International Capital Flows and Capital Account Liberalization Thorvaldur Gylfason

InternationInternational Capital al Capital Flows and Flows and Capital Capital Account Account LiberalizatiLiberalizationon Thorvaldur Gylfason

Two PartsTwo Parts

Part One: Part One:

International Capital International Capital MovementsMovements

Part Part TwoTwo::

External Debt DynamicsExternal Debt Dynamics

Goods and CapitalGoods and Capital

The argument for free trade in goods The argument for free trade in goods and services applies also to capitaland services applies also to capital

Trade in capital helps countries to Trade in capital helps countries to specialize according to specialize according to comparative comparative advantageadvantage, exploit , exploit economies of economies of scalescale, and promote , and promote competitioncompetition

Exporting equity in domestic firms not Exporting equity in domestic firms not only earns foreign exchange, but also only earns foreign exchange, but also secures access to capital, ideas, secures access to capital, ideas, know-how, technologyknow-how, technology

11

Symmetry between Symmetry between Trade in Goods and Trade in Goods and CapitalCapital

The balance of payments The balance of payments

R = X – Z + FR = X – Z + Fwherewhere

X X = exports of goods and services= exports of goods and services

Z Z = imports of goods and services= imports of goods and services

F F = net exports of capital= net exports of capital Foreign direct investmentForeign direct investment Portfolio investmentPortfolio investment Foreign borrowingForeign borrowing

Determinants of Determinants of Foreign TradeForeign Trade

Trade in goods and services Trade in goods and services depends ondepends on

Relative pricesRelative prices at home and abroad at home and abroad

Exchange rates Exchange rates (elasticity models)(elasticity models)

National incomesNational incomes at home and abroad at home and abroad

Geographical Geographical distancedistance from trading from trading partners (gravity models)partners (gravity models)

Trade policyTrade policy regime regimeTariffs and other barriers to tradeTariffs and other barriers to trade

Two Views of TradeTwo Views of Trade

The current account of the balance The current account of the balance of payments is defined as of payments is defined as B = X B = X – Z– Z

National income is National income is Y = E + X – ZY = E + X – Z

Therefore, current account is Therefore, current account is

B = X – Z = Y – EB = X – Z = Y – E

Two sides of the same coin:Two sides of the same coin:Deficit means that Deficit means that Z > XZ > X and and E > YE > Y

Surplus means that Surplus means that X > ZX > Z and and Y > EY > E

Foreign InvestmentForeign InvestmentCapital flowsCapital flows

Foreign borrowing, portfolio investment, Foreign borrowing, portfolio investment, foreign direct investmentforeign direct investment

Trade in equities depends onTrade in equities depends onInterest ratesInterest rates at home and abroad at home and abroad

Exchange rate expectationsExchange rate expectations

Geographical Geographical distancedistance from trading partners from trading partners

Capital account Capital account policy regimepolicy regimeCapital controls and other barriers to free flowsCapital controls and other barriers to free flows

Exports 1990-Exports 1990-20002000 (% of GDP) (% of GDP)

05

101520253035

World Low- and middle-income countries

High-incomecountries

1990

2000

Transition Countries: Transition Countries: Exports 2000 (% of Exports 2000 (% of GDP)GDP)

0 20 40 60 80 100

AlbaniaArmenia

ChinaRomaniaGeorgia

AzerbaijanKyrgyz Republic

UzbekistanLithuaniaRussian

LatviaMoldovaBulgaria

KazakhstanSloveniaUkraine

TurkmenistanHungaryBelarus

Czech RepublicSlovak Republic

TajikistanEstonia

World average

Growth in Trade Less Growth in Trade Less Growth in GDP 1990-2000 Growth in GDP 1990-2000 (%)(%)

-10 0 10 20 30

BelarusKazakhstan

ChinaKyrgyz Republic

UzbekistanSlovenia

Russian FederationTurkmenistan

BulgariaLatvia

UkraineAlbania

RomaniaHungary

Slovak RepublicCzech Republic

EstoniaLithuaniaMoldova

AzerbaijanVietnamGeorgia

FDI 1990-2000 (Net, FDI 1990-2000 (Net, % of Gross % of Gross Investment) Investment)

02468

10121416



1990

2000

FDI 1990-2000 (Gross, FDI 1990-2000 (Gross, % of GDP) % of GDP)

0

2

4

6

8

10

12



1990

2000

Transition Countries: FDI Transition Countries: FDI 2000 (Net, % of Gross 2000 (Net, % of Gross Investment)Investment)

-10 0 10 20 30 40 50 60

Kyrgyz RepublicBelarus

SloveniaRussian

ChinaAzerbaijan

UkraineTurkmenistan

UzbekistanHungaryTajikistanRomaniaVietnam

LithuaniaAlbania

LatviaCambodia

GeorgiaEstonia

Czech RepublicSlovak Republic

ArmeniaMoldova

KazakhstanBulgaria

World average

Transition Countries: FDI Transition Countries: FDI 2000 (Gross, % of GDP)2000 (Gross, % of GDP)

0 5 10 15

BelarusSloveniaUkraineRussian

AzerbaijanRomaniaLithuania

AlbaniaCambodia

VietnamGeorgia

ChinaKyrgyz Republic

HungaryLatvia

ArmeniaKazakhstan

BulgariaCzech Republic

MoldovaEstonia

Slovak Republic

World average

Capital FlowsCapital Flows

Facilitate borrowing abroad to Facilitate borrowing abroad to smooth consumption over timesmooth consumption over time

Dampen business cyclesDampen business cycles

Reduce vulnerability to domestic Reduce vulnerability to domestic economic disturbanceseconomic disturbances

Increase risk-adjusted rates of returnIncrease risk-adjusted rates of return

Encourage saving, investment, and Encourage saving, investment, and growthgrowth

Openness to Openness to FDIFDI and Growth 1965-98and Growth 1965-98

-8

-6

-4

-2

0

2

4

6

-4 -2 0 2 4 6 8

Actual less predicted FDI 1975-1998 (% of GDP, ppp)

An

nu

al g

row

th o

f G

NP

per

cap

ita

1965

-98,

ad

just

ed f

or

init

ial

inco

me

(%)

Botswana

An increase in openness to FDI by 2% of GDP is associated with an increase in per capita growth by more than 1% per year.

r = 0.62

85

countrie

s

r = r = rank rank correlatcorrelationion

Openness to Trade and Growth 1965-98

-8

-6

-4

-2

0

2

4

6

-40 -30 -20 -10 0 10 20 30 40

Actual less predicted exports 1965-98 (% of GDP)

An

nu

al

gro

wth

of

GN

P p

er

cap

ita

196

5-98

, a

dju

ste

d f

or

init

ial

inco

me

(%

)

Malaysia

Korea

Guinea Bissau

Belgium

87

countrie

s

An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year.

r = 0.42

Tariffs and Growth 1965-9882

countrie

s

-8

-6

-4

-2

0

2

4

6

0 10 20 30 40

Import duties (% of imports 1970-98)

An

nu

al g

row

th o

f G

NP

pe

r c

ap

ita

19

65

-98

, ad

jus

ted

fo

r in

itia

l in

co

me

(%

)

An increase in tariffs by 10% of imports is associated with a decrease in per capita growth by 1% per year.

r = -0.52

India

Cote d'Ivoire

Botswana

Pitfalls: Incomplete Pitfalls: Incomplete InformationInformation

Capital account liberalization, if Capital account liberalization, if well managed, stimulates saving well managed, stimulates saving and investment, efficiency, and and investment, efficiency, and economic growtheconomic growth

But information may be But information may be asymmetricasymmetricAdverse selectionAdverse selection

Moral hazardMoral hazard

HerdingHerding

Capital Account Capital Account LiberalizationLiberalizationNeeds to be orderly, gradual, well-Needs to be orderly, gradual, well-

sequencedsequenced

Effective prudential regulationEffective prudential regulationTo encourage banks to recognize risksTo encourage banks to recognize risks

To enable authorities to monitor threats to To enable authorities to monitor threats to stability of the financial system stability of the financial system

Sound macroeconomic policiesSound macroeconomic policies

SequencingSequencingPut bank supervision and sound policies in Put bank supervision and sound policies in

place first, then liberalizeplace first, then liberalize

External Debt External Debt Dynamics and Dynamics and SustainabilitySustainability22

Many countries have developed rapidly with the aid of external loans (US, Korea)

But many other countries have fared But many other countries have fared less well with their external debt less well with their external debt strategies because they borrowed strategies because they borrowed abroad to abroad to finance consumption, not finance consumption, not investmentinvestment

Consumption does not increase the Consumption does not increase the ability of indebted countries to ability of indebted countries to service their debts, nor does low-service their debts, nor does low-quality investmentquality investment

But But high-quality investmenthigh-quality investment doesdoes

External Debt: External Debt: Key ConceptsKey Concepts

Debt burdenDebt burdenAlso called Also called debt service ratiodebt service ratio

Equals the ratio of amortization Equals the ratio of amortization and interest payments to exportsand interest payments to exports

q = debt service ratioA = amortizationr = interest rate DF = foreign debtX = exports

X

rDAq

F

Interest burdenInterest burdenRatio of interest payments to Ratio of interest payments to

exportsexports

X

Aa q = a + bq = a + b

Amortization burdenAmortization burdenAlso called Also called repaymentrepayment burden burden

Ratio of amortization to exportsRatio of amortization to exports

X

rDb

F

External Debt: External Debt: Key ConceptsKey Concepts

How can we figure out a How can we figure out a country’s debt burden?country’s debt burden?Divide through definition of Divide through definition of qq by by

incomeincomeNow we have expressed Now we have expressed the debt service ratio in the debt service ratio in terms of familiar terms of familiar quantities: the interest quantities: the interest rate rate rr, the debt ratio , the debt ratio DDFF/Y/Y, and the export , and the export ratio ratio X/YX/Y as well as the as well as the repayment ratio repayment ratio A/YA/Y

Y

XY

Dr

Y

A

q

F

External Debt: External Debt: NumbersNumbers

Suppose that Suppose that r = 0.08r = 0.08

DDFF/Y = 0.50/Y = 0.50

A/Y = 0.06A/Y = 0.06

X/Y = 0.20X/Y = 0.20

5.02.0

1.0

0.2

5.008.006.0q

Here we have a Here we have a country that has to country that has to use use a half of its a half of its export earningsexport earnings to to service its external service its external debtdebt

Heavy burden!Heavy burden!

Y

XY

Dr

Y

A

q

F

Numerical ExampleNumerical Example

Transition Countries:Transition Countries: External Debt 2000 (PDV, External Debt 2000 (PDV, % of GDP)% of GDP)

0 20 40 60 80 100 120

BelarusChina

AlbaniaAzerbaijan

RomaniaArmeniaVietnamUkraine

KazakhstanGeorgia

LithuaniaCzech Republic

LatviaSlovak Republic

UzbekistanRussian

CambodiaHungaryEstonia

BulgariaMoldova

TajikistanKyrgyz Republic

Transition Countries: Transition Countries: External Debt 2000 (% of External Debt 2000 (% of ExportsExports))

0 50 100 150 200 250

BelarusAlbania

AzerbaijanChina

Czech RepublicUkraine

KazakhstanEstonia

Slovak RepublicVietnamRomaniaHungaryLithuania

LatviaGeorgiaArmenia

TajikistanUzbekistanCambodia

RussianBulgariaMoldova

Kyrgyz Republic

Transition Countries: External Transition Countries: External Debt ServiceDebt Service 2000 (% of 2000 (% of ExportsExports))

0 10 20 30 40

CambodiaAlbaniaBelarus

ChinaVietnamArmenia

AzerbaijanEstoniaGeorgiaRussian

TajikistanCzech Republic

LatviaBulgariaMoldova

KazakhstanLithuania

Slovak RepublicUkraine

RomaniaHungary

UzbekistanKyrgyz Republic

Debt accumulation is, by its nature, a Debt accumulation is, by its nature, a dynamicdynamic phenomenon phenomenonA large stock of debt involves high A large stock of debt involves high

interest payments which, in turn, add interest payments which, in turn, add to the external deficit, which calls for to the external deficit, which calls for further borrowing, and so on further borrowing, and so on Debt accumulation can develop into a Debt accumulation can develop into a

vicious circlevicious circle

How do we know whether a given debt How do we know whether a given debt strategy will spin out of control or not?strategy will spin out of control or not?To answer this, we need a little arithmetic To answer this, we need a little arithmetic

External Debt External Debt Dynamics Dynamics

Recall balance of payments Recall balance of payments equation:equation:BOP = X – Z + FBOP = X – Z + F

wherewhere

FF = capital inflow = capital inflow = = DDFF where where

DDFF = foreign debt = foreign debtCapital inflow, F, thus involves an Capital inflow, F, thus involves an

increase in the stock of foreign debt, increase in the stock of foreign debt, DDFF, or a decrease in the stock of , or a decrease in the stock of foreign claims (assets)foreign claims (assets)

So, F is a So, F is a flowflow and D and DF F is a is a stockstock

External External DebtDebt Dynamics Dynamics

Now assumeNow assumeZ = ZZ = ZNN + r + rDDFF

ZZ = total imports= total importsZZNN = non-interest imports = non-interest importsrrDDFF = interest payments = interest payments

Further, assumeFurther, assumeX = ZX = ZNN

BOP = 0BOP = 0 A flexible exchange rate maintains A flexible exchange rate maintains equilibrium in the balance of payments at equilibrium in the balance of payments at

all times all times

Then, it follows thatBOP = X – Z + BOP = X – Z + DDFF = = 00so that

DDFF = = rDrDFF

In other words:

rD

ΔDF

F

External External Debt Debt DynamicsDynamics

So, now we have:

rD

ΔDF

F

Now subtract growth rate of output from both sides:

g-rY

ΔY

D

ΔDF

F

Y

Yg

External Debt External Debt DynamicsDynamics

But what is

This is the proportional change of the debt ratio:

Y

ΔY

D

ΔDF

F

??

Y

D

Y

DΔ

Y

ΔY

D

ΔDF

F

F

F

This is an application of a simple rule of arithmetic:

%%(x/y) = (x/y) = %%x - x - %%yy

External Debt External Debt Dynamics Dynamics

z = x/yz = x/y

log(z) = log(x) – log(y)log(z) = log(x) – log(y)

log(z) = log(z) = log(x) - log(x) - log(y)log(y)

But what is But what is log(z) log(z) ??

So, we obtain

z

Δz

z

1

dt

dz

dt

dlog(z)Δlog(z)

y

Δy

x

Δx

z

Δz

Q.E.D.

Proof Proof

We have shown thatWe have shown that

grd

Δd

where

Debt ratio

Time

r r g g

r = gr = g

r r g g

Need economic Need economic growth to keep growth to keep the debt ratio the debt ratio under controlunder control

Y

Dd

F

Debt, Interest, and Debt, Interest, and Growth Growth

It is important to keep It is important to keep economic growtheconomic growth at home at home aboveabove – or at least not far – or at least not far below – the below – the world rate of interestworld rate of interest

Otherwise, the debt ratio keeps rising over Otherwise, the debt ratio keeps rising over timetime

External deficits can be OK, even over External deficits can be OK, even over long periods, as long as the external long periods, as long as the external debt does not increase faster than debt does not increase faster than output and the debt burden is output and the debt burden is manageable to begin with manageable to begin with

A rising debt ratio may also be OK as A rising debt ratio may also be OK as long as the borrowed funds are used long as the borrowed funds are used efficientlyefficiently

Once again, Once again, high-quality investment high-quality investment is keyis key

What Can We Learn What Can We Learn from This? from This?

Let us now study the interaction Let us now study the interaction between trade deficits, debt, and between trade deficits, debt, and growthgrowth

Two simplifying assumptions:Two simplifying assumptions:DDtt = aY = aYt t (omit the superscript F, so D = (omit the superscript F, so D =

DDFF))

Trade deficit is a constant fraction Trade deficit is a constant fraction aa of of outputoutput

YYtt = Y = Y00eegtgt

Output grows at a constant rate Output grows at a constant rate gg each yeareach year

Y

tExponential growth

Debt Dynamics: Debt Dynamics: Another Look Another Look

Y

time

Exponential growth implies a linear logarithmic growth path whose slope equals the growth rate

log(Y)

time

1

g

Pictures of Growth Pictures of Growth

T

0

tT dtΔDD at time T

Debt as the Sum of Debt as the Sum of Past Deficits Past Deficits

dteaYdtΔDDT

0

gt0

T

0

tT

T

0

tT dtΔDD at time T

DebtDebt as the Sum of as the Sum of Past Deficits Past Deficits

dteaYdtΔDDT

0

gt0

T

0

tT

gt0

T

0

gt0

T

0

tT eg

1aYdteaYdtΔDD

Evaluate this Evaluate this integral integral between 0 and between 0 and TT

T

0

tT dtΔDD at time T

DebtDebt as the Sum of as the Sum of Past Past DeficitsDeficits

dteaYdtΔDDT

0

gt0

T

0

tT

gt0

T

0

gt0

T

0

tT eg

1aYdteaYdtΔDD

Evaluate this integral between 0 and T

1eg

1aYe

g

1aYdteaYdtΔDD gT

0gt

0

T

0

gt0

T

0

tT

T

0

tT dtΔDDSo, as T goes to So, as T goes to infinity, Dinfinity, Dtt becomes becomes infinitely large.infinitely large.But that may be quite But that may be quite OK in a growing OK in a growing economy!economy!

at time T

Debt as the Sum of Debt as the Sum of Past DeficitsPast Deficits

T

0gt

0

T

T

Y

YeY

g

a

Y

D


T

0gt

0

T

T

Y

YeY

g

a

Y

D

T

0

T

0gt

0

T

T

Y

Y1

g

a

Y

YeY

g

a

Y

D


T

0gt

0

T

T

Y

YeY

g

a

Y

D

T

0

T

0gt

0

T

T

Y

Y1

g

a

Y

YeY

g

a

Y

D

gT

T

0

T

0gt

0

T

T e1g

a

Y

Y1

g

a

Y

YeY

g

a

Y

D


So, as T goes to So, as T goes to infinity, Dinfinity, DTT/Y/YTT approaches the approaches the ratio ratio a/ga/g

T

0gt

0

T

T

Y

YeY

g

a

Y

D

T

0

T

0gt

0

T

T

Y

Y1

g

a

Y

YeY

g

a

Y

D

gT

T

0

T

0gt

0

T

T e1g

a

Y

Y1

g

a

Y

YeY

g

a

Y

D

g

a

Y

D

T

Tlim T


SupposeSupposeTrade deficit is 6% of GNPTrade deficit is 6% of GNP

a = 0.06a = 0.06

Growth rate is 2% per yearGrowth rate is 2% per yearg = 0.02g = 0.02

Then the debt ratio approachesThen the debt ratio approachesd = a/g = 0.06/0.02 = 3d = a/g = 0.06/0.02 = 3

This point will be reachedThis point will be reached regardless regardless of the initial position ...of the initial position ...... as long as ... as long as aa and and gg remain remain

unchangedunchanged

Debt ratio

Time

3

Numerical Numerical Example Example

Suppose that r = 0.08 (as before)

D/Y = 3D/Y = 3 (our new number)

A/Y = 0.06 (as before)

X/Y = 0.20 (as before)

Here we have Here we have a country that a country that has to use has to use one one and a halfand a half of of its export its export earnings to earnings to service its service its debtsdebtsHeavy Heavy

burden, burden,

indeed!!!indeed!!!

5.10.2

30.080.06q

Y

XY

Dr

Y

A

q

F

Numerical Example, Numerical Example, AgainAgain






burden, burden,

indeed!!indeed!!

1.10.2

20.080.06q

Y

XY

Dr

Y

A

q

F







burden, burden,

indeed!indeed!

7.00.2

10.080.06q

Y

XY

Dr

Y

A

q

F






Here we have Here we have a country that a country that has to use has to use one one and a halfand a half of of its export its export earnings to earnings to service its service its debtsdebtsHeavy burden, Heavy burden,

but but

manageablemanageable

35.00.4

10.080.06q

Y

XY

Dr

Y

A

q

F


Must adjust policiesMust adjust policies

Must eitherMust eitherReduce trade deficitReduce trade deficit by stimulating by stimulating

exports or by reducing imports, orexports or by reducing imports, orIncrease economic growthIncrease economic growth

Otherwise, the debt ratio will reach Otherwise, the debt ratio will reach unmanageable levels, unmanageable levels, automaticallyautomaticallyNo country can afford external debt No country can afford external debt

equivalent to 2-3 times annual outputequivalent to 2-3 times annual output

What to Conclude?What to Conclude?

Because, after a while, the debt Because, after a while, the debt burden becomes burden becomes unbearable unbearable

Korea avoided thisKorea avoided thisIts Its export-oriented growth strategyexport-oriented growth strategy

reduced the numerator and reduced the numerator and increased the denominator of the increased the denominator of the debt ratio, thereby reducing its debt debt ratio, thereby reducing its debt burdenburden

An An import-substitution strategyimport-substitution strategy would would reduce both numerator and reduce both numerator and denominator, with an ambiguous denominator, with an ambiguous effect on the debt burdeneffect on the debt burden

And Why Not?And Why Not?

Transition Countries: External Transition Countries: External Debt ServiceDebt Service 2000 (% of 2000 (% of ExportsExports))

0 10 20 30 40

CambodiaAlbaniaBelarus

ChinaVietnamArmenia

AzerbaijanEstoniaGeorgiaRussian

TajikistanCzech Republic

LatviaBulgariaMoldova

KazakhstanLithuania

Slovak RepublicUkraine

RomaniaHungary

UzbekistanKyrgyz Republic

Still OK, but Still OK, but

be careful!be careful!

RecapRecap

Borrowers often renegotiate the terms of Borrowers often renegotiate the terms of their loans in mid-stream in order to their loans in mid-stream in order to delay repayments, that is, extend the delay repayments, that is, extend the

maturity of the loans, or tomaturity of the loans, or to reduce interest payments by replacing reduce interest payments by replacing

high-interest loans by loans with lower high-interest loans by loans with lower interestinterest

Sometimes, outright Sometimes, outright debt forgivenessdebt forgiveness may be called formay be called forBut debt forgiveness is But debt forgiveness is no substitute for no substitute for

sound economic policiessound economic policies Remember: our formula Remember: our formula d = a/g d = a/g holds in holds in

the long run regardless of initial the long run regardless of initial conditions conditions

Debt Renegotiations Debt Renegotiations and Forgiveness and Forgiveness

External borrowing is a necessary and External borrowing is a necessary and natural part of economic developmentnatural part of economic developmentThis requires countries that borrow to invest This requires countries that borrow to invest

the funds borrowed in the funds borrowed in high-quality capitalhigh-quality capital, , including health and educationincluding health and education

This is necessary to be able to service the This is necessary to be able to service the debtdebt

If the debt burden becomes too heavy, If the debt burden becomes too heavy, must either must either reduce deficitreduce deficit or or stimulate stimulate growthgrowthIt is always desirable anyway to do It is always desirable anyway to do

everything possible to encourage economic everything possible to encourage economic growthgrowth

Rapid growth allows more foreign borrowing Rapid growth allows more foreign borrowing without making the debt burden without making the debt burden unmanageable unmanageable

The Bottom Line

Documents

International Capital Flows and Capital Account Liberalization Thorvaldur Gylfason