Transcript The Challenges of Capital Inflows Including Aid

Thorvaldur Gylfason
Joint Vienna Institute/
Institute for Capacity Development
Distance Learning Course on
Financial Programming and Policies
Vienna, Austria
NOVEMBER 26–DECEMBER 7, 2012
Capital flows
 History,
theory, evidence
Foreign aid
 Effectiveness:
Does aid work?
 Macroeconomic challenges
Dutch disease
 Aid volatility

Definition
o
o
International capital movements refer to the flow
of financial claims between lenders and borrowers
The lenders give money to the borrowers to be
used now in exchange for IOUs or ownership shares
entitling them to interest and dividends later
Benefits of international trade in capital
Allows for specialization, like trade in commodities
o Allows for intertemporal trade in goods and
services between countries
o Allows for international diversification of risk
o
3
The case for free trade in goods and
services applies also to capital
Trade in capital helps countries to
specialize according to comparative
advantage, exploit economies of scale,
and promote competition
Exporting equity in domestic firms not
only earns foreign exchange, but also
secures access to capital, ideas, knowhow, technology
But financial capital is volatile
The balance of payments
R = X – Z + F
where
R = change in foreign reserves
X = exports of goods and services
Z = imports of goods and services
F = FX – FZ = net exports of capital
Foreign direct investment (net)
Portfolio investment (net)
Foreign borrowing, net of amortization
Trade in goods and services depends on
Relative prices at home and abroad
Exchange rates (elasticity models)
National incomes at home and abroad
Geographical distance from trading
partners (gravity models)
 Trade policy regime




Tariffs and other barriers to trade
Again, capital flows consist of foreign
borrowing, portfolio investment, and
foreign direct investment (FDI)
Trade in capital depends on
Interest rates at home and abroad
Exchange rate expectations
Geographical distance from trading
partners
Capital account policy regime
Capital controls and other barriers to free flows
Emerging countries
save a little
Real interest rate
Saving
Investment
Loanable funds
Real interest rate
Industrial countries
save a lot
Saving
Investment
Loanable funds
Emerging countries
Industrial countries
Financial globalization encourages investment in emerging
countries and saving in industrial countries
Real interest rate
Real interest rate
Saving
Borrowing
Investment
Loanable funds
Lending
Saving
Investment
Loanable funds
 Since
1945, trade in goods and services
has been gradually liberalized (GATT,
WTO)
 Big
exception: Agricultural commodities
 Since
1980s, trade in capital has also
been freed up
 Capital
inflows (i.e., foreign funds obtained
by the domestic private and public sectors)
have become a large source of financing
for many emerging market economies
Capital mobility
A stylized view of capital mobility 1860-2000
First era of
international
financial
integration
Return toward
financial
integration
Capital
controls
Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.
Capital flows result from interaction
between supply and demand
Capital is “pushed” away from
investor countries

Investors supply capital to recipients
Capital is “pulled” into recipient
countries

Recipients demand capital from investors
Internal factors “pulled” capital into LDCs
from industrial countries
Macroeconomic fundamentals in LDCs
 More productivity, more growth, less inflation
Structural reforms in LDCs
 Liberalization of trade
 Liberalization of financial markets
 Lower barriers to capital flows
Higher ratings from international agencies
External factors “pushed” capital from
industrial countries to LDCs
Cyclical conditions in industrial countries
 Recessions in early 1990s reduced investment
opportunities at home
 Declining world interest rates made IC investors
seek higher yields in LDCs
Structural changes in industrial countries
 Financial structure developments, lower costs of
communication
 Demographic changes: Aging populations save more
Improved allocation of global savings
allows capital to seek highest returns
Greater efficiency of investment
More rapid economic growth
Reduced macroeconomic volatility
through risk diversification dampens
business cycles
Income smoothing
Consumption smoothing
Open capital accounts may make receiving
countries vulnerable to foreign shocks
 Magnify domestic shocks and lead to contagion
 Limit effectiveness of domestic
macroeconomic policy instruments
Countries with open capital accounts are
vulnerable to
 Shifts in market sentiment
 Reversals of capital inflows
May lead to macroeconomic crisis
 Sudden reserve loss, exchange rate pressure
 Excessive BOP and macroeconomic adjustment
 Financial crisis
 Overheating
of the economy
 Excessive expansion of aggregate demand
with inflation, real currency appreciation,
widening current account deficit
 Increase in consumption and investment
relative to GDP
 Quality of investment suffers
 Construction booms – count the cranes!
 Monetary
consequences of capital inflows
and accumulation of foreign exchange
reserves depend on exchange regime
 Fixed exchange rate: Inflation takes off
 Flexible rate: Appreciation fuels spending boom
Source: IMF WEO, Oct. 2007, Chapter 3, Table 3.1.
6
0
0
1
,
6
0
0
Chile 1978-81
Mexico
1
,
4
0
0
5
0
0
1
,
2
0
0
Venezuela
4
0
0
1
,
0
0
0
Chile 1989-94
8
0
0
3
0
0
6
0
0
2
0
0
4
0
0
Sweden
Finland
2
0
0
1
0
0
0
0
3 2 1 0
1
2
3
4
5
6
2
0
0
7
Year with respect to start of inflow period
Note: The index for Finland, Mexico, and Sweden is shown on the left; the index for
Chile during the 1980s and 1990s and for Venezuela is shown on the right.
Source: World Bank (1997).
Large deficits
 Current account deficits
 Government budget deficits
Poor bank regulation
 Government guarantees (implicit or explicit), moral
hazard
Stock and composition of foreign debt
 Ratio of short-term liabilities to foreign reserves
Mismatches
 Maturity mismatches (borrowing short, lending long)
 Currency mismatches (borrowing in foreign currency,
lending in domestic currency)
 Financial
globalization is often blamed for
crises in emerging markets

It was suggested that emerging markets had
dismantled capital controls too hastily, leaving
themselves vulnerable
 More
radically, some economists view
unfettered capital flows as disruptive to
global financial stability
These economists call for capital controls and
other curbs on capital flows (e.g., taxes)
 Others argue that increased openness to
capital flows has proved essential for countries
seeking to rise from lower-income to middleincome status

 Capital
controls aim to reduce risks
associated with excessive inflows or
outflows
Specific objectives may include
 Protecting a fragile banking system
 Avoiding quick reversals of short-term
capital inflows following an adverse
macroeconomic shock
 Reducing currency appreciation when
faced with large inflows
 Stemming currency depreciation when
faced with large outflows
 Inducing a shift from shorter- to longerterm inflows
 Administrative

Outright bans, quantitative limits, approval
procedures
 Market-based



controls
Dual or multiple exchange rate systems
Explicit taxation of external financial
transactions
Indirect taxation

E.g., unremunerated reserve requirement
 Distinction


controls
between
Controls on inflows and controls on outflows
Controls on different categories of capital
inflows
 IMF
(which has jurisdiction over current
account, not capital account, restrictions)
maintains detailed compilation of member
countries’ capital account restrictions
 The information in the AREAER has been
used to construct measures of financial
openness based on a 1 (controlled) to 0
(liberalized) classification
 They show a trend toward greater financial
openness during the 1990s
 But these measures provide only rough
indications because they do not measure
the intensity or effectiveness of capital
controls (de jure versus de facto measures)
Capital
flows can play an important
role in economic growth and
development
 But
they can also create macroeconomic
vulnerabilities
Recipient
countries need to manage
capital flows so as to avoid hazards

Need sound policies as well as effective
institutions, including financial supervision,
and good timing
Development aid
 Unrequited
transfers from donor to
country designed to promote the
economic and social development
of the recipient (excluding
commercial deals and military aid)
Concessional loans and grants
included, by tradition
 Grant
element ≥ 25%
Development aid can be
 Public
or private
 Bilateral (from one country to another)
or multilateral (from international
organizations)
 Program, project, technical assistance
 Linked to purchase of goods and
services from donor country, or in kind
 Conditional in nature

IMF conditionality, good governance
Moral duty
Neocolonialism
Humanitarian intervention
Public good


National (e.g., education and health care)
International
Social justice to promote world unity
 UN aid commitment of 0.7% of GDP

World-wide redistribution


Increased inequality word-wide
Marshall Plan after World War II
1.5% of US GDP for four years vs. 0.2% today
 Think tank in Nairobi disagrees, see
www.irenkenya.com

Objectives
 Individuals
in donor countries vs.
governments in recipient countries

Who should receive the aid?
 Today’s

poor vs. tomorrow’s poor
Aid for consumption vs. investment
Conflicts
 Beneficiaries’ needs
 Donors’ interests
Aid is a recent phenomenon
Four major periods since 1950
 1950s:
Fast growth (US, France, UK)
 1960s: Stabilization and new donors

Japan, Germany, Canada, Australia
 1970s:
Rapid growth in aid again due
to oil shocks, recession, cold war
 1980s: Stagnation, aid fatigue, new
methods
Rapid growth of development aid
US provided 50% of total ODA

To countries ranging from Greece to South
Korea along the frontier of the “SinoSoviet bloc”
France provided 30%

To former colonies, mainly in West Africa
UK provided 10%

To Commonwealth countries
Stabilization of aid from traditional
donors and emergence of new donors

US contribution decreased considerably
after the Kennedy presidency (1961-63)
The French contribution decreased
starting from the early 1960s
New donors included Japan,
Germany, Canada, and Australia
Rapid growth in aid from industrial
countries in response to the needs of
developing countries due to
 Oil
shocks
 Severe drought in the Sahel
The donor governments promised to
deliver 0.7% of GNI in ODA at the UN
General Assembly in 1970
 The
deadline for reaching that target was
the mid-1970s
Stagnation of development
assistance
 Donor
fatigue?
 Private investor fatigue?
41
United States: largest donor in
volume, but low in relation to GDP
 US
aid amounts to 0.2% of GDP
Japan: second-largest donor in volume
Nordic countries, Netherlands
 Major
donors to multilateral programs
 Only countries whose assistance accounts
for 0.7% of GDP
EU: leading multilateral donor
Even though targets and agendas
have been set, year after year,
almost all rich nations have
constantly failed to reach their
agreed obligations of the 0.7% target
Instead of 0.7% of GNI, the amount
of aid has been around 0.4% (on
average), some $100 billion short
 Aid
fills gap between investment
needs and saving and increases
growth
 Poor
countries often have low savings and
low export receipts and limited
investment capacity and slow growth
 Aid
is intended to free developing
nations from poverty traps
 Example:
Capital stock declines if saving
does not keep up with depreciation
To understand the link between aid and
investment, consider resource
constraint identity by rearranging the
National Income Identity:
Y=C+I+G+X–Z
I = (Y – T – C) + (T – G) + (Z – X)
In words, investment is financed by the
sum of private saving, public saving,
and foreign saving
Poor
countries are trapped by poverty
 Driving
forces of growth (saving,
technological innovation, accumulation of
human capital) are weakened by poverty
 Countries become stuck in poverty traps
Aid
enables poor countries to free
themselves of poverty by enabling
them to cross the necessary
thresholds to launch growth
 Saving
 Technology
 Human capital
Is it feasible to lift all above a dollar a day?
How much would it cost to eradicate extreme
poverty? Let’s do the arithmetic (Sachs)
Number of people with less than a dollar a
day is 1.1 billion
Their average income is 77 cents a day, they
need 1.08 dollars
Difference amounts to 31 cents a day, or 113
dollars per year
Total cost is 124 billion dollars per year, or
0.6% of GNP in industrial countries
Less than they promised! – and didn’t deliver
Several
empirical studies have
assessed the impact of aid on growth,
saving, and investment
The results are somewhat inconclusive
 Most
studies have shown that aid has no
significant statistical impact on growth,
saving, or investment
However,
aid has positive impact on
growth when countries pursue “sound
policies”
 Burnside
and Dollar (2000)
aid has
sometimes been
compared to natural
resource discoveries
 Aid and growth are
inversely related
across countries
 Cause and effect
 156 countries,
1960-2000
Per capita growth adjusted for initial income (%)
 Foreign
r = rank correlation
r = -0.36
6
4
2
0
-2
-4
-6
-8
-20
0
20
40
60
Foreign aid (% of GDP)
80
 No
robust relationship between aid and
growth
 Aid works in “countries with good
policies”
 Aid works if measured correctly
 Distinction between fast impact aid
(infrastructure projects) and slow
impact aid (education)
 Infrastructure:
High financial returns
 Education and health: High social returns
 Aid
may lead to corruption
 Aid may be misused, by donors as well
as recipients
 Donors:
Excessive administrative costs
 Recipients: Mismanagement, expropriation
 Aid
is badly distributed, sometimes
for strategic reasons
 Supporting
opposition
government against political
 Aid
increases public consumption,
not public investment
 Aid is procyclical
 When
 Aid
it rains, it pours
leads to “Dutch disease”
 Labor-intensive
and export industries
contract relative to other industries in
countries receiving high aid inflows
 Dutch disease may undermine external
sustainability
 Aid
volatility and unpredictability
may undermine economic stability in
recipient countries
 Economic
vs. social impact
 Growth
is perhaps not the best
yardstick for the usefulness of aid
 Long

run vs. short run
E.g., increased saving reduces level of
GDP in short run, but increases growth of
GDP in long run
 Appreciation
of currency in real terms,
either through inflation or nominal
appreciation, leads to a loss of export
competitiveness
 In 1960s, Netherlands discovered natural
resources (gas deposits)


Currency appreciated
Exports of manufactures and services suffered,
but not for long
 Not
unlike natural resource discoveries, aid
inflows could trigger the Dutch Disease in
receiving countries
Real exchange rate
Aid leads to appreciation,
and thus reduces exports
C
B
A
Imports
Exports
plus aid
Exports
Foreign exchange
Real exchange rate
Oil discovery leads to appreciation,
and reduces nonoil exports
C
B
A
Imports
Exports
plus oil
Exports
Foreign exchange
 Aid
can play a key role in the development
of recipient countries, but it can also
generate macroeconomic vulnerabilities
 Recipients need to implement appropriate
policies to manage aid flows to avoid
macroeconomic hazards

The appropriate policy response needs to take
into account
Potential impact of aid on competitiveness
 Existence of constraints to aid absorption
 Risks linked to aid volatility and to external debt
sustainability

 Aid
is increasingly volatile and unpredictable
 Aid flows are 6-40 times more volatile than
fiscal revenue
 Volatility is largest for aid dependent
countries (Bulir and Hamann 2003, 2007)
 Volatility increased in the 1990s
 Aid delivery falls short of pledges by over 40%
 Reasons for aid volatility
 Donors: Changes in priorities; administrative
and budgetary delays
 Recipients: Failure to satisfy conditions

IMF conditionality often guides donors, helping them
decide if the country’s policies are on track
Aid
can play an important role in
the growth and development of
recipient countries …
…
but it can also create macroeconomic
vulnerabilities
Recipient
countries need to manage
aid flows so as to avoid hazards

Need to consider potential impact of aid on
 Competitiveness
 Constraints to aid absorption
 Risks linked to aid volatility and to external
debt sustainability These slides will be posted on my website:
www.hi.is/~gylfason