Paradox of Rich to Poor Capital Flows

Bob Lucas (Nobel laureate 1995) posed this paradox way back in 1990, Why does capital flow from poor to rich countries?

Ideally, it should flow from rich countries to poor ones as latter are capital scarce  and need capital to finance its growth plans. It also works for rich as it would give more returns going by the high risk, high return framework. (provided it is deployed in positive NPV (Net Present Value) projects, which is always the case) .

This fantastic paper from Rogoff et al explain further:

He rejected the standard explanation of expropriation risk and argued that paucity of capital flows to poor countries must instead be rooted in externalities in human capital formation favoring further investment in already capital rich countries.

Their idea however is unless the developing coutries (that are poor) improve their track record of debt defaults, we are not going to see much improvement. They explain:

There is no doubt that there are many reasons why capital does not flow from rich to poor nations yet the evidence we present suggests some explanations are more relevant than others. In particular, as long as the odds of non repayment are as high as 65 percent for some low income countries, credit risk seems like a far more compelling reason for the paucity of rich-poor capital flows. The true paradox may not be that too little capital flows from the wealthy to the poor nations, but that too much capital (especially debt) is channeled to debt intolerant’ serial defaulters.

So as per them, despite a huge default history, number of poor countries still get a lot of capital inflows. Nice insight and a nice twist on the head. I had covered the topic of sovereign defaults earlier as well, but that discussed whys and hows. This paper provides an extension of the thought.

A nice crisp read.

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