Do Capital flows help?

I happened to read another excellent survey last week. This time it was on Financial Globalization and it covers all the studies that have been done so far to understand whether capital flows have resulted in economic growth. I had posted on the same topic earlier as well.

It has been done by a very influential team of Economists – Ken Rogoff, Eswar Prasad etc and is aptly titled Financial Globalization: A reappraisal This paper is interesting in many aspects:

1. Effects on Growth: It says the evidence so far has been mixed as some papers have used de jure (as per the law) measures of financial openness and some have used de facto (as per practice) measures. Here is a summary:

“By both measures, advanced economies have become substantially integrated into global financial markets. For emerging market economies, average de jure openness has not changed much based on the IMF measure, but de facto integration has increased sharply over the last two decades. For other developing economies, de jure openness on average rose sharply over the last decade, to a level higher than that for emerging market economies, but the de facto measure has stayed flat over this period.

Further, the paper has a very interesting table which summarises most of the research on the subject so far and just a rough counting tells me out of 26 cited studies 18 show mixed evidence.

2. Effects on Volatility: The paper suggests more research in this area and says “there is little empirical evidence to support the view that capital account liberalization by itself increases vulnerability to crises. Indeed, the literature on the effects of financial integration on volatility (and crises) is much sparser than the literature on its growth effects. Further research is warranted in this area.”

3.Composition of Capital Flows: This is the most interesting part of the paper. The basic idea is that it is not right to dump all kinds of flows (i.e. equity vs debt, Portfolio investment vs FDI) as one and analyse the impact. Here are some major findings:

a) Impact of FDI on growth: The usual belief is that FDI is beneficial for growth as it has a positive impact on productivity through transfers of technology and managerial expertise. It has also been argued that FDI is less volatile than other inflows, making countries less vulnerable to sudden stops or reversals of these flows.

But empirical evidence does not show the effect. Out of 11 studies in the paper 10 show mixed effect where FDI alone could not be held responsible for growth.

Even empirical evidence on horizontal spillovers ( i.e. from a foreign company to another company in the same sector) is inconclusive, however, in case of vertical spillovers ( i.e. from the foreign company to its suppliers etc) we have some positive evidence.

 b) Impact of Portfolio Equity flows on growth: Most papers cited show that evidence is positive i.e. equity flows lead to growth.

c) Impact of Debt flows on growth: Well, this is an interesting finding. The paper says that debt flows are the riskier variety-

The procyclical and highly volatile nature of these flows, especially short-term bank loans, can magnify the adverse impact of negative shocks on economic growth. Debt flows lack the positive attributes of equity-like flows. They do not solve certain agency problems, can lead to inefficient capital allocation if domestic banks are poorly supervised, and generate moral hazard as debt is implicitly guaranteed by the government (in the case of corporate debt) and/or international financial institutions (both corporate and sovereign debt).The empirical literature on financial globalization is decisive that debt flows generate the greatest risks from financial openness. In particular, there is a systematic empirical link between exposure to short-term debt and the likelihood (and severity) of financial crises.”

This also explains why RBI has put a cap on the amount Foreign investors can invest in government and corporate bonds. To argue whether the limit should be increased is another issue,

4. The paper further discusses a new framework to understand the impact of capital flows.

 

“A key component of our argument is that it is not just the capital inflows themselves, but what comes along with the capital inflows, that drives the benefits of financial globalization for developing countries.

The paper says that there are many indirect benefits of financial integration which they call “collateral benefits” –development of the domestic financial sector, improvements in institutions, better macroeconomic policies etc. These collateral benefits then result in higher growth, usually through gains in allocative efficiency.

Overall, it is an excellent summary of the work done on the subject so far. A Must read!

 

Advertisements

12 Responses to “Do Capital flows help?”

  1. Policy Development « Mostly Economics Says:

    […] 22, 2007 at 1:46 pm · Filed under links and readings, macroeconomics, Policy 1. RBI lowers the interest rate a company can pay for Borrowing Abroad (popularly called External Commercial […]

  2. More on Capital Flows and growth « Mostly Economics Says:

    […] growth and development, State of the Art, finance, research I had posted earlier on this topic here and here. The last one was a summary of an excellent survey (which is a summary of the empirical […]

  3. Diffrence between trade in goods and trade in finance « Mostly Economics Says:

    […] in finance) is helpful or not, I have put findings of the most exhaustive paper on the subject here and here. And in nut-shell the evidence so far has been […]

  4. Great expectations and greater determination « Mostly Economics Says:

    […] however beg to differ. Statistics isn’t the only way of looking at things. As we learnt earlier, despite conventional thinking, financial globalisation isn’t beneficial when we look at the […]

  5. Top Stock investments online information blog Says:

    top stock picks

    Top Stock Picks Research

  6. Life Insurance blog Says:

    the insurance companies don’t want you to know

    Information on the life insurance industry

  7. How right is criticizing India’s financial sector policies? « Mostly Economics Says:

    […] float. But on this topic they seem to ignore the research. The most comprehensive research from Rogoff et al shows benefits from capital inflows are at best […]

  8. Is India investment constrained or saving constrained? « Mostly Economics Says:

    […] so far the evidence is at best mixed and this surprises the economists (not surprising though). This has led to variety of responses […]

  9. Literature Survey on Financial Globalisation « Mostly Economics Says:

    […] findings are quite similar to what Rogoff et al say in their paper. In that paper they review tons of literature and say the same – Though, there is little evidence […]

  10. BIS report on Capital Flows « Mostly Economics Says:

    […] case studies and full of graphs and charts. Despite near similar conclusions (see these papers from Rogoff , Obstfeld and numerous others), it is worth a […]

  11. India’s capital account liberalization - What is the real issue? « Mostly Economics Says:

    […] growth: no evidence whether capital flows matter (this is well known as pointed by Obstfeld and Rogoffin different studies). He also points to his own study which says non-industrial economies that rely […]

  12. Thresholds for financial globalisation « Mostly Economics Says:

    […] Thresholds for financial globalisation By Amol Agrawal In a new paperadvocates of financial globalisation write (see advocacy paper of the 2 of the authors here): […]

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.


%d bloggers like this: