International Capital Flows and Capital Account Liberalization

1. International Capital Flows and Capital Account Liberalization Thorvaldur Gylfason

2. Two Parts • Part One: • International Capital Movements • Part Two: • External Debt Dynamics

3. Goods and Capital 1 • The argument for free trade in goods and services applies also to capital • Trade in capital helps countries to specialize according to comparative advantage, exploit economies of scale, and promote competition • Exporting equity in domestic firms not only earns foreign exchange, but also secures access to capital, ideas, know-how, technology

4. Symmetry between Trade in Goods and Capital • The balance of payments • R = X – Z + F • where • X = exports of goods and services • Z = imports of goods and services • F = net exports of capital • Foreign direct investment • Portfolio investment • Foreign borrowing

5. Determinants of Foreign Trade • Trade in goods and services depends on • Relative prices at home and abroad • Exchange rates (elasticity models) • National incomes at home and abroad • Geographical distance from trading partners (gravity models) • Trade policy regime • Tariffs and other barriers to trade

6. Two Views of Trade • The current account of the balance of payments is defined as B = X – Z • National income is Y = E + X – Z • Therefore, current account is • B = X – Z = Y – E • Two sides of the same coin: • Deficit means that Z > X and E > Y • Surplus means that X > Z and Y > E

7. Foreign Investment • Capital flows • Foreign borrowing, portfolio investment, foreign direct investment • Trade in equities depends on • Interest rates at home and abroad • Exchange rate expectations • Geographical distance from trading partners • Capital account policy regime • Capital controls and other barriers to free flows

8. Exports 1990-2000(% of GDP)

9. Transition Countries: Exports 2000 (% of GDP) World average

10. Growth in Trade Less Growth in GDP 1990-2000 (%)

11. FDI 1990-2000 (Net, % of Gross Investment)

12. FDI 1990-2000 (Gross, % of GDP)

13. Transition Countries: FDI 2000 (Net, % of Gross Investment) World average

14. Transition Countries: FDI 2000 (Gross, % of GDP) World average

15. Capital Flows Facilitate borrowing abroad to smooth consumption over time Dampen business cycles Reduce vulnerability to domestic economic disturbances Increase risk-adjusted rates of return Encourage saving, investment, and growth

16. Openness to FDI and Growth 1965-98 85 countries r = 0.62 Botswana An increase in openness to FDI by 2% of GDP is associated with an increase in per capita growth by more than 1% per year. r = rank correlation

17. Openness to Trade and Growth 1965-98 87 countries r = 0.42 An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year.

18. Tariffs and Growth 1965-98 82 countries An increase in tariffs by 10% of imports is associated with a decrease in per capita growth by 1% per year. Botswana India Cote d'Ivoire r = -0.52

19. Pitfalls: Incomplete Information • Capital account liberalization, if well managed, stimulates saving and investment, efficiency, and economic growth • But information may be asymmetric • Adverse selection • Moral hazard • Herding

20. Capital Account Liberalization • Needs to be orderly, gradual, well-sequenced • Effective prudential regulation • To encourage banks to recognize risks • To enable authorities to monitor threats to stability of the financial system • Sound macroeconomic policies • Sequencing • Put bank supervision and sound policies in place first, then liberalize

21. External Debt Dynamics and Sustainability 2 Many countries have developed rapidly with the aid of external loans (US, Korea) But many other countries have fared less well with their external debt strategies because they borrowed abroad to finance consumption, not investment Consumption does not increase the ability of indebted countries to service their debts, nor does low-quality investment But high-quality investmentdoes

22. External Debt: Key Concepts Debt burden • Also called debt service ratio • Equals the ratio of amortization and interest payments to exports q = debt service ratio A = amortization r = interest rate DF = foreign debt X = exports

23. External Debt: Key Concepts Interest burden • Ratio of interest payments to exports Amortization burden • Also called repayment burden • Ratio of amortization to exports q = a + b

24. External Debt: Numbers How can we figure out a country’s debt burden? • Divide through definition of q by income Now we have expressed the debt service ratio in terms of familiar quantities: the interest rate r, the debt ratio DF/Y, and the export ratio X/Y as well as the repayment ratio A/Y

25. Numerical Example Suppose that • r = 0.08 • DF/Y = 0.50 • A/Y = 0.06 • X/Y = 0.20 Here we have a country that has to use a half of its export earnings to service its external debt Heavy burden!

26. Transition Countries:External Debt 2000 (PDV, % of GDP)

27. Transition Countries: External Debt 2000 (% of Exports)

28. Transition Countries: External Debt Service 2000 (% of Exports)

29. External Debt Dynamics Debt accumulation is, by its nature, a dynamic phenomenon • A large stock of debt involves high interest payments which, in turn, add to the external deficit, which calls for further borrowing, and so on Debt accumulation can develop into a vicious circle • How do we know whether a given debt strategy will spin out of control or not? To answer this, we need a little arithmetic

30. External Debt Dynamics Recall balance of payments equation: • BOP = X – Z + F where • F= capital inflow = DF where • DF = foreign debt • Capital inflow, F, thus involves an increase in the stock of foreign debt, DF, or a decrease in the stock of foreign claims (assets) • So, F is a flow and DF is a stock

31. External Debt Dynamics Now assume • Z = ZN + rDF • Z= total imports • ZN = non-interest imports • rDF = interest payments Further, assume • X = ZN • BOP = 0 A flexible exchange rate maintains equilibrium in the balance of payments at all times Then, it follows that BOP = X – Z + DF = 0 so that DF = rDF In other words:

32. External Debt Dynamics So, now we have: Now subtract growth rate of output from both sides:

33. External Debt Dynamics But what is ? This is the proportional change of the debt ratio: This is an application of a simple rule of arithmetic: %(x/y) = %x - %y

34. Proof z = x/y log(z) = log(x) – log(y) log(z) = log(x) - log(y) But what is log(z) ? So, we obtain Q.E.D.

35. Debt, Interest, and Growth Need economic growth to keep the debt ratio under control We have shown that Debt ratio r  g  where r = g r  g Time

36. What Can We Learn from This? It is important to keep economic growth at home above – or at least not far below – the world rate of interest Otherwise, the debt ratio keeps rising over time External deficits can be OK, even over long periods, as long as the external debt does not increase faster than output and the debt burden is manageable to begin with A rising debt ratio may also be OK as long as the borrowed funds are used efficiently Once again, high-quality investment is key

37. Debt Dynamics: Another Look Let us now study the interaction between trade deficits, debt, and growth Two simplifying assumptions: • Dt = aYt (omit the superscript F, so D = DF) • Trade deficit is a constant fraction a of output • Yt = Y0egt • Output grows at a constant rate g each year Y Exponential growth t

38. Pictures of Growth Y log(Y) g 1 time time Exponential growth implies a linear logarithmic growth path whose slope equals the growth rate

39. Debt as the Sum of Past Deficits at time T

40. Debt as the Sum of Past Deficits at time T

41. Debt as the Sum of Past Deficits at time T Evaluate this integral between 0 and T

42. Debt as the Sum of Past Deficits at time T So, as T goes to infinity, Dt becomes infinitely large. But that may be quite OK in a growing economy! Evaluate this integral between 0 and T

43. Debt as the Sum of Past Deficits

44. Debt as the Sum of Past Deficits

45. Debt as the Sum of Past Deficits

46. Debt as the Sum of Past Deficits So, as T goes to infinity, DT/YT approaches the ratio a/g

47. Numerical Example Debt ratio 3 Suppose • Trade deficit is 6% of GNP a = 0.06 • Growth rate is 2% per year g = 0.02 Then the debt ratio approaches • d = a/g = 0.06/0.02 = 3 This point will be reachedregardless of the initial position ... • ... as long as a and g remain unchanged Time

48. Numerical Example, Again Here we have a country that has to use one and a half of its export earnings to service its debts Suppose that • r = 0.08 (as before) • D/Y = 3(our new number) • A/Y = 0.06 (as before) • X/Y = 0.20 (as before) Heavy burden, indeed!!!

49. Numerical Example, Again Here we have a country that has to use one and a half of its export earnings to service its debts Suppose that • r = 0.08 (as before) • D/Y = 2(our new number) • A/Y = 0.06 (as before) • X/Y = 0.20 (as before) Heavy burden, indeed!!

50. Numerical Example, Again Here we have a country that has to use one and a half of its export earnings to service its debts Suppose that • r = 0.08 (as before) • D/Y = 1(our new number) • A/Y = 0.06 (as before) • X/Y = 0.20 (as before) Heavy burden, indeed!