L5: Financial Globalisation and Capital Flows

Question 1

why do financial and trade globalisation go together even if financial globalization ≠ trade globalization?

Answer 1

countries that liberalise trade in goods also liberalise financial markets to foreign investment but different in some dimensions even if it happens simultaneously across countries

Question 2

measure of financial globalisation

Answer 2

extent of the openness in cross-border financial transactions

financial globalisation tends to be something of developed countries and not developing countries

Question 3

de jure financial openness measures

Answer 3

what are the restrictions to international capital movements?

institutional measures of countries led by policies which make it harder or easier for domestic residents to buy foreign assets and vice versa

variety of measures like tariffs in trade which countries can put in place to limit the extent of the trade of financial assets across borders (e.g. capital controls, taxes on foreign investments, etc.)

Question 4

de facto financial openness measures

Answer 4

how much financial trade in assets?

measuring amount of trade and financial assets between countries

Question 5

flows vs. stocks

Answer 5

flows as the value of assets traded for a given year

stocks as the value of assets held in a given year (cumulative flows)

Question 6

measures of financial globalisation: stocks

Answer 6

international financial integration measure = (domestic assets held by foreigners + foreign assets held by domestic agents)/GDP

Question 7

measures of financial globalisation: flows

Answer 7

inflows/GDP -> net purchases of domestic assets by foreign investors

outflows/GDP -> net purchase of foreign assets by domestic investors

flows as a less good measure since they are potentially volatile and not smooth

Question 8

the first financial globalisation

Answer 8

world capital markets integrated at the end of the 19th century with European investors holding significant fraction of wealth abroad

capital outflows mostly to the “new world” in the form of portfolio investment which was driven by investment banks which became large (e.g. Barclays, Lloyds, etc.)

Question 9

causes of the first financial globalisation

Answer 9

no clear shipping cost to transport financial assets but various barriers to trade that eventually fell

transportation and communication: information
- easier for people to go and look at potential investment opportunities

global UK banks
- development of the financial sector in the UK where they became much more global

Question 10

Solow growth model

Answer 10

US as the new world vs. Europe as the old world (most advanced at the time)

much more capital at the end of the 19th century in the UK because they went through the first industrial revolution

Solow tells us returns to capital in the US must be high because there is little capital so return to capital must be high

so capital flows from capital-abundant countries (Europe) to capital-scarce ones (US)

European capital chased European labour and vice versa: both migrated to the new world where returns are high

Question 11

what does the production function show?

Answer 11

yt = At(kt)^a

• the better the technology, the more you produce
• At as an efficiency parameter (TFP)

concave graphs which means returns to capital are decreasing
- when you increase capital, you increase output much more when you have less capital than when you have more capital

Question 12

marginal productivity of capital (MPK)

Answer 12

additional unit of output per unit of capital (returns on capital)

derivative of the production function with respect to k

returns on capital fall as k (amount of capital) increases

Question 13

what happened when the US and UK traded financial assets during the first financial globalisation? (with reference to MPK graph)

Answer 13

decreasing returns on aggregate for MPK which intersect on the graph with the world interest rate (horizontal line)

when UK and US trade, US has more capital to begin with
- starts with US under autarky where returns to capital are higher than in the UK since they have less capital

when trade opens, capital accumulates in the US so MPK in the US decreases

• returns are higher in the US so people want to go there and there are increasing amounts of capital employed in the US
• capital moves towards the US up until the point where returns are equalised (with the UK) and at that point, it is no longer profitable to send massive amounts of capital to the US

Question 14

Washington consensus

Answer 14

collection of loosely articulated ideas at the beginning of the 1990s to modernise, reform, deregulate and open economies since countries would benefit from integrating financially with the rest of the world

suggested by the Solow model and potential benefits of financial globalisation which allow capital to move when returns are the highest

Question 15

expected gains from financial integration

Answer 15

trade gains

• countries borrow since they have high capital returns and finance investments in return
• pay back later with the benefits from high returns of capital

intemporal trade gains

• capital flows from capital-rich to capital-poor countries
• more investment in capital-poor countries so they reach steady-state in Solow quicker
• positive effect on growth

Question 16

what is the Lucas puzzle?

Answer 16

standard Solow prediction says that capital flows from capital-abundant to capital-poor countries but for many countries, it tends to flow the other way

fast-growing emerging countries tend to lend capital to slow-growing countries (not consistent with Solow) and many emerging markets lending to rich countries

Question 17

explanations of the Lucas puzzle

Answer 17

differences in TFP

• assumption had been that MPK was the same for every country and they all had the same technology
• some countries more productive than others

institutional quality
- returns to capital also determined by technology/institutions

capital market imperfections
- greater sovereign risk and greater government default in developing countries than developed countries

Question 18

benefits of financial integration

Answer 18

allocation of capital to places where returns are highest

might provide ability to diversify risk

Question 19

gravity in international finance

Answer 19

more surprising since there are no transport costs, but capital flows also obey some sort of gravity

more trade between larger countries and less trade in financial assets between countries further away

also more trade within a country than with foreigners

Question 20

reasons for gravity in international finance?

Answer 20

costs of acquiring information

• cheaper in local/domestic markets or neighbouring markets but more costly for foreign markets
• big factor

foreigners can be expropriated to foreign countries

• foreign countries favour domestic over foreign investments
• they know this so they invest domestically rather than deal with the possibility of being expropriated

countries that liberalise trade assets generate more trade of assets and financial assets within those countries

• EU and Eurozone where they liberalise together
• more trade between European countries than with other countries

currency risk

• richer countries and more developed countries have more stable currencies
• easier if you’re in the same currency area to invest

Question 21

national accounting formula

Answer 21

Y(GDP) = C + I + G + (EX - IM)

Question 22

GDP vs. GNI

Answer 22

GDP as value of all final goods and services produced within national borders

GNI as value of all final goods and services produced by national factors of production

Question 23

what is GNI with respect to GDP?

Answer 23

GNI = GDP + net receipts of factor income

GNI = C + I + G + (EX - IM) + NFI

Question 24

current account balance formula

Answer 24

CA = EX - IM + NFI

CA = GNI - C - I - G
- GNI = C + Sp + T where C is consumption, Sp is private saving and T is taxes

CA = C + Sp + T - C - I - G

CA = SP - I + T - G
- SG = T - G as public saving (fiscal surplus)

CA = SP + SG - I

Question 25

GNI formula

Answer 25

GNI = C + Sp + T

Question 26

current account deficit

Answer 26

spending more than what comes in (e.g. US)

country is not making enough to finance their own investments which means they have to borrow

also not enough saving in the economy

Question 27

current account surplus

Answer 27

country is lending to the rest of the world (e.g. China)

savings exceed national investment - saving more than what is invested in the economy

country has more income than what is spent and is saving in excess to what is invested in the economy

Question 28

twin deficit hypothesis

Answer 28

strong causal link fiscal deficit and current account deficit

Question 29

balance of payments (BOP)

Answer 29

registers all transactions with foreign economic agents

records transactions of one country with respect to all other foreign countries

3 main sorts of transactions

1. exports/imports of goods and services (CA)
2. sale and purchase of financial assets (FA)
3. certain transfers of wealth (KA)

BOP = CA + FA + KA

theoretically should balance so BOP = 0

Question 30

why does the BOP have to balance?

Answer 30

credits need to be matched by debits

Question 31

financial account formula

Answer 31

FA = inflows - outflows of financial assets

Question 32

capital account (KA)

Answer 32

KA = flows of non-financial assets between countries - debt forgiveness

Question 33

understanding current account deficits

Answer 33

what makes it that a country is saving too little or investing too much?

emphasis on growth of countries because when countries are growing quickly because of high returns to capital, they should be borrowing externally

if they know there are greater risks tomorrow and they want to borrow to finance growth, they should be buying more currently (higher rates of investment) which would lead to a CA deficit and low savings due to expectations of high incomes

high returns to capital so a good time to invest in that economy

Question 34

the Chinese savings puzzle

Answer 34

fast-growing and high productivity growth

growing so fast they should eventually borrow because there will be returns in the future

instead, they are a lender in world markets and have large investment rates but have savings growing at an even faster rate

Question 35

why do we observe the Chinese savings puzzle?

Answer 35

domestic financial distortions

• higher level of inequality whether it is geographical or within the income distribution
• unequal countries have higher propensities to save

politics

• financial repression with one main bank controlled largely by the government
• force people to contribue to savings and make sure they self-engineer high investment rates

precautionary motive
- lack of or undeveloped social security market so people are not covered by it and save to be covered

demographics
- drastic reduction in fertility from the one child policy so high ageing rates which trigger savings

Question 36

net foreign assets formula (with regards to current account)

Answer 36

CAt = NFAt - NFAt-1

if a country in year t has a CA deficit, its net external position (NFA) deteriorates

Question 37

when is NFAt < 0?

Answer 37

value of foreign assets held by the debtor country < value of domestic assets held by foreigners

Question 38

the US’ exorbitant privilege and exorbitant duty

Answer 38

large exorbitant privilege between what the US invests/lends and what they borrow

role of the USD as reserve currency

liquidity of US financial markets (foreigners willing to hold underperforming US assets because they are more liquid)

as a consequence of this, US external constraints are relaxed and there are CA deficits without a worsening of their external position