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Sources for financing domestic capital – is foreign saving a viable option for developing countries? Joshua Aizenman, Brian Pinto & Artur Radziwill UCSC & the NBER; The World Bank & CASE – Center for Social and Economic Research Department of Economics, Warsaw University 6 March, 2008 1 The purpose Studying the importance of external financing and financial integration in the development process. We propose a new and simple method for tracing the patterns and the depth of selffinancing. We apply this method, investigating the impact of financial liberalizations, in the 1990s, on self-financing rates and growth. 2 Two opposing views about financial integration Private debt or portfolio inflows in response to economic liberalisation have expanded sizeably, from less than $40 billion per year over the period 1983-1990, to an average of about $200 billion a year in the last five years. These capital inflows have provided additional resources to supplement domestic savings and support high levels of investment.” Andrew Crockett, 13/2/98. “Neither a borrower nor a lender be, for loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.” W. Shakespeare, from Hamlet. 3 Financial liberalization in the 1990’s: global perspectives The 1980s -- stagnation of economic growth and the rise in inflation associated with the 1982-89 debt crisis. 1990s – sweeping reforms in LATAM, exchange rate based stabilization programs, coupled with deep trade and financial liberalizations. The presumption – renewed external financing would augment domestic saving, increasing investment and the growth rate. 4 De jure measures of capital mobility Normalizing completely free capital mobility at 100, Edwards (2004) reports indexes of capital mobility. LATAM: increased from about 40 in the 1980s to about 75 in the 1990s. Asia: increased mildly from about 40 in the 1980s to 60 prior to the 1997 crisis, dropping to 55 in the aftermath of the crisis. The Middle East and North Africa: a much smaller increase throughout that time, from about 40 to 50. 5 Financial Openness (capital Inflow + outflow, % of GDP) 20 15 10 5 0 1970s East Asia 1980s Latin America 1990s Others OECD 6 Background literature I: conflicting views about financial liberalization The gains from financial integration are illusive (at best). Rodrik (1999), Stiglitz (2002), Gourinchas and Jeanne (2004). Significant gains from financial openness Bekaert et. al. (2002) and Henry (2003). All these studies focused on the formal acts associated with de-jure financial opening. 7 Background literature II Feldstein and Horioka (1980) S/I correlations as a measure of capital mobility; concluded that financial markets had a long way to go towards meaningful integration. Follow up studies: Some concluded that financial markets have become more integrated in recent decades. Others concluded that such correlations do not provide enough information to ascertain the true degree of integration of financial markets [see Obstfeld and Rogoff (1999) and Coakleya, Kulasib and Smithc (1998) for useful overviews of the literature]. 8 Methodology We focus on the ratio of cumulative discounted gross national saving and gross national investment. This ratio provides us with a measure of self-financing – the share of tangible capital that was financed by domestic savings. We use this ratio to investigate the 1990s. No obvious association between S/I correlations and self finance ratios. 9 Ideal Self financing ratio, fˆ unbounded backward discounting (1) fˆt S i 1 I i 1 t i t i (1 d ) (1 d ) i 1 i 1 d = depreciation rate I = gross investment in constant PPP S = gross national saving in constant PPP 10 Interpretation fˆt = 1 the entire stock of domestic capital is self-financed. 1- fˆt = foreign-financing ratio = the fraction of domestic capital that was financed by foreign saving. In practice, the unbounded backward discounting is not feasible due to scarcity of data. 11 Self financing ratio, with discounting horizon n n (2) f t ;n S i 1 n I i 1 t i t i i 1 kYt n (1 d ) n i 1 kYt n (1 d ) n (1 d ) (1 d ) k = fixed initial capital/GDP ratio, The denominator: the stock of capital. For a large n, the numerator is the hypothetical self-financed stock of capital, assuming that the country would have self financed its investment, without borrowing. 12 For an economy growing at a constant rate g (3) f t ;n fˆt (1 f t ;n ) (1 d ) /(1 g ) n 1 (1 d ) /(1 g ) n K t ;n gt 1 is the growth rate of the K t 1;n stock of capital at time t. For large n and d, the gap between measured and the ideal self-financing measure is inconsequential. 13 Self financing overtime (4) f t ;n f t 1;n St 1 I t 1 d gt (1 f t 1;n ) K t ;n 1 gt K t ;n gt 1 K t 1;n is the growth rate of the stock of capital at time t. Current account surpluses exceeding d gt ( f t 1; n 1) 1 gt would increase the self-financing ratio. 14 No obvious association between S/I correlations and self finance ratios. Consider a simple example, no uncertainty. Suppose that S = f I Trivially, correlation (S, I) = 1, independently from f . Our focus is on f , measuring the share of investment financed domestically. 15 Self financing: estimation We calculate f varying t, holding n constant. Base specification, k = 3, n = 10 and d = 0.1. A panel of self-finance ratios covering the 1990s for 47 developing and 22 OECD countries [data requirements: available S and I for every year 19812001, Source: 2004 WDI]. Variables GDP, gross national savings (including net current transfers from abroad) and gross fixed capital formation are expressed in constant local currency units. GDP per capita is expressed in constant 1995 US$. 16 All Developing Countries 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 91 92 93 94 95 96 97 98 99 00 01 Mean Mean - Standard Deviation Mean + Standard Deviation 17 LATAM 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 91 92 93 94 95 96 97 98 99 00 01 Mean Mean - Standard Deviation Mean + Standard Deviation 18 Asian Countries 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 91 92 93 94 95 96 97 98 Mean Mean - Standard Deviation Mean + Standard Deviation 99 00 01 19 African Countries 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 91 92 93 94 95 96 97 98 99 00 01 Mean Mean - Standard Deviation Mean + Standard Deviation 20 China India 1.2 1.3 15 1.2 1.1 10 1.1 10 1.0 5 1.0 0.9 0 5 0.9 -5 0 -10 91 92 93 94 95 Growth rate /left axis 96 97 98 99 00 01 Self-financing ratio /right axis 91 92 93 94 95 Growth rate /left axis 96 97 98 99 00 01 Self-financing ratio /right axis 21 Argentina Mexico 1.2 1.2 1.1 1.0 0.9 10 1.1 10 1.0 5 0.9 5 0 0 -5 -5 -10 -15 -10 91 92 93 94 95 Growth rate /left axis 96 97 98 99 00 01 02 Self-financing ratio /right axis 91 92 93 94 95 Growth rate /left axis 96 97 98 99 00 01 Self-financing ratio /right axis 22 Korea Malaysia 1.2 1.2 1.1 1.1 1.0 1.0 10 0.9 10 0.9 5 5 0 0 -5 -5 -10 -10 91 92 93 94 95 Growth rate /left axis 96 97 98 99 00 01 Self-financing ratio /right axis 91 92 93 94 95 Growth rate /left axis 96 97 98 99 00 01 Self-financing ratio /right axis 23 Financial openness and self financing The correlation between the change in defacto financial openness between 80s and 90s and the change in self-financing rates between 1991 and 2001 is zero. The financial opening was substantial - the average and median increases in financial openness were 65%, and 30%, respectively, changes in the self- financing rates were insignificant by comparison. 24 The association between deeper defacto financial integration and changes in self-financing ratios Self-financing ratio 2001/1991 3 2 1 0 0 1 2 3 4 5 6 Average ratio of gross financial flows to GDP 90s/80s 25 Self financing and growth Higher f are associated with higher growth rates. This effect is convex. A rise (drop) in f from 1 to 1.1 (from 1 to 0.9 ) is associated with an increase in the growth rate from 2.8% to 4.4% (from 2.8% to 2.2%). Better institutions are associated with less volatile f s. Better institutions are associated with a higher growth rate. The quality of institutions variable “soaks” the explanatory power from the volatility of selffinancing ratios, but leaving intact the positive convex effect of self-financing ratios on real per capita GDP growth. 26 Growth and self-financing ratio, cross-country analysis, 1990s 27 Main results No evidence of changes in the pattern of financing ratios of developing countries. Greater financial integration has resulted in inflows of foreign saving financing outflows of domestic saving, with little net impact on financing ratios [Dooley (1988), Mody & Murshid (2002), Bosworth and Collins (1999)] The average self-financing ratio for developing countries is about 90%. 28 Results II Greater integration of financial markets has not changed the dispersion of selffinancing rates S.d. of the cross-country distribution of selffinancing ratios in the 1990s is about 0.18. In the 1990s, countries with higher selffinancing ratios grew significantly faster than countries with low self-financing ratios. 29 Results III In a growth regression, a positive convex effect of self-financing ratios on real per capita GDP growth. Higher volatility of self-financing ratios is associated with lower growth rates. Better institutions are associated with a higher growth rate. In a growth regression, the quality of institutions variable “soaks” the explanatory power from the volatility of self-financing ratios, leaving intact the positive convex effect of self-financing ratios on real per capita GDP growth. 30 Inferences Despite greater financial integration, foreign savings have not provided, on average, a viable source of financing. Instead, financial integration leads to deeper diversification. No inference about direct causality – we cannot infer that policies aimed at increasing self-financing ratios would be growth and welfare improving. Our results do not rule out the possibility that financial liberalization may impact the “quality of growth,” as measured by TFP. 31