Site Loader
Rock Street, San Francisco

Developing countries in Asia and Latin America experienced a surge of capital inflows in the 1990’s. About $670 billion of foreign capital entered the developing nations in Latin America and Asia during the five years from 1990-94. This is about five times the $133 billion of flows in the previous five years, when there was a debt crisis and many of these countries did not have access to international capital markets. Although there was a substantial decline in capital flows to developing countries after the Mexican currency crisis in 1994, but the capital flows resumed by 1995 and have been sustained at relatively high levels. [pic]Proponents of capital account liberalization cite the growth-promoting attributes of capital flows as a key benefit of financial integration for developing countries.

For many developing countries ability to draw upon an international pool of financial capital offers large potential benefits. Low levels of capital per worker in these countries is one of the major reasons for low levels of GDP in these countries. Net foreign resource inflows can augment private savings and help these countries reach higher rates of capital accumulation and growth. Access to international capital markets provides the means to finance those resource flows.Some types of foreign capital flows, like Foreign Direct Investment, may also facilitate the transfer of managerial and technological know-how. Portfolio investment and foreign bank lending add to the depth and breadth of domestic financial markets.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!


order now

In some cases the free flow of capital across borders promotes more disciplined macroeconomic policies on the part of the nations receiving these capital flows. On the other hand, opening domestic financial markets to international transactions creates added risks, as has been seen during the east-Asian crisis.Developing countries that experience large inflows of foreign capital, as many Southeast-Asian countries did prior to the crisis, make themselves vulnerable to sudden and destabilizing withdrawals. Causes of the capital flows The factors that led to such capital flows in the developing countries can be categorized into two: ones that are external to the countries receiving the flows and others that are internal to the economy. The various factors are: 1) There was a substantial decline in world interest rates. For example, short-term interest rates in the US declined steadily in early 1990’s.Lower interest rates in the developed nations attracted investors to the high investment yields and improving economies in Asia and Latin America. Also the investors viewed investments in these economies less risky than before.

However with the tightening of monetary policy in the US and the resulting rise in interest rates made investment in Asia and Latin America less attractive. This triggered market corrections in several emerging stock markets as a large portion of investment in these countries was in form of portfolio equity which can be easily withdrawn. ) The early 1990’s brought recessions to the United States, Japan, and many countries of Europe.

This international swing in developing countries made profit opportunities in developing countries appear relatively more attractive. However, as the OECD economies move towards recovery in the mid-1990s, this factor became less important in generating capital flows to Latin America. The increased flow to developing countries thereafter was mainly because the relatively high returns on their emerging stock markets. This is one of the major reasons for increased capital flows to Brazil and India in the last few years. ) There has been a trend towards international diversification of investments in major financial centres and towards growing integration of world capital markets.

Increasing amounts of funds managed by institutional investors such as mutual funds and wealth management companies have entered emerging markets. Regulatory changes in the US and Europe have also made it easier for foreign institutional investors to invest in these countries. 4) Several developing countries began to adopt sound monetary and fiscal policies as well as market-oriented reforms that have included trade and capital market liberalization. ) Finally a large shift in capital flows to one or two large countries in the region may generate externalities for the smaller neighboring countries. These are called the contagion effects.

For example, Mexico’s and Chile’s re-entry into international capital markets in 1990’s made investors more familiar and more willing to invest in other emerging markets in Latin America. Although these are the mix of domestic and external factors, external factors were more important in the first half of 1990’s. Domestic factors also remained important in both the magnitude and the composition of capital flows.

Countries with sound domestic fundamentals attracted capital on a larger scale and with a higher proportion of long term investment Trends in the capital flows [pic] 1) As shown by figure 1, total international flows of capital expanded fourfold between 1978 and 1995. However, this trend is completely dominated by the high-income OECD countries, which received about 85 percent of the total. Despite the huge nominal increase in the capital inflows, as a share of GDP, total capital inflows and the portion going to industrial countries were roughly unchanged over the two decades ) A very rapid growth of capital flows to developing countries since 1990s was just a recovery from the severely depressed flows following the 1982 debt crisis. Flows to developing economies were about the same percentage of their output in 1995 as during 1978-81. Furthermore at 5% of the GDP,, capital flows to developing countries in 1995 are about the same proportion as flows to industrial countries, despite a far less sophisticated infrastructure of financial markets and institutions.

3) Capital flows to developing countries were concentrated among a few countries in Asia and Latin America.Five countries ( China, Mexico, Korea, Thailand, Brazil) accounted for nearly two-thirds of financial flows to developing countries in the 1990-95 period. 4) About half of the cumulative inflows have been associated with increased current account deficits, and that proportion has declined in the 1990’s. Approximately a third of the inflows have been funneled into reserve assets. The need to hold reserves lowers the overall net benefits of financial inflows, as the return on the reserves is low. In the aggregate, a third of the inflows have been offset by the financial outflows.

) As far as the composition of capital flows is concerned, it has shifted significantly toward FDI and way from bank loans. The 1990’s also witnessed an explosive growth in portfolio capital (equities and bonds), which was practically non-existent in prior decades. The composition of inflows also differs by region. Prior to 1982, bank loans either to governments or to other banks were the dominant type of financial transactions in Latin America. However growth in capital inflows in this region after 1982 has been concentrated on FDI and portfolio capital.

East Asia experienced an even more rapid growth in FDI, but lending there was more important than portfolio capital during the 1990’s. In fact, Asia accounted for most of the growth in bank loans to developing countries. 6) The three type of capital inflows (FDI, portfolio investment, and loans) are not significantly correlated with one another overtime or across countries.

That is, there is little tendency for countries with large amounts of portfolio capital or loans to receive correspondingly large amounts of FDI.China, the largest developing country recipient of FDI in the 1990s, obtained very little portfolio capital or lending, while Brazil, the largest recipient of portfolio capital among developing countries, reduced its reliance on loans and maintained a very restrictive policy towards FDI. Impact of Capital Flows on Developing Economies A lot of current policy decisions accept the notion that open capital markets are highly beneficial, and a large number of developing countries are increasingly diverting resources to reduce the financial instability and crisis so that capital flows can continue unabated.However there is a need to look into the varying effects of capital flows, all of which may not be beneficial for the country receiving these inflows. Also no strong link has been established between these capital flows and economic growth in a country. In the following section, I will look at the following issues relating to the impact of capital flows on the developing countries: 1) Macroeconomic effects of these inflows 2) Capital inflows and economic growth 3) Dependency theory Macroeconomic effects: pic] First, a substantial portion of the surge in capital inflows has been channeled to accumulation of foreign exchange reserves.

From 1990-1994, the share going to reserves has been 59% in Asia and 35% in Latin America. More recently, the pace of reserve accumulation is showing signs of slowing, and an increasing portion of the capital inflows has taken the form of larger current account deficits. Second, in most countries the capital inflows have been associated with widening current account deficits.This widening of current account deficits has usually involved both an increase in the national income and a decrease in savings (the gap between the two is current account deficit). In the countries considered in the above table, investment ratios have risen in most of them and the rate of savings has declined in roughly half of the countries. Third, as a result of fall in savings there has been a rise in private consumption spending. The import data in these countries suggests that consumption boom in these countries is driven by rising imports of durable goods.

This has been particularly true for Latin American countries including Argentina, Brazil, Colombia and Mexico. Fourth, in the countries examines in above table, there has been a rapid growth in the money supply in the first half of 1990s in both nominal and real terms. This follows logically from an increase in the economic activity observed in the recipient countries. However, several countries have demonstrated that it was possible, even in the face of large capital inflows (at least in the short run), for the central bank to curb the acceleration in the growth of the money supply.The central bank can do this in two ways. First, it can refrain from intervening in the foreign exchange market and simply allow the domestic currency to appreciate in response to the increased demand for domestic assets. In that case no international reserves are accumulated and no expansion in the monetary base ensues.

Alternatively, it can issue domestic bonds to provide for all or most of the foreign exchange purchases; that is, the expansionary effect on the monetary base of an increase in central bank holdings of foreign exchange reserves is offset by a reduction in domestic liquidity.Such action by a central bank is referred to as “sterilized intervention. ” Fifth, the surge in portfolio flows to the Asian and Latin American countries was accompanied by sharp increases in stock and real estate prices. Policy Management of Capital Inflows Several possible consequences of capital inflows are of special concern to policymakers. The capital inflows can lead to inflationary pressures, especially when they are monetized. Since an inflow of capital also implies a higher demand for a nation’s currency, it often means an appreciating exchange rate, which may widen the trade deficit to uncomfortable levels.If a nation’s banking system has difficulty handling the capital flows, there is some risk of financial destabilization and even banking crises.

Overall, in a world of high capital mobility, where capital inflows can depart just as rapidly as they arrived, there is a risk that their effects on inflation, the exchange rate and the financial sector can lead to severe macroeconomic instability. Such concerns have often led the authorities to react to the inflows by implementing a variety of policy measures. Monetary Policy: Sterilization and RegulationSterilization has been the most popular policy response to capital inflows in both Latin America and Asia. This policy aims at insulating the money supply and the exchange rate from the effect of the capital inflows; the intent is to mitigate inflationary pressures, the real exchange rate appreciation, and avoid the loss of control over the domestic money stock. ‘However, it is not clear that this policy can provide a lasting solution, and it can be costly.

The funds are being attracted into the country by the promise of higher expected interest rates.But if the capital inflow is sterilized, this will prevent the interest rate differential from narrowing, and may thus induce further capital inflows. In addition, since sterilization involves increasing the number of domestic bonds to offset the currency inflow, it results in an increase in public debt. Other costs are associated with sterilized intervention. If the central bank were simply to provide its own currency for purposes of foreign exchange without sterilization, it would allow the domestic money supply to increase.

The central bank would also end up holding foreign currency, which it could invest in the bonds of the foreign country. However, after selling domestic bonds to sterilize the currency inflow, the central bank must then pay interest on those bonds. To the extent that the interest rate on domestic bonds is higher than that on foreign exchange reserves (which is the case for most developing countries), this entails costs Controlling Capital Inflows and Liberalizing Capital Outflows Various countries imposed taxes on short-term borrowing abroad with the intent of discouraging inflows that are thought to be particularly speculative.Another response has been to soften the domestic impact of capital inflows by lowering the institutional barriers to capital outflows.

Fiscal Policy Some countries reacted to the surge in capital inflows by tightening fiscal policy, usually via a cut in public expenditures. To the extent that nontradable goods often represent a sizable share of government expenditure, cutting government spending will reduce the demand for nontradables relative to the demand for tradable goods. This step makes nontradables able to buy less of the goods traded on world markets-which effectively means limiting the appreciation of the real exchange rate.

However, the effectiveness of fiscal policy is limited in this situation. Changes in legislation and sensitive political actions usually cannot be undertaken on short notice, which would often be needed to offset the effects of the capital inflows. Furthermore, optimal fiscal policy considerations suggest that taxes and expenditures be set to reflect long-term goals, rather than in response to what can be excessively volatile fluctuations in international capital markets. Exchange Rate PolicyOne of the options for a capital-importing country is to let the nominal exchange rate appreciate in response to capital inflows. The main advantage of allowing greater exchange rate flexibility is that the appreciation in the real exchange rate is likely to occur through a change in the nominal exchange rate and not through higher inflation. Moreover, exchange rate flexibility might strengthen the degree of autonomy of domestic monetary policy precisely when central bank’s function as “lender of last resort” might be needed-for example, during a temporary subsequent reversal of capital inflows.A disadvantage of a pure float is that it may be associated with high volatility in the real exchange rate.

Massive and rapid capital inflows may induce such a steep and rapid exchange rate appreciation that it may damage the competitiveness of strategic sectors for economic growth, like nontraditional exports. To reduce the risk of excessive fluctuations in the real exchange rate, several countries have adopted crawling exchange rate bands, which can be seen as an intermediate case between fixed and flexible exchange rates. Capital flows and economic growthCapital inflows in a country can lead to economic growth through three channels-by increasing the domestic investment rate and/or by leading to investments associated with positive spillovers, such as the transfer of technology or skills and/or by increasing domestic financial integration. In this section I have given the model used in the “ working paper” to study the relationship between capital flows and economic growth. The relationship between capital flows and growth is examined using a simple endogenous-growth model called the AK model.This endogenous-growth framework highlights the potential effects of changes in financial variables (i. e.

, financial development and capital flows) on steady-state growth through their influence on capital accumulation. The framework is then extended to incorporate international capital flows. The closed-economy version of the AK model, the aggregate production of the economy is given by: [pic](1) where output is a linear function of the aggregate capital stock. There is no population growth this model and the economy produces only one good, which can be consumed or invested.By assuming that the capital stock depreciates at a rate of per period, gross investment equals: [pic](2) In this model, financial intermediaries are responsible for transforming savings into investment. In doing this, they absorb resources so that a dollar saved by households will generate less than a dollar’s worth of investment.

It is assumed that a fraction ? , of each dollar saved is available for investment, whereas 1- ? is retained by the financial intermediaries as a reward for the services supplied. This transaction cost can be seen as the spread between lending and borrowing rates charged by anks. In the closed-economy version of the model, capital market equilibrium requires that the fraction of savings by domestic residents left after financial intermediaries have taken their share must equal gross investment.

Thus, equilibrium in the capital market ensures that [pic](3) Using equations (1) through (3) we get the growth rate of output, g as: [pic](4) where s denotes the gross savings rate. Equation (4) thus represents the steady-state growth rate of a closed-economy AK model with financial intermediation.This equation reveals two main channels through which financial development can affect economic growth. The first channel involves the efficiency with which savings are allocated to investment. As banks engage in increased intermediation, they are likely to become more efficient at what they do, and thus the spread between their lending and borrowing rates falls. This results in an increase in the proportion of savings channeled to investment; thus, g will increase in equation (4) as a result of an increase in ?Second, an increase in financial intermediation can affect growth if it improves the allocation of capital. An important function of a financial intermediary is to allocate funds to those projects where the marginal product of capital is highest. In this model, an improvement in the allocation of capital translates into higher growth, because it increases the overall productivity of capital, A.

As financial intermediation increases, banks are assumed to gain experience in evaluating alternative investment projects and are thus better able to select high-yielding projectsThis framework can be extended to incorporate international capital flows. Now assume that foreign residents are now allowed to invest in this economy. Also, it is suppose that they invest through the financial intermediaries. If capital flows in( on net) then a larger pool of savings will be available for investment than in the absence of capital flows.

Thus, in the presence of international capital flows, the capital market equilibrium becomes [pic](3’) where NCFt. represents net international capital flows. The steady-state growth rate is now given by NCFt. pic] (4’) The steady-state growth rate of the AK framework with financial intermediation and international capital flows depicted in equation (4’) can now be compared with the growth rate of the closed-economy AK model with financial intermediation. This comparison highlights the various channels through which capital flows can influence economic growth in this simple endogenous-growth model. First, capital flows can promote growth if they lead to an increase in the investment rate. Thus, g* will be higher than g if s* is larger than s, all else being equal.For the savings rate to increase in the presence of international capital mobility, capital must flow in on net (i.

e. , NCFt > 0 ), capital flows must be used to finance investment and not consumption, and investment financed by foreign capital must not crowd out domestically financed investment. Second, capital flows can foster economic growth if they lead to investments that are associated with positive spillovers. The potential benefits that capital flows can entail by generating positive externalities have been emphasized in the FDI literature, although those types of benefits could also arise with other types of capital flows.The different channels through which positive externalities associated with FDI can occur are:first, foreign investment could increase competition in the host-country industry and hence force local firms to become more productive, by adopting more efficient methods or by investing in human and/or physical capital. In addition, since firms with foreign participation often have important linkages with domestic firms, they can influence the industrial structure of the host economy. In particular, they can help restructure key sectors of he economy by making them more competitive and export-oriented. Second, if foreign investment leads to increased training of labour and management, this could influence the rest of the economy if employees switch to locally owned firms or become entrepreneurs.

And third, foreign investment can be accompanied by technology transfer. Since many new technologies are developed and adapted by firms in industrialized countries, foreign investment may be the most important way for developing economies to gain access to them. 3 In the framework presented in this section, if capital flows lead to investments that generate positive spillovers, then this will increase the social marginal productivity of capital, so that A* will tend to be higher than A, all else being equal. The third way in which capital flows can have a positive influence on economic growth is if they lead to an increase in domestic financial intermediation. It was shown how an increase in financial intermediation in the context of a closed economy could foster higher growth if the intermediation makes the local banks more efficient at converting savings into investment (i. .

, if the spread falls), and/or better able to allocate savings to the most productive investment projects. Thus, to the extent that capital flows are intermediated by domestic financial institutions , they will tend to have a positive effect on growth by making the banking sector in the local economy more efficient (i. e.? ’>?. ) and/or better at selecting productive investment projects (i. e. , A*>A).

This simple framework also shows that the level of domestic financial development plays a role in the process linking capital inflows and economic growth.Consider two economies with different levels of financial-sector development. Let us suppose that the country with the more developed financial system is country 1 and the other is country 2. All else being equal, it would be true that A1> A2 and ? 1 > ? 2. Thus, even if both countries receive an equal amount of net capital inflows, this model predicts that the country with the more developed financial system will have a higher growth rate, because its financial sector is more efficient at converting the foreign funds into productive investments, and better able to allocate them to the most productive investment projects.Capital inflows in the presence of distortions The framework presented in the previous section implicitly assumes that international capital markets allocate resources efficiently, and thus that capital inflows are motivated by the investment opportunities in the local economy.

Some economists, however, expressed concern, even prior to the Mexican peso crisis in late 1994, that at least part of the capital flowing into emerging markets since the late 1980s may have been the result of excessive optimism or a response to the wrong incentives.One of the possibility is that the investors might be overly optimistic as to the prospects in a reforming developing country and that this could lead to overborrowing, and ultimately a financial crisis. Some economists also argued that at least some of the capital inflows into developing countries in the early 1990s were motivated by government guarantees rather than profitable investment opportunities created by economic reforms.Capital flows occurring in this context are not likely to be growth-promoting. Indeed, even though capital inflows motivated by distortions might lead to an increase in the investment rate, this will not contribute to higher growth unless the investment is productive. In terms of spillovers, this kind of speculative investment is not likely to generate any positive externalities, either in the financial or non-financial sectors of the economy.Thus, in summary, the above model leads to the conclusion that capital inflows are more likely to foster higher growth in developing countries if they are motivated by, and hence channeled into, productive investments, and if they lead to investments that generate positive spillovers through either the real or financial sector of the economy.

In addition, the effect of capital flows on economic growth is likely to be more pronounced the more developed the domestic financial sector. Dependency theoryOne of the most important theory relating a country’s level of development and its capital flows is dependency theory. This theory claims that First World nations become wealthy by extracting surplus labor and resources from the Third World. Capitalism perpetuates a global division of labor which causes the distortion of developing countries’ domestic economies, declining growth, and increased income inequality. To get out of this economically debilitating relationship, Third World nations must develop independent of foreign capital and goods.Applied specifically to Latin America by the dependency theorists, this theory became an ideology and the basis for official policy in the 1970s and was predicated on import substitution and a hostile attitude toward foreign investment. Import-substituting industrialization attempts to generate wealth through the domestic production of goods that were previously imported from the international market. It is accomplished through tariffs and other barriers which make foreign goods less competitive with local manufacturing.

Dependency came in two forms: The radical one, put forward by economists AndrC Gunder Frank and Amir Samin, claimed that the center grew at the expense of the periphery. The only solution for developing countries was to delink completely from the world economy. From the start, however, radical dependency faced troubles explaining positive correlation between expansion in the developed nations and recession in less developed or developing countries. The milder version of dependency, pioneered by Cardoso and his coauthor Enzo Faletto, and by others like Chile’s Osvaldo Sunkel and Mexico’s Pedro Paz, was more useful.It maintained that under capitalism both rich and poor could grow but would not benefit equally. It supported a mixture of protectionism and Keynesianism that became known as import-substituting industrialization. One of the central propositions of the dependency hypothesis is that international capitalism underdevelops Third World nations. If surplus wealth is taken from the Third World by multinational corporations, the economic performance of developing countries suffers to the benefit of foreign capital.

The profits that accrue from use of indigenous labor and resources are not reinvested in the host country, and this stifles development. This flow of wealth could be measured by the multinationals’ net profits overseas. Developing countries gradually lose control of their domestic economy or suffer distorted development. If the dependency theory is valid, one would expect that rates of economic growth are slower the higher the level of foreign capital penetration into the domestic economy. [pic]The Dependency Hypothesis As far as the evidence for dependency theory is concerned, Volker Bornschier; Christopher Chase-Dunn; Richard Rubinson in their paper in 1978, ‘ Cross-National Evidence of the Effects of Foreign Investment and Aid on Economic Growth and Inequality: A Survey of Findings and a Reanalysis in ‘The American Journal of Sociology”summarized the findings of various empirical studies conducted to study the effects of foreign investment on economic growth and income inequality.Their major findings were as follows( these findings are for the period between 1950 and 1970): (1) The effect of direct foreign investment and foreign aid has been to increase economic inequality within countries. This effect holds for income inequality, land inequality, and sectoral income inequality. (2) Flows of direct foreign investment and foreign aid have had a short-term effect of increasing the relative rate of economic growth of countries.

3) Stocks of direct foreign investment and foreign aid have had the cumulative effect of decreasing the relative rate of economic growth of countries. This effect is small in the short run (1-5 years) and gets larger in the long run (5-20 years). (4)This relationship, however, has been conditional on the level of development of countries. Foreign investment and aid have had negative effects in both richer and poorer developing countries, but the effect is stronger in the richer than in the poorer countries. (5) These relationships hold independent of geographical area.

Post Author: admin

x

Hi!
I'm Eric!

Would you like to get a custom essay? How about receiving a customized one?

Check it out