Capital Flows to Developing Countries: The Allocation Puzzle

The textbook neoclassical growth model predicts that countries with faster productivity growth should invest more and attract more foreign capital. We show that the allocation of capital flows across developing countries is the opposite of this prediction: capital seems to flow more to countries that invest and grow less. We then introduce wedges into the neoclassical growth model and find that one needs a saving wedge in order to explain the correlation between growth and capital flows observed in the data. We conclude with a discussion of some possible avenues for research to resolve the contradiction between the model predictions and the data.Capital Flows, Productivity, Growth

Dealing with Volatile Capital Flows

The tools and mechanisms with which emerging-market countries insure themselves against volatile capital flows are in a state of flux. Most emerging-market countries had accumulated an unprecedented level of international reserves before the 2008 global financial crisis. The crisis itself led to a large increase in International Monetary Fund (IMF) resources and the introduction of a new lending facility, the Flexible Credit Line. Meanwhile, some progress was made toward transforming the Chiang Mai Initiative into an Asian Monetary Fund, and the Greek debt crisis even prompted calls for the creation of a European Monetary Fund. How have emerging-market countries dealt with capital flow volatility in the current crisis? What is the appropriate level of reserves for emerging-market countries? How can international crisis-lending and liquidity-provision arrangements be improved? What role can financial regulation and capital controls play in dealing with volatile capital flows? Olivier Jeanne discusses these and other important questions that are useful to keep in mind when thinking about the reform of international liquidity provision for emerging-market countries to deal with volatile capital flows. Jeanne concludes that the IMF and the international community should make more efforts to establish normative rules for the appropriate level of prudential reserves in emerging-market and developing countries and actively develop with its members a code of good practice for prudential capital controls.

Capital Flows to Developing Countries: the Allocation Puzzle

capital flows, emerging countries, Feldstein Horioka, neoclassical growth model, Lucas puzzle

Capital Flows to Developing Countries: The Allocation Puzzle

According to the consensus view in growth and development economics, cross country differences in per-capita income largely reflect differences in countries' total factor productivity. We argue that this view has powerful implications for patterns of capital flows: everything else equal, countries with faster productivity growth should invest more, and attract more foreign capital. We then show that the pattern of net capital flows across developing countries is not consistent with this prediction. If anything, capital seems to flow more to countries that invest and grow less. We argue that this result -- which we call the allocation puzzle -- constitutes an important challenge for economic research, and discuss some possible research avenues to solve the puzzle.

The Elusive Gains from International Financial Integration

Standard theoretical arguments tell us that countries with relatively little capital benefit from financial integration as foreign capital flows in and speeds up the process of convergence. We show in a calibrated neoclassical model that conventionally measured welfare gains from this type of convergence appear relatively limited for the typical emerging country. The welfare gain from switching from financial autarky to perfect capital mobility is roughly equivalent to a one percent permanent increase in domestic consumption for the typical emerging economy. This is negligible relative to the potential welfare gain of a take-off in domestic productivity of the magnitude observed in some of these countries.

A tractable model of precautionary reserves, net foreign assets, or sovereign wealth funds

We model the motives for residents of a country to hold foreign assets, including the precautionary motive that has been omitted from much previous literature as intractable. Our model captures many of the principal insights from the existing specialized literature on the precautionary motive, deriving a convenient formula for the economy’s target value of assets. The target is the level of assets that balances impatience, prudence, risk, intertemporal substitution, and the rate of return. We use the model to shed light on two topical questions: The “upstream” flows of capital from developing countries to advanced countries, and the long-run impact of resorbing global financial imbalance

Excessive Volatility in Capital Flows: A Pigouvian Taxation Approach

This paper analyzes prudential controls on capital flows to emerging markets from the perspective of a Pigouvian tax that addresses externalities associated with the deleveraging cycle. It presents a model in which restricting capital inflows during boom times reduces the potential outflows during busts. This mitigates the feedback effects of deleveraging episodes, when tightening financial constraints on borrowers and collapsing prices for collateral assets have mutually reinforcing effects. In our model, capital controls reduce macroeconomic volatility and increase standard measures of consumer welfare.capital flows, deleveraging episodes, emerging market economies, Pigouvian tax

The Mussa Theorem (and Other Results on IMF-Induced Moral Hazard)

Using a simple model of international lending, we show that as long as the IMF lends at an actuarially fair interest rate and debtor governments maximize the welfare of their taxpayers, any changes in policy effort, capital flows, or borrowing costs in response to IMF crisis lending are efficient. Thus, under these assumptions, the IMF cannot cause moral hazard, as argued by Michael Mussa (1999 and 2004). It follows that examining the effects of IMF lending on capital flows or borrowing costs is not a useful strategy to test for IMF-induced moral hazard. Instead, empirical research on moral hazard should focus on the assumptions of the Mussa theorem. Copyright 2005, International Monetary Fund

Managing Credit Booms and Busts: A Pigouvian Taxation Approach

We study a dynamic model in which the interaction between debt accumulation and asset prices magnifies credit booms and busts. We find that borrowers do not internalize these feedback effects and therefore suffer from excessively large booms and busts in both credit flows and asset prices. We show that a Pigouvian tax on borrowing may induce borrowers to internalize these externalities and increase welfare. We calibrate the model with reference to (1) the US small and medium-sized enterprise sector and (2) the household sector and find the optimal tax to be countercyclical in both cases, dropping to zero in busts and rising to approximately half a percentage point of the amount of debt outstanding during booms.boom-bust cycles, financial crises, systemic externalities, macroprudential regulation, precautionary savings