L5: Financial Globalisation and Capital Flows Flashcards
why do financial and trade globalisation go together even if financial globalization ≠ trade globalization?
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
measure of financial globalisation
extent of the openness in cross-border financial transactions
financial globalisation tends to be something of developed countries and not developing countries
de jure financial openness measures
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.)
de facto financial openness measures
how much financial trade in assets?
measuring amount of trade and financial assets between countries
flows vs. stocks
flows as the value of assets traded for a given year
stocks as the value of assets held in a given year (cumulative flows)
measures of financial globalisation: stocks
international financial integration measure = (domestic assets held by foreigners + foreign assets held by domestic agents)/GDP
measures of financial globalisation: flows
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
the first financial globalisation
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.)
causes of the first financial globalisation
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
Solow growth model
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
what does the production function show?
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
marginal productivity of capital (MPK)
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
what happened when the US and UK traded financial assets during the first financial globalisation? (with reference to MPK graph)
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
Washington consensus
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
expected gains from financial integration
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
what is the Lucas puzzle?
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
explanations of the Lucas puzzle
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
benefits of financial integration
allocation of capital to places where returns are highest
might provide ability to diversify risk
gravity in international finance
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
reasons for gravity in international finance?
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
national accounting formula
Y(GDP) = C + I + G + (EX - IM)
GDP vs. GNI
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
what is GNI with respect to GDP?
GNI = GDP + net receipts of factor income
GNI = C + I + G + (EX - IM) + NFI
current account balance formula
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
GNI formula
GNI = C + Sp + T
current account deficit
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
current account surplus
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
twin deficit hypothesis
strong causal link fiscal deficit and current account deficit
balance of payments (BOP)
registers all transactions with foreign economic agents
records transactions of one country with respect to all other foreign countries
3 main sorts of transactions
- exports/imports of goods and services (CA)
- sale and purchase of financial assets (FA)
- certain transfers of wealth (KA)
BOP = CA + FA + KA
theoretically should balance so BOP = 0
why does the BOP have to balance?
credits need to be matched by debits
financial account formula
FA = inflows - outflows of financial assets
capital account (KA)
KA = flows of non-financial assets between countries - debt forgiveness
understanding current account deficits
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
the Chinese savings puzzle
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
why do we observe the Chinese savings puzzle?
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
net foreign assets formula (with regards to current account)
CAt = NFAt - NFAt-1
if a country in year t has a CA deficit, its net external position (NFA) deteriorates
when is NFAt < 0?
value of foreign assets held by the debtor country < value of domestic assets held by foreigners
the US’ exorbitant privilege and exorbitant duty
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
