Theory Lecture 4

Question 1

How do Global capital markets improve the welfare?

Answer 1

Global capital markets improve the welfare of both debtor and creditor nations by allowing
firms borrow to undertake investment that maximizes the PV

Question 2

The implication for the direction of capital flows:

Answer 2

 For Cobb-Douglass production function in per-worker terms, ఈ,
MPK is ఈିଵ ௤
௞ (diminishing returns to K).
 With the same productivity A across countries, the poorer capital scarce country (smaller
k) has higher MPK and, hence, higher returns to investment.
The capital should flow to poor countries. (diagram 3)

Question 3

What does the diminishing returns to capital states

Answer 3

the diminishing returns to capital, the poorer capital scarce country (smaller k) has higher MPK

Question 4

Anomalies or “puzzles” in international finance, related to international equity
investments

Answer 4

1. Feldstein-Horoikapuzzle.
2. Lucas paradox.
3. Global imbalances.

Question 5

The Feldstein-HoriokaPuzzle. What is this anomaly about?

Answer 5

• This anomaly is about correlation of national savings and investment.
• Theory: In integrated global financial market,
 savings flow to countries with the most productive investment opportunities.
 domestic saving rates would be uncorrelated with domestic investment rates,
unless a country experiences a positive shock in both Invand Sav.
• Feldstein and Horoika1980 Econ. J documented that national savings rates are highly
correlated with domestic investment rates(long period averages, 1960-74).

• The FH puzzle had been disappearing pre crisis in 2001-09
• But it’s back during and after the recession, 2009-12 (similar to OR estimates).
Countries rely very little on external finance to fund investment.

Question 6

the Lucas Paradox. What is this anomaly about?

Answer 6

• This anomaly is about the determinantsand directionof int’l investment flows.
• Theory: In integrated global financial market,
 savings flow to countries with the most productive investment opportunities.
 with the same productivity across countries, the capital scarce (“poor”) country
has higher returns to investment (higher MPK). The capital should flow from rich
to poor countries.

Robert Lucas (1990)AER “Why Doesn’t Capital Flow from Rich to Poor Countries?” wrote:
If this model were anywhere close to being accurate, and if world capital markets were anywhere close to being free and complete, it is clear that, in the face of return differentials of this magnitude, investment goods would flow rapidly from the United States and other wealthy countries to India and other poor countries. Indeed, one would expect no investment to occur in the wealthy countries. . . .
• Lucas (1990) shows for Marginal Productivity of Capital (MPK), or “returns to investment”, of the US and India in 1988: MPKIndia1988 = 58 MPKUSA 1988
• The obvious conclusion from what we see in the data
Not enough capital flows from rich to poor countries!

Question 7

Global imbalances. What is this anomaly about?

Answer 7

To understand this anomaly you need to get familiar with the accounting of
international transactions (such as imports and exports, Foreign Direct Investments) in
country accounting.
Specifically,
1. The Balance of Payments statistics, and
2. System of National Accounts in open economies.

 The BOP is always in balance. We can talk about deficits and surpluses only in relation to individual
accounts: CA, FA.
 Some countries consistently run large imbalanceson their BOP.

Interpreting Global imbalances from the prospective of the Balance of Payments statistics
• The U.S. consistently runs CA deficit (CA<0) matched by a FA deficit (FA<0).
The “World debtor”: large trade deficits are paid for by sales of financial assets.
• Germany (or NL) has CA surplus (CA>0) and a matching FA surplus (FA>0).
A creditornation: purchases financial assets overseas through larger exports than imports.
• China runs large trade surpluses (and CA>0) and sizable FA deficits (FA<0). Puzzle?What item
offsets?
Official reserves! China hoards huge FX reserves, a foreign asset! It provides credit to the U.S.

Question 8

Explaining the Lucas Paradox

Answer 8

• The obvious conclusion from what we see in the data
Not enough capital flows from rich to poor countries!
• Lucas: assumptions must be wrong… But which ones?
• Alfaro, Kalemli-Ozcan, and Volosovych (2008) REStatinvestigate the role of different theoretical
explanations for the Lucas Paradox in a systematic empirical study.
For the period 1971-1998, the most important variable in explaining the Lucas Paradox is Institutional
Quality (control of corruption, protection of property rights, rule of law, etc.)

• The theoretical explanations for the Lucas Paradox

1. Differences in Fundamentals ( F( . ) or A)
2. International Capital Market Failures

-> the Lucas Paradox disappears with the addition of institutional quality.

Key take away from Alfaro, Kalemli-Ozcan, and Volosovych (2008) REStat:
We see very little investment flowing from rich (Netherlands) to poor countries (Madagascar)
countries (the Lucas Paradox) primarily because
 investors are not protected in those countries by high-quality political and economic institutions
(control of corruption, protection of property rights, rule of law, etc.).
 Risks from poor “investment climate” exceed potential return due to low capacity (low capital
stock).
 There are not enough opportunities for productive investment for complete convergence of
capital per worker to occur, even with fully open (“efficient”) capital markets.

The literature after from Alfaro, Kalemli-Ozcan, and Volosovych (2008) reached the
consensusthat
the A termin At f( kit ), defining risk-adjusted return,may primarily reflect a
country’s social efficiency(institutions, public policies, and cultural differences) –
not technical efficiency (technology, management).

Question 9

“Allocation puzzle”

Answer 9

In fact, country risk premiums may be large enough to cause capital toflow “uphill” from
poor to rich.

-> Capital flows “uphill” from poor to rich

Question 10

Capital “allocation puzzle” within poor countries

Answer 10

• In fact, things might be even worse for developing countries…
• An “allocation puzzle” (Gourinchasand Jeanne ‘13 REStud) :
allocation across dev countries is negativelycorrelated with productivity (=return)!
• Capital flows measured with current account: CA=S-I, so total net inflows is (-1*CA)

Question 11

Explaining the “allocation puzzle”, Alfaro et al. ‘14

Key take away from Alfaro, Kalemli-Ozcan, and Volosovych (2014) JEEA:

Answer 11

 Using (-1)*CA to test the basic model on where and why capital is flowing is not informative.
 It is important to measure (and understand!) two types of CF within the CA: a) by private investors;
b) sovereign-to-sovereign transactions.
The sovereign-to-sovereign CF lead to upstream capital flows and global imbalances.
There is no puzzling uphill behavior of CFonce we measure private CF correctly.