Lecture 24: International Dimensions IIICapital Flows

Dave Donaldson and Esther Duflo

14.73 Challenges of World Poverty

International Dimensions III: Plan for the lecture

� What are capital flows between countries?

� Why might capital flows matter?

� Some empirical evidence.

Capital Flows

� Capital flows in/out of a country are measured in the capital accounts (sometimes called the ‘capital and financial accounts’)

� Capital flows are defined as flows of assets (in contrast to the flows of goods, which are measured in the current accounts)

� Flows of assets can take two main forms: 1. (Net) Foreign Direct Investment (FDI): Acquiring ownership

with control (usually defined as a minimum 10 % stake in voting shares). Can be done through setting up a subsidiary/company, pursuing a joint venture, merger, acquisition, etc.

2. (Net) Portfolio/other investment: purchase of stocks, bonds or other financial instruments without acquiring legal control.

� From the perspective of a developing country, is (net inward) FDI any different from (net inward) portfolio investment?

Capital Flows

Latin

America’s Growth

71

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

-5-4-3-2-10123

54

Perc

enta

ge o

f GD

P

Source: ECLAC estimates, based on IMF, International Financial Statistics.

Total Foreign direct investment

Net Resource Transfers

Financial flows

Figure by MIT OpenCourseWare.

Some Accounting Identities

� Y = C + I + G + X − M

� Y = C + S + T

� X − M = KA (KA is net capital inflow)

� ⇒ (S − I ) + (T − G ) = KA

The Key Question

� What types of (foreign and domestic) capital, if any, should we allow to be traded in and out of a country we care about?

Benefits of International Portfolio Capital Mobility

� Improved consumption smoothing � Break S = I link and raise investment

� If, for some reason, domestic saving (S) is small, this need not constrain investment (I ) to be small too.

� Improved macroeconomic discipline.

� More competition in the banking (and wider investing) sector.

Costs of International Portfolio Capital Mobility

� (Possibly) heightened volatility: � Key idea: portfolio capital (‘hot capital’) can go in and out

quickly � Investors in (e.g.) London seek highest risk-adjusted

returns—slight changes in perceptions of fundamentals, or exchange rates, can lead to immediate inflows or withdrawals of capital. There may also be herding and contagion. All of this is exaggerated by leverage.

� Sudden withdrawals can lead to ‘liquidity runs’ and ‘sudden stops’. Sudden inflows can lead to inflationary pressures.

� As the financial crisis of 2007-08 made clear, when the financial sector of a country goes into crisis, the finance-using (ie producing) sectors of the economy can suffer a great deal. And these issues are probably more severe in countries with weak financial systems.

Indonesia’s 1997 Crisis

� In a series of papers, Duncan Thomas has exploited the availability of high-quality household expenditure data (IFLS) to study the consequences of Indonesia’s 1997 crisis for Indonesian citizens.

The Crisis And the IFLS surveys

Effects on Economic Outcomes: Urban PCE is ‘per capita (in household) expenditure’

Effects on Economic Outcomes: Rural PCE is ‘per capita (in household) expenditure’

How Households Responded

Effects on Education Spending

administered an individual-specific interview, and in that interview, a battery of questions

are asked about current and prior school attendance. (The questions are answered by the

child’s caretaker if the child is age 10 or under). We use the answers from those questions

in our analyses based on IFLS since the respondent to these questions is chosen because he

or she is better informed about the index child, relative to the person completing the

household roster.

Column (3) restricts the sample of IFLS2 respondents to those from households that

were living, in 1993, in the seven provinces included in IFLS2+. This restriction has little

impact on the estimates, indicating that in terms of school attendance the IFLS2+

provinces are not much different from the full set of IFLS provinces. The final column

presents the nonenrollment rates in 1998, based on IFLS2+. The same patterns observed

for the whole country based on SUSENAS and reported in Table 2a emerge in the IFLS

sample. Young children are much less likely to be in school in 1998, relative to 1997,

whereas older children are slightly more likely to be in school.

The relationship between school attendance and PCE is presented for IFLS

respondents in Fig. 2. Household PCE is measured in 1997. Enrollment rates increase

with PCE in both 1997 and 1998—but not at the same rate. The gap between the two

lines provides information about how the impact of the financial crisis on education

enrollments is distributed. Among children in low-PCE households, enrollments

Fig. 2. School enrollments by per capita expenditure.

D. Thomas et al. / Journal of Development Economics 74 (2004) 53–8566

Benefits of Inward FDI

� More efficient use of world’s resources.

� Transfer of knowledge/technology to other domestic firms.

� More competition in domestic market.

� Exploit intra-firm capital markets

� Overcome trade frictions. (Almost half of current US trade occurs within firms.)

Costs of FDI

� Volatility may still be severe (see Bergin, Feenstra and Hanson (2009) figure)

� ‘Sweatshop labor’ � Not clear—multinational firms pay higher wages. � However, there appears to be some slack (see Harrison and

Scorse (2009) figure)

Volatility of FDI: Bergin et al (2009) 4 industries that comprise over 75 % of Mexican Maquiladoras

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Employment for production workers in Mexico and U.S. offshoring industries(log values, seasonally adjusted and HP filtered)

Mexico apparelU.S. apparel (NAICS 315) Mexico electronic

materials

U.S. electronics (NAICS 334)

Mexico electrical mach.

Mexico transport equlp.

U.S. transport equlp. (NAICS 336)

U.S. electrical mach. (NAICS 335)

Date Date

Figure by MIT OpenCourseWare.

Anti-Sweatshop Campaigns and FDI Wages Harrison and Scorse (2009) on Indonesia

34

Figure 2: Articles about "Sweatshops" and "Child Labor" Major U.S. and World Publications 1990-1999

0

200

400

600

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1000

1200

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Source:LexisNexis*Maximum Articles Displayed=1000

Num

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Sweatshop Articles

Child Labor Articles

Figure 3: Share of Articles on Sweatshops or Child Labor in Indonesia Relative to all Other Articles on the Indonesian Economy in the NYT3 Period Moving Average (Source: LexisNexis)

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Anti-Sweatshop Campaigns and FDI Wages Harrison and Scorse (2009) on Indonesia

8

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10 12 14 16 18Log production worker wages in real rupiahs

Freq

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log

prod

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Treatment (TFA only) 1990 Treatment (TFA only) 1996Control (non-TFA) 1990 Control (non-TFA) 1996

Distribution log production worker wages in 1990 and 1996 comparing textiles, footwear, and apparel (TFA)

enterprises with others exporting and foreign enterprises only

Figure by MIT OpenCourseWare.

MIT OpenCourseWarehttp://ocw.mit.edu

14.73 The Challenge of World Poverty Fall 2009 For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.