International Financial Development Lecture Summary
74 views 3 purchases
Course
International Financial Development (EBM207A05)
Institution
Rijksuniversiteit Groningen (RuG)
Summary of the six lecture for the course International Financial Development. The summary includes the lectures slides and additional notes added during the lectures.
Lectures International Finance and Development
Lecture 1 – Allocation of Capital Flows
The Evolution of Capital Flows
When an economy is depressed, that is when capital is needed most. However, whenever
there is a crisis the capital flows stop.
- In the early 1970s increased international bank lending to developing countries
- Early 1980s a sharp drop in flows following the Latin American debt crisis.
- Rebound in 1990s especially loans to Latin America
- Slow down after Asian Financial crisis hit in the late 90s,
- Rebound in late 1990s
- Slow down during Global Financial Crisis
- Another rebound from 2016 this time slower
- So what explains this trend?
Theories of Capital Flows: Lucas Puzzle
We start with Lucas (1990); Why does capital not flow from rich to poor countries? A look at
neoclassical model. Assume 2 countries, one rich (A) and another poor (B) with similar
production and constant returns to scale production function. According to the law of
diminishing returns the marginal product of capital is higher in B. The returns to investment
in poor countries are much higher in the poor country.
- Capital seems to be much more productive in the US than in India. However, should
be 58 times that of the US.
- Why is this? Why is capital not going there? This is the central question to economic
development.
Lucas explanation for puzzle:
- Differences in human capital. First benefit. Difference in labour quality or human
capital per worker. If the quality of human capita is higher in the US than in India,
therefore this is more productive in the US. India cannot utilize the capital as
productively.
- External benefits of human capital. Second benefit. Two countries (one high
density of human capital), you get a second benefit from this human capital namely a
spill-over effect. Knowledge spill-overs from the productivity effects of a worker.
There are external benefits of a country's stock of human capital that accrue primarily
to producers within that country
- Capital market imperfections. Absence of an effective mechanism for enforcing
international borrowing (investment) agreements. Also classified as political risk.
1. Institutional features of the colonial era: colonial powers arrangement with the
Third World, and the frequent granting of exclusive trading rights to European
monopoly companies. Some sort of unwritten agreement that the capital mainly
stays with the colonial country (emperor).
2. Restrictions (including heavy taxation of capital inflows): on capital flows imposed
by the borrowing country due to mistrust of foreigners. Due to mistrust of foreign
capital, the capital becomes more heavily restricted.
Lucas concluded by arguing for human capital accumulation and tying aid to the recipient’s
openness to foreign investment on competitive terms.
Further Theories of Capital Flows Puzzle
Theoretical explanations for the ‘Lucas paradox’ can be grouped into two categories:
1. Fundamentals of Production
a. Technological differences (improve to attract capital)
b. Missing factors of production (lower endowments of human capital)
c. Government policy differences across countries
1
, Lectures International Finance and Development
i. Tax policies can lead substantial differences in capital-labour ratios
ii. Inflation may tax and decrease the return to capital
iii. Government can explicitly limit capital flows by imposing capital
controls
d. Institutional structure
i. Rules of the game, both informal (traditions, customs) and formal
(laws, constitutions) that define the structure of an economy.
Institutions protect property rights. E.g. you want to buy land, that is
owned by a person but there is no documentation of this. This is
dependent for the flow of capital.
ii. Poor institutions can lead to lack of productive capacities or
uncertainty of returns in an economy and drive a wedge between
expected returns and ex post returns.
2. Market Failure
a. Sovereign risk. Where a sovereign, defaults on foreign loan contracts; seizes
foreign assets located within its border, or prevents domestic residents from
abiding by foreign contracts.
b. Asymmetric information.
i. Can be ex ante (adverse selection). Desire to go to a certain country
where there is not much information about where you end up with the
wrong investments.
ii. Interim (moral hazard), where investors cannot assess domestic
market/lenders cannot monitor borrowers’ investments, there is
underinvestment.
iii. Ex post (costly state verification). Very expensive to apply.
Other Theoretical Classifications: Push and Pull Factors (Fratzscher, 2012)
- Pull factors are the domestic characteristics (demand-side factors) that influence
risks and returns to investors.
o Domestic macroeconomic fundamentals, domestic policies
o Market imperfections
- Push factors are external conditions (supply-side factors)
o Global risk
o Global commodity prices (cycle in the global commodity prices)
o US economic growth and US interest rates
Which theory best explains Lucas Paradox? Fundamentals or market failures? Still remains
an issue.
The Question of the Allocation Puzzle
Fundamentals or market failure? The question of the allocation puzzle
- Standard growth theory can account for cross-country differences in capital
o Therefore high productivity growth countries invest more and attract more
capital.
2
, Lectures International Finance and Development
- However it appears fast growing countries receive less capital flows. This is the
famous allocation puzzle (Gourinchas and Oliver, 2013).
You still have the size issue
Now you have the flow issue, why is it going to the lower average productivity growth
countries instead of higher productivity growth countries?
Possible Explanations Offered
- The link between savings and growth. For domestic savings to increase in the open
economy, there must be a friction that prevents domestic saving and foreign savings
from being perfect substitutes. The friction encourages high savings but less
investment.
o In those economies you see less investments because money is saved and
not invested. When those domestic savings are invested in foreign capital.
o If you want to move capital from country A to B don’t just look at fundamentals
but also at savings.
- The link between trade and growth.
o Developing countries with higher productivity growth tend to be countries in
which the tradable sector is larger relative to the non-tradable sector.
o The allocation puzzle is explained if savings increased more than investment
in the productivity period.
- The link between financial development and growth
o Low domestic financial development constrains domestic demand and
increase domestic savings.
o It constrains ability to borrow against future income, ability to insure efficiently
and encourages precautionary savings.
o It also reduces the responsiveness of investment to productivity growth.
o The allocation puzzle, then, some countries have low financial development
but undertake high savings growth rate forcing high investment in foreign
assets and generating a foreign surplus
Have the Puzzles been explained?
- Still remains an issue
- Fundamentals or market failures?
- Lucas (flow level) puzzle and allocation puzzle of capital flows remain largely an area
of interest and interrogation especially because of the consequences foreign capital
flows have on economic development.
Trends in Capital Flows
- Evidence of cycles (booms and busts) in flows
- A rising trend and possible convergence?
European Union North America
Africa Asia
Latin America and the Caribbean Transition economies
Summary
› Capital flows are quite complex and appears to be driven by a host of factors related
to fundamentals of production and market failure.
› Identifying the single most important determinants of capital flows is therefore
complex.
› Heterogeneity in capital flows warrants attention
› Country context is more nuanced
› Different types of capital flows have different development impact
Lecture 2 – Private Capital Flows: Types, Consequences and Impact
Private Capital Flows
1. Foreign Direct Investment
4
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller etimmer4. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $3.75. You're not tied to anything after your purchase.
