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[size=0.9em]Revisiting the paradox of capital
[size=0.9em]Emine Boz, Luis Cubeddu, Maurice Obstfeld 09 March 2017
[size=0.9em]After intensifying through the 2000s until the Global Crisis, the ‘uphill’ flow of capital from poor to rich countries decelerated and has recently reversed. This column documents that saving shifts by China, commodity-exporting emerging and developing economies, and advanced economies played key roles in accounting for the apparently puzzling pattern in the pre-crisis decade. Ongoing policy uncertainties in advanced economies mean large and persistent downhill flows of capital are unlikely in the near term. Going forward, capital flows to emerging and developing economies will need to be supported by policies that enhance the benefits of inflows, temper capital flow volatility, and improve the resilience and depth of domestic financial markets.
Basic economic theory suggests that saving should flow from relatively wealthy, capital-rich countries to poorer countries where capital is scarce and profitable investment opportunities should therefore be abundant. While that pattern broadly held true before WWI, it has been harder to observe after WWII, as stressed by Robert Lucas (1990) nearly three decades ago. Indeed, around the start of the current millennium and up until the 2008 Global Crisis, poorer countries had growing current account surpluses and richer countries growing deficits, leading to what Mervyn King and Raghuram Rajan in 2006 characterised as an “uphill flow” of capital in the global economy (King 2006, Rajan 2006). Recent research has argued that even within the group of emerging market and developing economies (EMDEs), capital flows do not necessarily favour countries with relatively higher productivity growth (Prasad et al. 2007, Gourinchas and Jeanne 2013).
Uphill flows intensify (2000-08)During 2000-08, uphill flows intensified (Figure 1). Measuring total flows by the size of the current account deficit, the difference between national saving and investment, advanced economies as a group received persistent and sizable net inflows, peaking at about 1% of global GDP in the run-up to the Global Crisis. These inflows were mirrored by large and growing outflows from China and commodity-exporting (especially fuel-exporting) EMDEs, which were in turn supported by China’s integration into the global economy, low global interest rates, and the sharp rise in commodity prices. Other East Asian emerging markets apart from China saved more in the wake of the Asian crisis of the late 1990s, as noted by Bernanke (2005). Meanwhile, the rest of EMDEs (82 out of the 99 countries in this group) continued to receive net inflows, although at a more moderate pace than advanced economies when measured as a share of world GDP.
Figure 1 Current account balance by country groups
Sources: IMF World Economic Outlook and IMF staff calculations.
Notes: The charts are based on an unbalanced panel comprising 142 countries in 1980 and 148 countries in 1990. 2016 data are projections as of January, 2017. Advanced economy-EMDE breakdown follows the latest World Economic Outlook while the commodity exporter country group is based on Chapter 2 of October 2015 World Economic Outlook. Part of the large and positive current account discrepancy through 1991 is due to lack of data for the USSR.
Capital outflows from EMDEs during the pre-crisis decade were dominated by offical reserve accumulation (Figure 2). China and EMDE commodity exporters accumulated foreign exchange reserves to back their export-oriented growth model and smooth the use of the commodity windfall, respectively. A number of EMDEs also built up precautionary foreign exchange reserves. However, FDI continued to flow in the ‘right’ direction during the entire period, from rich to poor, as savers in advanced economies exploited investment opportunities in the developing world.
Figure 2. EMDEs: Net capital inflow composition and reserve accumulation
Sources: IMF Financial Flows Analytics, IMF World Economic Outlook and IMF staff calculations.
Notes: The charts are based on an unbalanced panel comprising 129 in 1980 and 140 countries in 1990.
The leading role for reserve accumulation is consistent with other evidence. Other researchers have documented that sovereign-to-sovereign flows, including foreign reserve accumulation, accounted for a large share of uphill flows; and that apart from such flows, the data are consistent with net private capital flowing from rich to poor countries (Alfaro et al. 2014). This result is also broadly consistent with the finding that non-reserve capital flows respond strongly to growth differentials (IMF 2016). If reserve-accumulating countries had refrained from intervening to keep their currencies from appreciating, their current account balances, equal to the net outflow of capital, would have been lower. Reserve accumulation therefore accentuated the global uphill capital flow.
Interestingly, uphill flows did not prevent falling investment in advanced economies or rising investment in EMDEs (Figure 3). Even though lower capital-labour ratios in poorer countries should determine the direction of flows, surges in saving or investment, for example due to looser balance-sheet constraints or productivity improvements, can lead to deviations from the prediction of the theory. However, investment-to-GDP ratios in advanced economies actually declined during 2000-08, suggesting that the uphill flows did not support an expansion of investment in these countries, but rather, a decline in saving. In contrast, and despite the intensification of outflows from EMDEs during the pre-crisis decade, investment grew strongly in these countries as a group (especially in China), although it was more than offset by a surge in saving, with income growth (including that resulting from the commodity windfall) outpacing the growth of domestic absorption. In the 2000s, therefore, the net flow of capital from poor to rich countries was more a reflection of saving behaviour than investment needs.
Uphill flows slow and reverse (2009-present)Uphill flows slowed during the Global Crisis and reversed more recently. The post-crisis deleveraging and associated investment declines led to lower net inflows into advanced economies as a whole. These developments were matched by reduced outflows from EMDEs, as China started to rebalance its economy toward domestic absorption and the commodity income windfall for commodity exporters vanished. By 2015, EMDEs as a group registered a small net capital inflow, as net inflows into most EMDEs more than offset the continuing net outflows from China (Figure 1).
The slowdown and eventual reversal in uphill flows were largely mirrored by official reserve movements. Since 2014, the stock of EMDE official reserves has fallen, reflecting the emergence of current account deficits in commodity exporting EMDEs and the intensification of private outflows, especially from China, where policy uncertainties prompted residents to accelerate the pace of rebalancing from domestic to foreign assets. The recent sales of EMDE offical foreign reserves limited currency depreciation and prevented a sharper external adjustment, thereby supporting the reduction and ultimate reversal of the uphill flow. Such foreign reserve sales, which are official capital inflows, imply that private (that is, non-reserve) net capital inflows need not match the behaviour of total net capital inflows, and indeed some EMDEs have recently experienced higher overall net inflows despite decreased private net inflows (IMF 2016).
Since the Global Crisis, investment and saving have diverged between rich and poor countries (Figure 3). In advanced economies, improvements in the current account balance were driven by falling investment, which more than offset the decline in their saving as a share of global GDP. Meanwhile, the deterioration in the current account balance of EMDEs reflected relatively faster investment growth, which, despite decelerating sharply from its unusual pre-crisis highs, outpaced the growth of saving. Thus, the current net flow of global saving is in the direction of supporting higher EMDE investment.
Figure 3. Change in the current account balance: Role of saving and investment
Sources: IMF World Economic Outlook and IMF staff calculations.
Notes: 2016 data are projections as of January, 2017. Advanced economy (AE)-EMDE breakdown follows the latest World Economic Outlook. Change in saving includes a small discrepancy so as to ensure that the current account matches the difference between saving and investment.
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