Download Capital flow-2006-05

A Solution to Two Paradoxes of
International Capital Flow
Jiandong Ju and Shang-Jin Wei
* Personal views, not those of the IMF
Motivation

Cross-border capital flow reached nearly $6 trillion in
2004. Less than 10% goes to developing countries.

The paradox of too little capital flow: in a one-sector
model, marginal product of capital is lower in rich
country, but the amount of capital from rich to poor
countries is too small (the Lucas Paradox)
Example: India vs the U.S. (5800% difference in MPK)

The paradox of too much capital flow: in a 2-sector,
2-factor model, factor prices are equalized in a free
trade world (FPE due to Samuelson). So there is no
incentive for any capital to flow.
Objectives of the paper

Existing explanations of the Lucas paradox do
not survive in a generalization to a 2X2 model

To build a micro-founded non-neo-classical
theory to solve the two paradoxes

To highlight (possibly different) roles of financial
development and property rights institutions in
international capital flows
Existing explanation of the Lucas paradox
within a neo-classical framework





Difference in effective labor
Missing factor (e.g. human capital)
Sovereign risk (Reinhart and Rogoff)
Trade cost (Obstfeld and Rogoff)
Difference in TFP (of which institution is a special
case)
Common problem:
They do not survive in a generalization to a neoclassical two sector, two factor model
Chain rule of FPE
Lemma 1:
Let # factors = m. All other neo-classical
assumptions apply. For any two countries, factor
prices are equalized if the countries can be linked by
a sequence of country pairs, and if the countries
within each pair produce a common set of m
products.

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


Example: Two factors (land and capital)
US and India may not produce anything in common, and
may not even trade with each other. But FPE could hold if
US-Greece (apple & apricot)
Greece-Thailand (beer and bottle)
Thailand-India (cabbage and carriage)

If existing explanations of the Lucas paradox don’t work,
what about textbook reasons that break the FPE in the
2X2X2 model?

Difference in technology



No eqbm in general (Panagariya)
We are NOT saying that FPE is realistic,
but that it is much more difficult to escape from the
tyranny of FPE that the existing literature may have
realized.
Intuitive outline of our model

We work with a two-sector model but with two twists

To resolve the Lucas paradox, we introduce a
financial contract between entrepreneurs and
investors: Each only gets a slice of the marginal
product of physical capital.

To move away from FPE, we introduce
heterogeneous entrepreneurs, which result in
sector- level DRS (despite firm-level CRS).
Re-do Lucas’ example: India vs the U.S.





India’s K/L ratio is only 1/15 of the U.S.
Its financial system is also much less efficient
In the absence of capital flow, the return to financial
investment is lower in India than in the U.S.
India experiences an outflow of financial capital
At the same time, because Indian’s return to
physical capital is higher -> Inflow of FDI
Inflow of FDI is bigger than it would have been if its
financial system had been more efficient


Return differential is smaller than Lucas’ calculation
Much smaller friction can stop the capital flows
Roadmap

The Model

Two key parameters



Comparative Statics

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
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
Financial development
Control of expropriation risk (property rights protection)
Free trade in goods
Financial capital flow
FDI
World capital market equilibrium
Some very preliminary/suggestive evidence
Model Description


Within an economy (2 sectors, 2 factors)
For a given sector:


Labor
Capitalists (each endowed w one unit of capital)





Entrepreneurs + financial investors
Linked by financial contracts
2-period production; Liquidity shock in 2nd period
Moral hazard problem
Two country world economy

Various scenarios of capital flows
Time line of the model
The Model
Financial Contract:
Solution
Allocation of Capital within and across Sectors

Lemma 2: The more productive entrepreneurs enter
the heterogeneous sector, while the less productive
ones enter the homogeneous sector. In the
heterogeneous sector, relatively more productive
entrepreneurs manage more capital.
Free Entry Conditions
A “Stolper-Samuelson Plus” theorem holds:
(Prop 1)
When p ↑ → r ↑ but w↓
 When λ ↑ → r ↑ but w↓
 When θ ↑ → r ↑ but no change in w
 When N1 ↑ → r↓ but w↑
But FPE does not hold!

Determination of Factor Prices

Proposition 1: An increase in N1 will decrease r but increase w.
An improvement in the level of financial development will
increase r but has no effect on w. Lower expropriation risk
increases r but decrease w.
Equilibrium Conditions
A “Rybczynski Plus” theorem holds:
(Prop 2)
(under a modified non-reversal of factor intensity)
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When K↑ (or L↓) → N1↑, y1↑ more than y2↑,
and p↓
When θ ↑ → y1 ↑ and y2↑ proportionately, but
no change in p (or N1)
When λ ↑ → N1&N2 ↓, y1& y2↑ proportionately,
but no change in p
Comparative Statics

Proposition 2: The increase in K will increase N1, and
decrease the relative price of good 1. The improvement in
the level of financial development, however, has no effect on
outputs and the commodity price. Lower risk expropriation
decreases N1 and N2, but has no effect on p.
Combining Propositions 1 and 2
→ N1↑
→ r↓ but w ↑

When K/L↑

The intuition from a one-sector model is restored in
this two-sector, two-factor model!

Question: Is the Lucas Paradox also restored?
No! The differential in returns to capital depends on
c1f/(1+f), which can be very small
Evidence: Caselli and Feyrer (2005)


(prop 2)
(prop 1)
Moving from closed to open economy
Four-step discussion
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

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Free trade in goods
Just financial capital flow (+ free trade)
Just FDI (+ free trade)
Both types of capital flows (free trade)
Free Trade in Goods

Two countries differ in factor endowments and levels of
financial development and property rights protection.

Prop 3: The Heckscher-Ohlin theorem still holds: Each
country exports the good that uses its more abundant
factor intensively.
Financial Capital Flow

Proposition 4: If the two countries have the same
level of property rights protection and financial
development, financial capital will flow out of the
capital abundant country, and into the capital scarce
one. If the two countries have the same capital-labor
ratio, financial capital will flow out of the country
with lower financial development or poorer property
rights protection and into the other one.
Foreign Direct Investment

Proposition 5: Suppose trade in goods is free and expropriation
risk in the two countries are the same, FDI will flow out of the
capital abundant country to the labor abundant country. If the
two countries have the same K/L ratio, then FDI will go from the
country with poor property rights protection to the other.

Free capital mobility + free goods trade

If a country has low K/L and low θ, then it
experiences two way gross flows (outflow of
financial capital but inflow of FDI), and a small
net flow
e.g. China

If a country has a low K/L and low λ, then
outflow of financial capital + outflow of FDI

e.g. Zimbabwe
Contrasting effects of poor financial development vs.
poor property rights protection

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A lower level of financial development results in a
lower r, which generates an outflow of financial
capital. As a result, w becomes lower, which
attracts more FDI than otherwise.
Worse property rights protection results in both a
lower profit, leading to less FDI, and a lower r,
leading to outflow of financial capital
Empirical evidence: Wei 2006
Property rights protection, financial development,
and composition of capital flow (Wei, 2006, “connecting two
views on financial globalization …”)
FDI/total
foreign
liability
IV Regression
Portolio equity
Portolio debt
/total foreign
/total foreign
liability
liability
Loan/total
foreign liability
Institutional Quality
0.67**
(0.29)
-0.11
(0.11)
0.38**
(0.17)
-0.81*
(0.40)
Financial
development
-0.88*
0.31*
-0.40
0.65
(0.46)
(0.18)
(0.27)
(0.66)
Resource a
0.13
(0.13)
0.04
(0.05)
0.05
(0.08)
-0.15
(0.18)
Openness a
0.12*
(0.07)
0.01
(0.03)
-0.08*
(0.04)
-0.23
(0.14)
Observations
R-squared
34
0.36
34
0.40
34
0.47
33
0.56
Measure of Institutions – Average of Six World Bank Indicators
Capital Bypass Circulation, or transfusion
Free capital mobility + free trade + free mobility of entrepreneurs

Proposition 6: A unique equilibrium: Inefficient
financial system is completely bypassed.

In the transition to the eqbm, the country with a higher initial
K/L always exports capital on net (i.e. running a CA deficit)
So a scenario in which the US runs a current account (CA)
deficit, China CA surplus can in principle be rationalized w/o




Exchange rate policy
Mercantilist trade strategy
Fiscal deficit
Capital Bypass Circulation
F
O*
K+K*
B*
Y1
K
FCF
FDI
H
C
A*
E
A
Y2
B
O
L
L+L*
Capital Bypass Circulation, or transfusion
Capital Market Equilibrium: Different
Expropriation Risk
Different Expropriation Risk

In equilibrium, wage is always higher in the country with better financial
institution or lower expropriation risk.

Prop 5:

Suppose the two countries are diversified in the
equilibrium with free trade and free capital
mobility, then the wage rate is always (at least
weakly) higher in the country with better property
rights protection or with better financial
development
Conclusions

Existing explanations of the Lucas paradox don’t survive
in a model with two sectors and two factors. It is difficult
to simultaneously resolve Lucas paradox and FPE in a
neo-classical framework

We build a micro-founded non-neoclassical model
Key twists:
 Financial contracts
 Heterogeneous firms
The model highlights (potentially different) roles of
financial development and property rights protection
It generates predictions about gross as well as net
capital flows. It avoids both the Lucas paradox and FPE.


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Future Work (I)


Solution to other puzzles in int’l finance?
Feldstein-Horioka puzzle
Shutting down risk-sharing motivation
 Small friction to capital mobility
→ ∆investment = ∆saving

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Home bias in equity holdings

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Equity instead of direct financing contracts
Small friction to capital mobility
Future Work (II)

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Empirics
Dynamics
Welfare analysis



/conflict of interest
Alternative financial contracts
Frictions to capital flow
Financial development, corruption, and composition
of capital flows: Preliminary evidence
Challenge:
measures of institutions may be endogenous
Instrumental variable for government corruption:
 Initial cost to colonizers –mortality rate of European
settlers before 1850
 Acemoglu, Johnson, and Robinson (AER 2001)
 Alternative: initial population density in 1500
Instrumental variables for financial
development:

Legal origins: La Porta, Lopez-de-silanes,
Shleifer, and Vishny (JPE 1998)

Settler mortality
(History-based) instrumental variables

Corruption is mostly affected by settler
mortality but not by legal origin

Financial development is affected by both
legal origins and settler mortality.

(1)
The basic specification:
Composition(j) = β1 Corruption(j)
+ β2 FinDev(j) + Z(j)Γ + e(j)
Zj is a vector of control variables,
β1, β2, and Γ are parameters
ej is a random error.
Table 7: Adding more control variables (IV Regressions)
FDI/total foreign
liability
(1)
-0.55**
(0.24)
(2)
-0.42*
(0.25)
Portolio
equity/total
foreign liability
(3)
(4)
0.09
0.17*
(0.10)
(0.09)
Financial development
-0.87*
(0.48)
-0.76
(0.46)
0.31*
(0.19)
0.38**
(0.16)
-0.48*
(0.26)
-0.42*
(0.25)
0.72
(0.68)
0.28
(0.54)
Resource a
0.13
(0.13)
0.12
(0.13)
0.04
(0.05)
0.04
(0.04)
0.05
(0.07)
0.05
(0.07)
-0.15
(0.18)
-0.16
(0.14)
Openness a
0.13*
(0.07)
0.17**
(0.07)
0.01
(0.03)
0.04
(0.02)
-0.09**
(0.04)
-0.07*
(0.04)
-0.22
(0.15)
-0.39**
(0.12)
FDI restrition Dummy
-0.01
(0.05)
-0.06
(0.06)
-0.00
(0.02)
-0.03*
(0.02)
0.05*
(0.03)
0.02
(0.03)
-0.04
(0.07)
0.09
(0.06)
34
0.36
0.04*
(0.02)
34
0.43
34
0.40
0.03**
(0.01)
34
0.58
34
0.53
0.02*
(0.01)
34
0.59
33
0.57
-0.10**
(0.02)
33
0.74
Corruption(GCR/WDR)
Log(GDP)
Observations
R-squared
Portolio debt
/total foreign
liability
(5)
(6)
-0.34** -0.27*
(0.14)
(0.13)
Loan/total
foreign liability
(7)
0.69*
(0.34)
(8)
0.29
(0.28)
Explaining the Ratio of FDI/ Total Foreign Liabilities in 2003
Corruption(GCR/WDR)
-0.10**
(0.04)
Financial development
IV regressions
-0.65**
(0.23)
0.17*
(0.09)
-1.07**
(0.44)
-0.56**
(0.24)
-0.88*
(0.46)
Resource a
0.13
(0.13)
Openness a
0.12*
(0.07)
Observations
R-squared
40
0.15
34
0.09
34
0.28
34
0.36
First Stage Regressions:
Using Histories to Instrument Modern-day Institutions
(1)
Log(settler
mortality)
Corruption(GCR/WDR)
(2)
(3)
(4)
Financial development
(5)
(6)
(7)
Institutional Quality
(8)
(9)
0.46**
0.31**
-0.21**
-0.38**
-0.29**
(0.08)
(0.08)
(0.03)
(0.07)
(0.07)
Log(Population
density in 1500)
0.27**
(0.07)
0.10
(0.08)
-0.07**
(0.03)
Legal origin
(French)
0.37
(0.23)
0.62**
(0.22)
-0.18**
(0.08)
-0.14*
(0.08)
-0.18**
(0.08)
-0.06
(0.17)
Legal origin
(German)
0.00
(0.00)
0.00
(0.00)
0.74*
(0.38)
0.00
(0.00)
0.00
(0.00)
0.00
(0.00)
Legal origin
(Scandivanian)
0.00
(0.00)
0.00
(0.00)
0.70*
(0.38)
0.00
(0.00)
0.00
(0.00)
0.00
(0.00)
Legal origin
(Socialist)
0.71
(0.66)
0.79
(0.72)
-0.25**
(0.10)
-0.29
(0.21)
-0.14
(0.25)
-0.98**
(0.45)
40
0.36
44
0.20
120
0.14
60
0.47
73
0.14
Observations
R-squared
44
0.44
48
0.24
70
0.33
61
0.29

Evidence is still preliminary, but intriguing

More needs to be done
Welfare Impacts: Financial Capital flow

The welfare effect of financial capital outflow is
determined by the trade off between investors' gain
and entrepreneurs' loss. If the later dominates the
former, welfare is reduced at home due to financial
capital outflow.