Timothy Boobier Grazia Manisera Steffy Ndjotong   Increasingly over recent decades, especially since the recent global economic crisis, the neoclassical economic framework has been questioned. One particularly controversial aspect of it is the notion that capital should flow from richer to poorer countries, yet there is extensive theoretical and empirical literature that question this notion.  We will cover: ◦ The neoclassical growth model in question. ◦ The observed structure and evolution of global capital flows over recent decades. ◦ The Lucas Paradox and possible explanations:        Poor Institutional Quality Human Capital Differentials Insufficient Public Infrastructure Financial Sector Underdevelopment Credit Risk and Serial Default Home Bias Role of Central Banks ◦ The relevant policy issues.  The standard neoclassical production function is a Cobb-Douglas function: ◦ Constant returns to scale. ◦ Diminishing returns to each factor. ◦ The factors here are capital (K) and labour (N), where A is the labour-augmenting level of technology: Y K   AN  1  Given constant returns and assuming homogenous labour and capital inputs and technology level, we can divide through by AN to give:   Y  K    AN  AN  or Y K  So if income per effective worker is not equal across countries, this must be due to different levels of capital per effective worker. Given diminishing returns to each factor, if the capital stock differs across countries then those countries with lower capital stocks will offer higher marginal productivity of capital.  The marginal product of capital (r) is given by: the derivative of the production function with the respect to capital so, K 1  1 r   K  AN  Y   1  K  AN   K   K Y   Lucas (1990) compares Indian and US MPKs: ◦ Letting 𝛼 = 0.4 (an average of US and Indian capital shares), the formula implies that the MPK in India is 58 times that of the US.    In the model, capital is assumed to be perfectly mobile and flows to where the rate of return to their investments would be highest. So given return differentials of this magnitude, capital would flow rapidly from the US and other wealthy countries to India and other poor countries. Has this been the case?   Below: Total equity inflows (= inflows of FDI + portfolio equity investment, whereas ‘total’ includes debt as well) were much higher to rich countries relative to poor countries, and this is while equity inflows made up a larger proportion of total inflows for poor countries as well. Contradicting the neoclassical model, this is a stark demonstration of the Lucas Paradox, after Robert Lucas. The upward trend here is to do with liberalisation, technological advances in communications and transport, and other globalising forces. IMF data from 1970-2000 interpreted by Alfaro et al (2005)   A more up-to-date version below, using World Bank data: This is split by income grouping of countries, and first we look at Portfolio Equity Inflows: Portfolio equity, net inflows 1,000,000,000,000 800,000,000,000 Current US$ 600,000,000,000 Low income 400,000,000,000 High income Middle income 200,000,000,000 0 -200,000,000,000 (World dataBank: World Development Indicators & Global Development Finance, accessed 20/11/2012)  And for Foreign Direct Investment net inflows: Foreign direct investment, net inflows 2,000,000,000,000 1,800,000,000,000 1,600,000,000,000 1,400,000,000,000 Current US$ 1,200,000,000,000 1,000,000,000,000 800,000,000,000 Low income High income Middle income 600,000,000,000 400,000,000,000 200,000,000,000 0 -200,000,000,000 (World dataBank: World Development Indicators & Global Development Finance, accessed 20/11/2012)  The explanations for the Lucas Paradox are generally grouped into two categories: ◦ Differences in fundamentals that affect the production structure of the economy. – differences in human capital stock, institutional quality and infrastructure. ◦ International capital market imperfections, mainly sovereign risk and asymmetric information. Capital does not to flow to high returns because of market failures.   Alfaro, Kalemli-Ozcan and Volosovych (2005) (AKV): differences in institutional quality between richer and poorer countries explain the Lucas Paradox. Institutions are ‘the rules of the game in society’: ‘they consist of both informal constraints (traditions, customs) and formal rules (regulations, laws and constitutions). They create the incentive structure of an economy.’  Institutional quality proxied by the International Country Risk Guide’s (ICRG) political safety variables: ◦ Composite index made from sum of indices of e.g. government stability, no-corruption, law and order, bureaucratic quality, etc.  The relationship between this and capital inflows is significant: ◦ Institutional quality is shown to be an important determinant of capital inflows, especially those indices that are closer to proxies of property rights protection, such as the no-corruption index and protection from expropriation. ◦ This is explained through their effect on investment decisions:  Property rights of entrepreneurs which protect against expropriation of profits or against blocking of adoption of new technologies by elites, thus encourage innovation and investment.  Risk of endogeneity: ◦ Reverse causality ◦ Selection bias  So instrument it with Acemoglu, Johnson and Robinson’s (2000,2001) (AJR) historical settler mortality variables: ◦ If European settlement was discouraged by diseases then the Europeans set up worse institutions.  AKV also investigate historical legal origins: ◦ Which coloniser’s legal codes and organisations were instituted in the country in question.  IV regression: Yi    1InstitutionalQuality  2 HumanCapital  3 AI   British         Dependent variable: Inflows of Total Equity per capita. Institutional Quality instrumented by settler mortality. Controls for human capital, international capital market imperfections (asymmetric information). Dummy for British legal origins (French as default). Successful - institutional quality has a causal effect on attracting capital inflows (β1 significant at 1% level). Legal origins also matter – French in a negative direction and British in a positive direction (γ significant at 10% level).     AJR’s methodology flawed? Glaeser, La Porta, Lopez-de-Silanes and Shleifer (2004) (GLLS) reject their instrument, saying that the disease environment still affects economic variables today. This implies that endogeneity bias is still likely. So it is possible that institutional improvement is stimulated by the capital inflows, not the other way around. Thought-provoking yet inconclusive.  Lucas himself argued that differences in the human capital stock explained the capital flow patterns. ◦ Even after correcting for capital per effective worker rather than per worker (inclusion of the variable A), there is still a factor of 5 difference in rates of return between rich and poor countries.  So augment the production function! ◦ Include human capital (H) – the skill levels, knowledge, creativity and so on of the workforce.  It takes a variation of the form:  Y K H     AN  1   such that in per effective worker terms it is roughly,  Y K H  Eliminates the return differential on physical capital, which works well in a cross-country comparison. This could therefore be said to explain the paradox. ◦ However, based on assumption that the external benefits of human capital accrue entirely to producers within that country ◦ And there are no, for example, knowledge spillovers between countries. ◦ This assumption is arguably too strong.  Manzocchi and Martin (1996) (MM): ◦ Find that an ‘augmented-Solow’ model’s prediction on capital flows are consistent with the evidence on net capital flows to developing countries from 1960-82. ◦ After 1982, however this breaks down, likely due to:  Outbreak of the 1980s Debt Crisis  Widespread occurrence of foreign debt repudiation by developing countries. ◦ BUT paper is now dated: ◦ Evolution of financial markets, complexity and volatility => there is more to it.  Causa and Soto (2006) (CS): ◦ Different methodology => ‘Anti-Lucas Paradox’! ◦ They take account of Balassa-Samuelson Effect:  Lower productivity in developing country tradable sectors translates into price levels below the world price level, rather than using PPP data for calculating Total Factor Productivity and Capital-Output Ratios.  PPP prices overestimate the market value of the productivity of physical capital in poorer countries. When accounted for, the Lucas Paradox disappears!  When extended to only manufacturing, the capital-output ratio is actually higher in the poorest countries: the paradox is reversed, hence the ‘Anti-Lucas Paradox’!  Due to insufficient physical infrastructure in the country. ◦ Foreign investment must develop its own: ◦ Infrastructure undercapitalisation is thus associated with manufacturing sector overcapitalisation!  At odds with lots of the rest of the relevant literature. ◦ CS find that poor institutional quality contributes to the Anti-Lucas Paradox: bad institutions decrease the provision of productive infrastructure capital.  Even if MPK is equalised in CS’s framework, it is intuitively not for the reason that investors follow only returns: ◦ Default risk matters, as well as risk entailed by imperfect information. ◦ No perfect capital mobility ◦ Often a lack of transparency, more so in developing countries.   So to understand international capital flows, financial sectors should be considered at least as much as the real economy. Regardless of the Balassa-Samuelson Effect, in absolute terms, capital flows ‘uphill’ and developing countries finance developed countries.   Prasad, Rajan and Subramanian (2006) (PRS): Weak absorption capacity of developing economy financial sectors: ◦ Profitable investment opportunities may be constrained by financial sector impediments and hence available opportunities may be financed by domestic savings.   No evidence that additional financing in excess of domestic savings is the channel through which financial integration delivers its benefits. Savings is the driver of investment and there is little reliance on foreign capital for fast growth.  At industry-level, capital inflows bring:  Depends on:  ◦ A source of competition that pushes down capital costs ◦ Know-how such as credit evaluation skills ◦ May press for more transparency and better governance ◦ Financial dependence of the industry in question ◦ Level of financial development of the economy. PRS find clear benefits from financial integration for financially-dependent industries when a country’s financial system is above median levels of development but at lower levels of development, these industries do not grow faster and may even grow slower!  This can be linked to Rajan’s analysis of the Asian Crisis of 1997 in Fault Lines. E.g. South Korea, development largely financed by corporate debt and loans from overleveraged state-owned banks. ◦ Due to the lack of financial development and the lack of transparency with regards to balance sheets, foreign investors kept their credit in foreign currency (currency mismatch) and with short-term maturity (maturity mismatch). ◦ When the crisis hit, investors did not roll-over the short-term debt, which also rocketed in value relative to the domestic currency, and the consequent economic crisis and restructuring was much more severe.   Thus PRS’ analysis clearly indicates that the effect of capital flows depends on the structure of the economy in question, meaning the main industries and the principal financing methods. These of course in turn affect the attractiveness of the economy to foreign capital and of course government policies towards inflows, to be discussed later.  Reinhart and Rogoff (2004) (RR): ◦ When the odds of non-repayment for some lowincome countries are as high as 65%, credit risk seems a much more suitable explanation for capital not flowing downhill. ◦ They describe some developing countries as ‘debt intolerant’ ‘serial defaulters’ – where default exacerbates weak political institutions, laying the seeds for further defaults down the road.  Above, we see how it is the poorest countries which are in default most, despite having much lower debt levels than richer countries! So this seems a relatively simple and intuitive explanation – investors are looking after their money!    We can summarise this as the notion of ‘Home Bias’. Feldstein and Horioka (1980): strong correlation between domestic savings and domestic investment. Suggest that investment patterns are explained by: ◦ ◦ ◦ ◦  Risk aversion Portfolio considerations Imperfect information and Institutional rigidities. FDI is more often to do with: ◦ Implementing market strategies ◦ Exploiting production knowledge, or ◦ Overcoming trade restrictions.  More to do with long-term flows.   But not all flows are private capital! The ‘Revived Bretton Woods System’ Dooley, Landau and Garber (2004): ◦ US current account deficits are financed through Asian governments purchasing dollar-denominated foreign assets as part of a foreign exchange reserves management strategy to maintain their exchange rate pegs, so as to maintain competitive exports (and to avoid repeat of 1997). ◦ Chinese undervaluation of the renminbi is a case in point.  So short-term capital flows uphill because of policy too!      Differing policy objectives among countries. Gaining development finance… BUT what if the money dries up? Policy must also avoid excessive volatility of capital flows and instability in financial markets. And what about exchange rate regime? ◦ Undervaluation - Revived Bretton Woods   Volatility arguably linked to the unprecedented globalisation and liberalisation of the securities market in the 1990s Exacerbating the already huge increase in developing country ‘Twin Crises’ (financial and exchange crises) ◦ ◦ ◦ ◦   1980s Debt Crises Mexican Tequila Crisis 1994 East Asian Crisis 1997 Default of Argentina 2002. Thus policy should balance the need for foreign capital with macroeconomic stability, while maintaining institutional specificity, to the country’s development strategy: The appropriate extent of financial openness can depend on the extent of dependence on external finance for its industries, as well as for other industries that may emerge, while not compromising stability.  Potential upgrading of the economy  Discipline: ◦ In the technical, technological, knowledge and organisational sense ◦ Encouraging financial development ◦ Incentive for maintaining competitiveness and for strengthening of institutions ◦ BUT there can also be a ‘race to the bottom’:  Labour and environmental regulations, excessive liberalisation.  The appropriate extent of financial openness is thus determined by: ◦ Industrial structure of the economy ◦ Intended extent of exchange rate management ◦ BUT also the subjective favoured development path.  India and China for example interfere extensively in financial markets and have heavy capital controls.  Consensus appears to be increasingly that: ◦ Long-term capital flows are good for development and growth when subject to appropriate regulatory frameworks ◦ But that short-term capital flows can be excessively volatile and should therefore be controlled.  First pushed by economists such as Joseph Stiglitz and Dani Rodrik who criticised capital account openness for developing countries, for the consequent heightened risk of crisis.  Current crisis brought much mainstream economic thought into question. ◦ Now less forceful advocacy of financial integration in policy-making circles ◦ More thoughtful analysis of capital markets.  The IMF in 2010 finally accepted the use of controls on capital inflows as legitimate practice to prevent exchange rate overshooting and asset price bubbles. ◦ Chile and Colombia successes in tilting the composition of inflows toward less vulnerable liability structures ◦ Still relatively quiet on outflows: Malaysia in 1997 as success example.  This diagram represents the IMF’s recommended policy decision process with regards to capital controls, largely as a last resort. Pro-financial integration.  Wary of risk management.  Recognition of institutional specificity for different countries.  Controls still as a last resort (despite being used by most G20 members in some form).     Regarding longer-term capital flows, recommendations always context-specific. No explanations of Lucas Paradox are conclusive. But they suggest that to attract long-term capital: ◦ Public investment in human capital. ◦ Public investment in infrastructure: investment would be more attractive without need for overcapitalisation. ◦ Strengthening of institutions  Protection from expropriation and rule of law to encourage entrepreneurship and technological development  Decreasing corruption and improving bureaucratic quality to facilitate investment processes. ◦ Establishing a good track-record of debt repayment.  These measures are beneficial for development in general – still, current trends indicate wide acceptance of FDI as beneficial by governments. ◦ Most countries have continued to liberalize and facilitate FDI, despite the crisis. ◦ Trends towards increasing regulatory measures over foreign investment are highly context-specific. ◦ Nationalisation and expropriation measures were as part of bailout/rescue packages ◦ Reassuring rather than especially worrying on the whole. UNCTAD (2010) World Investment Report   Regarding financial sector development: Again specific to the country: ◦ A more developed financial sector can attract more portfolio investment ◦ The more developed it is, the smaller the risk of currency or maturity mismatch precipitating crises ◦ BUT the extent to which an economy should be financialised (regarding household and corporate debt, dependence on private pension funds or savings and loan associations, and so on) is both country-specific and arguably subjective.                 Acemoglu, Daron, Simon Johnson & James A. Robinson (2001) ‘The Colonial Origins of Comparative Development: An Empirical Investigation’, American Economic Review, 91(5), 1369-1401. Alfaro, Laura; Kalemli-Ozcan, Sebnem; Volosovych, Vadym (2008), “Capital Flows in a Globalized World: The Role of Policies and Institutions,” Review of Economics and Statistics 90 (2), pp. 347–368. 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Evidence from a Cross-section of Developing Countries,” Economie Internationale, 72, 7–24. Prasad, Eswar, Raghuram Rajan, and Arvind Subramanian (2007), “Foreign Capital and Economic Growth,” Brookings Papers on Economic Activity, Spring, pp. 153–230. Rajan, Raghuram G. (2010) Fault Lines: How Hidden Fractures Still Threaten the World Economy. Princeton University Press: Princeton, New Jersey. Reinhart, Carmen & Kenneth Rogoff (2004) ‘Serial Default and the ‘Paradox’ of Rich to Poor Capital Flows’, NBER working paper no. 10296, February. United Nations Conference on Trade and Development, World Investment Report 2010, New York: United Nations. World Bank (accessed 20/11/2012) World dataBank; [URL: http://databank.worldbank.org/ ].