Financial Liberalization and Capital Flows: Facts Alberto Martin CRE, UPF, Barcelona GSE, MF July 6, 2015 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 1 / 46
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 F MF s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) De facto: increase in capital ows, foreign assets and liabilities Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 2 / 46
Financial globalization: de jure () Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 3 / 46
Financial globalization: de jure () Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 4 / 46
De facto measures of nancial globalization 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 (NFA) 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) out ows t in ows t = NFA t Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 5 / 46
Financial globalization: de facto () Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 6 / 46
Financial globalization: de facto () Source: Lane and Milesi Ferretti (2014) Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 7 / 46
Financial globalization: de facto () Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 8 / 46
n 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 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 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 9 / 46
Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 10 / 46
Consequences / expected gains of nancial liberalizaion Standard narrative: various bene ts from nancial globalization mproved allocation of capital Capital ows to most 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 F F Risk sharing makes it possible to adopt risky, high-return technologies ncreased growth and volatility of output Miscellanea: discipline on domestic policy makers, spillover e ects of FD, etc... Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 11 / 46
Consequences / expected gains of nancial liberalizaion Standard models predict that nancial liberalization should generate: Capital ows towards capital-scarce countries Higher growth Decreased volatility of consumption relative to output Evidence from recent decades seem to be at odds with basic models Small size and wrong direction of capital ows Mixed e ects of nancial liberalization mperfect degree of risk-sharing among countries Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 12 / 46
A simple model to x ideas Small country: overlapping generations of size 1 Representative member of generation t maximizes: u (c t,t ) + β 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 c t,t = w t+1 t A When old: receives return to capital (full dereciation), consumes c t,t+1 = r t+1 k t+1 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 13 / 46
A simple model to x ideas Cobb-Douglas production function: y t = k α t, i.e. labor from young combined with capital from old in each period Competitive factor markets: w t = (1 α) k α t and r t = α k α 1 t Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 14 / 46
Conventional view: autarky No borrowing from or lending to foreigners Young can only invest in domestic capital The law of motion of the capital stock is where s k t+1 = s A k α t β (1 α) is the (gross) savings rate 1 + β These are the dynamics of the Solow model The steady state is k A SS = (s A) 1 1 α and A r A SS = α s 1 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 15 / 46
Conventional view: autarky No borrowing from or lending to foreigners Young can only invest in domestic capital The law of motion of the capital stock is where s k t+1 = s A k α t β (1 α) is the (gross) savings rate 1 + β These are the dynamics of the Solow model The steady state is k A SS = (s A) 1 1 α and A r A SS = α s 1 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 16 / 46
Conventional view: nancial liberalization Removes barriers to access international nancial market (FM) FM has commitment and buys and sells any bonds with expected gross return 1. Assume country also has commitment to repay its debts. Thus, R t+1 = R t+1 = 1 The budget constraints of generation t are c t,t = w t k t+1 A b t+1 R t+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 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 17 / 46
Conventional view: nancial liberalization Observations savings are una ected due to log utility: k t+1 A + b t+1 Rt+1 + b t+1 = s kt α = β R t+1 1 + β (1 α) k t α in this simple model, gross positions are indetermined in equilibrium: only net positions b t+1 + b t+1 are pinned down Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 18 / 46
Conventional view: nancial liberalization The new law of motion of the capital stock is α A k α 1 t+1 1 = 0, i.e., mg. return to investment equals mg. cost of funds (R t+1 ) mmediate convergence to current account: s t k SS = (α A) 1 1 α i t = s k α t Main e ects of nancial liberalization Capital stock and output grow in capital scarce-countries (i.e., k A SS < k SS ) Response to shocks? F F F k SS A Sensitivity to savings shocks (β) is reduced Sensititivity to (anticipated) productivity shocks (A) is enhanced n the face of uncertainty, correlation between consumption and output is reduced Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 19 / 46
Consequences/expected gains of nancial liberalization Standard narrative predicts di erent types of bene ts from nancial globalization mproved allocation of capital (mixed evidence) Capital ows tomore 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...) n a nutshell, the evidence points to: Small size and wrong direction of capital ows Mixed e ects of nancial liberalization mperfect degree of risk-sharing among countries Two strands of evidence: nancial liberalization and data on capital ows Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 20 / 46
Evidence on nancial liberalization: Kose, Prasad, Rogo, Wei (2009) Recap of theory: nancial liberalization should have positive e ects on Growth: more capital ows to capital-scarce countries, potential increase of TFP Volatility: e ect on output volatility ambiguous, but consumption volatility should fall Comovement: consumption correlation among countries should increase Analyze evidence and existing literature: what are the conclusions? Measurement of nancial openess: De jure De facto: F F F domestic and foreign prices of similar assets (capital in ows + capital out ows)/gdp (foreign assets + foreign liabilities)/gdp Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 21 / 46
mpact of nancial liberalization and 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 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 22 / 46
- 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 ND DN MYS LKA 0.03 PRT DOM TUN ESP BGD TUREGYAUS NOR 0.02 PAK NPLJPN CR GRC USA GHA DEU FN AUT TAURY CAN TTO SR FRA DNK SWE RN COL SLV TZA NZL GTM BRAFJ JAM 0.01 MEXPHL PER ARGBOL SEN ECUPNG HND DZA KEN 0 MW 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 CR MYS ND KOR TUN 0.01 GTM TUR SLV SR USATTO AUS BGDCOL LKA GHA PAK DN URY 0 ZAF THA SEN ESP BRA MEX TZA RN VEN TA NOR CANPRT FN AUT FRA SWE ARG GRC BOL FJ HND DNK NPL DZA PRY KEN NER NZL DEU ZMB ECU -0.01 CMR JPNPHL JAM PER MW 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 ND DNMYS LKA 0.03 PRT DOM TUN ESP BGD NOR EGY TUR AUS 0.02 CR PAK NPL JPNUSA DEU AUT CAN TA DNK FRA FN URY GHA GRC SR SWE TZA TTO COL SLV JAM RN ZMB NZL 0.01 BRA GTM MEX PHL SEN PER BOL ECU FJ ARG HND 0 MW 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 CR DOM TUN ND KOR 0.01 GTM SRSLV TUR GHA TTO USA COL AUS BGD LKA PAK DN URY 0 TZA SEN MEX ZAF THA RN BOL FJ BRA VEN CAN TA AUT ESPPRT HND DNKFRA NOR FN SWE KEN PRY GRC ARG NZL DEU JAMZMB NER ECU DZA NPL -0.01 CMR PHLJPN PER TGOMW -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 for abbreviated country names.
nterpreting this evidence with care Henry (2007) casts doubts on these results standard neoclassical model predicts temporary, not permanent increase in growth after liberalization in steady state, 1 αa 1 α k ss = R 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) Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 24 / 46
892 Journal of Economic Literature, Vol. XLV (December 2007) nterest Rate Panel A: The Cost of Capital r r t o t Growth Rate of K Panel B: nvestment 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 mpact of Liberalization on the Cost of Capital, nvestment, and Growth
nterpreting this evidence with care n 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%) Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 26 / 46
nterpreting this evidence with care n 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) 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 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 30 / 46
mpact 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 Ratio of consumption growth volatility to output growth volatility seems to have increased in recent period of nancial globalization F 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 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 31 / 46
Distinction between portfolio ows, debt ows and FD Portfolio ows (equity market liberalization) FD Evidence from micro data: liberalization appears to help industries that are dependent on external nance Strongest evidence 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 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 32 / 46
Other, collateral bene ts of capital ows n 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 mproved institutional quality and governance mproved 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 mproved macroeconomic policies Once again, beware of endogeneity! Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 33 / 46
- 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 SR FN 0.6 TA NOR DNK KORZAF CAN TUN SWE CHL 0.4 MUS GRC USA SLVDN EGY FJ TTO BOL URY BRA PHL ND HND BGD PAK DZA ECU RN LKA KEN 0.2 SEN COLCR DOM MEX PNGTGO JAM ZWE GTM NPL PRYPER ARG TUR CMR VEN NER GHA TZA MW ZMB 0 0 50 100 150 200 250 300 Mean financial openness Stock Market Capitalization/ GDP 1.2 USA 1 0.8 FN SWE JPN AUS CAN CHL 0.6 FRA ESP JAM DNK 0.4 THA PHLSR NZL KOR TTO GRC DEU MUS TA NOR NDCHN ZWE BRA ARG PRT 0.2 MEX RN TUR EGY AUT COL SLV KEN PAK LKA DN PERGHA NPL CR ECU VEN TUN FJ BOL MW HND ZMB 0 BGD GTM PRY TZA URY 0 50 100 150 200 250 300 Mean financial openness Figure 6B. Financial Openness and nstitutional Quality, 1985 2004 nstitutional Quality Control of Corruption 2.5 3 nstitutional Quality 2 1.5 1 0.5 0-0.5-1 FN NOR DNK SWE AUS NZL CAN DEUAUT USA PRTFRA JPN ESP CHL CRTA MUS GRC SR URY KOR TTO MYS ZAF THA TUN BRA MEX SLVARG JAM ND DOMFJPHL GHA TURLKA EGY PER BOL CHN SEN HND GTM COL TZA MW ZMB BGDNPL ECUPNG PRY NER VEN RN DN PAKCMR KEN TGO ZWE DZA Control of Corruption 2.5 2 1.5 1 0.5 0-0.5-1 FN NZL DNK SWE NOR CAN AUS AUT USA DEU FRA ESP CHL PRT JPN SR CR TA GRC URY MUS ZAF MYS KOR TUN FJ TTO BRA TURLKA EGY PER NDCHNMEXTHA COL DOM SLVARG SEN JAM NPL PHL GHA RN DZA BGD ZWE GTM BOL PNG MW PAK NER ECU VENHND PRYDN 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 nflation 0-0.5 TUR ZMB -1 ZWE VEN ECU URY -1.5 BRA GHA MEX MW RN COL -2 DOM PRY CR JAM PER GTM BOL TZA SRHND ZAFARG LKA KEN -2.5 DN EGY SLV GRC CHL ND NPL DZA PHL PAK PNG TTO BGDMUS PRT -3 CHN KOR TUN NERESP TA FJ -3.5 CMR THA USAUSNOR NZL DNK CAN SWE SEN TGO MYSFN 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 SLVDN VEN AUS NZL DEU JAM GTM RN BGDMUS PHL TTO AUT COLCR USAESP URY ND CAN FN SWE MEXPERGHA TUN TZATGO MYS PAKZAF EGY HND FRA KEN -5 JPN ARG BOL PNG ZWE FJ PRT TUR SEN NPL NER TASR LKA -10 MW 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. nstitutional quality data are from Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi (2005) and cover the period 1996-2004. nstitutional 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 ndicators and the MF's nternational Financial Statistics and World Economic Outlook databases. nflation is defined as the annual change in CP. Government Budget Balance is the difference between government revenues and government expenditures. See Appendix for abbreviated country names.
Evidence on nancial 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 Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 36 / 46
Evidence on size and direction of capital ows 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 α t According to theory, capital should ow until return to investment (A αkt α 1 ) is equalized across countries A simple calibration of ndia and the US shows k US 15 k NDA : should lead to massive capital ows! Yet, we do not seem to observe this.... WHY? Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 37 / 46
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 judicial/ nancial systems limit how much capital an economy may intermediate... Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 38 / 46
n some sense, back to where we were... But current patterns of capital ows are di erent from what they were... Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 39 / 46
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)) Do governments play a role? (Kalemli-Ozcan et al. (2012)) Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 42 / 46
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 F 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: imperfect judicial/ nancial systems Sovereign risk: economic and political borders do not coincide Martin (CRE, UPF, Barcelona GSE, MF) CRE Macroeconomics Summer School July 6, 2015 46 / 46