Global Imbalances or Why are the Poor financing the Rich?

Raghuram Rajan

Outline

Much has been written about global imbalances and the paradox of the poor (China) financing the rich (USA).Is this “bad”? With the world awash with capital, should developing countries not attempt to attract more of it to grow faster?Traditional view

Poor countries are starved of capital

Marginal productivity of capital should be high

Opening up to foreign capital should increase investments and increase their growth rates.

Outline contdImplications

Capital should flow from rich to poor countriesAmongst poor countries, capital should flow to the most productive

Also, for poor countries

Capital inflow should be strongly positively correlated with growth (and investment)

Is this happening? No!Why not?

Facts

Capital not flowing more to poor countries over time as they improve their financial systems. Flow reversing in recent times.

Relative Incomes of Capital-Exporting and Capital-Importing Countries

.4.6

.81

Rel

ativ

e pe

r cap

ita G

DP

wei

ghte

d by

cur

r. ac

c.

1970 1975 1980 1985 1990 1995 2000 2005Year

Surplus Countries Deficit Countries

Relative Incomes of Capital-Exporting and Capital-Importing Countries: Leaving out the US and China

.4.6

.81

19 70 19 75 19 80 19 85 19 90 19 95 20 00 20 05Y ea r

S urp lu s C ou ntrie s D e fic it C o un tries

Facts contd.

Amongst the poor countries, capital has not flowed to the fastest growing amongst them (“Allocation paradox”:

Gourinchas and Jeanne, 2006).Capital inflow measured by CA deficit

= Domestic Investment-Domestic Savings= Amount financed from abroad

The Allocation of Capital Flows to Non-Industrial Countries 1970-2004

Low-Growth

M edium-Growth

High-Growth

China

India

-800

-300

200

700

1200

Bill

ions

of U

S$

Low-Growth M edium-Growth High-Growth China India

0.3%

1.6%

4.1%

7.6%

2.9%

The Allocation of Capital Flows to Non-Industrial Countries1985-1997 and 2000-2004

Low

Low

Medium

Medium

High

High

China

China

India

India

-500

0

500

Bill

ions

of U

S$

Low Medium High China India

1985 - 1997

2000 - 2004

0.2%

1.7% 3.6%

8.9%

3.7% 0.3%

2.4%

3.7%

8.5%

4.1%

Not all capital flows have followed the same pattern

FDI has behaved differently in the past, going to the fastest growing countries.Even this has reversed in recent years.

The Allocation of Net FDI Flows to Non-Industrial Countries

0

100

200

300

400

500

600

Bill

ions

of U

S$

Low-Growth Medium-Growth High-Growth China India

1970 - 2004

1985 - 1997

2000 - 2004

Low:0.3

Medium: 1.6%

High: 4.1%

China: 7.6%

India: 2.9%

Low: 0.2%

Medium: 1.7%

High: 3.6%

China: 8.9%

India: 3.7%

Low: 0.3%

Medium: 2.4%

High: 3.7%

China: 8.5%

India: 4.1%

Facts contd.

Non-industrial countries that have utilized the most foreign capital have tended to grow more slowly.

Not just a recent phenomenon.

Correlation Between average Growth and the average Current Account Balance, non-industrial countries, 1970-2004

DZA

ARG

BGD

BOL

BRA

CMR

CHL

CHN

COLCRI

CYP

CIV

DOM

ECU

EGY

SLV

ETH

GHA

GTM HTIHND

IND

IDN

IRN

ISR

JAM

JORKEN

KOR

MDG

MWI

MYS

MLI

MUS

MEXMAR

NGA

PAKPAN

PRY

PER

PHLRWA

SEN

SLE

ZAF

LKA

TZA

THA

TTO

TUN

TUR

UGA

URY

VENZMBZWE

-20

24

68

Per

cap

ita G

DP

grow

th

-10 -5 0 5Average current account balance to gdp

Growth and the Current Account Balance over Time: Non-parametric Relationship

-6-4

-20

24

Per

cap

ita G

DP

gro

wth

-5 0 5 10 15Average current account balance to GDP

1970-79 1985-971990-97 1999-04

Facts contd.

Traditional model: Given a level of investment, how it is financed – through domestic or foreign savings – should not matter for growth.

Fact: For non-industrial countries, given a level of investment, the more it is financed through domestic savings, the higher the associated growth is.

Above Median

Below Median

Below Median

Above Median

0.00

1.00

2.00

3.00

Ave

rage

Per

Cap

ita G

DP

Gro

wth

Investment/GDP

Current Account/GDP

Figure 6. Current Accounts, Investment and Growth in Developing Countries

Summarizing the facts

Foreign capital usage negatively correlated with growthSeems to run through savings rather than investment

Countries more likely to grow if they consume less and save more during growth spurts

Seems to be a phenomenon associated with non-industrial countries.

These facts are inconsistent with the textbook model

So what explains the facts?

1. Financial system cannot effectively intermediate foreign capital– Investment not helped by foreign resources – Foreign capital does not help growth, but does not

hurt either

2. Sharp increase in domestic consumption and reliance on foreign capital for investment leads to overvaluation, and hence lower exports, returns to investment, and overall growth– Greater reliance on foreign capital instead of

domestic savings could hurt growth.

Testing Explanation 1: The Financial Development Channel

If foreign capital works by providing additional resources for investment, then:

In countries that receive more foreign capital,

Sectors that have a greater dependence on financing should grow more;

And this effect of foreign capital on growth will be diluted or eliminated in countries with poor domestic financial development.

Evidence is consistent with the explanation.

Explanation 2: Foreign Capital, Overvaluation and Growth

Too much domestic consumption leads to excessive reliance on foreign capital inflows, in order to finance investment.This leads to overvaluation and slower growth.

Three pieces of evidence:

Reliance on foreign capital→OvervaluationOvervaluation→Lower overall growthPossible channel from overvaluation to overall growth is manufacturing exports

Export intensive industries tend to grow slower in countries with overvalued exchange rates.

1: Foreign capital and Overvaluation, 1970-2004

KOR

IRN

BGD

IND

ETHDZAZAF

MUS

GUY

TUR

URY

LKAZWE

ISR

MDG

HTI

MWIKEN

PAKIDN

CMR

SLVRWA

PRY

COL

VEN

SEN

ARG

MAR

BRA

JOR

GHA

PHL

CIV

MLI

GTMECU

UGA

THA

CHLHNDDOMPEREGY

CHN

TZA

JAM

TUN

CRI

MEX

CYP

NGA

SLE

ZMB

TTO

BOLMYS

PAN

-50

050

100

Res

idua

ls o

f ave

rage

ove

rval

uatio

n

-.02 -.01 0 .01 .02 .03Residuals of average net fdi flows to GDP

coef = 837.49992, (robust) se = 363.32526, t = 2.31

Conclusions

Foreign capital, as a form of net financing, does not play much of a role in the growth of non-industrial countries, while it does play a role in industrial countries Our explanation: Non-industrial countries may have limited ability to absorb it

Financial sector may not be able to allocate arm’s length capital.Countries may be more prone to exchange rate overvaluation.

Given absorptive capacity, not necessarily a bad thing if capital flows from poor to rich countriesThis does not necessarily mean developing countries should closethemselves to capital flows – foreign capital could play a role in enhancing absorptive capacity.

Collateral benefitsIt does suggest, though, a greater focus on enhancing absorptivecapacity.

Enhancing the capacity of the domestic financial system.Financial infrastructure

Information acquisition and sharingInstitutions to enhance reliabilityLaws and enforcement

Enhancing other forms of domestic capacity – e.g., domestic savings and domestic human capital

Perhaps not a coincidence that rise of global imbalances has been accompanied by strong world growth. But nothing can go on forever!