CAPITAL FLOWS

Capital Flows

Abstract

Does capital flow from rich to poor countries? We return the Lucas paradox and discover the role of capital account limitations in shaping capital flows at different stages of economic development. We discover that, when accounting for the degree of capital account openness, the forecast of the neoclassical theory is established: less developed countries likely to experience net capital inflows and other developed countries be likely to experience net capital outflows, conditional of different countries' characteristics. The results are focused by foreign direct investment, portfolio equity investment, and to some degree by loans to the private sector.

Capital Flows from Rich to Poor Countries

Introduction

In his celebrated paper, Lucas (1990, p92) poses the question “why doesn't capital flow from rich to poor countries”. The simplest neoclassical model of trade and growth predicts that poor countries with low levels of capital relative to labour would offer high returns on investment and therefore attract capital flows from rich, capital abundant countries. However, as Lucas points out, poor countries are often lacking in factors of production that are complementary to capital, such as human capital, implying that the marginal product of capital in these countries is not likely to be as large as what simple differences in capital labour ratios would suggest. While Lucas (1990, p92) considers capital market imperfections as a candidate explanation for why capital does not flow to poor countries, he is sceptical that it is an important development issue relative to the need to foster accumulation of human capital.

A major puzzle that arises from the observed patterns of current account positions is the fact that capital is seemingly flowing “uphill”, i.e. from capital-scarce emerging countriesto capital-rich developed economies, a phenomenon dubbed the “Lucas paradox”. However, this paradox may only partly account for the observed dynamics of current account balances and is chiefly, albeit not exclusively, related to the relative positions of China and the United States. However, even though other countries may confirm better to the theoretical prescriptions - with large or growing current account surpluses in Germany and Japan and corresponding deficits in emerging Europe and Turkey, for instance other factors may equally contribute to these dynamics (Uribe, 2006, p36).

At the macroeconomic level, falling wage shares are likely to contribute to rising market shares as unit labour costs decline, boosting export growth while restricting domestic demand and imports. However, as declining wage shares are now a reality in many countries, especially the larger ones, such a general trend would not suffice to explain the divergence in current account positions. In addition, the microeconomic picture needs to be taken into account, which reveals a growing income and wage within-country inequality around the world. Such divergence of income at the level of individual households has been said to lead to stronger rather than weaker domestic demand growth when low-income households are being given the capacity to push up their consumption level through easy access to credit (Prasad, 2010, p30).

For instance, policy initiatives such as facilitating access ...