THE CHALLENGES OF CAPITAL INFLOWS

INCLUDING AIDThorvaldur Gylfason

Joint Vienna Institute/Institute for Capacity Development

Distance Learning Course on Financial Programming and Policies

Vienna, AustriaNOVEMBER 26–DECEMBER 7, 2012

OUTLINE Capital flows

History, theory, evidence Foreign aid

Effectiveness: Does aid work?Macroeconomic challenges

Dutch diseaseAid volatility

3

Definitiono International capital movements refer to the flow

of financial claims between lenders and borrowerso The lenders give money to the borrowers to be

used now in exchange for IOUs or ownership shares entitling them to interest and dividends later

Benefits of international trade in capitalo Allows for specialization, like trade in commoditieso Allows for intertemporal trade in goods and

services between countrieso Allows for international diversification of risk

CAPITAL FLOWS 1

The case for free trade in goods and services applies also to capital

Trade in capital helps countries to specialize according to comparative advantage, exploit economies of scale, and promote competitionExporting equity in domestic firms not only earns foreign exchange, but also secures access to capital, ideas, know-how, technologyBut financial capital is volatile

GOODS AND CAPITAL

The balance of payments R = X – Z + Fwhere

R = change in foreign reservesX = exports of goods and servicesZ = imports of goods and servicesF = FX – FZ = net exports of capital

Foreign direct investment (net)Portfolio investment (net)Foreign borrowing, net of amortization

SYMMETRY BETWEEN GOODS AND CAPITAL

X includes aid

Trade in goods and services depends on

Relative prices at home and abroad

Exchange rates (elasticity models) National incomes at home and

abroad Geographical distance from trading

partners (gravity models) Trade policy regime

Tariffs and other barriers to trade

DETERMINANTS OF TRADE IN GOODS AND SERVICES

Again, capital flows consist of foreign borrowing, portfolio investment, and foreign direct investment (FDI)

Trade in capital depends onInterest rates at home and abroadExchange rate expectationsGeographical distance from trading

partnersCapital account policy regime

Capital controls and other barriers to free flows

DETERMINANTS OF TRADE IN CAPITAL

CAPITAL FLOWS: CONCEPTUAL FRAMEWORKEmerging

countries save a little

Saving

Investment

Rea

l int

eres

t rat

e

Loanable funds

CAPITAL FLOWS: CONCEPTUAL FRAMEWORK

Industrial countries save a lot

Saving

Investment

Rea

l int

eres

t rat

e

Loanable funds

CAPITAL FLOWS: CONCEPTUAL FRAMEWORKEmerging

countriesIndustrial countries

Saving

Saving

Investment Investment

Rea

l int

eres

t rat

e

Rea

l int

eres

t rat

e

Borrowing

Lending

Loanable funds Loanable funds

Financial globalization encourages investment in emerging countries and saving in industrial countries

RELEVANCE AND CONTEXT Since 1945, trade in goods and

services has been gradually liberalized (GATT, WTO) Big exception: Agricultural commodities

Since 1980s, trade in capital has also been freed up Capital inflows (i.e., foreign funds

obtained by the domestic private and public sectors) have become a large source of financing for many emerging market economies

EVOLUTION OF CAPITAL FLOWS

Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.

A stylized view of capital mobility 1860-2000

Cap

ital

mob

ility

First era of internationa

l financial integration

Capital controls

Return toward

financial integration

TOTAL CAPITAL INFLOWS (USD, BILLIONS)

Capital flows result from interaction between supply and demandCapital is “pushed” away from investor countries Investors supply capital to recipients

Capital is “pulled” into recipient countriesRecipients demand capital from

investors

CAUSES OF CAPITAL INFLOWS:PUSH VS. PULL FACTORS

Internal factors “pulled” capital into LDCs from industrial countries

Macroeconomic fundamentals in LDCsMore productivity, more growth, less inflation

Structural reforms in LDCsLiberalization of tradeLiberalization of financial markets Lower barriers to capital flows

Higher ratings from international agencies

CAUSES OF CAPITAL INFLOWS:PUSH VS. PULL FACTORS

CAUSES OF CAPITAL INFLOWS:PUSH VS. PULL FACTORSExternal factors “pushed” capital from

industrial countries to LDCs Cyclical conditions in industrial

countriesRecessions in early 1990s reduced investment

opportunities at homeDeclining world interest rates made IC

investors seek higher yields in LDCs Structural changes in industrial

countriesFinancial structure developments, lower costs

of communicationDemographic changes: Aging populations

save more

Improved allocation of global savings allows capital to seek highest returnsGreater efficiency of investment More rapid economic growthReduced macroeconomic volatility through risk diversification dampens business cyclesIncome smoothingConsumption smoothing

EFFECTS OF CAPITAL INFLOWS:POTENTIAL BENEFITS

Open capital accounts may make receiving countries vulnerable to foreign shocks Magnify domestic shocks and lead to contagionLimit effectiveness of domestic macroeconomic

policy instrumentsCountries with open capital accounts are vulnerable to Shifts in market sentiment Reversals of capital inflowsMay lead to macroeconomic crisisSudden reserve loss, exchange rate pressureExcessive BOP and macroeconomic adjustmentFinancial crisis

EFFECTS OF CAPITAL INFLOWS:POTENTIAL RISKS I

Overheating of the economy Excessive expansion of aggregate demand

with inflation, real currency appreciation, widening current account deficit

Increase in consumption and investment relative to GDP

Quality of investment suffers Construction booms – count the cranes!

Monetary consequences of capital inflows and accumulation of foreign exchange reserves depend on exchange regime

Fixed exchange rate: Inflation takes off Flexible rate: Appreciation fuels spending

boom

EFFECTS OF CAPITAL INFLOWS:POTENTIAL RISKS II

EPISODES OF LARGE NET PRIVATE CAPITAL INFLOWS: NUMBER, SIZE, AND ENDING

Source: IMF WEO, Oct. 2007, Chapter 3, Table 3.1.

-3 -2 -1 0 1 2 3 4 5 6 70

100

200

300

400

500

600

-200

0

200

400

600

800

1,000

1,200

1,400

1,600

Year with respect to start of inflow periodNote: The index for Finland, Mexico, and Sweden is shown on the

left; the index for Chile during the 1980s and 1990s and for Venezuela is shown on the right.

Source: World Bank (1997).

Sweden

Venezuela

Chile 1978-81 Mexico

Chile 1989-94

Finland

REAL STOCK PRICES DURING INFLOW PERIODS, SELECTED COUNTRIES

Large deficitsCurrent account deficitsGovernment budget deficits

Poor bank regulationGovernment guarantees (implicit or explicit),

moral hazardStock and composition of foreign debt

Ratio of short-term liabilities to foreign reservesMismatches

Maturity mismatches (borrowing short, lending long)

Currency mismatches (borrowing in foreign currency, lending in domestic currency)

EARLY WARNING SIGNS

RATIO OF SHORT-TERM LIABILITIES TO FOREIGN RESERVES IN ASIA 1997

Guidotti-Greenspan rule

FINANCIAL CRISES IN 1990S CALLED CAPITAL LIBERALIZATION IN DOUBT Financial globalization is often blamed for

crises in emerging marketsIt was suggested that emerging markets had

dismantled capital controls too hastily, leaving themselves vulnerable

More radically, some economists view unfettered capital flows as disruptive to global financial stabilityThese economists call for capital controls

and other curbs on capital flows (e.g., taxes)Others argue that increased openness to

capital flows has proved essential for countries seeking to rise from lower-income to middle-income status

Capital controls aim to reduce risks associated with excessive inflows or outflows

Specific objectives may includeProtecting a fragile banking systemAvoiding quick reversals of short-term

capital inflows following an adverse macroeconomic shock

Reducing currency appreciation when faced with large inflows

Stemming currency depreciation when faced with large outflows

Inducing a shift from shorter- to longer-term inflows

ROLE OF CAPITAL CONTROLS 

TYPES OF CAPITAL CONTROLS Administrative controls

Outright bans, quantitative limits, approval procedures

Market-based controlsDual or multiple exchange rate systemsExplicit taxation of external financial

transactions Indirect taxation

E.g., unremunerated reserve requirement Distinction between

Controls on inflows and controls on outflowsControls on different categories of capital

inflows

IMF (which has jurisdiction over current account, not capital account, restrictions) maintains detailed compilation of member countries’ capital account restrictions

The information in the AREAER has been used to construct measures of financial openness based on a 1 (controlled) to 0 (liberalized) classification

They show a trend toward greater financial openness during the 1990s

But these measures provide only rough indications because they do not measure the intensity or effectiveness of capital controls (de jure versus de facto measures)

IMF ANNUAL REPORT ON EXCHANGE ARRANGEMENTS AND EXCHANGE RESTRICTIONS

CONCLUSION ON CAPITAL FLOWS Capital flows can play an

important role in economic growth and developmentBut they can also create

macroeconomic vulnerabilities Recipient countries need to

manage capital flows so as to avoid hazardsNeed sound policies as well as effective

institutions, including financial supervision, and good timing

Development aid Unrequited transfers from donor to country designed to promote the economic and social development of the recipient (excluding commercial deals and military aid)

Concessional loans and grants included, by tradition Grant element ≥ 25%

FROM CAPITAL INFLOWS TO AID: DEFINITION 2

Development aid can bePublic or privateBilateral (from one country to another) or multilateral (from international organizations)

Program, project, technical assistance

Linked to purchase of goods and services from donor country, or in kind

Conditional in nature IMF conditionality, good governance

DEFINITION

MOTIVATION: WHY AID? Moral duty Neocolonialism Humanitarian intervention Public good

National (e.g., education and health care)International

Social justice to promote world unity UN aid commitment of 0.7% of GDP

World-wide redistributionIncreased inequality word-wideMarshall Plan after World War II

1.5% of US GDP for four years vs. 0.2% today Think tank in Nairobi disagrees, see

www.irenkenya.com

ObjectivesIndividuals in donor countries vs. governments in recipient countriesWho should receive the aid?

Today’s poor vs. tomorrow’s poorAid for consumption vs. investment

ConflictsBeneficiaries’ needsDonors’ interests

MOTIVATION: WHY AID?

PAST TRENDS Aid is a recent phenomenon Four major periods since 1950

1950s: Fast growth (US, France, UK)1960s: Stabilization and new donors

Japan, Germany, Canada, Australia1970s: Rapid growth in aid again due to oil shocks, recession, cold war

1980s: Stagnation, aid fatigue, new methods

PAST TRENDS: 1950S Rapid growth of development aid US provided 50% of total ODA

To countries ranging from Greece to South Korea along the frontier of the “Sino-Soviet bloc”

France provided 30%To former colonies, mainly in West Africa

UK provided 10%To Commonwealth countries

PAST TRENDS: 1960S Stabilization of aid from traditional

donors and emergence of new donors US contribution decreased considerably

after the Kennedy presidency (1961-63) The French contribution decreased

starting from the early 1960s New donors included Japan, Germany,

Canada, and Australia

PAST TRENDS: 1970S Rapid growth in aid from industrial

countries in response to the needs of developing countries due to Oil shocksSevere drought in the Sahel

The donor governments promised to deliver 0.7% of GNI in ODA at the UN General Assembly in 1970The deadline for reaching that target

was the mid-1970s

PAST TRENDS: 1980S AND 1990S Stagnation of development assistanceDonor fatigue?Private investor fatigue?

41

DONOR FATIGUE?

WHO ARE THE DONORS? United States: largest donor in

volume, but low in relation to GDPUS aid amounts to 0.2% of GDP

Japan: second-largest donor in volume

Nordic countries, Netherlands Major donors to multilateral programsOnly countries whose assistance

accounts for 0.7% of GDP EU: leading multilateral donor

WHO ARE THE DONORS? Even though targets and

agendas have been set, year after year, almost all rich nations have constantly failed to reach their agreed obligations of the 0.7% target

Instead of 0.7% of GNI, the amount of aid has been around 0.4% (on average), some $100 billion short

OFFICIAL DEVELOPMENT ASSISTANCE BY DONOR 2004 (% OF GNP)

OFFICIAL DEVELOPMENT ASSISTANCE BY DONOR 2005 (USD BILLION)

MACROECONOMICS OF AID Aid fills gap between investment

needs and saving and increases growthPoor countries often have low savings

and low export receipts and limited investment capacity and slow growth

Aid is intended to free developing nations from poverty trapsExample: Capital stock declines if saving does not keep up with depreciation

AID AND INVESTMENT To understand the link between aid and investment, consider resource constraint identity by rearranging the National Income Identity:

Y = C + I + G + X – ZI = (Y – T – C) + (T – G) + (Z – X)

In words, investment is financed by the sum of private saving, public saving, and foreign saving

Aid is treated as part of government saving which increases domestic resources to finance investment.

AID AND GROWTH Poor countries are trapped by poverty

Driving forces of growth (saving, technological innovation, accumulation of human capital) are weakened by poverty

Countries become stuck in poverty traps Aid enables poor countries to free

themselves of poverty by enabling them to cross the necessary thresholds to launch growthSavingTechnologyHuman capital

AID AND POVERTY Is it feasible to lift all above a dollar a day?

How much would it cost to eradicate extreme poverty? Let’s do the arithmetic (Sachs)

Number of people with less than a dollar a day is 1.1 billionTheir average income is 77 cents a day, they need 1.08 dollars

Difference amounts to 31 cents a day, or 113 dollars per year

Total cost is 124 billion dollars per year, or 0.6% of GNP in industrial countries

Less than they promised! – and didn’t deliver

Several empirical studies have assessed the impact of aid on growth, saving, and investment

The results are somewhat inconclusiveMost studies have shown that aid has

no significant statistical impact on growth, saving, or investment

However, aid has positive impact on growth when countries pursue “sound policies”Burnside and Dollar (2000)

EMPIRICAL STUDIES OF AID

AID AND GROWTH Foreign aid has

sometimes been compared to natural resource discoveries

Aid and growth are inversely related across countries

Cause and effect 156 countries,

1960-2000

-8

-6

-4

-2

0

2

4

6

-20 0 20 40 60 80

Foreign aid (% of GDP)Per

cap

ita g

row

th a

djus

ted

for i

nitia

l inc

ome

(%) r = -

0.36

r = rank correlation

DOES AID WORK?THE CURRENT DEBATE No robust relationship between aid

and growth Aid works in “countries with good

policies” Aid works if measured correctly Distinction between fast impact aid

(infrastructure projects) and slow impact aid (education)Infrastructure: High financial returnsEducation and health: High social

returns

REASONS FOR THE POSSIBLE INEFFECTIVENESS OF AID I Aid may lead to corruption Aid may be misused, by donors as

well as recipients Donors: Excessive administrative

costsRecipients: Mismanagement,

expropriation Aid is badly distributed,

sometimes for strategic reasonsSupporting government against

political opposition

REASONS FOR THE POSSIBLE INEFFECTIVENESS OF AID II Aid increases public consumption, not

public investment Aid is procyclical

When it rains, it pours Aid leads to “Dutch disease”

Labor-intensive and export industries contract relative to other industries in countries receiving high aid inflows

Dutch disease may undermine external sustainability

REASONS FOR THE POSSIBLE INEFFECTIVENESS OF AID III Aid volatility and unpredictability

may undermine economic stability in recipient countriesEconomic vs. social impact

Growth is perhaps not the best yardstick for the usefulness of aidLong run vs. short run

E.g., increased saving reduces level of GDP in short run, but increases growth of GDP in long run

DUTCH DISEASE Appreciation of currency in real terms,

either through inflation or nominal appreciation, leads to a loss of export competitiveness

In 1960s, Netherlands discovered natural resources (gas deposits)Currency appreciated Exports of manufactures and services

suffered, but not for long Not unlike natural resource discoveries,

aid inflows could trigger the Dutch Disease in receiving countries

See “Dutch Disease” in the New Palgrave Dictionary of

Economics Online

Foreign exchange

Real

exc

hang

e ra

te

Imports

Exports

AID REDUCES EXPORTS

Exports plus aid

Aid leads to appreciation, and thus reduces exports

A

C B

Foreign exchange

Real

exc

hang

e ra

te

Imports

Exports

OIL: SAME STORY

Exports plus oil

Oil discovery leads to appreciation, and reduces nonoil exports

A

C B

Aid can play a key role in the development of recipient countries, but it can also generate macroeconomic vulnerabilities

Recipients need to implement appropriate policies to manage aid flows to avoid macroeconomic hazardsThe appropriate policy response needs to take

into account Potential impact of aid on competitiveness Existence of constraints to aid absorption Risks linked to aid volatility and to external debt

sustainability

MANAGEMENT OF AID FLOWS: MAIN LESSONS

AID VOLATILITY AND UNPREDICTABILITY Aid is increasingly volatile and unpredictable

Aid flows are 6-40 times more volatile than fiscal revenue

Volatility is largest for aid dependent countries (Bulir and Hamann 2003, 2007)

Volatility increased in the 1990sAid delivery falls short of pledges by over

40% Reasons for aid volatility

Donors: Changes in priorities; administrative and budgetary delays

Recipients: Failure to satisfy conditions IMF conditionality often guides donors, helping

them decide if the country’s policies are on track

CONCLUSION ON AID Aid can play an important role in

the growth and development of recipient countries …… but it can also create

macroeconomic vulnerabilities Recipient countries need to

manage aid flows so as to avoid hazardsNeed to consider potential impact of aid

on Competitiveness Constraints to aid absorption Risks linked to aid volatility and to

external debt sustainability

THE END

These slides will be posted on my website: www.hi.is/~gylfason