Timothy Boobier Grazia Manisera Steffy Ndjotong

Timothy Boobier
Grazia Manisera
Steffy Ndjotong
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
Increasingly over recent decades, especially
since the recent global economic crisis, the
neoclassical economic framework has been
questioned.
One particularly controversial aspect of it is
the notion that capital should flow from
richer to poorer countries, yet there is
extensive theoretical and empirical literature
that question this notion.

We will cover:
◦ The neoclassical growth model in question.
◦ The observed structure and evolution of global capital
flows over recent decades.
◦ The Lucas Paradox and possible explanations:
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Poor Institutional Quality
Human Capital Differentials
Insufficient Public Infrastructure
Financial Sector Underdevelopment
Credit Risk and Serial Default
Home Bias
Role of Central Banks
◦ The relevant policy issues.

The standard neoclassical production
function is a Cobb-Douglas function:
◦ Constant returns to scale.
◦ Diminishing returns to each factor.
◦ The factors here are capital (K) and labour (N),
where A is the labour-augmenting level of
technology:
Y K

 AN 
1

Given constant returns and assuming homogenous labour and
capital inputs and technology level, we can divide through by AN
to give:


Y
 K 
 
AN  AN 
or
Y K

So if income per effective worker is not equal across countries, this
must be due to different levels of capital per effective worker.
Given diminishing returns to each factor, if the capital stock differs
across countries then those countries with lower capital stocks will
offer higher marginal productivity of capital.

The marginal product of capital (r) is given
by: the derivative of the production function
with the respect to capital so,
K
1
 1
r
  K  AN 
Y
 
1

K  AN  
K


K
Y


Lucas (1990) compares Indian and US MPKs:
◦ Letting 𝛼 = 0.4 (an average of US and Indian capital
shares), the formula implies that the MPK in India is 58
times that of the US.
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In the model, capital is assumed to be perfectly
mobile and flows to where the rate of return to
their investments would be highest.
So given return differentials of this magnitude,
capital would flow rapidly from the US and other
wealthy countries to India and other poor
countries.
Has this been the case?
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Below: Total equity inflows (= inflows of FDI + portfolio
equity investment, whereas ‘total’ includes debt as well)
were much higher to rich countries relative to poor
countries, and this is while equity inflows made up a larger
proportion of total inflows for poor countries as well.
Contradicting the neoclassical model, this is a stark
demonstration of the Lucas Paradox, after Robert Lucas.
The upward
trend here is to
do with
liberalisation,
technological
advances in
communications
and transport,
and other
globalising
forces.
IMF data from
1970-2000
interpreted by
Alfaro et al
(2005)
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A more up-to-date version below, using World Bank data:
This is split by income grouping of countries, and first we look at Portfolio Equity
Inflows:
Portfolio equity, net inflows
1,000,000,000,000
800,000,000,000
Current US$
600,000,000,000
Low income
400,000,000,000
High income
Middle income
200,000,000,000
0
-200,000,000,000
(World dataBank:
World
Development
Indicators & Global
Development
Finance, accessed
20/11/2012)
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And for Foreign Direct Investment net inflows:
Foreign direct investment, net inflows
2,000,000,000,000
1,800,000,000,000
1,600,000,000,000
1,400,000,000,000
Current US$
1,200,000,000,000
1,000,000,000,000
800,000,000,000
Low income
High income
Middle income
600,000,000,000
400,000,000,000
200,000,000,000
0
-200,000,000,000
(World dataBank:
World
Development
Indicators & Global
Development
Finance, accessed
20/11/2012)

The explanations for the Lucas Paradox are
generally grouped into two categories:
◦ Differences in fundamentals that affect the
production structure of the economy. – differences
in human capital stock, institutional quality and
infrastructure.
◦ International capital market imperfections, mainly
sovereign risk and asymmetric information. Capital
does not to flow to high returns because of market
failures.
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Alfaro, Kalemli-Ozcan and Volosovych (2005)
(AKV): differences in institutional quality
between richer and poorer countries explain
the Lucas Paradox.
Institutions are ‘the rules of the game in
society’: ‘they consist of both informal
constraints (traditions, customs) and formal
rules (regulations, laws and constitutions).
They create the incentive structure of an
economy.’

Institutional quality proxied by the International
Country Risk Guide’s (ICRG) political safety
variables:
◦ Composite index made from sum of indices of e.g.
government stability, no-corruption, law and order,
bureaucratic quality, etc.

The relationship between this and capital inflows
is significant:
◦ Institutional quality is shown to be an important
determinant of capital inflows, especially those indices
that are closer to proxies of property rights protection,
such as the no-corruption index and protection from
expropriation.
◦ This is explained through
their effect on investment
decisions:
 Property rights of
entrepreneurs which protect
against expropriation of
profits or against blocking of
adoption of new
technologies by elites, thus
encourage innovation and
investment.

Risk of endogeneity:
◦ Reverse causality
◦ Selection bias

So instrument it with Acemoglu, Johnson and
Robinson’s (2000,2001) (AJR) historical settler
mortality variables:
◦ If European settlement was discouraged by diseases then
the Europeans set up worse institutions.

AKV also investigate historical legal origins:
◦ Which coloniser’s legal codes and organisations were
instituted in the country in question.
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IV regression:
Yi    1InstitutionalQuality  2 HumanCapital  3 AI   British  
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Dependent variable: Inflows of Total Equity per capita.
Institutional Quality instrumented by settler mortality.
Controls for human capital, international capital market
imperfections (asymmetric information).
Dummy for British legal origins (French as default).
Successful - institutional quality has a causal effect on
attracting capital inflows (β1 significant at 1% level).
Legal origins also matter – French in a negative direction
and British in a positive direction (γ significant at 10%
level).
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AJR’s methodology flawed?
Glaeser, La Porta, Lopez-de-Silanes and
Shleifer (2004) (GLLS) reject their instrument,
saying that the disease environment still
affects economic variables today. This implies
that endogeneity bias is still likely.
So it is possible that institutional
improvement is stimulated by the capital
inflows, not the other way around.
Thought-provoking yet inconclusive.
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Lucas himself argued that differences in the
human capital stock explained the capital
flow patterns.
◦ Even after correcting for capital per effective worker
rather than per worker (inclusion of the variable A),
there is still a factor of 5 difference in rates of
return between rich and poor countries.

So augment the production function!
◦ Include human capital (H) – the skill levels,
knowledge, creativity and so on of the workforce.

It takes a variation of the form:

Y K H



 AN 
1  
such that in per effective worker terms it is roughly,

Y K H

Eliminates the return differential on physical capital, which
works well in a cross-country comparison. This could
therefore be said to explain the paradox.
◦ However, based on assumption that the external benefits of
human capital accrue entirely to producers within that country
◦ And there are no, for example, knowledge spillovers between
countries.
◦ This assumption is arguably too strong.
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Manzocchi and Martin (1996) (MM):
◦ Find that an ‘augmented-Solow’ model’s prediction
on capital flows are consistent with the evidence on
net capital flows to developing countries from
1960-82.
◦ After 1982, however this breaks down, likely due
to:
 Outbreak of the 1980s Debt Crisis
 Widespread occurrence of foreign debt repudiation by
developing countries.
◦ BUT paper is now dated:
◦ Evolution of financial markets, complexity and
volatility => there is more to it.

Causa and Soto (2006) (CS):
◦ Different methodology => ‘Anti-Lucas Paradox’!
◦ They take account of Balassa-Samuelson Effect:
 Lower productivity in developing country tradable sectors
translates into price levels below the world price level, rather
than using PPP data for calculating Total Factor Productivity
and Capital-Output Ratios.
 PPP prices overestimate the market value of the productivity
of physical capital in poorer countries. When accounted for,
the Lucas Paradox disappears!
 When extended to only manufacturing, the capital-output
ratio is actually higher in the poorest countries: the paradox
is reversed, hence the ‘Anti-Lucas Paradox’!

Due to insufficient physical infrastructure in
the country.
◦ Foreign investment must develop its own:
◦ Infrastructure undercapitalisation is thus associated
with manufacturing sector overcapitalisation!

At odds with lots of the rest of the relevant
literature.
◦ CS find that poor institutional quality contributes to
the Anti-Lucas Paradox: bad institutions decrease
the provision of productive infrastructure capital.
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Even if MPK is equalised in CS’s framework, it is
intuitively not for the reason that investors follow
only returns:
◦ Default risk matters, as well as risk entailed by imperfect
information.
◦ No perfect capital mobility
◦ Often a lack of transparency, more so in developing
countries.
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So to understand international capital flows, financial
sectors should be considered at least as much as the
real economy.
Regardless of the Balassa-Samuelson Effect, in
absolute terms, capital flows ‘uphill’ and developing
countries finance developed countries.
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Prasad, Rajan and Subramanian (2006) (PRS):
Weak absorption capacity of developing economy
financial sectors:
◦ Profitable investment opportunities may be constrained
by financial sector impediments and hence available
opportunities may be financed by domestic savings.
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No evidence that additional financing in excess
of domestic savings is the channel through which
financial integration delivers its benefits.
Savings is the driver of investment and there is
little reliance on foreign capital for fast growth.
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At industry-level, capital inflows bring:
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Depends on:
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◦ A source of competition that pushes down capital costs
◦ Know-how such as credit evaluation skills
◦ May press for more transparency and better governance
◦ Financial dependence of the industry in question
◦ Level of financial development of the economy.
PRS find clear benefits from financial integration
for financially-dependent industries when a
country’s financial system is above median levels
of development but at lower levels of
development, these industries do not grow faster
and may even grow slower!
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This can be linked to Rajan’s analysis of the Asian Crisis of 1997
in Fault Lines. E.g. South Korea, development largely financed by
corporate debt and loans from overleveraged state-owned
banks.
◦ Due to the lack of financial development and the lack of transparency with
regards to balance sheets, foreign investors kept their credit in foreign
currency (currency mismatch) and with short-term maturity (maturity
mismatch).
◦ When the crisis hit, investors did not roll-over the short-term debt, which
also rocketed in value relative to the domestic currency, and the
consequent economic crisis and restructuring was much more severe.
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Thus PRS’ analysis clearly indicates that the effect of capital flows
depends on the structure of the economy in question, meaning
the main industries and the principal financing methods.
These of course in turn affect the attractiveness of the economy
to foreign capital and of course government policies towards
inflows, to be discussed later.
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Reinhart and Rogoff (2004) (RR):
◦ When the odds of non-repayment for some lowincome countries are as high as 65%, credit risk
seems a much more suitable explanation for capital
not flowing downhill.
◦ They describe some developing countries as ‘debt
intolerant’ ‘serial defaulters’ – where default
exacerbates weak political institutions, laying the
seeds for further defaults down the road.
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Above, we see how it is the poorest countries which are in
default most, despite having much lower debt levels than richer
countries! So this seems a relatively simple and intuitive
explanation – investors are looking after their money!
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We can summarise this as the notion of ‘Home Bias’.
Feldstein and Horioka (1980): strong correlation
between domestic savings and domestic investment.
Suggest that investment patterns are explained by:
◦
◦
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Risk aversion
Portfolio considerations
Imperfect information and
Institutional rigidities.
FDI is more often to do with:
◦ Implementing market strategies
◦ Exploiting production knowledge, or
◦ Overcoming trade restrictions.
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More to do with long-term flows.
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But not all flows are private capital!
The ‘Revived Bretton Woods System’ Dooley,
Landau and Garber (2004):
◦ US current account deficits are financed through Asian
governments purchasing dollar-denominated foreign
assets as part of a foreign exchange reserves
management strategy to maintain their exchange rate
pegs, so as to maintain competitive exports (and to
avoid repeat of 1997).
◦ Chinese undervaluation of the renminbi is a case in
point.
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So short-term capital flows uphill because of
policy too!
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Differing policy objectives among countries.
Gaining development finance…
BUT what if the money dries up?
Policy must also avoid excessive volatility of
capital flows and instability in financial
markets.
And what about exchange rate regime?
◦ Undervaluation - Revived Bretton Woods
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Volatility arguably linked to the unprecedented globalisation and
liberalisation of the securities market in the 1990s
Exacerbating the already huge increase in developing country
‘Twin Crises’ (financial and exchange crises)
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1980s Debt Crises
Mexican Tequila Crisis 1994
East Asian Crisis 1997
Default of Argentina 2002.
Thus policy should balance the need for foreign capital with
macroeconomic stability, while maintaining institutional
specificity, to the country’s development strategy:
The appropriate extent of financial openness can depend on the
extent of dependence on external finance for its industries, as
well as for other industries that may emerge, while not
compromising stability.
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Potential upgrading of the economy
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Discipline:
◦ In the technical, technological, knowledge and organisational sense
◦ Encouraging financial development
◦ Incentive for maintaining competitiveness and for strengthening of
institutions
◦ BUT there can also be a ‘race to the bottom’:
 Labour and environmental regulations, excessive liberalisation.
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The appropriate extent of financial openness is thus determined
by:
◦ Industrial structure of the economy
◦ Intended extent of exchange rate management
◦ BUT also the subjective favoured development path.

India and China for example interfere extensively in financial
markets and have heavy capital controls.
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Consensus appears to be increasingly that:
◦ Long-term capital flows are good for development
and growth when subject to appropriate regulatory
frameworks
◦ But that short-term capital flows can be excessively
volatile and should therefore be controlled.
 First pushed by economists such as Joseph Stiglitz and
Dani Rodrik who criticised capital account openness
for developing countries, for the consequent
heightened risk of crisis.
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Current crisis brought much mainstream
economic thought into question.
◦ Now less forceful advocacy of financial integration in
policy-making circles
◦ More thoughtful analysis of capital markets.

The IMF in 2010 finally accepted the use of
controls on capital inflows as legitimate practice
to prevent exchange rate overshooting and asset
price bubbles.
◦ Chile and Colombia successes in tilting the composition
of inflows toward less vulnerable liability structures
◦ Still relatively quiet on outflows: Malaysia in 1997 as
success example.
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This diagram
represents the IMF’s
recommended policy
decision process with
regards to capital
controls, largely as a
last resort.
Pro-financial integration.
 Wary of risk management.
 Recognition of institutional specificity for
different countries.
 Controls still as a last resort (despite
being used by most G20 members in
some form).
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Regarding longer-term capital flows,
recommendations always context-specific.
No explanations of Lucas Paradox are conclusive.
But they suggest that to attract long-term capital:
◦ Public investment in human capital.
◦ Public investment in infrastructure: investment would be
more attractive without need for overcapitalisation.
◦ Strengthening of institutions
 Protection from expropriation and rule of law to encourage
entrepreneurship and technological development
 Decreasing corruption and improving bureaucratic quality to
facilitate investment processes.
◦ Establishing a good track-record of debt repayment.

These measures are beneficial for
development in general – still, current trends
indicate wide acceptance of FDI as beneficial
by governments.
◦ Most countries have continued to liberalize and
facilitate FDI, despite the crisis.
◦ Trends towards increasing regulatory measures
over foreign investment are highly context-specific.
◦ Nationalisation and expropriation measures were as
part of bailout/rescue packages
◦ Reassuring rather than especially worrying on the
whole.
UNCTAD (2010)
World Investment Report
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Regarding financial sector development:
Again specific to the country:
◦ A more developed financial sector can attract more
portfolio investment
◦ The more developed it is, the smaller the risk of
currency or maturity mismatch precipitating crises
◦ BUT the extent to which an economy should be
financialised (regarding household and corporate
debt, dependence on private pension funds or
savings and loan associations, and so on) is both
country-specific and arguably subjective.
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No; 6013, December.
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