Financial Liberalization and Capital Flows: Facts Alberto Martin CREI, Universitat Pompeu Fabra and Barcelona GSE July 2014
The rise of nancial globalization Since the late 1970s Dramatic increase in nancial openness across countries De jure: lower legal and regulatory restrictions to capital ows Based on information from IMF s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) De facto: increase in capital ows, foreign assets and liabilities
The rise of nancial globalization Since the late 1970s Dramatic increase in nancial openness across countries De jure: lower legal and regulatory restrictions to capital ows De facto: increase in capital ows, foreign assets and liabilities
De facto measure of nancial openness Stocks: the value of assets held in a given year foreign assets held by domestics, domestic assets held by foreigners the di erence between the two is the country s net foreign asset position (NF A) important issue of valuation Flows: the value of assets traded for a given year in ows: net purchases of domestic assets by foreign investors (e.g., a loan by a foreign bank to a domestic rm) out ows: net purchases of foreign assets by domestic investors (e.g., a domestic household buying a bond issued by a foreign government) outflows t inflows t = NF A t
Source: Lane and Milesi Ferretti (2014)
In some sense, back to where we were... Financial globalization was strong at the end of the 19th century World capital markets were highly integrated Share of UK wealth invested abroad: 17% in 1870 and 33% in 1913 (larger than any country today). This wealth was mostly invested in natural resource-abundant, high growing regions UK composition of foreign assets: Canada + Australia (28%), US (15%), Latin America (24%) This process was interrupted during the world wars, and reversed after World War II
What are the consequences/expected gains of nancial globalization? Standard narrative predicts di erent types of bene ts from nancial globalization Improved allocation of capital Capital ows towards its more productive uses: capital-scarce, high-productivity countries Higher growth for receiving countries (and for world as a whole) Risk sharing Local risks can be diversi ed through the trade of assets Decreased volatility of consumption relative to output Other e ects Risk shifting Possibility of risk sharing makes it possible to adopt risky, high-return technologies Increased growth and volatility of output Miscellanea: market discipline on domestic policy makers, spillover e ects of FDI, etc...
A simple model to x ideas Small country: overlapping generations of size 1 Representative member of generation t maximizes: u (c t;t ) + E t [u (c t;t+1 )] with u() = ln() when young: supplies one unit of labor, earns wage w t, invests with productivity A to produce capital k t+1, k t+1 = A t i t consumes k t+1 c t;t = w t A when old: receives return to capital (full depreciation), consumes c t;t+1 = r t+1 k t+1
A simple model to x ideas Small country: overlapping generations of size 1 Representative member of generation t maximizes: u (c t;t ) + E t [u (c t;t+1 )] with u() = ln() when young: supplies one unit of labor, earns wage w t, invests with productivity A to produce capital k t+1, k t+1 = A t i t consumes k t+1 c t;t = w t A when old: receives return to capital (full depreciation), consumes Cobb-Douglas production function: Competitive factor markets: c t;t+1 = r t+1 k t+1 y t = k t w t = (1 ) k t and r t = k 1 t
Conventional view: Autarky The law of motion of the capital stock is where s 1 + k t+1 = s A k t (1 ) is the (gross) savings rate
Conventional view: Autarky The law of motion of the capital stock is where s 1 + k t+1 = s A k t (1 ) is the (gross) savings rate These are the dynamics of the Solow model The steady state is k A SS = (s A) 1 1 and A r A SS = s 1
Conventional view: Financial liberalization Removes barriers to access international nancial market (IFM) IFM has commitment and buys and sells any bonds with expected gross return 1. Assume country also has commitment to repay its debts. Thus, The budget constraints of generation t are c t;t = w t k t+1 A R t+1 = R t+1 = 1 b t+1 Rt+1 b t+1 R t+1, c t;t+1 = r t+1 k t+1 + b t+1 + b t+1, where b t+1 and b t+1 respectively denote domestic holdings of foreign and domestic bonds. Domestic and foreign bonds are perfect substitutes
Conventional view: Financial liberalization Observations savings are una ected due to log utility: k t+1 A + b t+1 R t+1 + b t+1 R t+1 = s k t in this simple model, gross positions are indetermined in equilibrium: only net positions b t+1 + b t+1 are pinned down
Conventional view: Financial liberalization The new law of motion of the capital stock is A k 1 t+1 1 = 0, i.e. the marginal return to investment equals the marginal cost of funds (R t+1) There is immediate convergence to current account: s t k SS = ( A) 1 1 i t = s k t k SS A Main e ects of nancial liberalization Capital stock and output grow in capital scarce-countries (i.e., kss A < k SS) Response to shocks? Sensitivity to savings shocks () is reduced lower e ect of savings on output Sensititivity to (anticipated) productivity shocks (A) is enhanced greater investment can be nanced with foreign borrowing In the face of uncertainty, correlation between consumption and output is reduced domestic shocks can be insured with the IFM (risk sharing)
What are the consequences/expected gains of nancial globalization? Standard narrative predicts di erent types of bene ts from nancial globalization Improved allocation of capital (mixed evidence) Capital ows towards its more productive uses: capital-scarce, high-productivity countries Higher growth for receiving countries (and for world as a whole) Risk sharing (mixed evidence) Local risks can be diversi ed through the trade of assets Decreased volatility of consumption relative to output Other e ects (perhaps...) In a nutshell, the evidence points to: Small size and wrong direction of capital ows Mixed e ects of nancial liberalization Imperfect degree of risk-sharing among countries Two strands of evidence: nancial liberalization and data on capital ows
Evidence on Financial Liberalization: Kose, Prasad, Rogo and Wei (2009) Recap of theory: nancial liberalization should have positive e ects on Growth: more capital should ow to capital-scarce countries, with potential spillovers on TFP Volatility: prediction on output volatility is not obvious, but it should unambiguously decrease consumption volatility by allowing for diversi cation Comovement: related to previous, consumption correlation among countries should increase Analyze evidence and existing literature: what are the conclusions? Measurement of nancial openess: De jure De facto: domestic and foreign prices of similar assets (capital in ows + capital out ows)/gdp (foreign assets + foreign liabilities)/gdp
Impact of nancial liberalization on growth No relationship between level of nancial openness and GDP growth (1985-2004) Weak positive relationship between change in nancial openness and growth But it disappears when other controls are introduced Beware of endogeneity throughout!: in this regard, case studies might be informative, but they are equally unconclusive
- 67 - Figure 5A. Level of Financial Openness and GDP Growth, 1985 2004 Unconditional Relationship Conditional Relationship 0.06 KOR 0.06 Growth rate of per capita GDP 0.05 THA MUS CHL 0.04 IND IDN MYS LKA 0.03 PRT DOM TUN ESP BGD TUREGYAUS NOR 0.02 PAK NPLJPN CRI GRC USA GHA DEU FIN AUT ITAURY CAN TTO ISR FRA DNK SWE IRN COL SLV TZA NZL GTM BRAFJI JAM 0.01 MEXPHL PER ARGBOL SEN ECUPNG HND DZA KEN 0 MWI PRY ZAF VEN NER TGO -0.01 ZWE CMR -0.02 0 50 100 150 200 250 300 Mean financial openness Growth rate of per capita GDP 0.05 0.04 0.03 MUS CHL 0.02 EGY DOM CRI MYS IND KOR TUN 0.01 GTM TUR SLV ISR USATTO AUS BGDCOL LKA GHA PAK IDN URY 0 ZAF THA SEN ESP BRA MEX TZA IRN VEN ITA NOR CANPRT FIN AUT FRA SWE ARG GRC BOL FJI HND DNK NPL DZA PRY KEN NER NZL DEU ZMB ECU -0.01 CMR JPNPHL JAM PER MWI TGO -0.02 ZWE -0.03 0 50 100 150 200 250 300 Mean financial openness Figure 5B. Change in Financial Openness and GDP Growth, 1985 2004 Unconditional Relationship Conditional Relationship 0.06 KOR 0.06 Growth rate of per capita GDP 0.05 THA MUS CHL 0.04 IND IDNMYS LKA 0.03 PRT DOM TUN ESP BGD NOR EGY TUR AUS 0.02 CRI PAK NPL JPNUSA DEU AUT CAN ITA DNK FRA FIN URY GHA GRC ISR SWE TZA TTO COL SLV JAM IRN ZMB NZL 0.01 BRA GTM MEX PHL SEN PER BOL ECU FJI ARG HND 0 MWI DZA PRY ZAF VEN TGONER -0.01 CMR ZWE -0.02-150 -50 50 150 250 350 450 Change in financial openness Growth rate of per capita GDP 0.05 0.04 0.03 MUS CHL 0.02 EGYMYS CRI DOM TUN IND KOR 0.01 GTM ISRSLV TUR GHA TTO USA COL AUS BGD LKA PAK IDN URY 0 TZA SEN MEX ZAF THA IRN BOL FJI BRA VEN CAN ITA AUT ESPPRT HND DNKFRA NOR FIN SWE KEN PRY GRC ARG NZL DEU JAMZMB NER ECU DZA NPL -0.01 CMR PHLJPN PER TGOMWI -0.02 ZWE -0.03-150 -50 50 150 250 350 450 Change in financial openness Notes: Growth refers to the average real per capita GDP growth. Financial openness is defined as the ratio of gross stocks of foreign assets and liabilities to GDP and is based on a dataset constructed by Lane and Milesi- Ferretti (2006). The second panel uses residuals from a cross-section regression of growth on initial income, population growth, human capital and the investment rate. See Appendix II for abbreviated country names.
Interpreting this evidence with care... Henry (2007) casts doubts on these results the standard neoclassical model predicts temporary, not permanent increase in growth after liberalization in steady state, k ss = A R 1 1 nancial liberalization provides temporary growth by lowering the interest rate in the long run, growth in k depends on growth in A Theoretical predictions of liberalization on growth (assuming some gradual adjustment)
892 Journal of Economic Literature, Vol. XLV (December 2007) Interest Rate Panel A: The Cost of Capital r r t o t Growth Rate of K Panel B: Investment n + g t o t Growth Rate of Y L Panel C: Growth Rate of GDP per Worker g t o t ln ( Y L ) Panel D: Level of GDP Per Worker Permanent effect of liberalization t o t Figure 2. The Impact of Liberalization on the Cost of Capital, Investment, and Growth
Interpreting this evidence with care... In regressing growth on openness, Henry (2007) argues that we should look at time, not cross-country variation (temporary e ects) we should distinguish between developing and developed countries (opposite implications of openness for growth) be careful on how we measure liberalization (de jure vs. de facto) He looks at instances of stock market liberalization (di. measures): ndings fall in the cost of capital (measured through stock prices) increase in investment and in output growth Problems endogeneity (is liberalization undertaken when gains are high?) identi cation (many reforms simultaneous) even then, e ect is signi cant but small (i.e., increase in stock market value of 30%)
Interpreting this evidence with care... In regressing growth on openness, Henry (2007) argues that we should look at time, not cross-country variation (temporary e ects) we should distinguish between developing and developed countries (opposite implications of openness for growth) be careful on how we measure liberalization (de jure vs. de facto) He looks at instances of stock market liberalization and nds... fall in the cost of capital increase in investment and in output growth Problems endogeneity (is liberalization undertaken when gains are high?) identi cation (many reforms simultaneous) At the end of the day, e ect is signi cant but small (i.e., increase in stock market value of 30%) perhaps return to foreign investors not so high weak institutions, nancial frictions
Impact of nancial liberalization on volatility (Kose et al.) No evidence that nancial liberalization has reduced consumption volatility No systematic evidence of relationship between liberalization and output volatility Evidence that ratio of consumption growth volatility to output growth volatility has actually increased in recent period of nancial globalization moreover, this increase in consumption volatility tends to increase with nancial openness, at least up to a level Mixed evidence on the impact of nancial liberalization on cross-country correlation of consumption growth
Distinction between portfolio ows, debt ows, and FDI Portfolio ows (equity market liberalization) FDI Evidence from micro data seems to support the notion that liberalization helps industries that are dependent on external nance Strongest evidence comes from micro data: consistent with the existence of transfer of knowledge to suppliers and custormers, i.e. of vertical spillovers Debt ows (porfolio bond ows and bank loans) These ows are highly volatile and procyclical Also, weaker countries tend to rely on short-term debt denominated in foreign currency, which can increase the likelihood of a crisis
A di erent perspective is to look at other, collateral bene ts of capital ows In this view, it is not nancial liberalization per se, but rather its collateral bene ts, that may increase growth Threshold e ects: might be important to have good institutions in place to reap these bene ts Financial sector development For example, bene ts of foreign-owned banks Improved institutional quality and governance Improved corporate governance (due to better monitoring, decreased cost of external nance, etc...) Relationship to public governance: for example, allowing rms to be listed abroad might increase their value Improved macroeconomic policies Once again, beware of endogeneity!
- 68 - Figure 6A. Financial Openness and Financial Development, 1985 2004 Private Credit/ GDP Stock Market Capitalization/ GDP 1.2 1.6 1 JPN DEU 1.4 ZAF MYS Private Credit/ GDP AUT PRTFRA 0.8 ESP NZL MYS THA AUS ISR FIN 0.6 ITA NOR DNK KORZAF CAN TUN SWE CHL 0.4 MUS GRC USA SLVIDN EGY FJI TTO BOL URY BRA PHL IND HND BGD PAK DZA ECU IRN LKA KEN 0.2 SEN COLCRI DOM MEX PNGTGO JAM ZWE GTM NPL PRYPER ARG TUR CMR VEN NER GHA TZA MWI ZMB 0 0 50 100 150 200 250 300 Mean financial openness Stock Market Capitalization/ GDP 1.2 USA 1 0.8 FIN SWE JPN AUS CAN CHL 0.6 FRA ESP JAM DNK 0.4 THA PHLISR NZL KOR TTO GRC DEU MUS ITA NOR INDCHN ZWE BRA ARG PRT 0.2 MEX IRN TUR EGY AUT COL SLV KEN PAK LKA IDN PERGHA NPL CRI ECU VEN TUN FJI BOL MWI HND ZMB 0 BGD GTM PRY TZA URY 0 50 100 150 200 250 300 Mean financial openness Figure 6B. Financial Openness and Institutional Quality, 1985 2004 Institutional Quality Control of Corruption 2.5 3 Institutional Quality 2 1.5 1 0.5 0-0.5-1 FIN NOR DNK SWE AUS NZL CAN DEUAUT USA PRTFRA JPN ESP CHL CRIITA MUS GRC ISR URY KOR TTO MYS ZAF THA TUN BRA MEX SLVARG JAM IND DOMFJIPHL GHA TURLKA EGY PER BOL CHN SEN HND GTM COL TZA MWI ZMB BGDNPL ECUPNG PRY NER VEN IRN IDN PAKCMR KEN TGO ZWE DZA Control of Corruption 2.5 2 1.5 1 0.5 0-0.5-1 FIN NZL DNK SWE NOR CAN AUS AUT USA DEU FRA ESP CHL PRT JPN ISR CRI ITA GRC URY MUS ZAF MYS KOR TUN FJI TTO BRA TURLKA EGY PER INDCHNMEXTHA COL DOM SLVARG SEN JAM NPL PHL GHA IRN DZA BGD ZWE GTM BOL PNG MWI PAK NER ECU VENHND PRYIDN TZA TGO ZMB CMR KEN -1.5 0 50 100 150 200 250 300 Mean financial openness -1.5 0 50 100 150 200 250 300 Mean financial openness
- 69 - Figure 6C. Financial Openness and Macroeconomic Policies, 1985 2004 Monetary Policy Fiscal Policy Log Inflation 0-0.5 TUR ZMB -1 ZWE VEN ECU URY -1.5 BRA GHA MEX MWI IRN COL -2 DOM PRY CRI JAM PER GTM BOL TZA ISRHND ZAFARG LKA KEN -2.5 IDN EGY SLV GRC CHL IND NPL DZA PHL PAK PNG TTO BGDMUS PRT -3 CHN KOR TUN NERESP ITA FJI -3.5 CMR THA USAUSNOR NZL DNK CAN SWE SEN TGO MYSFIN AUT FRA -4 DEU -4.5 JPN -5 0 50 100 150 200 250 300 Mean financial openness Government Budget Balance (%GDP) 10 DZA 5 NOR KOR CHL 0 DOM PRY CMR THA ECU DNK CHN BRA SLVIDN VEN AUS NZL DEU JAM GTM IRN BGDMUS PHL TTO AUT COLCRI USAESP URY IND CAN FIN SWE MEXPERGHA TUN TZATGO MYS PAKZAF EGY HND FRA KEN -5 JPN ARG BOL PNG ZWE FJI PRT TUR SEN NPL NER ITAISR LKA -10 MWI ZMB GRC -15 0 50 100 150 200 250 300 Mean financial openness Notes: The financial integration data are based on a dataset constructed by Lane and Milesi-Ferretti (2006). Financial Development data are taken from Beck and Al-Hussainy (2006). Private Credit refers to credit given to the private sector by deposit money banks and Stock Market Capitalization is defined as the value of listed shares. Institutional quality data are from Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi (2005) and cover the period 1996-2004. Institutional Quality is the average of the following indicators: Voice and Accountability, Political Stability, Government Effectiveness, Regulatory Quality, Rule of Law, and Control of Corruption. Monetary and fiscal data are from the World Bank's World Development Indicators and the IMF's International Financial Statistics and World Economic Outlook databases. Inflation is defined as the annual change in CPI. Government Budget Balance is the difference between government revenues and government expenditures. See Appendix II for abbreviated country names.
Evidence on Financial Liberalization: Bon glioli (2008) Analyzes e ects of nancial liberalization on Growth in the capital stock Growth in TFP Sample of 70 countries between 1975 and 1999 Main nding: de jure and de facto measures of nancial liberalization Do not seem to explain growth in the capital stock Seem to be signi cantly and positively correlated with growth in TFP Moreover, nancial liberalization seems to raise likelihood of banking crises We shall return to this point
Evidence on Size and Direction of Capital Flows Capital ows between developed and developing countries: much smaller than would be predicted by neo-classical models (Lucas 1990) According to the benchmark model, nancial liberalization should lead to... capital ows towards capital-scarce countries (and decrease in R) at least temporarily, higher growth Consider the production function y t = k t According to theory, capital should ow until return to investment (A kt 1 ) is equalized across countries A simple calibration of India and the US shows k US 15 k INDIA : should lead to massive capital ows! Yet, we do not seem to observe this.... WHY?
Alternative explanations... Di erences in human capital? Maybe this makes capital more productive in developed countries, or... Human capital increases TFP because of spillovers Mismeasurements? Maybe the return to capital is actually equalized across countries Even if capital is scarce in developing countries, it is also less productive there Caselli-Feyrer (2007): once income of nonrenewable capital is accounted for, return to renewable capital seems similar between developed and developing countries Financial frictions? Sovereign risk: di culty of enforcing contracts across borders limits ows Or maybe, bad nancial systems limit how much capital an economy may intermediate...
In some sense, back to where we were... But current patterns of capital ows are di erent from what they were...
On direction of capital ows... Recently, global imbalances have caught the attention of economists (Caballero et al., Zilibotti et al.) High growth developing countries (especially China) are actually exporting capital to the rest of the world Hard to interpret according to standard theory And, even if you look at developing countries as a group... Low-growth countries seem to be importing too much capital whereas high-growth countries seem to be exporting too much of it (Prasad et al. (2007), Gourinchas and Jeanne (2009))
On direction of capital ows... Recently, global imbalances have caught the attention of economists (Caballero et al., Zilibotti et al.) High growth developing countries (especially China) are actually exporting capital to the rest of the world And, even if you look at developing countries as a group... Low-growth countries seem to be importing too much capital whereas high-growth countries seem to be exporting too much of it (Prasad et al. (2007), Gourinchas and Jeanne (2012)) Do governments play a role? (Kalemli-Ozcan et al. (2012))
Current account balances
Current account balances
Concluding Remarks Dramatic rise of nancial globalization Large cross-holdings of assets among developed countries Less signi cant for the developing world Size/direction of capital ows seem hard to account for with standard theory Basic predictions of standard model seem at odds with the data No systematic evidence that nancial liberalization leads to capital in ows and faster growth Threshold e ects? No systematic evidence that nancial liberalization reduces volatility of consumption Can nancial frictions help us to reconcile the standard model with the evidence? Contractual frictions: implications in closed vs. open economy Sovereign risk: speci c to the open economy