Today we are fortunate to have a guest contribution authored by Laura Alfaro (Harvard), Sebnem Kalemli-Ozcan (U. Maryland) and Vadym Volosovych (Erasmus University Rotterdam). This post is based on “Sovereigns, Upstream Capital Flows, and Global Imbalances” (2014).
Uphill capital flows and global imbalances have taken center stage at academic and policy debates for some time. Over the past two decades, capital seems to have been flowing upstream from fast-growing to stagnant countries. At the same time, emerging market economies experiencing rapid growth have accumulated vast foreign reserves. Many of the theoretical explanations advanced for these phenomena center on these high growth emerging countries’ relatively higher saving rates—either due to insurance or mercantilist reasons—channeled to countries that supply safe assets such as the U.S. (see for example Caballero, Farhi, and Gourinchas (2008) and Gourinchas and Jeanne (2013)). Although external imbalances have decreased quite a bit since the global financial crisis, they have not disappeared yet.
In Alfaro-Kalemli-Ozcan and Volosovych (2014) we show that such net capital outflows during last decades from high growth emerging markets and/or net capital inflows to low growth emerging markets, are driven by sovereign-to-sovereign transactions. By sovereign-to-sovereign transactions we mean capital flows between two official bodies, such as government debt and aid, where both the debtor and the creditor is a public agency or an international institution. This finding explains why the correlation between productivity growth and net capital flows measured as the current account balance with a reversed sign—that is, the difference between a nation’s investment and its savings— might yield different results depending on the sample used by different researchers. Net capital flows consist of net private flows and net public flows, and the correlations of these two types of net flows with productivity growth differ in sign.
Figures 1 and 2 demonstrate this fact visually. They both plot long run correlation between net capital flows and growth over 1980-2007, where net capital flows are measured with current account sign reversed. The only difference between the figures is the country samples. Figure 1 is based on a smaller sample that is dominated by countries from Asia and Africa, whereas Figure 2 plots the same correlation using a larger sample including Eastern European countries. The difference is striking.
Figure 1: Average Net Capital Flows and Growth, 1980-2007
Figure 2: Average Net Capital Flows and Growth, 1980-2007
The negative correlation between net capital flows and growth can be fully explained by sovereign-to-sovereign transactions being dominant in the sample used in Figure 1. This sample is composed of African and Asian countries. Over the past 30 years, capital flows into low-productivity developing countries (mostly in Africa) have largely taken the form of official aid/debt (concessional flows from bilateral and multilateral donor institutions). When aid flows are subtracted from total flows, there is total capital flight out of these countries. Figure 3 below shows this to be the case for Tanzania as an example where current account deficit (net capital inflows) and aid flows track each other one-to-one.
Net capital outflows from high-productivity emerging markets (mostly in Asia)—a more recent phenomenon of upstream capital flows—have been in the form of official reserves accumulation. Interestingly, these Asian countries accumulate vast foreign reserves and borrow in the form of FDI and portfolio equity flows as shown in Figure 4.
Figure 3: Net capital Flows and Aid Flows, Tanzania, 1980-2007
The reason why the negative correlation in Figure 1 disappears in Figure 2 is because Figure 2 uses a larger sample and hence weight of African and Asian countries diminishes. Figure 5 demonstrates this, where most of the developing high growth countries are net importers of capital during 1980-2007. The figure plots net capital flows for the developing high-growth countries by splitting these countries into net creditors and net debtors. High-growth countries are the ones with growth rates above the mean growth rate of the entire period or above the mean growth rate calculated year by year. Almost 50 out of 60 countries with growth rates above the mean growth rate over 1970—2000 are net importers of capital as predicted by the textbook small open economy model.
Figure 5: Net Exporters and Importers of Capital among High-Growth Emerging Markets, 1980-2007
These results are consistent with large-sample work which documented weakly positive or insignificant correlations between current account and growth. See, for example, Chinn and Prasad (2003) and references therein. The smaller sample results are consistent with those of Reinhart and Tashiro (2013), who show that Asian central banks are the ones buying reserves in developed countries and hence are responsible for the capital outflows.
Decomposing Total Capital Flows into Private and Public Flows
In order to explain these patterns systematically, we have constructed measures of private and public net capital flows for a large cross-section of developing countries, considering both the creditor and the debtor sides of international transactions (The data will be available on the website http://www.sovereign-to-sovereign-flows.com/.). Net private capital flows include net inflows of foreign direct investment (FDI), portfolio equity investment, and private debt. For private debt we consider both private sector’s borrowing on net and also debt investment by foreign private investors. Net public capital flows include, among other things, grants, concessional aid, or any government-guaranteed debt, where reserves is netted out from all. Using these measures, we find (a) that a country’s net international private capital flows (inflows minus outflows of private capital) are positively correlated with its productivity growth and (b) that a country’s sovereign net debt flows (government borrowing minus accumulation of foreign reserves) are negatively correlated with its growth only if the government debt is financed by another sovereign.
It is interesting that net public debt when the creditor side of this debt is a private agent is still positively correlated with growth. This means that the foreign private investors’ behavior is consistent with the neoclassical model regardless of whether the borrower is a private or public entity, or the borrowing is guaranteed by the state: foreign private investor invests in high growth country, either in the high growth country’s private sector or in its public sector. One obtains a negative correlation of total net capital flows with growth (capital outflows from growing countries) if sovereign capital, coming from other official entities, dominates the current account.
Figures 6 and 7 demonstrate the robust positive relation between private capital flows and growth and negative one with public capital flows and growth respectively. The red dotted lines superimpose the regression without the outliers seen, yielding the same result.
Different Decomposition Methods
How do we decompose total capital flows into private and public components? There are two ways to do this. First method is a direct one, where we get data on private and public capital flows. This method requires data from both the creditor and the debtor sides of debt transactions. The most direct and straightforward measure of private flows is the sum of net FDI, equity, and that part of the debt that can be considered—with a high degree of confidence—private. The main difficulty involves decomposing total debt into private and public components because the International Monetary Fund’s (IMF) Balance of Payments statistics, the traditional source of such data, do not fully identify private and public issuers and holders of debt securities. We perform such a decomposition using data from the World Bank’s Global Development Finance database. There is no a priori reason to focus on developing countries as opposed to the whole world other than the fact that decomposing net debt flows into private and public components can only be done for countries classified as developing.
Figure 6: Net Private Capital Flows and Growth, 1980-2007
Figure 7: Net Public Capital Flows and Growth, 1980-2007
This is because these countries are required by the World Bank to report the amounts and types of foreign debt, including the creditor side, in order to be eligible for international borrowing.
The second method measures private capital flows as a “residual”; that is, subtracting all public flows from a measure of total capital flows (such as the negative of the current account balance). The issue here is that if one does not subtract all sovereign-to-sovereign flows, then the resulting residual measure of private capital flows will be “contaminated” by public flows and will give misleading results if the public and private flows behave differently—as we find they do. We perform both methods and obtain the same results.
Facts and the Neoclassical Model
How do we interpret these results in relation to benchmark theory? The neoclassical growth model relies on a representative consumer. In essence, there is no government, or at least no government that does anything different from what the atomistic agent or the social planner would do. But if the government and private agents do behave differently, as we show, then we need different models to explain the behavior of the private sector and the behavior of the government. For example, one could take the behavior of the government as given (that is, the government is accumulating reserves for some un-modeled reason) and then ask if the observed behavior of the private sector is consistent with the predictions of the neoclassical model. If, in the presence of high growth, the private sector is saving a lot, then there would be a private saving “puzzle.” But if the private sector is running a current account deficit, as we clearly show in this paper, then one could say that the private sector conforms to the neoclassical theory and that the only theoretical problem is to understand the behavior of the government which had been taken as a given. In fact, our results confirm this very conjecture.
Our findings emphasize that the failure to consider official flows as the main driver of uphill flows and global imbalances is an important shortcoming of the recent literature. Sovereigns and official donors invest in low return countries for other considerations. Not taking this behavior into account can easily lead to misleading conclusions about the general facts regarding capital flows and misguide policy implications. These findings would hopefully encourage national and international agencies to assemble and disseminate more detailed statistics on international transactions.
Alfaro, L., S. Kalemli-Ozcan , and V. Volosovych, 2014. “Sovereigns, Upstream Capital Flows, and Global Imbalances” conditionally accepted to Journal of European Economic Association.
Caballero, R. J., E. Farhi, and P. O. Gourinchas, 2008. “An Equilibrium Model of ‘Global Imbalances’ and Low Interest Rates.” American Economic Review, 98, 358 ˝U-393.
Chinn, M. D. and E. S. Prasad, 2003. “Medium-Term Determinants of Current Accounts in Industrial and Developing Countries: An Empirical Exploration.” Journal of International Economics, 59, 47–76.
Gourinchas, P.-O. and O. Jeanne, 2013. “Capital Flows to Developing Countries: The Allocation Puzzle.” Review of Economic Studies, 80, 1484–1515.
Reinhart, C. and Tashiro, T. 2013. “Crowding Out Redeﬁned: The Role of Reserve Accumulation.” NBER Working Paper No. 19652. Cambridge, MA: National Bureau of Economic Research.
This post written by Sebnem Kalemli-Ozcan.