM CAPITAL FLOWS: RESPONSE TO ASSET RISK IN A SMALL ECONOMY

An open capital account allows long-term capital flows to automatically mitigate adverse effects of export instability on domestic saving and investment. An application of portfolio management theory shows that risks that are systematic to the domestic market are diversified internationally. This may help explain why foreign investment finances many high-risk investments in export sectors of LDCs and why results of studies of the effects of export instability show inconsistent results. This theory is presented and tested empirically.