International Capital Flows in Developing Countries and Capital Market Inefficiencies, Applying the Three Gap Model to a History of Liberalization

This paper applies the Three Gap Model developed by Bacha (1990) to the Heavily Indebted Poor Countries (HIPCs)2, during the time frame 1960 to 2017 with yearly observations. Several predictions and assumptions of the Model are tested empirically with panel data regressions and tests for structural breaks in the relationship between investment and capital flows. Overall, limited support is found for the Three Gap Model and the results highlight the need for extensive customization and parametrization of the Model subject to country level characteristics in order for it to adequately advise policymakers. In addition to the empirical diagnostics on the Three Gap Model, this paper also endeavors to assess the exogeneity of capital flows in developing countries by considering the impact of US macroeconomic variables on the international reserves and real exchange rates in the HIPCs during the 2008 to 2019 time frame with monthly observations, by replicating the VAR model contained in Calvo, Leiderman and Reinhart (1993). The evidence supporting the influence of the US variables on the real exchange rates and foreign reserves in the HIPCs is deemed unconvincing.