international capital flows: issues in transition economies thorvaldur gylfason

International International

Capital Flows: Capital Flows:

Issues in Issues in

Transition Transition

EconomiesEconomies

Thorvaldur Gylfason

OutlineOutline

1)1) Symmetry between trade Symmetry between trade in goods and services and in goods and services and capital movementscapital movements

2)2) Gains from capital flowsGains from capital flows

3)3) Empirical evidence of Empirical evidence of capital flows and growthcapital flows and growth

4)4) Pitfalls and policiesPitfalls and policies

Goods and CapitalGoods and Capital

The argument for free trade in goods The argument for free trade in goods and services applies also to capitaland services applies also to capital

Trade in capital helps countries to Trade in capital helps countries to specialize according to specialize according to comparative comparative advantageadvantage, exploit , exploit economies of economies of scalescale, and promote , and promote competitioncompetition

Exporting equity in domestic firms Exporting equity in domestic firms not only earns foreign exchange, but not only earns foreign exchange, but also secures access to capital, ideas, also secures access to capital, ideas, know-how, technologyknow-how, technology

11

Symmetry between Symmetry between Trade in Goods and Trade in Goods and CapitalCapital

The balance of payments The balance of payments

R = X – Z + FR = X – Z + Fwherewhere

X X = exports of goods and services= exports of goods and services

Z Z = imports of goods and services= imports of goods and services

F F = net exports of capital= net exports of capital Foreign direct investmentForeign direct investment Portfolio investmentPortfolio investment Foreign borrowingForeign borrowing

Determinants of Determinants of Foreign TradeForeign Trade

Trade in goods & services depends Trade in goods & services depends onon

Relative pricesRelative prices at home and abroad at home and abroad

Exchange rates Exchange rates (elasticity models)(elasticity models)

National incomesNational incomes at home and abroad at home and abroad

Geographical Geographical distancedistance from trading from trading partners (gravity models)partners (gravity models)

Trade policyTrade policy regime regimeTariffs and other barriers to tradeTariffs and other barriers to trade

Two Views of TradeTwo Views of Trade

The current account of the balance The current account of the balance of payments is defined as of payments is defined as B = X B = X – Z– Z

National income is National income is Y = E + X – ZY = E + X – Z

Therefore, current account is Therefore, current account is B = X – Z = Y – EB = X – Z = Y – E

Two sides of the same coin:Two sides of the same coin:Deficit means that Deficit means that Z > XZ > X and and E > YE > Y

Surplus means that Surplus means that X > ZX > Z and and Y > EY > E

Determinants of Determinants of Foreign InvestmentForeign InvestmentCapital flowsCapital flows

Foreign borrowing, portfolio investment, Foreign borrowing, portfolio investment, foreign direct investmentforeign direct investment

Trade in equities depends onTrade in equities depends onInterest ratesInterest rates at home and abroad at home and abroad

Exchange rate expectationsExchange rate expectations

Geographical Geographical distancedistance from trading partners from trading partners

Capital account Capital account policy regimepolicy regimeCapital controls and other barriers to free flowsCapital controls and other barriers to free flows

Why Capital MovesWhy Capital Moves Capital moves across national Capital moves across national

borders to exploit borders to exploit welfare gains welfare gains from tradefrom trade

Welfare gains from trade stem Welfare gains from trade stem from from price differencesprice differences at home at home and abroadand abroad

Price differences reflect Price differences reflect different costsdifferent costs

Different costs reflect Different costs reflect different different levels of efficiencylevels of efficiency

Comparative advantage Comparative advantage is keyis key

22

If the world interest rate is lower If the world interest rate is lower than the domestic interest rate, than the domestic interest rate, the country will be a the country will be a borrowerborrower in in world financial markets world financial markets

Domestic firms will want to borrow Domestic firms will want to borrow at the lower world interest rateat the lower world interest rate

Domestic households will reduce Domestic households will reduce their saving because the domestic their saving because the domestic interest rate moves down to the interest rate moves down to the level of the world interest ratelevel of the world interest rate

Conceptual Conceptual FrameworkFramework

Real interest rate

0 Saving, investment

Saving

Investment

World interest rate

World equilibrium

Domesticsaving

Domesticinvestment

Domestic equilibrium

Borrowing


0

Saving

World interest rate

Investment

World equilibrium


A

B

C

D

Borrowing


Real interest rate

Saving, investment

0

Saving

Investment

World equilibrium


A

Consumer surplusbefore borrowing

C

B

Producer surplusbefore borrowing

Real interest rate

Saving, investment


0

Saving

World interest rate

Investment

World equilibrium


A

Consumer surplusafter borrowing

B D

CProducer surplusafter borrowing

Borrowing


Real interest rate

Saving, investment

The area D shows the increase in total surplus and represents the gains from borrowing

Before trade After trade Change

Consumer surplusConsumer surplus A A + B + D + (B + D)

Producer surplusProducer surplus B + C C - B

Total surplus A + B + C A + B + C + D + D


Borrowers are better off and Borrowers are better off and savers are worse offsavers are worse off

Borrowing raises the economic Borrowing raises the economic well-being of the nation as a whole well-being of the nation as a whole because the gains of borrowers because the gains of borrowers exceed the losses of saversexceed the losses of savers

If world interest rate is If world interest rate is aboveabove domestic interest rate, savers are domestic interest rate, savers are better off and borrowers are worse better off and borrowers are worse off, and nation as a whole still off, and nation as a whole still gainsgains

Gains from Trade: Gains from Trade: Three Main Three Main ConclusionsConclusions

Real interest rate

0 Saving, investment

Saving

Investment

World interest rate

World equilibrium

Domesticinvestment

Domesticsaving


Lending


0

Saving

World interest rate

Investment

World equilibrium


A

B

C

D


Real interest rate

Saving, investment

Lending

0

Saving

Investment

World equilibrium


Consumer surplusbefore borrowing

Real interest rate

Saving, investment


Producer surplusbefore borrowing

A

B

C

0

Saving

World interest rate

Investment

World equilibrium


Consumer surplusafter borrowing


Real interest rate

Saving, investment

A

Producer surplusafter borrowing

Lending

D

C

B

The area D shows the increase in total surplus and represents the gains from lending

Before trade After trade Change

Consumer surplusConsumer surplus AA + B

B + C + D Producer surplusProducer surplus C

- B

Total surplus A + B + C A + B + C + D + D


B + D

Causes of Capital Causes of Capital FlowsFlows

Internal (Internal (pullpull) factors) factorsIncreased productivity and growthIncreased productivity and growthSound macroeconomic fundamentalsSound macroeconomic fundamentalsStructural reformsStructural reformsIncreased money demandIncreased money demandEmergence of financial markets with Emergence of financial markets with

better infrastructurebetter infrastructureLiberalization of trade and capital Liberalization of trade and capital

marketsmarkets

Causes of Capital Causes of Capital FlowsFlows

External (External (pushpush) factors) factorsDecrease in world interest ratesDecrease in world interest rates

Search for higher yields in LDCsSearch for higher yields in LDCs Reduced default risk of LDCsReduced default risk of LDCs

Changes in financial systems abroadChanges in financial systems abroad Deregulation of institutional investorsDeregulation of institutional investors Decline in communication costsDecline in communication costs

Demographics of industrial countriesDemographics of industrial countries Larger pool of saving in ICsLarger pool of saving in ICs Lower returns to capital in ICsLower returns to capital in ICs

Effects of Capital Effects of Capital FlowsFlows Facilitate borrowing abroad to Facilitate borrowing abroad to

smooth consumption over timesmooth consumption over time Dampen business cyclesDampen business cycles Reduce vulnerability to domestic Reduce vulnerability to domestic

economic disturbanceseconomic disturbances Increase risk-adjusted rates of Increase risk-adjusted rates of

returnreturn Encourage saving, investment, and Encourage saving, investment, and

economic growtheconomic growth

Effects of Capital Effects of Capital FlowsFlows

Overheating of economyOverheating of economyExpansion of aggregate demandExpansion of aggregate demandInflationInflationReal appreciation of currencyReal appreciation of currencyWidening current account deficitWidening current account deficit

Monetary consequences Monetary consequences depend on exchange rate depend on exchange rate regimeregime

Empirical EvidenceEmpirical Evidence

Look at numbers describing Look at numbers describing trade and capital flows around trade and capital flows around the world as well as in the world as well as in transition countriestransition countries

Look also at evidence of the Look also at evidence of the relationship between trade, relationship between trade, investment, and economic investment, and economic growth across countriesgrowth across countries

33

Exports 1990-Exports 1990-20002000 (% of GDP) (% of GDP)

05

101520253035

World Low- and middle-income countries

High-incomecountries

1990

2000

Empirical evidence

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

0 20 40 60 80 100

AlbaniaArmenia

ChinaRomaniaGeorgia

AzerbaijanKyrgyz Republic

UzbekistanLithuaniaRussian

LatviaMoldovaBulgaria

KazakhstanSloveniaUkraine

TurkmenistanHungaryBelarus

Czech RepublicSlovak Republic

TajikistanEstonia

World average

Growth in Trade Less Growth in Trade Less Growth in GDP 1990-2000 Growth in GDP 1990-2000 (%)(%)

-10 0 10 20 30

BelarusKazakhstan

ChinaKyrgyz Republic

UzbekistanSlovenia

Russian FederationTurkmenistan

BulgariaLatvia

UkraineAlbania

RomaniaHungary

Slovak RepublicCzech Republic

EstoniaLithuaniaMoldova

AzerbaijanVietnamGeorgia

FDI 1990-2000 (Net, FDI 1990-2000 (Net, % of Gross % of Gross Investment) Investment)

02468

10121416



1990

2000

FDI 1990-2000 (Gross, FDI 1990-2000 (Gross, % of GDP) % of GDP)

0

2

4

6

8

10

12



1990

2000

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

-10 0 10 20 30 40 50 60

Kyrgyz RepublicBelarus

SloveniaRussian

ChinaAzerbaijan

UkraineTurkmenistan

UzbekistanHungaryTajikistanRomaniaVietnam

LithuaniaAlbania

LatviaCambodia

GeorgiaEstonia

Czech RepublicSlovak Republic

ArmeniaMoldova

KazakhstanBulgaria

World average

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

0 5 10 15

BelarusSloveniaUkraineRussian

AzerbaijanRomaniaLithuania

AlbaniaCambodia

VietnamGeorgia

ChinaKyrgyz Republic

HungaryLatvia

ArmeniaKazakhstan

BulgariaCzech Republic

MoldovaEstonia

Slovak Republic

World average

Sectoral Distribution of Net Sectoral Distribution of Net Capital Flows to Developing Capital Flows to Developing CountriesCountries

0

10

20

30

40

50

60

70

80

1978-81 1982-89 1990-95 1996-01

Per

cent

of T

otal

Cap

ital F

low

s

Private sector flows Public sector flows

1978-81 1982-89 1990-95 1996-01

Perc

en

t of

tota

l cap

ital fl

ow

s

Net Private Capital Net Private Capital Flows to Developing Flows to Developing CountriesCountries

-100

-50

0

50

100

150

1994 1995 1996 1997 1998 1999 2000 2001 2002

Bill

ion

s o

f US

Do

llars

Direct Investment Portfolio Investment Other private flows

1994 1995 1996 1997 1998 1999 2000 2001 2002

Billion

s o

f U

S d

ollars

Net Private Capital Net Private Capital Flows to Flows to TransitionTransition EconomiesEconomies

-25

-15

-5

5

15

25

35

1994 1995 1996 1997 1998 1999 2000 2001 2002

Bill

ion

s o

f US

Do

llars

Direct investment Portfolio investment Other

1994 1995 1996 1997 1998 1999 2000 2001 2002

Billion

s o

f U

S d

ollars

Figure. Reversals in Net Private Capital Flows

0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0

Argentina 1982-83

Indonesia 1984-85

Malaysia 1986-89

Argentina 1988-89

Venezuela 1992-94

Turkey 1993-94

Venezuela 1987-90

Thailand 1996-97

Mexico 1981-83

Korea 1996-97

Mexico 1993-95

Billions of US$Source : IMF, World Economic Outlook data base.

9% of GDP

18% of GDP

15% of GDP

12% of GDP

11% of GDP

6% of GDP

10% of GDP

7% of GDP

10% of GDP

5% of GDP

4% of GDP

Mexico 1993-95

Korea 1996-97

Mexico 1981-83

Thailand 1996-97

Venezuela 1987-90

Turkey 1993-94

Venezuela 1992-94

Argentina 1988-89

Malaysia 1986-89

Indonesia 1984-85

Argentina 1982-83

Reversals in Net Private Reversals in Net Private Capital Flows to Capital Flows to EmergingEmerging EconomiesEconomies

Billions of US dollars

10 20 30 40 50 60

Reversals of capital flows

Slowdown in growth

Insufficient reserves

Level and composition of debt

Weak banks Contagion

Openness to Openness to FDIFDI and Growth 1965-98and Growth 1965-98

-8

-6

-4

-2

0

2

4

6

-4 -2 0 2 4 6 8

Actual less predicted FDI 1975-1998 (% of GDP, ppp)

An

nu

al g

row

th o

f G

NP

per

cap

ita

1965

-98,

ad

just

ed f

or

init

ial

inco

me

(%)

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 = 0.62

85 countries

r = rank r = rank correlatiocorrelatio

nn

Openness to Trade and Growth 1965-98

-8

-6

-4

-2

0

2

4

6

-40 -30 -20 -10 0 10 20 30 40

Actual less predicted exports 1965-98 (% of GDP)

An

nu

al

gro

wth

of

GN

P p

er

cap

ita

196

5-98

, a

dju

ste

d f

or

init

ial

inco

me

(%

)

Malaysia

Korea

Guinea Bissau

Belgium

87 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 1965-9882

countries

-8

-6

-4

-2

0

2

4

6

0 10 20 30 40

Import duties (% of imports 1970-98)

An

nu

al g

row

th o

f G

NP

pe

r c

ap

ita

19

65

-98

, ad

jus

ted

fo

r in

itia

l in

co

me

(%

)

An increase in tariffs by 10% of imports is associated with a decrease in per capita growth by 1% per year.

r = -0.52

India

Cote d'Ivoire

Botswana

Pitfalls: Incomplete Pitfalls: Incomplete InformationInformation Capital account liberalization, if Capital account liberalization, if

well managed, stimulates saving well managed, stimulates saving and investment, efficiency, and and investment, efficiency, and economic growtheconomic growth

But information may be But information may be asymmetricasymmetricAdverse selectionAdverse selectionMoral hazardMoral hazardHerdingHerding

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Capital Account Capital Account LiberalizationLiberalization

The EndThe End Needs to be orderly, gradual, well-Needs to be orderly, gradual, well-

sequencedsequenced Effective prudential regulationEffective prudential regulation

To encourage banks to recognize risksTo encourage banks to recognize risksTo enable authorities to monitor threats to To enable authorities to monitor threats to

stability of the financial system stability of the financial system Sound macroeconomic policiesSound macroeconomic policies SequencingSequencing

Put bank supervision and sound policies in Put bank supervision and sound policies in place first, then liberalizeplace first, then liberalize

These slides will be posted on my website: www.hi.is/~gylfason

international capital flows: issues in transition economies thorvaldur gylfason

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