International Capital Flows: Issues in Transition Economies Thorvaldur Gylfason.

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Presentation transcript:

International Capital Flows: Issues in Transition Economies Thorvaldur Gylfason

Outline 1)Symmetry between trade in goods and services and capital movements 2)Gains from capital flows 3)Empirical evidence of capital flows and growth 4)Pitfalls and policies

Goods and Capital The argument for free trade in goods and services applies also to capital  Trade in capital helps countries to specialize according to comparative advantage, exploit economies of scale, and promote competition  Exporting equity in domestic firms not only earns foreign exchange, but also secures access to capital, ideas, know-how, technology 1

Symmetry between Trade in Goods and Capital The balance of payments  R = X – Z + F where X = exports of goods and services X = exports of goods and services Z = imports of goods and services Z = imports of goods and services F = net exports of capital F = net exports of capital Foreign direct investment Foreign direct investment Portfolio investment Portfolio investment Foreign borrowing Foreign borrowing

Determinants of Foreign Trade Trade in goods & services depends on Relative prices at home and abroad Exchange rates (elasticity models) National incomes at home and abroad Geographical distance from trading partners (gravity models) Trade policy regime Tariffs and other barriers to trade

Two Views of Trade The current account of the balance of payments is defined as B = X – Z National income is Y = E + X – Z Therefore, current account is  B = X – Z = Y – E Two sides of the same coin: Deficit means that Z > X and E > Y Surplus means that X > Z and Y > E

Determinants of Foreign Investment Capital flows Foreign borrowing, portfolio investment, foreign direct investment Trade in equities depends on Interest rates at home and abroad Exchange rate expectations Geographical distance from trading partners Capital account policy regime Capital controls and other barriers to free flows

Why Capital Moves  Capital moves across national borders to exploit welfare gains from trade  Welfare gains from trade stem from price differences at home and abroad  Price differences reflect different costs  Different costs reflect different levels of efficiency  Comparative advantage is key 2

 If the world interest rate is lower than the domestic interest rate, the country will be a borrower in world financial markets  Domestic firms will want to borrow at the lower world interest rate  Domestic households will reduce their saving because the domestic interest rate moves down to the level of the world interest rate Conceptual Framework

Real interest rate 0 Saving, investment Saving Investment World interest rate World equilibrium Domestic saving Domestic investment Domestic equilibrium Borrowing Conceptual Framework

0 Saving World interest rate Investment World equilibrium Domestic equilibrium A B C D Borrowing Conceptual Framework Real interest rate Saving, investment

0 Saving Investment World equilibrium Domestic equilibrium A Consumer surplus before borrowing C B Producer surplus before borrowing Real interest rate Saving, investment Conceptual Framework

0 Saving World interest rate Investment World equilibrium Domestic equilibrium A Consumer surplus after borrowing B D C Producer surplus after borrowing Borrowing Conceptual Framework Real interest rate Saving, investment

The area D shows the increase in total surplus and represents the gains from borrowing Before tradeAfter tradeChange Consumer surplus AA + B + D+ (B + D) Producer surplus Producer surplusB + C C- B Total surplusA + B + CA + B + C + D+ D Conceptual Framework

Borrowers are better off and savers are worse off Borrowers are better off and savers are worse off Borrowing raises the economic well- being of the nation as a whole because the gains of borrowers exceed the losses of savers Borrowing raises the economic well- being of the nation as a whole because the gains of borrowers exceed the losses of savers If world interest rate is above domestic interest rate, savers are better off and borrowers are worse off, and nation as a whole still gains If world interest rate is above domestic interest rate, savers are better off and borrowers are worse off, and nation as a whole still gains Gains from Trade: Three Main Conclusions

Real interest rate 0 Saving, investment Saving Investment World interest rate World equilibrium Domestic investment Domestic saving Domestic equilibrium Lending Conceptual Framework

0 Saving World interest rate Investment World equilibrium Domestic equilibrium A B C D Conceptual Framework Real interest rate Saving, investment Lending

0 Saving Investment World equilibrium Domestic equilibrium Consumer surplus before borrowing Real interest rate Saving, investment Conceptual Framework Producer surplus before borrowing A B C

0 Saving World interest rate Investment World equilibrium Domestic equilibrium Consumer surplus after borrowing Conceptual Framework Real interest rate Saving, investment A Producer surplus after borrowing Lending D C B

The area D shows the increase in total surplus and represents the gains from lending Before tradeAfter tradeChange Consumer surplus A A + B B + C + D Producer surplus Producer surplusC - B Total surplusA + B + CA + B + C + D+ D Conceptual Framework B + D

Causes of Capital Flows Internal (pull) factors Increased productivity and growth Increased productivity and growth Sound macroeconomic fundamentals Sound macroeconomic fundamentals Structural reforms Structural reforms Increased money demand Increased money demand Emergence of financial markets with better infrastructure Emergence of financial markets with better infrastructure Liberalization of trade and capital markets Liberalization of trade and capital markets

Causes of Capital Flows External (push) factors Decrease in world interest rates Decrease in world interest rates  Search for higher yields in LDCs  Reduced default risk of LDCs Changes in financial systems abroad Changes in financial systems abroad  Deregulation of institutional investors  Decline in communication costs Demographics of industrial countries Demographics of industrial countries  Larger pool of saving in ICs  Lower returns to capital in ICs

Effects of Capital Flows  Facilitate borrowing abroad to smooth consumption over time  Dampen business cycles  Reduce vulnerability to domestic economic disturbances  Increase risk-adjusted rates of return  Encourage saving, investment, and economic growth

Effects of Capital Flows  Overheating of economy Expansion of aggregate demand Expansion of aggregate demand Inflation Inflation Real appreciation of currency Real appreciation of currency Widening current account deficit Widening current account deficit  Monetary consequences depend on exchange rate regime

Empirical Evidence  Look at numbers describing trade and capital flows around the world as well as in transition countries  Look also at evidence of the relationship between trade, investment, and economic growth across countries 3

Exports (% of GDP) Empirical evidence

Transition Countries: Exports 2000 (% of GDP) World average

Growth in Trade Less Growth in GDP (%)

FDI (Net, % of Gross Investment)

FDI (Gross, % of GDP)

Transition Countries: FDI 2000 (Net, % of Gross Investment) World average

Transition Countries: FDI 2000 (Gross, % of GDP) World average

Sectoral Distribution of Net Capital Flows to Developing Countries Percent of total capital flows

Net Private Capital Flows to Developing Countries Billions of US dollars

Net Private Capital Flows to Transition Economies Billions of US dollars

Mexico Korea Mexico Thailand Venezuela Turkey Venezuela Argentina Malaysia Indonesia Argentina Reversals in Net Private Capital Flows to Emerging Economies Billions of US dollars Reversals of capital flows  Slowdown in growth  Insufficient reserves  Level and composition of debt  Weak banks  Contagion

Openness to FDI and Growth Botswana An increase in openness to FDI by 2% of GDP is associated with an increase in per capita growth by more than 1% per year. r = countries r = rank correlation

Openness to Trade and Growth countries An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year. r = 0.42

Tariffs and Growth countries An increase in tariffs by 10% of imports is associated with a decrease in per capita growth by 1% per year. r = India Cote d'Ivoire Botswana

Pitfalls: Incomplete Information  Capital account liberalization, if well managed, stimulates saving and investment, efficiency, and economic growth  But information may be asymmetric Adverse selection Adverse selection Moral hazard Moral hazard Herding Herding 4

Capital Account Liberalization The End  Needs to be orderly, gradual, well- sequenced  Effective prudential regulation To encourage banks to recognize risks To encourage banks to recognize risks To enable authorities to monitor threats to stability of the financial system To enable authorities to monitor threats to stability of the financial system  Sound macroeconomic policies  Sequencing Put bank supervision and sound policies in place first, then liberalize Put bank supervision and sound policies in place first, then liberalize These slides will be posted on my website: