Academic journal article NBER Reporter

Cross-Border Capital Flows, Fluctuations and Growth

Academic journal article NBER Reporter

Cross-Border Capital Flows, Fluctuations and Growth

Article excerpt

What is the extent of international financial integration, and how does such integration affect economic fluctuations and growth? Does the effect differ during tranquil times versus times of financial crisis? Does financial integration transmit shocks across the globe and lead to contagion? In recent research, together with my co-authors, I search for answers to these and other related questions, using both macro-level country data and micro-level firm data.

Capital Flows: Where and Why?

One common definition of international financial integration is the amount of cross-border capital flows. These flows can take the form of foreign direct, portfolio equity, and debt investment, constituting the financial account -- the mirror image of current account in the balance-of-payments statistics. Figure 1 plots the average current account balance with reverse sign as a measure of total net capital flows from more than 150 countries, together with different types of flows. (1)

The black dashed line shows that the world is running a current account deficit, roughly around 4 percent of GDP, implying positive net capital flows on average since the 1970s. (2) Since the 1990s, however, countries seem to be net borrowers in FDI and equity investment and net lenders in debt instruments. (3) This simple plot hints that current account may not be informative in terms of testing the predictions of certain classes of models for the amount and direction of capital flows and their implications for economic fluctuations and growth. The appropriate definition (FDI versus debt, public versus private, or net versus gross flows) must be used depending on the question asked.

For example, the neoclassical model predicts a large amount of capital flows based on return differentials from capitalabundant rich countries to capital-scarce poor ones. The lack of such flows in the data is known as the Lucas paradox. The recent period of global imbalances has seen a related paradox, where capital flows in the reverse direction (when measured from current account), from "still poor but growing fast" countries such as China to "rich but not growing" countries such as the United States. Laura Alfaro, Vadym Volosovych, and I have investigated the reasons for both of these phenomena. (4)

Our results show that in a sample of developed and developing countries, the positive correlation between capital flows and GDP per capita (that is, the Lucas paradox) during 1970-2000 goes away once we account for the effect of institutional quality: rich countries receive more foreign investment because they have better institutions. Exogenous variation in institutional quality, measured by the historical determinants of institutions, is the most important determinant of capital flows, causally explaining the Lucas Paradox. (5)


If capital is flowing to productive places in the long run, where longrun productivity is proxied by institutional quality, then why do we worry about capital flows from China to the United States, where the latter clearly has higher quality institutions? We worry because the standard models imply that China must have received more capital flows than, say Zimbabwe, in a sample of developing countries, given China's faster catch-up productivity growth to the United States. This does not seem to be the case. The fast growing countries accumulate a large amount of reserves and export capital to slow growing countries, causing global imbalances.

In our 2011 paper, we decompose international capital flows into public and private components (private debt, FDI, equity flows versus public flows). We focus on a sample of developing countries since the 1980s and measure the amount of private and public capital flows these countries have received in relation to their catch-up growth. It turns out that upstream flows and global imbalances are manifestations of the same underlying phenomenon: sovereign-to-sovereign flows in the form of government debt from official lenders, reserve accumulation, and aid. …

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