Download International Capital Flows

Thorvaldur Gylfason
Outline
1) Symmetry between trade in
goods and services and capital
movements
2) Gains from capital flows
3) Empirical evidence of capital
flows and growth
4) Pitfalls and policies
Goods and Capital
The argument for free trade in goods
and services applies also to capital
 Trade in capital helps countries to
specialize according to comparative
advantage, exploit economies of
scale, and promote competition
 Exporting equity in domestic firms
not only earns foreign exchange, but
also secures access to capital, ideas,
know-how, technology
Symmetry between Trade
in Goods and Capital
The balance of payments
R = X – Z + F
where
X = exports of goods and services
Z = imports of goods and services
F = net exports of capital
 Foreign direct investment
 Portfolio investment
 Foreign borrowing
Determinants of
Foreign Trade
Trade in goods & services depends on
Relative prices at home and abroad
Exchange rates (elasticity models)
National incomes at home and abroad
Geographical distance from trading
partners (gravity models)
Trade policy regime
Tariffs and other barriers to trade
Two Views of Trade
The current account of the balance of
payments is defined as B = X – Z
National income is Y = E + X – Z
Therefore, current account is
 B=X–Z=Y–E
Two sides of the same coin:
Deficit means that Z > X and E > Y
Surplus means that X > Z and Y > E
Determinants of
Foreign Investment
Capital flows
Foreign borrowing, portfolio investment,
foreign direct investment
Trade in equities depends on
Interest rates at home and abroad
Exchange rate expectations
Geographical distance from trading partners
Capital account policy regime
Capital controls and other barriers to free flows
Why Capital Moves
 Capital moves across national
borders to exploit welfare gains
from trade
 Welfare gains from trade stem from
price differences at home and
abroad
 Price differences reflect different
costs
 Different costs reflect different
levels of efficiency
 Comparative advantage is key
Conceptual Framework
If the world interest rate is lower than
the domestic interest rate, the
country will be a borrower in world
financial markets
Domestic firms will want to borrow at
the lower world interest rate
Domestic households will reduce their
saving because the domestic interest
rate moves down to the level of the
world interest rate
Conceptual Framework
Real interest rate
Saving
Domestic
equilibrium
World
equilibrium
Borrowing
0
Domestic
saving
Domestic
investment
World
interest
rate
Investment
Saving, investment
Conceptual Framework
Real interest rate
Saving
A
Domestic
equilibrium
World
equilibrium
B
C
D
Borrowing
World
interest
rate
Investment
0
Saving, investment
Conceptual Framework
Real interest rate
Consumer surplus
before borrowing
Saving
A
Domestic
equilibrium
World
equilibrium
0
B
C
Producer surplus
before borrowing
Investment
Saving, investment
Conceptual Framework
Real interest rate
Consumer surplus
after borrowing
A
Domestic
equilibrium
World
equilibrium
B
C
D
Borrowing
Producer surplus
after borrowing
0
Saving
World
interest
rate
Investment
Saving, investment
Conceptual Framework
Before trade
After trade
Change
Consumer surplus
A
A+B+D
+ (B + D)
Producer surplus
B+C
C
-B
A+B+C
A+B+C+D
+D
Total surplus
The area D shows the increase in total surplus
and represents the gains from borrowing
Gains from Trade:
Three Main Conclusions
 Borrowers are better off and savers
are worse off
 Borrowing raises the economic wellbeing of the nation as a whole
because the gains of borrowers
exceed the losses of savers
 If world interest rate is above
domestic interest rate, savers are
better off and borrowers are worse
off, and nation as a whole still gains
Conceptual Framework
Real interest rate
Saving
World
interest
rate
World
equilibrium
Domestic
equilibrium
Lending
0
Domestic
investment
Investment
Domestic Saving, investment
saving
Conceptual Framework
Real interest rate
World
equilibrium
Domestic
equilibrium
Lending
A
B
D
Saving
World
interest
rate
C
Investment
0
Saving, investment
Conceptual Framework
Real interest rate
Consumer surplus
before borrowing
A
Domestic
equilibrium
World
equilibrium
B
C
Producer surplus
before borrowing
0
Saving
Investment
Saving, investment
Conceptual Framework
Real interest rate
Consumer surplus
after borrowing
A
Domestic
equilibrium
World
equilibrium
Lending
B
D
C
Producer surplus
after borrowing
0
Saving
World
interest
rate
Investment
Saving, investment
Conceptual Framework
Before trade
After trade
Change
Consumer surplus
A+B
A
-B
Producer surplus
C
B+C+D
A+B+C
A+B+C+D
Total surplus
B+D
+D
The area D shows the increase in total surplus
and represents the gains from lending
Causes of Capital Flows
Internal (pull) factors
Increased productivity and growth
Sound macroeconomic fundamentals
Structural reforms
Increased money demand
Emergence of financial markets with
better infrastructure
Liberalization of trade and capital
markets
Causes of Capital Flows
External (push) factors
Decrease in world interest rates
 Search for higher yields in LDCs
 Reduced default risk of LDCs
Changes in financial systems abroad
 Deregulation of institutional investors
 Decline in communication costs
Demographics of industrial countries
 Larger pool of saving in ICs
 Lower returns to capital in ICs
Effects of Capital Flows
Facilitate borrowing abroad to
smooth consumption over time
Dampen business cycles
Reduce vulnerability to domestic
economic disturbances
Increase risk-adjusted rates of
return
Encourage saving, investment, and
economic growth
Effects of Capital Flows
Overheating of economy
Expansion of aggregate demand
Inflation
Real appreciation of currency
Widening current account deficit
Monetary consequences depend on
exchange rate regime
Empirical Evidence
Look at numbers describing trade
and capital flows around the world
as well as in transition countries
Look also at evidence of the
relationship between trade,
investment, and economic growth
across countries
Exports 1990-2000
(% of GDP)
35
30
25
20
15
10
5
0
1990
2000
World
Low- and middleincome countries
High-income
countries
Transition Countries:
Exports 2000 (% of GDP)
Estonia
Tajikistan
Slovak Republic
Czech Republic
Belarus
Hungary
Turkmenistan
Ukraine
Slovenia
Kazakhstan
Bulgaria
Moldova
Latvia
Russian
Lithuania
Uzbekistan
Kyrgyz Republic
Azerbaijan
Georgia
Romania
China
Armenia
Albania
0
20
40
60
World average
80
100
Growth in Trade Less Growth
in GDP 1990-2000 (%)
Georgia
Vietnam
Azerbaijan
Moldova
Lithuania
Estonia
Czech Republic
Slovak Republic
Hungary
Romania
Albania
Ukraine
Latvia
Bulgaria
Turkmenistan
Russian Federation
Slovenia
Uzbekistan
Kyrgyz Republic
China
Kazakhstan
Belarus
-10
0
10
20
30
FDI 1990-2000 (Net,
% of Gross Investment)
16
14
12
10
8
6
4
2
0
1990
2000
World
Low- and middleincome countries
High-income
countries
FDI 1990-2000 (Gross,
% of GDP)
12
1990
10
2000
8
6
4
2
0
World
Low- and middleincome countries
High-income
countries
Transition Countries: FDI 2000
(Net, % of Gross Investment)
Bulgaria
Kazakhstan
Moldova
Armenia
Slovak Republic
Czech Republic
Estonia
Georgia
Cambodia
Latvia
Albania
Lithuania
Vietnam
Romania
Tajikistan
Hungary
Uzbekistan
Turkmenistan
Ukraine
Azerbaijan
China
Russian
Slovenia
Belarus
Kyrgyz Republic
-10
0
10
20
30
40
World average
50
60
Transition Countries: FDI
2000 (Gross, % of GDP)
Slovak Republic
Estonia
Moldova
Czech Republic
Bulgaria
Kazakhstan
Armenia
Latvia
Hungary
Kyrgyz Republic
China
Georgia
Vietnam
Cambodia
Albania
Lithuania
Romania
Azerbaijan
Russian
Ukraine
Slovenia
Belarus
0
5
10
15
World average
of total capital flows
Percent
Percent of Total Capital Flows
80
Sectoral Distribution of Net Capital
Flows to Developing Countries
70
60
50
40
30
20
10
0
1978-81
1978-81
1982-89
1982-89
Private sector flows
1990-95
1990-95
Public sector flows
1996-01
1996-01
Net Private Capital Flows to
Developing Countries
150
Billions
USdollars
Dollars
US
of of
Billions
100
50
0
-50
-100
1994
1994
1995
1995
1996
1996
Direct Investment
1997
1997
1998
1998
1999
1999
Portfolio Investment
2000
2000
2001
2001
Other private flows
2002
2002
Net Private Capital Flows to
Transition Economies
35
Billions
of US
Dollars
dollars
of US
Billions
25
15
5
-5
-15
-25
1994
1994
1995
1996
1997
1997
1995
1996
Direct investment
1998
1999
2000
1998
1999
2000
Portfolio investment
2001
2001
Other
2002
2002
Reversals in Net Private Capital
Figure.
Reversals
in Net Private Capital
Flows
Flows
to Emerging
Economies
Mexico1993-95
1993-95
Mexico
12% of GDP
9% of GDP
Korea1996-97
1996-97
Korea
Mexico1981-83
1981-83
Mexico
18% of GDP
Thailand
Thailand1996-97
1996-97
15% of GDP
Venezuela
1987-90
Venezuela
1987-90
11% of GDP
Turkey1993-94
1993-94
Turkey
6% of GDP
Venezuela
1992-94
Venezuela
1992-94
10% of GDP
Argentina
Argentina1988-89
1988-89
7% of GDP
Malaysia1986-89
1986-89
Malaysia
10% of GDP
Indonesia1984-85
1984-85
Indonesia
Argentina
1982-83
Argentina
1982-83
5% of GDP
Billions of US dollars
4% of GDP
0.0
10
10.0
20.0
20
Source : IMF, World Economic Outlook data base.
30.0
30
40.0
40
Billions of US$
50.0
50
60.0
60
70.0
Annual growth of GNP per capita 1965-98, adjusted for
initial income (%)
Openness to FDI and
Growth 1965-98
r = 0.62
6
Botswana
4
2
0
-4
0
-2
2
4
6
-2
-4
-6
An increase in openness to
FDI by 2% of GDP is
associated with an increase
in per capita growth by
more than 1% per year.
-8
Actual less predicted FDI 1975-1998 (% of GDP, ppp)
8
Annual growth of GNP per capita 1965-98, adjusted for
initial income (%)
Openness to Trade and
Growth 1965-98
6
r = 0.42
4
Korea
2
Malaysia
Belgium
0
-40
-30
-20
-10
0
10
20
30
40
-2
Guinea
Bissau
-4
-6
An increase in
openness by 14% of
GDP is associated
with an increase in
per capita growth by
1% per year.
-8
Actual less predicted exports 1965-98 (% of GDP)
Tariffs and Growth
1965-98
Annual growth of GNP per capita 1965-98, adjusted
for initial income (%)
6
An increase in tariffs
by 10% of imports is
associated with a
decrease in per
capita growth by
1% per year.
Botswana
4
2
0
0
10
20
30
India
40
-2
-4
Cote d'Ivoire
-6
r = -0.52
-8
Import duties (% of imports 1970-98)
Pitfalls: Incomplete
Information
Capital account liberalization, if well
managed, stimulates saving and
investment, efficiency, and
economic growth
But information may be asymmetric
Adverse selection
Moral hazard
Herding
Capital Account
Liberalization
These slides will be posted
on my website:
www.hi.is/~gylfason
Needs to be orderly, gradual, wellsequenced
Effective prudential regulation
To encourage banks to recognize risks
To enable authorities to monitor threats
to stability of the financial system
Sound macroeconomic policies
Sequencing
Put bank supervision and sound policies
in place first, then liberalize