World Capital Flows: Who Invests Where and How Much Essay

World capital flows: Who invests where and how much? Presented By: Ankit Jaini (Y8087) Supervisor: Dr. Somesh K. Mathur ECO 231 Abstract Through this paper I plan to re-examine Lucas’s famous question, “Why doesn’t capital flow from rich countries to poor countries? ” in the wake of the explosion of “emerging markets” investment over the past decade and also look into patterns of foreign investment.

Although more of a subjective analysis rather than an empirical one, I have tried to include a bit of quantitative estimation too in the paper with the hope of sufficiently describing and portraying my understanding of the paradox. Introduction Standard economic theory tells us that financial capital should, on net, flow from richer to poorer countries. That is, it should flow from countries that have more physical capital per worker—and hence where the returns to capital are lower-to those that have relatively less capital-and hence greater unexploited investment opportunities.

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In principle, this movement of capital should make poorer countries better off by giving them access to more financial resources. As financial globalization increases, these flows from industrial to developing countries will increase, making all countries better off. This would seem an ideal situation, but what is the reality? In a famous article written in 1990, Robert Lucas pointed out that capital flows from rich to poor countries were very modest, and nowhere near the levels predicted by theory.

Financial globalization has surged in the past decade and a half. While cross-border capital flows worldwide have risen substantially, reaching nearly $6 trillion in 2004, less than 10 percent of them go to developing countries. What then has become of the empirical paradox that Lucas identified? Has increasing financial integration resolved it? The Chart on the next page shows the less availability of capital for the poor countries. *source: World Development Indicator database (World Bank) Review of Literature

The only main literature I referred to was the original paper by Lucas (1990). Lucas (1990): Using a one-sector model, Lucas (1990) suggested that it was a paradox that more capital does not flow from rich to poor countries. His reasoning goes as follows. Let y = f (L, K) be the production function where y is the output produced using labour L and capital K. Let ‘p’ be the price of goods, and ‘w’ and ‘r’ be returns to labour and capital, respectively. Firm’s profit maximization problem gives: r = p? f (L, K)/? K = p? f (1, K/L)/? K

With free trade, the price of goods is equalized across countries. The Law of Diminishing Marginal Product implies that ‘r’ is higher in the country with lower per capita capital. As an illustration, Lucas calculated that the return to capital in India should be 58 times as high as that in the United States. Facing a return differential of this magnitude, Lucas argued, we should observe massive capital flows from rich to poor countries. That it does not happen has come to be known as the Lucas paradox. Lucas (1990) discussed three possible explanations: 1.

A worker in a rich country could be several times more productive than her counterpart in a poor country. 2. Human capital may be a missing factor and is likely much higher in a rich country. 3. Political risk and hence required risk premium may be substantially higher in a poor country. Examining the paradox In my perspective besides the three explanations given by Lucas, the main theoretical explanations for the Lucas paradox can be grouped into two categories. The first group of explanations includes differences in fundamentals that affect the production structure of the economy.

These can be omitted factors of production, government policies, and institutions. All of these affect the marginal product of capital via the production function. The second group of explanations focuses on international capital market imperfections, mainly sovereign risk and asymmetric information. Although the capital is productive and has a high return in developing countries, it does not go there because of the market failures. Below I describe these groups in a bit of detail. 1. Fundamentals •Omitted Factors of Production:

What Lucas showed was that assuming a small open economy where output is produced using capital (K) and labour (L) via a Cobb-Douglas production function. Yt = AtF(Kt, Lt) = AtKt? Lt1-? F`(. ) > 0, F“(. ) < 0, F(0) = 0 (1) where Y denotes output and A is the productivity parameter. If all countries share a common technology, perfect capital mobility implies the instantaneous convergence of the interest rates. Hence, for countries i and j, Atf`(kit) = rt = Atf`(kjt) (2) where f(. is the net of depreciation production function in per capita terms. The property of diminishing returns to capital implies that in the transition process, resources will flow from capital abundant countries (low returns) to capital scarce countries (high returns). However we can account for the lack of capital flows from rich to poor countries by looking at the existence of other factors—such as human capital and land—that positively affect the returns to capital but are generally ignored by the conventional neoclassical approach.

For example, if human capital positively affects capital’s return, less capital tends to flow to countries with lower endowments of human capital. Thus, if the production function is in fact given by Yt = AtF(Kt, Zt, Lt) = AtKt? Zt? Lt1-? -? (3) where Zt denotes another factor that affects the productive process, then (2) misrepresents the implied capital flows. Hence, for countries i and j, the true return is given by Atf`(kit, zit) = rt = Atf`(kjt, zjt) (4) •Government Policies Government policies can be another impediment to the flows and the convergence of the returns.

For example, differences across countries in government tax policies can lead to substantial differences in capital-labour ratios. Also, inflation may work as a tax and decrease the return to capital. In addition, the government can explicitly limit capital flows by imposing capital controls. We can model the effect of these distortive government policies by assuming that government’s tax capital returns at a rate ? , which differs across countries. Hence, for countries i and j, the true return is given by Atf`(kit)(1-? it) = rt = Atf`(kjt)(1-? t) (5) •Institutions Institutions are the rules of the game in a society. They consist of both informal constraints (traditions, customs) and formal rules (rules, laws, constitutions, laws). They provide the incentive structure of an economy. Institutions are understood to affect economic performance through their effect on investment decisions by protecting the property rights of entrepreneurs against the government and other segments of society and preventing elites from blocking the adoption of new technologies.

In general, weak property rights due to poor institutions can lead to lack of productive capacities or uncertainty of returns in an economy. Moreover, capital-labour ratios across countries might differ because of differences in cultural context and technological capacity. We model these as differences in At, which captures overall differences in efficiency in the production across countries. Hence, for countries i and j, the true return is given by Aitf`(kit) = rt = Ajtf`(kjt) (6) 2. International Capital Market Imperfections •Asymmetric Information

Asymmetric information problems, intrinsic to capital markets, can be ex-ante (adverse selection), interim (moral hazard) or ex-post (costly state verification). In general, under asymmetric information, the main implications of the neoclassical model regarding the convergence of returns and capital flows tend not to hold. In a model with moral hazard, for example, where lenders cannot monitor borrowers’ investment, poor countries’ per capita investment depends positively on per capita wealth. Alternatively, if foreign investors are handicapped in terms of domestic market information, they tend to under invest.

These cases all lead to higher interest rates in capital importing countries. •Sovereign Risk Sovereign risk is defined as any situation, where a sovereign defaults on loan contracts with foreigners, seizes foreign assets located within its borders, or prevents domestic residents from fully meeting obligations to foreign contracts. The problem stems from the fact that repayment incentives for sovereign debts differ from those of a contract between two nationals because the ability of a court to force a sovereign entity to comply is extremely limited.

Sovereign debtors may repay some of their debts because of the threat of future exclusion from international capital markets or direct imposition of penalties. In both cases the optimal level of borrowing and lending – and thus convergence in returns – cannot be achieved. Besides these factors, others like the existence of trade costs could explain the low but positive international capital flow. Trade costs do break factor price equalization. However, as tariffs and transport costs decline over time, factor prices (including returns to capital) should converge across countries.

This should lead to a decline in international capital flow (by the logic of factor price equalization), which is contradicted by the data. Cross-country differences in total factor productivity (TFP) are another influential explanation of the Lucas paradox. If the TFPs in both sectors are many times higher in the U. S. than in India, then return to capital in the U. S. could be only slightly lower than in India, justifying the observed small amount of capital flow. What drives the TFP differential across countries can be quality of institutions, including better protection of property rights and better control of bureaucratic corruption.

Recent U. S. current account deficits and Chinese current account surpluses are also a big part of the reason why capital is flowing “uphill”. Having said all this, some say the Lucas paradox isn’t such a paradox at a closer look. Many developing countries are beset by a variety of problems- inadequate infrastructure, a poorly educated labour force, corruption, and a tendency to default on debt from abroad, among other factors- that reduce the risk-adjusted returns to investment. These problems could explain why capital does not flow to developing countries in the quantities one would expect.

Chart 2 below shows that the net amount of foreign capital flowing to relatively high growth developing countries has been smaller than that flowing to the medium- and low-growth groups. During 2000–04, the pattern is truly perverse, with China, India, high-growth, and medium-growth countries all exporting significant amounts of capital, while low-growth countries receive significant amounts. That ‘capital flows to developing countries do not follow growth’ has also been dubbed the allocation puzzle. On examining Chart 3 below, we see that during the period (2000–04), net FDI flows do not follow growth.

They do, however, follow over the period 1970–2004, with the fastest-growing group of nonindustrial countries receiving the most FDI and China receiving substantial amounts. This suggests that fast-growing countries do have better investment opportunities, which is why they attract more FDI. Chart 2: Perverse Trends • *Source: International Financial Statistics (IMF, 2005), UNCTAD- Country Fact Sheets. Chart 3: Better Opportunities •*Source: International Financial Statistics (IMF, 2005), UNCTAD- Country Fact Sheets.

Table 1 below shows the major difference between FDI inflows in the Asian countries especially China and India. This suggests that fast-growing countries do have better investment opportunities, which is why they attract more FDI. Yet they do not use more foreign capital overall and, in the case of China, they export capital on net. Table 1: FDI Inflows in Asia in 2005-06 *Source: UNCTAD, World Investment Report 2007 Conclusions This paper examined the role of different explanations for the lack of flows of capital from rich to poor countries—the Lucas paradox—in a theoretical framework.

Broadly speaking, the theoretical explanations for this paradox include differences in fundamentals affecting the production structure versus international capital market imperfections. Fundamentals include omitted factors of production, government policies, and institutions and the second group includes asymmetric information and sovereign debt, while still other factors include trade costs and differences in total factor productivity. The perverse trend of world capital flows is shown especially FDI in non-industrial and ‘emergent market’ countries like India and China.

Future Areas of Study The Lucas Paradox is related to some of the major puzzles in international macroeconomics and finance. These are the lack of investment in foreign capital markets by the home country residents (the home bias puzzle); the low correlations of consumption growth across countries (the lack of international capital market integration or the risk sharing puzzle). All of these puzzles deal with the question of the lack of international capital flows. In particular, it is still not clear what is more important in explaining the Lucas paradox: fundamentals or market failures.

Future work could include research in this area. References •Lucas, Robert, 1990, “Why Doesn’t Capital Flow from Rich to Poor Countries? ” American Economic Review, Vol. 80 (May), pp. 92–96. •‘International Capital Flows’, Shang-Jin Wei (IMF, CCFR, NBER and CEPR). •‘The Paradox of Capital’, Eswar Prasad, Raghuram Rajan, and Arvind Subramanian. •‘Increasing private capital flows to developing countries’, Kinda, Tidiane (MPRA working paper). •‘Why doesn’t Capital Flow from Rich to Poor Countries? An Empirical Investigation’, Laura Alfaro, Sebnem Kalemli-Ozcan, Vadym Volosovych. Gourinchas, Pierre-Olivier, and Olivier Jeanne, 2007, “Capital Flows to Developing Countries: The Allocation Puzzle,” IMF Working Paper, forthcoming. •Calvo, Guillermo, Leonardo Leiderman and Carmen Reinhart (1996), “Inflows of Capital to Developing Countries in the 1990s,” The Journal of Economic Perspectives. •World Bank Policy Research Working Papers. •UNCTAD statistics. •Reinhart C, Rogoff K. 2004. Serial Default and the “Paradox” of Rich to Poor Capital Flows. American Economic Review 94(2): 52-58. •Schneider F, Frey B. 1985. Economic and political determinants of foreign direct investment.

World Development 13(2): 161-175. •Temple J. , 1999, “The New Growth Evidence”, Journal of Economic Literature, volume 37(1), pp 112-156. Data Sources •World Development Indicator database (World Bank, 2005) •International Financial Statistics (IMF, 2005) •International Monetary Fund, 2002, International Investment Position: A Guide to Data Sources •Updated Barro-Lee dataset (Barro and Lee, 2000) •Datasets for the first era of financial globalization (Obstfeld and Taylor, 2003; Clemens and Williamson, 2004; Ferguson and Schularick, 2006).


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