Does Financial Sector Development Augment Cross-Border Capital Flows?

ABSTRACT

The sharp increase in volatility of capital flows in recent years has resulted in many countries altering the regulations governing the flow of foreign capital only to find such changes having a limited impact. We postulate that one reason for the limited effectiveness of such changes in regulations is the level of financial sector development in the country. As a country enhances its level of financial sector development, it also develops more and more sophisticated financial instruments. The more advanced the domestic financial instruments are, and the deeper is the integration of the domestic financial markets with the world markets, the greater is the likelihood of developing strategies to bypass capital account management measures. In this paper, we use various empirical techniques to identify the impact of financial sector development on capital flows, after accounting for regulatory regime. The empirical results indicate that there is a threshold effect in the financial sector development capital flow relationship. In particular, financial sector development augments greater integration with global capital flows only above a threshold level. Below the threshold level we find financial development reduces the extent of integration with global capital markets.     

Financial integration, capital mobility, and income convergence

Recent studies have found that capital moves 'uphill' from poor to rich countries, and brings little or no growth dividend when it does flow into poor economies. We show that Europe does not conform to this paradigm. In the European experience of financial integration, capital has flown from rich to poor countries, and such inflows have been associated with significant acceleration of income convergence. Analysing broader samples of countries, we find that 'downhill' capital flows tend to be observed above certain thresholds in institutional quality and financial integration. But Europe remains different even when allowing for such threshold effects, and its experience is similar to that of interstate flows within the United States. Our findings are consistent with the notion that financial diversification reduces countries' incentives to save in order to self-insure against specific shocks.
— Abdul Abiad, Daniel Leigh and Ashoka Mody     

Taxation of International Private Capital Flows and Securities Transactions in Developing Countries: Do Public Finance Considerations Augment the Macroeconomic Dividends?

This paper examines policies to tax international private capital flows and securities transactions in developing countries. Many recent studies focus on the macroeconomic dividends associated with these policies (namely, their contribution to macroeconomic and financial stability and lengthened investor time horizons). In this paper I explore whether the potential of these policies to raise much‐needed tax revenues in developing countries augments their well‐known macroeconomic benefits. To my knowledge, there has been no effort to examine systematically the public finance issues related to the taxation of international private capital flows or securities transactions in the developing country context. I conclude that the public finance implications of these policies in middle‐income developing countries offers additional support to the macroeconomic case for them. To different degrees, taxation of international private capital flows and securities transactions has the potential to raise modest revenues in middle‐income countries. However, far more important is the potential of these policies to offer valuable macroeconomic dividends on the national level. These national macroeconomic dividends have the potential to bear fruit globally. This is because experiences with financial contagion over the last decade suggest that global financial stability can be enhanced via the promotion of domestic financial stability in developing countries.     

Private capital inflows and stock market interface in sub-Saharan Africa

The financial market school of thought argues that financial market plays a key role in facilitating capital flows to less developed countries of the world. This school considers stock market a strong and potent channel of attracting and mobilizing capital for development across the globe. The study in this paper is therefore undertaken to determine the validity of this argument, by investigating how the stock market interfaces with other variables to influence capital flows to sub-Saharan Africa. The empirical evidence clearly validates the importance of stock market by showing its direct positive impact on all the components of private capital inflows, an impact that is significantly enhanced by return on investment in the market. The stock market is also revealed to have a maximum threshold that suggests it possesses the capacity to channel a significant proportion of potential capital inflows. These findings point to the importance of raising the level of stock market development in order to attract more capital flows to the region, and indeed the less developed regions of the world.     

Assessing Macroprudential Policies: Case of South Korea*

In this paper, we develop methods for assessing the sensitivity of capital flows to global financial conditions. We use these methods to assess the impact of macroprudential policies introduced by South Korea in 2010. Relative to a comparison group of countries, we find that the sensitivity of capital flows into South Korea to global conditions decreased in the period following the introduction of macroprudential policies.     

Exchange rate volatility and capital inflows: role of financial development

There is vast literature examining the impact of exchange rate volatility on various macroeconomic aggregates such as economic growth, trade flows, domestic investment, and more recently capital flows. However, these studies have ignored the role of financial development while examining the impact of exchange rate volatility on capital flows. This study aims to analyze the impact of exchange rate volatility on capital inflows towards developing countries by incorporating the role of financial development over the time period 1980–2013. In this regard, the behavior of two types of capital flows is examined: physical capital inflows measured as foreign direct investment, and financial inflows quantified through remittance inflows. The empirical investigation comprises the direct as well as indirect effect of exchange rate volatility on capital inflows. The study employs dynamic system GMM estimation technique to empirically estimate the effect of exchange rate volatility on capital inflows. The empirical results of the study identify that exchange rate volatility dampens both physical and financial inflows towards developing countries. The indirect impact of exchange rate volatility through financial development, however, turns out positive and statistically significant. This finding reflects that financial development helps in reducing the harmful impact of exchange rate volatility on capital inflows. Hence, the study concludes that a developed financial system is an important channel through which developing countries may improve capital inflows in the long run.     

Remittances,financial development,and growth

Despite the increasing importance of remittances in total international capital flows, the relationship between remittances and growth has not been adequately studied. This paper studies one of the links between remittances and growth, in particular how local financial sector development influences a country's capacity to take advantage of remittances. Using a newly-constructed dataset for remittances covering about 100 developing countries, we find that remittances boost growth in countries with less developed financial systems by providing an alternative way to finance investment and helping overcome liquidity constraints. This finding controls for the endogeneity of remittances and financial development, does not depend on the particular measure of financial sector development used, and is robust to a number of robustness tests, including threshold estimation. We also provide evidence that there could be an investment channel trough which remittances can promote growth especially when the financial sector does not meet the credit needs of the population.     

Foreign Capital in a Growth Model

Within the mechanism of endogenous growth, this paper empirically investigates the impact of financial capital on economic growth for a panel of 60 developing countries, through the channel of domestic capital formation. By estimating the model for different income groups, it is found that while private FDI flows exert beneficial complementarity effects on the domestic capital formation across all income‐group countries, the official financial flows contribute to increasing investment in the middle income economies, but not in the low income countries. The latter appears to demonstrate that the aid‐growth nexus is supported in the middle income countries, whereas the misallocation of official inflows is more likely to exist in the low income countries, suggesting that aid effectiveness remains conditional on the domestic policy environment.     

A Solution to Two Paradoxes of International Capital Flows

International capital flows from rich to poor countries can be regarded as either too small(the Lucas paradox in a one-sector model)or too large(when compared with the logic of factor price equalization in a two-sector model).To resolve the paradoxes,we introduce a non-neoclassical model which features financial contracts and firm heterogeneity.In our model,free trade in goods does not imply equal returns to capital across countries.In addition,rich patterns of gross capital flows emerge as a function of financial and property rights institutions.A poor country with an inefficient financial system may simultaneously experience an outflow of financial capital but an inflow of FDI,resulting in a small net flow.In comparison,a country with a low capital-to-labor ratio but a high risk of expropriation may experience an outflow of financial capital without a compensating inflow of FDI.     

(NON‐)RESILIENCY OF FOREIGN DIRECT INVESTMENT IN THE UNITED STATES DURING THE 2007–2009 FINANCIAL CRISIS

We study the contraction of foreign direct investment (FDI) flows in the United States during the recent financial crisis and show their unusual non‐resiliency, which depends in part on the global nature of the economic recession, but also on the increases in the cost of financing FDI in the economies in which the flows originate. To formally study the effects of external financial conditions on FDI in the United States, we exploit the three dimensions of a panel of US inward FDI flows organized by recipient US industries, source countries and years for the recorded flows. Changes in the cost of finance in the source countries have little or no effect on total inward flows (the sum of equity, debt and reinvested earnings) over the 2006–2010 period. However, US industries characterized by more financial vulnerability experience statistically significant variations in the debt and equity components of inward FDI flows in response to the changes in the cost of capital that occurred in the source countries during the crisis.     

Alternate instruments to manage the capital flow conundrum: A study of selected Asian economies

Capital inflows to and outflows from emerging market economies (EME) have increased significantly since 2000. This rapid increase, accompanied by a sharp rise in volatility, has amplified the complexity of macroeconomic management in EME. While foreign capital provides additional financing for productive investment and offers avenues for risk diversification, unbridled flows exacerbate financial and macroeconomic instability. In this paper, we focus on the experience of six emerging Asian economies (EAE) in dealing with capital flows. Using quarterly data, we identify the waves of capital flows experienced by these EAE and the efficacy of the various policy measures taken. The policy choices include negotiating the trilemma (i.e. balancing the need for monetary policy autonomy, exchange rate flexibility and capital account openness), as per the demands of the macroeconomic situation. The paper also analyses the extent to which intervention in the foreign exchange market and imposition of short‐term capital flow management measures have aided countries to negotiate the trilemma. The efficacy of these responses have been varied across countries, implying that a judicious mix of these measures, along with improvement in financial and institutional development, is required to effectively counter the vagaries of capital flows.     

Intermediation costs and capital flows

In this paper, we modify the standard neoclassical model by incorporating financial intermediation in order to deliver returns consistent with the observation that capital primarily flows to middle income countries. We build a static contracting framework where costly intermediation together with an adverse selection problem have quantitatively important effects on capital flows. When intermediation costs are ignored, the model behaves like the neoclassical model in terms of capital returns. However, when intermediation costs are considered, returns to capital in middle income countries could exceed those in poor and rich countries—high costs of intermediation cause poor countries to concentrate their investments in projects with low returns, while the standard neoclassical effect lowers returns in capital-rich countries. When we embed the return function from the static analysis in a two-country dynamic model, there is capital outflow from a poor country that removes capital controls and becomes open. Even though the closed economy dominates in terms of capital employed in production, it is the open economy that dominates in terms of income, consumption and welfare.     

The Elusive Gains from International Financial Integration

Standard theoretical arguments tell us that countries with relatively little capital benefit from financial integration as foreign capital flows in and speeds up the process of convergence. We show in a calibrated neoclassical model that conventionally measured welfare gains from this type of convergence appear relatively limited for the typical emerging market country. The welfare gain from switching from financial autarky to perfect capital mobility is roughly equivalent to a 1% permanent increase in domestic consumption for the typical non-OECD country. This is negligible relative to the welfare gain from a take-off in domestic productivity of the magnitude observed in some of these countries.     

Macroeconomic stabilization in developing economies: Are optimal policies procyclical?

Many empirical studies provide evidence that macroeconomic policies as well as capital flows exhibit procyclical characteristics in developing economies. In particular Kaminsky et al. [2004. When it rains, it pours: Procyclical capital flows and macroeconomic policies. NBER Macroeconomics Annual, MIT Press] demonstrate that a large group of middle-income countries run contractionary policies and experience capital flight during times of recession. This paper investigates the role of international financial markets in explaining these macroeconomic policy and capital flow characteristics. An optimal fiscal and monetary policy problem is formulated and solved for a small-open economy that faces a country-specific interest rate spread in international financial markets. It is found that, in the presence of the country spread, optimal fiscal and monetary policies as well as capital flows are procyclical under a reasonable parametrization. Optimal policies and capital flows turn countercyclical in the absence of the country spread. This pattern is robust to a range of alternative model specifications.     

OPTIMAL FOREIGN BORROWING REVISITED

Foreign capital has become increasingly important in financing investment and growth in developing countries. Foreign capital flows, however, can be volatile as is evident from the recent financial crises. It has also recently been noted by researchers that there is little systematic empirical evidence that foreign capital contributes to the economic growth of developing countries. In this context, this paper attempts to theoretically reevaluate the borrowing behaviour of a developing economy that relies on foreign borrowing for its capital formation. In particular, this paper investigates the implications of different lending policies of international financial institutions. It is found that no matter whether the borrowing interest rate increases with the level of foreign debt per capita or with the foreign‐capital/total‐capital ratio, the economy always moves toward the stationary state. The result holds even when the representative agent regards the interest rate given as constant. This implies that foreign borrowing does help economic growth, irrespective of lending policies of international financial institutions.     

The IMF and the Liberalization of Capital Flows

We evaluate the claim that the International Monetary Fund precipitated financial crises during the 1990s, by pressuring countries to liberalize their capital accounts prematurely. Using data from a panel of developing economies from 1982–98, we examine whether the changes in the regime governing capital flows took place during participation in IMF programs. We find evidence that IMF program participation is correlated with capital account liberalization episodes during the 1990s. We verify the robustness of our results using alternative indicators of capital account openness. To determine whether decontrol was premature, we compare the economic and financial characteristics of countries that decontrolled during IMF programs with those of countries who did so independently, and find some evidence of IMF-led premature liberalizations.     

Global financial cycle and Brazil’s financial integration

ABSTRACT

Recent studies have discussed the influence of the global financial cycle on capital flows to emerging and developing countries. This paper evaluates the relationship between the greater degree of financial integration, and macroeconomic performance over the last two decades in Brazil. The literature has highlighted the Brazilian experience as being paradigmatic among emerging countries regarding the relationship between financial integration and regulation of capital flows to deal with boom and bust cycles. Methodologically, we employ a vector autoregressive model with error correction that allows us to evaluate the cointegration between the variables. Our main hypothesis is that a greater degree of financial integration is associated with negative developments in variables such as gross domestic product, country risk, interest rates, and exchange rate volatility. In addition, this study presents a further contribution by observing the existence of the interaction between the consequences of financial integration and the global financial cycle. More specifically, we found that: (i) an increase in the degree of financial integration generates deeper effects in downward periods of the global financial cycle; and (ii) a decline in that cycle generates greater impacts when a higher degree of financial integration is present.     

Capital flows and growth dynamics in Central and Eastern Europe

This article assesses the importance of capital flows as measured by the current account balance for the growth dynamics of the EU countries from Central and Eastern Europe. Economic growth in these countries was on average relatively high before the global financial crisis but markedly lower after the crisis. Panel data econometrics using annual data for 1997–2015 point to the contemporaneous current account balance having a sizeable negative effect on annual GDP growth. Estimations using many control variables and instrumental variables suggest that the negative effect is mainly demand driven. Counterfactual simulations show that growth rates in all CEE countries would have been lower in the absence of capital flows, and this applies particularly to the countries with the most disadvantageous starting points.     

A new approach to capital flows: Theory and evidence

This paper examines how an open economy determines its financial openness and deals with volatile capital flows when deciding to utilize them for output growth. We find that higher economic instability is an inevitable price paid for faster growth if a country permits wider openness without reversing its financial vulnerability. We prove that the country can leave its capital market wider open to achieve higher growth and lower instability if its financial system has been strengthened substantially. We show why some financially advanced countries request reluctant developing countries to liberalize their immature markets and how the conflict of interest between the two parties is formulated. The paper also presents a large sample of cross-country experiences with tradeoffs between growth and instability, with the observed evidence supporting our theoretical predictions.     

Capital Flows, Capitalization, and Openness in Emerging East Asian Economies

We examine the international capital flows of seven East Asian emerging economies over the last decade and a half. We find that domestic capital market conditions appear to be the best predictors of the changes in the total capital flows of these countries. Overall, changes in capital market openness are less helpful in explaining the behavior of the recent capital flows of these economies. Finally, we find that, while US macroeconomic conditions are strong predictors of GDP growth in the region, US conditions matter very little for the region's capital flows.