Gains from International Capital Mobility Chapter 10

Outline International allocation of savings and investment The degree of international capital market integration A puzzle: The Feldstein-Horioka study Where does capital flow? Is the destination of capital flows consistent with the theory? Institutions, financial development and growth The role of capital flows in risk diversification Firm investment and asymmetric information

International allocation of savings and investment Two main benefits: International capital can channel national savings to its most productive investment opportunities including opportunities in foreign countries. International capital mobility enables the spreading of investment risk (diversification).

From the balance of payments accounting we know that a current account deficit (surplus) is matched by a capital inflow (outflow). S – I ≡ CA (current account balance) So excess savings or a national savings surplus (S > I) needs to be invested abroad. What causes capital inflows or outflows?

Determinants of international capital flows Financial transactions and risk Channeling savings towards investment: directly (via capital markets) or indirectly (via financial intermediaries) Suppose we have the following. SH = SH(rH); SF = SF(rF) + + and IH = IH(rH); IF = IF(rF) – –

Capital stock: Law of diminishing marginal returns Optimal (equilibrium) level of investment: The point at which marginal productivity of capital (MPC) equals the cost of capital. International capital mobility makes both countries better off. (Fig. 10.1)

Figure 10.1 International capital mobility is welfare-enhancing

The difference between home and foreign time preference for consumption leads to the emergence of international capital flows. This is similar to the mechanism underlying trade in goods and services except that we are now dealing with inter-temporal trade. In the absence of exchange rate risk and transaction costs, international capital mobility will lead to interest rate convergence between countries.

Thrift and saving money: Country differences (Box 10.1)

The degree of international capital market integration Fig. 10.1 implies that with international capital mobility and financial market integration there should be no interdependence between national savings and national investments. However, Martin Feldstein and Charles Horioka (1980) found a very high correlation between national savings and national investment (in OECD countries). This is puzzling! See Tables 10.2 and 10.3.

Where does capital flow? Is the destination of capital flows consistent with the theory? Does capital flow in the wrong direction? Fig. 10.2

Figure 10.2 Capital re-allocation between Home and Foreign

Institutions, financial development and growth Douglas North (1993) IMF study (2003) Acemoglu et al. (2001), Easterly (2002) and Rodrik et al. (2002), all agree that “institutions are probably the most important deep structural explanation of income differences.” Laporta et al. (1997, 1998): The role of legal origin. Levine and Zervos (1998) studied the effect of institutions on financial development.

Capital flows and risk diversification A macroeconomic model does not allow us to understand the motives for capital flows from the perspective of the firm or the individual portfolio investor. Portfolio investment and risk sharing Insurance against shocks through portfolio diversification (Box 10.3).

Firm investment and asymmetric information Incomplete information Asymmetric distribution of information Firm investment, supply of funds and symmetric information (Fig. 10.3) Adverse selection problem Moral hazard problem

Figure 10.3 Firm investment, supply of funds and asymmetric information

Figure 10.4 Bank efficiency scores; per cent rank and score (%) Source: based on data from Hasan et al. (2009).