Revisiting the paradox of capital
Basic economic theory suggests that saving should flow from relatively wealthy, capital-rich countries to poorer countries where capital is scarce and profitable investment opportunities should therefore be abundant. While that pattern broadly held true before WWI, it has been harder to observe after WWII, as stressed by Robert Lucas (1990) nearly three decades ago. Indeed, around the start of the current millennium and up until the 2008 Global Crisis, poorer countries had growing current account surpluses and richer countries growing deficits, leading to what Mervyn King and Raghuram Rajan in 2006 characterised as an uphill flow of capital in the global economy (King 2006, Rajan 2006). Recent research has argued that even within the group of emerging market and developing economies (EMDEs), capital flows do not necessarily favour countries with relatively higher productivity growth (Prasad et al. 2007, Gourinchas and Jeanne 2013).
Uphill flows intensify (2000-08)
During 2000-08, uphill flows intensified (Figure 1). Measuring total flows by the size of the current account deficit, the difference between national saving and investment, advanced economies as a group received persistent and sizable net inflows, peaking at about 1% of global GDP in the run-up to the Global Crisis. These inflows were mirrored by large and growing outflows from China and commodity-exporting (especially fuel-exporting) EMDEs, which were in turn supported by China's integration into the global economy, low global interest rates, and the sharp rise in commodity prices. Other East Asian emerging markets apart from China saved more in the wake of the Asian crisis of the late 1990s, as noted by Bernanke (2005). Meanwhile, the rest of EMDEs (82 out of the 99 countries in this group) continued to receive net inflows, although at a more moderate pace than advanced economies when measured as a share of world GDP.
Figure 1 Current account balance by country groups
Sources: IMF World Economic Outlook and IMF staff calculations.
Notes: The charts are based on an unbalanced panel comprising 142 countries in 1980 and 148 countries in 1990. 2016 data are projections as of January, 2017. Advanced economy-EMDE breakdown follows the latest World Economic Outlook while the commodity exporter country group is based on Chapter 2 of October 2015 World Economic Outlook. Part of the large and positive current account discrepancy through 1991 is due to lack of data for the USSR.
Capital outflows from EMDEs during the pre-crisis decade were dominated by offical reserve accumulation (Figure 2). China and EMDE commodity exporters accumulated foreign exchange reserves to back their export-oriented growth model and smooth the use of the commodity windfall, respectively. A number of EMDEs also built up precautionary foreign exchange reserves. However, FDI continued to flow in the right' direction during the entire period, from rich to poor, as savers in advanced economies exploited investment opportunities in the developing world.
Figure 2. EMDEs: Net capital inflow composition and reserve accumulation
Sources: IMF Financial Flows Analytics, IMF World Economic Outlook and IMF staff calculations.
Notes: The charts are based on an unbalanced panel comprising 129 in 1980 and 140 countries in 1990.
The leading role for reserve accumulation is consistent with other evidence. Other researchers have documented that sovereign-to-sovereign flows, including foreign reserve accumulation, accounted for a large share of uphill flows; and that apart from such flows, the data are consistent with net private capital flowing from rich to poor countries (Alfaro et al. 2014). This result is also broadly consistent with the finding that non-reserve capital flows respond strongly to growth differentials (IMF 2016). If reserve-accumulating countries had refrained from intervening to keep their currencies from appreciating, their current account balances, equal to the net outflow of capital, would have been lower. Reserve accumulation therefore accentuated the global uphill capital flow.
Interestingly, uphill flows did not prevent falling investment in advanced economies or rising investment in EMDEs (Figure 3). Even though lower capital-labour ratios in poorer countries should determine the direction of flows, surges in saving or investment, for example due to looser balance-sheet constraints or productivity improvements, can lead to deviations from the prediction of the theory. However, investment-to-GDP ratios in advanced economies actually declined during 2000-08, suggesting that the uphill flows did not support an expansion of investment in these countries, but rather, a decline in saving. In contrast, and despite the intensification of outflows from EMDEs during the pre-crisis decade, investment grew strongly in these countries as a group (especially in China), although it was more than offset by a surge in saving, with income growth (including that resulting from the commodity windfall) outpacing the growth of domestic absorption. In the 2000s, therefore, the net flow of capital from poor to rich countries was more a reflection of saving behaviour than investment needs.
Uphill flows slow and reverse (2009-present)
Uphill flows slowed during the Global Crisis and reversed more recently. The post-crisis deleveraging and associated investment declines led to lower net inflows into advanced economies as a whole. These developments were matched by reduced outflows from EMDEs, as China started to rebalance its economy toward domestic absorption and the commodity income windfall for commodity exporters vanished. By 2015, EMDEs as a group registered a small net capital inflow, as net inflows into most EMDEs more than offset the continuing net outflows from China (Figure 1).
The slowdown and eventual reversal in uphill flows were largely mirrored by official reserve movements. Since 2014, the stock of EMDE official reserves has fallen, reflecting the emergence of current account deficits in commodity exporting EMDEs and the intensification of private outflows, especially from China, where policy uncertainties prompted residents to accelerate the pace of rebalancing from domestic to foreign assets. The recent sales of EMDE offical foreign reserves limited currency depreciation and prevented a sharper external adjustment, thereby supporting the reduction and ultimate reversal of the uphill flow. Such foreign reserve sales, which are official capital inflows, imply that private (that is, non-reserve) net capital inflows need not match the behaviour of total net capital inflows, and indeed some EMDEs have recently experienced higher overall net inflows despite decreased private net inflows (IMF 2016).
Since the Global Crisis, investment and saving have diverged between rich and poor countries (Figure 3). In advanced economies, improvements in the current account balance were driven by falling investment, which more than offset the decline in their saving as a share of global GDP. Meanwhile, the deterioration in the current account balance of EMDEs reflected relatively faster investment growth, which, despite decelerating sharply from its unusual pre-crisis highs, outpaced the growth of saving. Thus, the current net flow of global saving is in the direction of supporting higher EMDE investment.
Figure 3. Change in the current account balance: Role of saving and investment
Sources: IMF World Economic Outlook and IMF staff calculations.
Notes: 2016 data are projections as of January, 2017. Advanced economy (AE)-EMDE breakdown follows the latest World Economic Outlook. Change in saving includes a small discrepancy so as to ensure that the current account matches the difference between saving and investment.
Long-term capital movements in theory and reality
A careful look at the uphill flows of the previous decade and their reversal indicates a key role for saving behaviour. A country whose real interest rate would be above global rates if it were unable to borrow from abroad would tend to attract global saving when it accesses the world capital market. In contrast, a country whose real interest rate is below the world's when it is cut off from the global capital market would tend to lend some of its saving abroad when it integrates with the world capital market. Thus, the sign of the gap between the hypothetical autarky interest rate and world rates indicates whether a country will be a net recipient or exporter of capital. Importantly, that sign depends not only on the marginal productivity of domestic investment, but also on saving patterns, which can reflect demographics, culture, the degree of financial-market development, and policies.
Other things being equal, countries with lower ratios of capital to labour should have higher autarky interest rates. But other things are usually not equal. Lucas (1990) asked why countries with very low capital-to-labour ratios do not have sky-high autarky interest rates; one reason he suggested was the scarcity of human capital complementary with physical capital. But there are others. A high propensity to save can overwhelm the effects of capital scarcity, just as a surge in investment productivity can raise the return to investment notwithstanding an already high capital-to-labour ratio. Conversely, weak institutions and property rights can lower the perceived productivity of investment, as emphasised by Alfaro et al. (2008). Even when the return to investment is potentially high, financial market imperfections can reduce the autarky interest rate, limiting investment and driving saving abroad, as in the models of Caballero et al. (2008) and Mendoza et al. (2009). Evidence over decades, ranging from Harberger (1980) to Caselli and Feyrer (2007), suggests rather limited divergences in the rates of return to capital across countries, not closely related to differences in measured capital-to-labour ratios.
A country's equilibrium capital inflow also can depend on investor attitudes. If global investors develop an aversion to a country's assets, including through a generalised rise in risk aversion or home bias, that can act as a tax that raises the cost of borrowing above the global risk-free' interest rate. The same is true of an increase in perceived default risk (Lucas 1990, Reinhart and Rogoff 2004). Similarly, foreign investor exuberance can act as a borrowing subsidy. Volatile investor-driven capital flows complicate policymaking, in part because it may be hard to ascertain if they are driven by fundamentals or fickle sentiment.
Although many writers have labelled an uphill net flow of capital as perverse', more nuanced views of the world therefore can rationalise it. Whether capital flows perversely thus depends on the degree to which economic distortions as opposed to more benign economic fundamentals are at work, not only in pushing investment from its efficient level but in distorting national saving. However, diagnosing the underlying drivers of capital flows in real time is not easy, and there can be a grey area of vulnerability where investor expectations may become self-fulfilling, thereby attenuating the link between capital flows and economic fundamentals. A detailed evaluation would have to assess the allocation of capital inflows country by country. One thing is clear, though: in view of the inherent uncertainties, economic resilience requires strong institutions and policy frameworks.
Outlook and policy implications
The uphill capital flows that emerged around the turn of the millennium reflected factors, mostly on the saving side, that proved ultimately not to be sustainable. These factors included low saving and high credit growth in advanced economies, intensive export orientation at the expense of consumption in China, and the related elevated level of global commodity prices. At the same time, EMDEs invested substantially more of their outputs than advanced economies during 2000-08, as one would expect given their generally lower stocks of capital (albeit with China no longer relatively capital-scarce after the mid-2000s). Saving patterns have changed since the Global Crisis, helping to unwind the uphill flow, but at the same time, world real investment growth has slowed.
Going forward, the direction of flows will depend on the relative strength of several forces. Another surge in EMDE saving is unlikely, given China's gradual adjustment to a slower, more consumption-oriented growth model and the relatively subdued outlook for commodities. Stronger growth and infrastructure needs in EMDEs, as well as structural changes like demographics in advanced economies, could push excess saving to EMDEs. However, prospects of monetary policy normalisation in advanced economies could work in the opposite direction, especially if associated with adverse balance sheet effects in EMDEs. The latter possibility has gathered force after the US presidential election, as US inflation expectations and the value of the dollar have risen sharply on the back of anticipated fiscal expansion. Moreover, global uncertainties remain large, not least because of the rising risk of protectionism, which could predominantly hurt emerging markets. A large and persistent downhill flow of capital therefore seems unlikely to develop in the near term.
Reaping the benefits of capital inflows remains a central challenge for EMDEs. In general, this will require that these countries further strengthen policy frameworks to lower the risk of potential capital flow reversals triggered by higher US interest rates and a stronger US dollar. Exchange rate flexibility, in particular, can help insulate EMDEs from changes in global financial conditions, although at times foreign exchange intervention may be needed to maintain orderly market conditions. Moreover, as highlighted by a vast literature on the topic, robust institutions and policy frameworks (Obstfeld 1998, Kose et al. 2006, Ghosh et al. 2016), including well-functioning domestic and international financial markets (Igan et al. 2016), remain crucial to harness the benefits of capital inflows.
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