Gains from International Capital Mobility

Chapter 10

Outline1. International allocation of savings and investment

2. The degree of international capital market integration– A puzzle: The Feldstein-Horioka study

3. Where does capital flow? – Is the destination of capital flows consistent with the

theory?

4. Institutions, financial development and growth

5. The role of capital flows in risk diversification

6. Firm investment and asymmetric information

International allocation of savings and investment

Two main benefits:– International capital can channel national

savings to its most productive investment opportunities including opportunities in foreign countries.

– International capital mobility enables the spreading of investment risk (diversification).

• From the balance of payments accounting we know that a current account deficit (surplus) is matched by a capital inflow (outflow).

S – I ≡ CA (current account balance)• So excess savings or a national savings

surplus (S > I) needs to be invested abroad.

• What causes capital inflows or outflows?

Determinants of international capital flows• Financial transactions and risk• Channeling savings towards investment:

directly (via capital markets) or indirectly (via financial intermediaries)

• Suppose we have the following.

SH = SH(rH); SF = SF(rF) + +

and IH = IH(rH); IF = IF(rF) – –

Capital stock: Law of diminishing marginal returns

Optimal (equilibrium) level of investment: The point at which marginal productivity of capital (MPC) equals the cost of capital.

International capital mobility makes both countries better off.

(Fig. 10.1)

Figure 10.1 International capital mobility is welfare-enhancing

2

1

3a 3b 4a 4b

IHIF

SH

SF

rH0

rH1

rF0

rF1

r r

S, I S, ISH1 SF1IH1 IF1SH0=IH0 SF0=IF0

net gain = net gain =

2

1

3a 3b 4a 4b

IHIF

SH

SF

rH0

rH1

rF0

rF1

r r

S, I S, ISH1 SF1IH1 IF1SH0=IH0 SF0=IF0

net gain = net gain =(a) (b)

The difference between home and foreign time preference for consumption leads to the emergence of international capital flows.

This is similar to the mechanism underlying trade in goods and services except that we are now dealing with inter-temporal trade.

In the absence of exchange rate risk and transaction costs, international capital mobility will lead to interest rate convergence between countries.

Thrift and saving money: Country differences (Box 10.1)

Table 10.1 Respondents mentioning thrift as an important quality to teach children (%) Country Percentage Country Percentage Thailand 57 Taiwan 50 Vietnam 44 China 37 India 18 Germany 18 Japan 15 United States 6 Great Britain 6 Spain 2 Mean 12

Source: World Values Survey, 2008 fifth wave, own calculations

The degree of international capital market integration

Fig. 10.1 implies that with international capital mobility and financial market integration there should be no interdependence between national savings and national investments.

However, Martin Feldstein and Charles Horioka (1980) found a very high correlation between national savings and national investment (in OECD countries). This is puzzling!

See Tables 10.2 and 10.3.

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business© Cambridge University Press, 2013 Chapter 10 – Gains from international capital mobilityTable 10.2 Correlation between national savings and investment, 1960–2010

1960–9 1970–9 1980–9 1990–9 2000-10

Australia 0.64 0.52 0.35 0.74 0.79

Austria −0.07 0.64 0.88 0.49 -0.25

Belgium 0.86 0.59 0.46 −0.49 -0.01

Canada 0.61 0.34 0.76 0.04 0.07

Denmark −0.25 0.79 0.81 0.82 0.75

Finland 0.43 0.53 0.62 0.25 0.27

France 0.70 0.73 0.82 0.72 -0.14

Germany 0.33 0.94 −0.49 0.04 -0.2

Italy 0.72 −0.15 0.85 −0.38 0.69

Japan 0.80 0.92 0.23 0.93 0.82

Netherlands −0.74 −0.95 −0.94 −0.96 0.4

Norway 0.44 −0.68 −0.68 0.79 0.33

Spain 0.66 0.83 0.64 0.47 0.33

Sweden 0.16 0.62 0.19 0.53 0.83

Switzerland −0.70 0.95 0.85 0.84 0.12

United Kingdom 0.51 −0.67 −0.62 0.32 0.9

USA −0.47 −0.88 0.00 −0.79 0.89

Average 0.27 0.30 0.28 0.26 0.39

Source: Ostrup (2002) and own calculations, OECD, National Accounts, 2011.

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business© Cambridge University Press, 2013 Chapter 10 – Gains from international capital mobilityTable 10.3 The Feldstein–Horioka test (see (10.4))

Period α0 α1 Explained variance (R2)

1960–4 7.02 (1.50)a 0.70 (3.75) 0.50

1965–9 8.78 (2.07) 0.65 (3.90) 0.50

1970–4 5.93 (1.96) 0.74 (6.62) 0.74

1975–9 6.47 (1.45) 0.78 (4.17) 0.54

1980–4 12.17 (4.36) 0.48 (3.81) 0.49

1985–9 10.41 (3.91) 0.54 (4.57) 0.58

1990–4 10.26 (5.88) 0.53 (6.46) 0.74

1995–7 7.83 (2.93) 0.56 (4.74) 0.58

1998-2009b 21.97 (69.10) 0.03 (0.93) 0.05 Source: see Table 10.2. Note: at-statistics in brackets. b In 2010 there are some missing data

Where does capital flow?

Is the destination of capital flows consistent with the theory?

Does capital flow in the wrong direction?

Fig. 10.2

Figure 10.2 Capital re-allocation between Home and Foreign

Ohome Oforeign

B

C

MPCforeignMPChome

A

KFKH

rH0

rH1

rF0

rF1

E0E1Ohome Oforeign

B

C

MPCforeignMPChome

A

KFKH

rH0

rH1

rF0

rF1

E0E1

Institutions, financial development and growth

Douglas North (1993) IMF study (2003) Acemoglu et al. (2001), Easterly (2002) and

Rodrik et al. (2002), all agree that “institutions are probably the most important deep structural explanation of income differences.”

Laporta et al. (1997, 1998): The role of legal origin.

Levine and Zervos (1998) studied the effect of institutions on financial development.

Beugelsdijk, Brakman, Garretsen, and van Marrewijk International Economics and Business© Cambridge University Press, 2013 Chapter 10 – Gains from international capital mobilityTable 10.4 Shareholder and creditor protection in countries with different legal origins

Shareholder rights index (Anti-director index, LaPorta et al. 1998)

Revised anti-directors index (Djankov et al. 2008)

Anti self dealing index (Djankov et al. 2008)

Creditor rights index (LaPorta et al. 1998)

English Common law heritage

4 4.19 0.66 3.11

French civil law heritage

2.33 2.91 0.33 1.58

German civil law heritage

2.33 3.04 0.38 2.33

Scandinavian civil law heritage

3 3.80 0.39 2

World average 3 3.37 0.44 2.3 Source: LaPorta et al. (1998) and Djankov et al. (2008)

Capital flows and risk diversification

A macroeconomic model does not allow us to understand the motives for capital flows from the perspective of the firm or the individual portfolio investor.

Portfolio investment and risk sharingInsurance against shocks through portfolio

diversification (Box 10.3).

Firm investment and asymmetric information

Incomplete informationAsymmetric distribution of informationFirm investment, supply of funds and

symmetric information (Fig. 10.3)Adverse selection problemMoral hazard problem

Figure 10.3 Firm investment, supply of funds and asymmetric information

Fs(NW)

Fd

r

Funds

a

b

ra

rb

XI*

r0

c

Fs(NW)

Fd

r

Funds

a

b

ra

rb

XI*

r0

c

Figure 10.4 Bank efficiency scores; per cent rank and score (%)

Bank efficiency scores; per cent rank and score

0

20

40

60

80

100

0 20 40 60 80 100rank

scor

e

average

Ethiopia

Netherlands

USASwitzerland

South Africa

Thailand

Congo Rep

China

Philippines

Angola

RussiaBelarus

Source: based on data from Hasan et al. (2009).