International Investment Patterns

Philip R. LaneWBI Seminar, Paris, April 2006

Introduction

• What determines aggregate capital inflows and outflows?• What determines bilateral patterns in international investment?• Role of Institutions and Policies― Lessons from recent literature― Case study: China and India― Case study: Central and Eastern Europe (CEE)― Challenges for macroeconomic policy; the adjustment process

Level of International Financial Integration

• Increasing in income per capita• Increasing in trade openness - complementarity• Increasing in domestic financial development• Increasing in external account liberalization

Panel Analysis of financial integration, 1982-2001

(Dep. Var.: change in financial integration)

(1) (2) (3) (4) (5)

0.17 0.03 0.02 -0.01 -0.01 External

Liberalization (3.69)*** (.5) (.36) (.5) (.2) Trade openness 2.35 2.96 1.10 1.53 (3.62)*** (4.88)*** (3.37)*** (4.58)***

2.15 0.99 1.56 Log GDP per capita (2.74)*** (3.65)*** (5.06)***

0.92 0.93 Stock market capitalization (18.3)*** (17.4)***

Adjusted R2 0.12 0.31 0.41 0.89 0.9 Number of obs. 72 72 72 66 59

Net Creditors versus Net Debtors

• Level of income per capita• Demographic factors• Level of public debt

Institutions

Good institutions lead to:• Greater financial integration• Greater ability to attract capital inflows• Improved ‘quality’ of inflows – more portfolio equity, more FDI,

more bonds• Improved ‘quality’ of outflows – less capital flight; lower need to

hold reserves• Lower spreads• Institutional mix: general versus financial

Bilateral Investment Patterns

• What explains why country A invests in country B?• Country A’s propensity to invest overseas• Country B’s general attractiveness as a destination• Bilateral linkages between A and B― Important for ‘investor base’― Important for transmission of shocks― Important for risk analysis― Important for asset pricing and return comovements

Bilateral Linkages

• Optimal diversification has a bilateral dimension― Trade risk― GDP / return risk• Information frictions― Gravity variables (Distance, Language, Colonial Ties … )― Also Trade volume• Bilateral trading costs― Bilateral exchange rate stability, language, common institutional

framework etc

Main Findings

• Asset holdings significantly correlated with trade linkages• Distance also matters (more so for FDI, banks than portfolio

flows)• Institutional similarity• Asset holdings less influenced by ‘return hedging’ factors• Strong impact of currency union (EMU) – on equity; portfolio

debt• More generally, ‘regional’ policies matter

The International Financial Integration of China and India

Introduction

• Goal: quantitative profile of the IFI of China and India• Current situation; future evolution• Volume-based approach: EWN II; CPIS; BIS; national sources• Net positions• Gross holdings of foreign assets and liabilities• External capital structure• Geographical distribution• Currency composition

Outline

• The International Balance Sheets of China and India: A Profile• The Future Evolution of Capital Flows• Macroeconomic Policy and International Financial Integration• Conclusions

-35

-30

-25

-20

-15

-10

-5

0

5

10

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

ChinaIndia

Net Foreign Asset Positions

XS of NFA Positions

R O M

PO L

BIH

M KD

SVN

H R V

LT U

H U N

LVA

EST

SVK C ZEU ZB

U KR

T KMC H N

T JK

R U S

M D A

BG R

KG Z

KAZ

G EO

ALB BLR

AZE

AR M

PN G

ZM B

BFA

U G A

T U N

T G O

T ZA

SW Z

SD N

N AM

SEN

R W A

N G A

M O Z

M AR

M U S

M LI

M D G

KEN

C IVG IN

G H A

G AB

E T H

T C D

C M R

BW A

AG O

D ZA

VN M

T H A

PH L

PAK

N PL

M YS

LAO

KO R

ID N

IN D

LKA

KH M

BG D

YEM

EG Y

SYR

SAU

LBN

JO R ISR

IR N

T T OJAM

VEN

U R Y

PER

PR Y

PAN

N IC

M EXH N D

G T M

SLV

EC U

D O M

C R I

C O L C H L

BR A

BO L

AR G

ZAF

T U R

-150

-100

-50

0

50

100

6.00 6.50 7.00 7.50 8.00 8.50 9.00 9.50 10.00 10.50 11.00

G D P per cap ita , PPP

NFA

to G

DP

World’s Largest Creditors and Debtors

Country NFA/GDPW NFA/GDPW

Japan 4.34 India -0.18Switzerland 1.25 Argentina -0.18Taiwan 1.06 New Zealand -0.22Hong Kong 1.05 Hungary -0.24United Arab Emirates 0.54 Portugal -0.28Germany 0.54 Indonesia -0.29Singapore 0.46 Canada -0.30Norway 0.40 Poland -0.32Saudi Arabia 0.39 Turkey -0.33China 0.32 Greece -0.37Kuwait 0.31 United Kingdom -0.67France 0.27 Mexico -0.71Belgium 0.27 Brazil -0.72Libya 0.16 Italy -0.75Qatar 0.15 Australia -0.96Iran, Islamic Republic o 0.12 Spain -1.19Luxembourg 0.09 United States -6.49

IFI/GDP

0 .0 0

2 0 .0 0

4 0 .0 0

6 0 .0 0

8 0 .0 0

1 0 0 .0 0

1 2 0 .0 0

1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4

C h in aIn d ia

XS of IFI/GDP

RO M

PO L

BIH

M KD

SVN

HRV

LTU

HUNLVA

EST

SVK CZE

UZBUKR

TKM

CHN

TJK

RUSM DA

BG RKG Z KAZ

G EO

ALB

BLR

AZE

ARM

PNGZM B

BFA

UG A

TUNTG O

TZASW Z

SDN

NAM

SEN

RW ANG A

M O ZM AR

M US

M LI

M DG

KEN

CIV

G IN

G HA

G AB

ETH

TCD

CM R

BW A

AG O

DZAVNM

THA

PHL

PAKNPL

M YS

LAO

KO RIDN

IND

LKA

KHM

BG D

YEM EG Y

SYR

SAU

LBN

JO R

ISR

IRN

TTO

JAM

VEN

URY

PERPRY

PAN

NIC

M EX

HND

G TM

SLV

ECU DO M

CRICO L

CHL

BRA

BO L

ARG

ZAF

TUR

0

50

100

150

200

250

300

350

400

6.00 6.50 7.00 7.50 8.00 8.50 9.00 9.50 10.00 10.50 11.00

G DP per capita, PPP

IFI t

o G

DP

XS: Foreign Assets / GDP

T U R

Z A F

A R G

B O L

B R A

C H L

C O L

C R I

D O M

E C U

S L V

G T M

H N D

M E X

N IC

P A N

P R Y

P E R

U R Y

V E N

J A M

T T OC Y P

IR N

IS R

J O R

L B NS A U

S Y R

E G Y

Y E M

B G D

K H MH K G IN D

ID N

K O R

L A O

M Y S

N P L

P A KS G P

T H A

V N M

D Z A

A G O

B W AC M R

B E N

E T H

G A B

G H A

G IN

C IV

K E N M D G

M L IM U S

M A R

M O Z

N G A R W A

S E N

N A M

S D N

S W Z T Z A

T G O

T U N

U G AB F A

Z M B

P N G

A R M

A Z E

B L R

A L B

G E OK A Z

K G Z

B G R

M D A

R U S

T J K

C H NT K M

U K R

U Z BC Z E

S V K

E S T

L V A

H U N

L T UH R V

S V N

M K D

B IHP O L

0

2 0

4 0

6 0

8 0

1 0 0

1 2 0

1 4 0

1 6 0

1 8 0

6 .0 0 6 .5 0 7 .0 0 7 .5 0 8 .0 0 8 .5 0 9 .0 0 9 .5 0 1 0 .0 0 1 0 .5 0

G D P p e r c a p ita , P P P

Fore

ign

asse

ts to

GD

P

XS: Official Reserves / GDP

P O L

B IH

M K D

S V N

H R VL T U

H U N L V AE S T

S V K

C Z E

U Z B

U K R

T K M

C H N

T J K

R U S

M D AB G R

K G Z

K A Z

G E O

A L B

B L R

A Z E

A R M

P N GZ M B

B F A

U G A

T U N

T G OT Z A

S W Z

S D N

N A M S E N

R W AN G A

M O Z

M A R

M U S

M L I

M D G

K E NC IV

G IN

G H A

G A B

E T H

B E N

C O G

T C DC M RB W A

A G O

D Z A

V N M

T H A

S G P

P A K

N P L

M Y S

L A O

K O R

ID N

IN D

H K G

K H M

B G D

Y E M

E G Y

S Y RS A U

L B N

J O R

IS R

IR NC Y P T T O

J A M

V E N

U R Y

P E RP R Y

P A N

N IC

M E X

H N D

G T M S L V

E C U D O M

C R I

C O L

C H L

B R AB O L

A R G

Z A F

T U R

0

1 0

2 0

3 0

4 0

5 0

6 0

6 .0 0 6 .5 0 7 .0 0 7 .5 0 8 .0 0 8 .5 0 9 .0 0 9 .5 0 1 0 .0 0 1 0 .5 0 1 1 .0 0

G D P p e r c a p ita , P P P

Res

erve

s

Global Distribution of Official Reserves

Country

Share in Global

ReservesJapan 21.50China 15.84Taiwan 5.91Euro Area 5.41Korea 5.13India 3.26Hong Kong 3.19Russia 3.11Singapore 2.89United States 1.96Malaysia 1.71Mexico 1.65Switzerland 1.43Brazil 1.36Thailand 1.25

Share in Global Equity Liabilities

0 .0 0

0 .5 0

1 .0 0

1 .5 0

2 .0 0

2 .5 0

3 .0 0

3 .5 0

4 .0 0

4 .5 0

5 .0 0

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

F D I L ia b S h a re C h in aF D I L ia b S h a re In d iaP o r t E q L ia b S h a re C h inP o r t E q L ia b S h a re In d ia

Share in Global Debt Liabilities

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Debt Liab ChinaDebt Liab India

China: Net Equity and Net Debt

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

China NETEQChina NETDE

India: Net Equity and Net Debt

-35.0

-30.0

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

5.0

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

India NETIndia NET

Debt Shares in Foreign Assets and Liabilities

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

China D_SH_AChina D_SH_LIndia D_SH_AIndia D_SH_L

FDI Share in Foreign Equity Assets and Liabilities

30

40

50

60

70

80

90

100

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

China FDI_EQ_FA China FDI_EQ_FLIndia FDI_EQ_FAIndia FDI_EQ_FL

China’s FDI Liabilities

Share

World 100Hong Kong SAR 45United States 8.9Japan 8.7Taiwan POC 7.4British Virgin Islands 6.9Korea 4.8Singapore 4.8United Kingdom 2.3Germany 1.8France 1.3Other 8.2

India’s FDI liabilities

Share

Mauritius 35.6United States 16.5Japan 6.9Netherlands 6.9UK 6.6Germany 4.4Singapore 3.1France 2.7Korea 2.2Switzerland 2Other 13.2

Total 100

Sources of Portfolio Investment

China IndiaEquity Debt Equity Debt

World 100 100 World 100 100United States 28.6 16.3 United States 41.2 13.4EU15 24.7 20.4 EU15 24.1 22.8Japan 4.6 10.3 Japan 0.2 11.9Singapore 3.9 10.3 Singapore 0.4 16.6Hong Kong SAR 34.3 36.7 Mauritius 31.5 27.8ROW 4 5.9 ROW 2.6 7.6

Pattterns in BIS Banking Data

China IndiaInward Outward Inward Outward

Europe 7.1 14.1 30.8 36.3UK 22.5 14.4 63 35.6Japan 7.4 13.9 1.3 8.4US 0 0.1 0.1 0.1Hong Kong SAR 63.1 57.5 4.9 19.6Total 100 100 100 100

China: Bilateral Regressions

FDI Portfolio Portfolio BankEquity Debt Liabilities

Size 1.15 1.02 0.42 0.01(7.0)*** (3.68)*** (2.31)** (.54)

Trade 8.15 3.74 -8.25 0.77(2.59)** (.62) (1.96)* (1.88)*

Distance -1.3 -1.06 -3.69 -0.05(1.93)* (1.04) (4.69)** (.47)

ERVOL -0.02 -1.06 -1.31 -0.012(.17) (4.3)*** (6.94)*** (.78)

Adj R2 0.77 0.5 0.75 0.84

N 25 37 26 15

India: Bilateral Regressions

FDI Portfolio Portfolio BankEquity Debt Liabilities

Size 1.64 1.04 0.11 0.02(6.22)*** (3.0)*** (.37) (.48)

Trade 3.9 1.05 0.84 -0.013(2.7)** (1.7) (1.01) (.15)

Distance -3.8 1.86 0.63 -0.09(1.15) (1.05) (.18) (.33)

ERVOL -0.94 -1.15 -0.35 -0.05(.61) (3.27)*** (.32) (.51)

Adj R2 0.76 0.38 0.25 0.07

N 15 30 16 15

Currency Composition of Debt Liabilities

China India

Dollar 89.9 71.8Euro 1.9 10.1Yen 6.9 0.6Sterling 1.2 17.3Swiss Franc 0.1 0.2

The Future Evolution of Capital Flows

• Depends on domestic financial reforms• Depends on world market conditions• NFA• Level of IFI• External Capital Structure• Bilateral Patterns• Currency Composition

China and India: Projected GDP relative to G-7

0.00

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

90.00

2005

2007

2009

2011

2013

2015

2017

2019

2021

2023

2025

2027

2029

2031

2033

2035

2037

2039

2041

2043

2045

2047

2049

ChinaIndia

Macroeconomic Policy

• Exchange Rate Regime• Banking Reform• Transformation of reserves• Increase in macroeconomic volatility• Valuation Channel

Capital flows to Emerging Europe

Objective

• Put trends in external capital flows and their composition in perspective (compare CEE with EU15, other emerging mkts)

• Provide simple calculations on ‘sustainable’ future capital flows• Draw implications for future trade surpluses

Road map

• Capital flows and external position: stylized facts (1995-2004)• Bilateral exposure• Implications for medium-term factor flows

Capital flows 1995-2004

• Large! – Initial liabilities very small (except Bul, Hun, Pol)– Strong growth prospects– Obsolete capital

External liabilities in 1994 were small...

Net external position in 1994 (percent of GDP)

Kazakhstan

Syria

MoroccoEgypt

Swaziland

Ecuador

Iran

Bulgaria

Paraguay

Guatemala

Algeria

Macedonia

Tunisia

Romania

Jordan

Russia

Dominican Rep.

Namibia

Peru

Thailand

FijiEl Salvador

Colombia

Latvia

Lithuania

Turkey

Estonia

South Africa

Mauritius

Slovak Republic

Jamaica

Poland

Malaysia

Brazil

Panama

Lebanon

Costa Rica

Hungary

Gabon

Chile

Czech Republic

Trinidad and Tobago

Venezuela, Rep. Bol.

Mexico

UruguayArgentina

Slovenia

-120

-100

-80

-60

-40

-20

0

20

1000 2000 3000 4000 5000 6000 7000 8000

GDP per capita

NFA

/GD

P

...but MUCH larger at end-2004

Net external position (pct of GDP), 2004

Slovenia

Portugal

Oman

Trinidad and Tobago

Argentina

Czech Republic

Mexico

Uruguay

Chile

HungaryEstonia

Poland

Croatia

Venezuela, Rep. Bol.

Costa Rica

Latvia

Slovak RepublicLithuania

Panama

Lebanon

Mauritius

Malaysia

GabonBrazil

South Africa

Turkey

Jamaica

Dominican Republic

Thailand

Tunisia

Russia

Peru

El Salvador

RomaniaColombia

Algeria

Bulgaria

Jordan

Kazakhstan

Iran

Macedonia

GuatemalaEgyptBelarus

Albania

Ecuador

Paraguay

-120

-100

-80

-60

-40

-20

0

20

1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 11000

GDP per capita

NFA

/GD

P

International financial integration is increasing...

CEE countries

EU 15

Other emerging markets

0

50

100

150

200

250

300

350

400

450

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

...with equity liabilities playing a more important role....

CEE countries

EU 15

Other em. mkts

10

15

20

25

30

35

40

45

50

55

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

...and particularly so FDI....

CEE countries

EU 15

Other em. mkts

10

15

20

25

30

35

40

45

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Reserves play an important role among external assets,

more so than elsewhere

CEE countriesFX share

Equity share

0

10

20

30

40

50

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

EU 15

FX share

Equity share

0

10

20

30

40

50

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Other emerging and developing economies

FX share

Equity share

0

10

20

30

40

50

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

In most CEE countries net equity liabilities are larger than net debt

Bulgaria

Czech Republic

Slovak Republic

Estonia

Latvia

Hungary

Lithuania

Croatia

Slovenia

Poland

Romania

-40

-30

-20

-10

0

10

20

30

-100 -90 -80 -70 -60 -50 -40 -30 -20 -10 0

net equity (pct of GDP)

net d

ebt (

pct o

f GD

P)

Returns on external liabilities

• Returns on FDI are linked to economic performance (high when the economy does well, low otherwise)

• This implies better risk-sharing relative to foreign-currency debt...

• ...and can help productivity growth...• ...but the price is a higher cost

Financial integration with the EU is particularly strong

Sources of FDI (2002)

EMU UK US DEN SWE SWI. CEEC

Bulgaria 87.0 5.3 5.7 1.0 1.0Croatia 81.4 1.8 1.1 2.7 13.0Czech Republic 82.3 5.3 4.3 1.0 1.9 4.4 0.9Estonia 47.4 0.7 1.5 3.4 46.1 0.8Hungary 79.2 7.3 8.1 0.7 2.3 1.5 1.0Latvia 25.7 1.1 -0.6 15.7 44.6 13.5Lithuania 23.5 0.5 2.8 34.7 24.5 14.0Poland 73.1 7.4 9.3 2.9 3.8 3.1 0.3Romania 89.4 1.3 7.7 0.4 1.1Slovakia 83.5 8.6 0.7 1.4 5.8Slovenia 95.5 1.6 0.0 3.0

Implications for future flows

• External liabilities cannot grow faster than GDP forever...• “Sustainable” flows imply a stable ratio of net external liabilities to

GDP....•• For example, with 8% nominal growth and liabilities of 50% of GDP,

the CA balance would be -4%( )SS SS

t tca g NFAπ≈ − +

Does this imply that large capital inflows can persist without any adjustment?

• Not quite. • As liabilities accumulate, investment income payments to

foreigners increase• To keep the CA from deteriorating, the trade balance

(broadly defined) must improve....• ...because servicing external debt and FDI is costly

...and the improvement must be large...

Trade balance

(average 2001-2004)

NFA-stabilizing

trade balance

Implied current account balance

(baseline)

Bulgaria -5.2 1.2 -3.9Czech Republic -1.3 1.3 -2.2Slovak Republic -3.6 1.3 -2.8Estonia -4.4 1.8 -8.4Latvia -8.1 0.8 -4.8Hungary -1.9 1.2 -6.3Lithuania -3.6 0.5 -3.4Poland -0.8 0.9 -3.4

What can countries do?

• Strengthen export growth (and hope for recovery in the euro area!)

• Contain budget deficits (that contribute to widening current account imbalances)

• Be prepared for leaner times on global capital markets

Upside and downside risks

• Credible policies and integration with EU can lower spreads, implying more favorable debt dynamics...

• But there is limited scope for exchange rate correction to ease the trade balance adjustment, at least with current exchange rate regimes