Durable flows, durable benefits

©David Rooney

In a world of volatility, poorer countries should aim for equity inflows – portfolio equity and FDI – if they want growth to last.

The proponents of open capital markets are often criticised for offering more “banner-waving” than hard evidence on the benefits that developing countries can derive from free capital flows. Indeed, in contrast to the benefits of free trade in goods and services, the empirical evidence that economists have been able to establish on the costs and benefits of foreign savings has been very sketchy and contradictory.

This failure can easily be explained: a rigorous attempt to quantify the gains that countries have made from international capital mobility would require a fully articulated model in which the situation of no capital movements could be simulated for comparison. Moreover, the time series for private capital flows to developing countries, except for foreign direct investment (FDI), are not yet long enough to draw strong conclusions since the flows started in earnest only at the end of the 1980s. Finally, studies which focus on the absence or presence of capital controls cannot allow for varying degrees of intensity in the operation of capital-account restrictions.

A statement as common as it is trivial is that capital flows carry benefits as well as risks. But can we establish something close to a pecking order for the broad categories of capital flows in terms of their benefits and risks for the recipient countries? The answer is yes, although it requires looking at the channels through which these benefits and risks emerge.

Economic theory suggests that foreign savings can be beneficial in many ways. They stimulate capital accumulation by adding to domestic savings and they raise the recipient economy’s efficiency (e.g., through improving resource allocation, instilling competition, improving human capital, deepening domestic financial markets and reducing local capital costs). At the same time, foreign savings lower consumption risks through enlarging choices for portfolio diversification and by sharing risks more evenly between capital exporters and importers.

Risky flows

The inherent risks to specific types of capital flows are twofold. First, they can magnify welfare losses due to distorted consumption and production patterns; and second, they can lead to bankruptcies and output losses if capital suddenly flows back out again. In the former case, countries will be worse off if the foreign savings are attracted into protected sectors. While trade liberalisation and structural reform in most capital-importing countries have made this concern less relevant today, ill-regulated financial sectors have often created credit boom distortions that foreign flows have magnified.

As to the risk of sudden withdrawal, the bankers’ adage that “it is not speed that hurts, but the sudden stop” was more than validated in the Asian crisis, with widespread bankruptcies, defunct local credit channels and obsolete human capital. The larger the real devaluation needed to accommodate swings in capital flows, the deeper will be the ensuing financial turmoil.

How then do these benefit and risk channels relate to specific types of capital flows? It is often maintained that distinguishing between types of flows generates little policy insight, for essentially two reasons. First, capital flows are said to be fungible. That would imply, for example, that we could not discern any difference between the impact of foreign direct investment or short-term debt flows on private or government consumption. Second, it has been argued that capital-flow labels have become meaningless in the presence of derivatives or efforts to circumvent capital controls. These claims, however, ignore the evidence that has been emerging.

It now appears that FDI, long-term bank lending (often long-term project loans in syndicated lending) and short-term trade credits are less reversible than portfolio and short-term bank credit flows. Moreover, the more stable flows are mostly tied to particular investments and users, financing real assets. Short-term bank lending and portfolio flows, by contrast, constitute only an indirect link between foreign savings and domestic investment. In other words, these forms of financing can spill over into unsustainable consumer spending bubbles.

A recent study by Marcelo Soto at the OECD Development Centre explored the growth effect of various categories of private capital flows in a sample covering 44 developing countries over the period 1986-97. As expected and in line with earlier studies, the paper shows that foreign direct investment – with a lag of one year – significantly boosts per capita income growth in the recipient economy. In fact, a ten-percentage point rise in the FDI-GNP ratio would increase the long-run steady-state income level by 3% and short-term per capita income by 1%.

Perhaps surprisingly, the most important growth impact was found to flow from portfolio equity flows. The reasons are clear: these flows loosen the constraining effects of local financial conditions and can spur growth in dynamic industries. Equity flows also stimulate the liquidity of domestic stock markets, improving resource allocation and lowering capital cost to high-return activities.

Bonds, by contrast, did not produce any significant impact on growth in the study, and foreign bank lending – short-term and long-term – was found to undermine future per capita income growth in recipient countries, unless local banks were sufficiently capitalised.

This result confirms earlier hunches: under-capitalised banks tend to engage in excessive risk taking in a gamble to earn their way out of difficulties. And to stem the decline in risk-weighted capital ratios, banks will increase their exposure to government liabilities or other zero-risk weighted assets. But good risks, by contrast, remain under-financed and growth prospects undermined. Foreign bank lending intensifies these two distortions. Which is why, in a downturn, the resulting misallocation of resources and weak bank balance sheets intensifies credit slumps and widespread bankruptcies.

The conclusion of all this has to be that authorities are right to encourage capital inflows. And equity investment and FDI are preferable to debt instruments. This does not mean that developing countries should raise fiscal and other incentives or lower their labour and environmental standards to attract FDI; the aim should rather be to encourage transparent and predictable rules, provide the necessary infrastructure and avoid macroeconomic extravagancies. Avoiding protracted import substitution, educating people and reducing distortions, in wealth distribution for instance, have been shown to maximise FDI’s benefits. Moreover, FDI flows cannot easily be reversed in the short term.

How can these FDI and portfolio inflows be stimulated? Reforms, like abolishing foreign ownership limits and caps on voting rights, raising accounting and disclosure standards and providing instruments for hedging foreign exchange risks, would help, as would providing further liquidity in secondary markets to attract funds. Portfolio equity flows can drive up asset price inflation, and this may require more regulatory attention with respect to bank system exposure, corporate disclosure and accounting standards and liquidity requirements for market makers. Finally, foreign savings in the form of foreign bank lending will contribute to growth only if the banking system is well capitalised. Until that happens, lending will be drawn towards the “bad” risks, while the “good” risks that developing countries need for their long-term growth will be under-financed.

References

• Oman, C., Policy Competition for Foreign Direct Investment: A Study of Competition among Governments to Attract FDI, OECD Development Centre Studies, Paris 2000.

• Soto, M., Capital Flows and Growth in Developing Countries: Recent Empirical Evidence, OECD Development Centre Technical Paper No.160, Paris 2000.

©OECD Observer, No 226/227 Summer 2001




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