Institutions, Capital Flows and Financial Integration

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Institutions, Capital Flows and Financial
Integration

• James R. Lothian
• Fordham University
• Keynote Address to the
• Conference on Emerging Markets Finance
• Cass School of Business
• London, May 5-6, 2005
• Sponsored by Cass School of Business, JIMF, ESRC
  and EBRD

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I. Introduction

• Focus of presentation International capital
  flows in particular, capital flows from the
  developed to the less developed countries.
• Why are such flows not larger?
• Question has puzzled economists for the past four
  decades.
• What makes it especially puzzling today is the
  much greater degree of financial integration now
  than then
• Adding to the puzzle Fact that a century ago
  such flows were substantial

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II. The Lucas-Schultz Paradox

• Robert E. Lucas, Jr. (1990) poses the question
  Why doesn't capital flow from rich to poor
  countries?
• It does not, he says, but should since such poor
  countries lack capital when viewed by
  rich-country standards.
• If the neoclassical model were even close
  ...return differentials of this 58 times
  greater magnitude, investment goods would flow
  rapidly from the United states and other wealthy
  countries to India and other poor countries.

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Schultzs view

• Theodore W. Schultz considered the same question
  but from a different perspective.
• Schultz argued that the capital stock in poor
  countries was not low but high and of the wrong
  kind.
• What was actually scarce were higher quality
  physical capital and the increased human capital
  that farmers and other workers needed to utilize
  it
• Rates of return to these higher quality inputs
  were high but rates of return to the traditional
  inputs were low.
• The question, therefore, was why investments in
  the higher quality inputs have not been made

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III. Capital Market Integration in Historical
Perspective

• Three stylized facts of particular interest
• First Financial integration now is much greater
  than 30 years ago and quite probably greater than
  even 10 years ago.
• Second Despite these increases it has only
  recently returned to the level at which it stood
  in 1913.
• Third The time pattern of integration has
  differed greatly between developed and less
  developed countries.

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Real interest rates historically

• Examine cross-country standard deviations of ex
  post real interest rates
• Can view the ex ante real interest differential
  as
• ?-?' ??-??' (?-?? ) - (?'-??'
• where ? and ?? are real ex ante returns on
  financial and physical assets and a prime
  indicates the foreign country.

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• The ex post differential can, therefore, be
  viewed as
• r-r' ??-??' (?-?? ) - (?'-??') e
• where r-r' is the ex post real interest
  differential and e is the relative error in
  inflation forecasts.
• Use quinquennial averages of data to lessen
  the effects of these errors
• First r.h.s term reflects the degree of
  arbitrage across countries the second, the
  degree of financial intermediation within the two
  countries.

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Fig 1a. Real long-term interest rates,
cross-country standard deviations, 1800-2000
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Fig 1b. Real short-term interest rates,
cross-country standard deviations, 1800-2000
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Real interest rate results reflected in other data

• Equity returns (Lothian, 2002 Obstfeld and
  Taylor, 2002),
• Quantity indicators such as capital flows and
  stocks of foreign assets (Lothian, 2000 Obstfeld
  and Taylor, 2004),
• Feldstein-Horioka savings-retention coefficients
  (Obstfeld and Taylor, 2004),
• Trade flows (Grassman,1980 Lothian, 2000) all
  tell a similar story to that of real interest
  rates.

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Fig 2. Real short-term interest rates,
cross-country standard deviations for 89
countries,1997-2003
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The expanded data set

• Three features of the chart stand out
• Increased cross-country divergences as the three
  non-OECD groups are added sequentially
• Declines for the OECD and for OECD plus Asia
  during the last decade and a half
• Progressive narrowing of real-interest rate
  divergences in the case of OECD versus Asia and
  the lack thereof for the OECD versus the other
  two groups.
• Integration therefore much less complete for the
  periphery vis-à-vis the OECD core, but increasing
  for Asia, and perhaps some of Latin
  America-Caribbean, but not for Africa.

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Poor countries Now and Then

• Quantity data tell very much the same story with
  regard to recent years as the real-interest data.
• In 1997, 82 of foreign capital investment
  stocks were in countries with levels of income
  that were 60 or greater that of U.S. and only
  14 in countries with income levels 40 or less
  that of U.S.

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• Situation however was much different a century
  ago
• In 1913, countries with incomes 40 or less that
  of the U.S. had a 50 share of the total and
  countries with income 60 or more that of the
  U.S. had a 46 share.

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Fig. 3a. Distribution of shares of world stock
offoreign investment capital by level of
receiving country income per capita (US100)
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Fig. 3b. Distribution of ratios of world foreign
investment capital to income by level of
receiving country income per capita (US100)
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IV. Economic Growth and the Lucas-Schultz Paradox

• Closely related to the question of why capital
  does not flow from rich to poor countries is the
  question of why poor countries do not grow much
  more rapidly.
• In the neoclassical model, capital flows to
  equate real returns and real-income convergence
  are two aspects of the same process.

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Growth accounting

• Standard equation takes the form
• dy sL dL sK dK R
• where
• dy is the change in the log of real output,
• dL the change in the log of the labor force,
• dK the change in log of the capital stock,
• sL and sK are the shares of the two factors
• R is the residual, the part of dy unexplained by
  the weighted growth rates of L and K

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The relative contributionsof K and L

• In most exercises, R is positive and fairly
  substantial, often exceeding the contribution of
  one or the other input and at times the
  contributions of both.
• Terms applied to R technological change, human
  capital accumulation and later total factor
  productivity (TFP).

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Schultz, Transforming Traditional Agriculture
(1964)

• Technological improvements and human capital
  accumulation simply different sides of the same
  coin.
• Both are improvements in the quality of the
  conventional labor and capital inputs.
• Standard growth models not designed to consider
  the differences in levels of the rates of return
  to incentives to investment and growth.
• One of the reasons is that the profitability of
  new classes of factors of production have been
  concealed under technical change.

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Harberger in AEA Presidential Address 1998

• Harberger picks up on some of Schultzs theme.
• Conventional labels for R should be replaced.
• A better way of viewing R was in terms of real
  cost reduction rather than technical change or
  TFP.
• Changes the focus from inventions and
  externalities to microeconomics.

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The focus on real cost reductions

• Enables us to peel the onion a step further and
  ask the next logical set of questions
• What factor or factors typically account for
  these real cost reductions?
• Why do those factors operate more strongly during
  some time periods and in some places than in
  others?

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Harberger Government policies and societal
institutions are key

• Good policies price stability, an absence of
  distorting government intervention at the levels
  of the firm and the household, open international
  trade and the like and good institutions, the
  enforcement of private property being key
  enable growth.
• Provide incentive to engage in activities that
  reduce real costs and also raise the rate of
  return to investment.
• Bad policies and bad societal institutions have
  reverse effects.

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Policies and institutions

• Impact of institutional factors on growth has
  been the theme of a much other literature in
  recent years Norths (1990), historical
  treatments, to DeSotos (2000) descriptive
  account of the day-to-day difficulties
  entrepreneurs faced in developing countries, to
  econometric investigations of various sorts
  (e.g., Barro, 1998).
• Recent cross-country study (2004) by Gwartney,
  Holcombe, and Lawson (GHL) is particularly
  germane.

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The GHL Study

• Major feature of the study is the use of the
  Economic Freedom of the World Index (EFW)
• EFW index is made up of 5 component indices
  size of government, legal system and property
  rights, sound money, freedom to trade
  internationally, and regulation, each of which,
  in turn, has anywhere from 3 to 18 components.
• GHL use the EFW index as a regressor in
  cross-country regressions along with other
  variables common in the growth literature as
  controls to investigate the impact of policies
  and institutions on both on the level of real
  per capita GDP and its rate of growth.

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• GHL report statistically significant and
  economically meaningful EFW effects in all
  instances.
• Find largely similar effects for the per-worker
  stocks of physical and human capital, the rates
  of change of both and the ratios of investment
  and foreign direct investment to GDP.
• Rerun real GDP growth regressions using residuals
  from these latter regressions in place of the
  actual variables as regressors.
• Allowing for both direct and indirect EFW effects
  in this way increases the estimated EFW impact
  substantially.

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V. Policies, Institutions and Capital Flows

• I extend the GHL approach is to capital flows
• Use the EFW index and data from Lane and
  Milesi-Ferretti (2001) and the World Banks
  Global Development Finance data base.
• Find substantial differences in flows across
  countries grouped by level of EFW index and
  statistically significant relationships

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Fig. 4a. Distribution of foreign investment to
GDP by level of EFW index in 1997
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Fig. 4b. Distribution of per capita FDI by level
of EFW index, 1997-2001
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Table 1. Cross-country regressions Foreign
capital stocks on EFW index

• Dependent variable Nobs Const. EFW RSQ SEE
• Ratio of for. invest. 64 -23360 4038 0.224 7356
• to population -3.604 4.236
• Ratio of net for. invest. 64 -0.699 0.135 0.184 0
  .279
• to GDP -2.840 3.736
• Ratio of FDI to population 84 -207.2
  48.5 0.147 103.8 -2.710 3.760
• 
  

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VI. Conclusions

• Lets return to the question with which we
  started why capital flows to poor countries
  remain so sparse.
• Savers in rich countries, it seems, should be
  taking much greater advantage of the high returns
  that in principle should await them as they did a
  century ago.
• I have argued that the reason it is not happening
  now is due to the institutions that are in place
  and the policies that have been pursued in many
  if not most poor countries
• In this regard, the emerging market countries
  are, I believe, the exception that proves the
  rule.