Question

Describe the features of capital flows during the old era of financial globalization, and during the modern era: which are the main differences? In an open economy is the investment rate determined by the domestic savings rate? Does national income coincide with GDP? What is the distinction between the domestic capital stock and national wealth?

International Macroeconomic (Reference text book Gobal Market Capital by Obsfeld Taylor

Answer 1

1. Relative to their contribution to global output and trade, emerging and developing economies historically have accounted for a much smaller share of activity in global finance. In recent years, developing countries have accounted for 30 percent of world production and trade and more than half of global growth but only 22 percent of the world’s capital market capitalization of $49.5 trillion, merely 8 percent of gross capital flows, and 9.6 percent of global external assets.
2. Even after the surge of cross-border capital flows in the 1990s and 2000s, global investors’ exposure to developing countries remains limited relative to their exposure to developed countries. No emerging-market currency is used internationally to a significant extent.
3. During the 1990s, net capital flows to developing countries increased markedly. In 1996, net private capital flows were $190 billion, almost four times larger than in 1990. During 1990-97, annual net private capital inflows were also larger than those preceding the 1982 debt crisis, and more heavily concentrated. Five countries accounted for more than 50 percent, and a dozen countries accounted for 75 percent, of total inflows. Most of the surge was concentrated in Asia and Latin America. Consequently, 140 of 166 developing nations collectively accounted for less than 5 percent of total inflows.
4. In the 1970s, bank lending was the larger component of capital flows, the most important recipient of which was the public sector. In the 1990s, by contrast, the surge was dominated by bonds, foreign direct investment, and portfolio investment, and the private sector did most of the external borrowing.
5. The heightened interest of foreign investors in some developing countries has led to their increased integration into the global financial system, with benefits for those countries and for the global economy.

Impact:

large capital inflows can lead to overheating, greater exchange rate volatility, and—eventually—to large outflows because of changes in expected returns on assets, investor herding, and contagion effects. To address these problems, policymakers have used a combination of countercyclical and structural policies, as well as other measures designed to reduce net capital inflows or change their composition or maturity and decrease their volatility.

Causes of capital inflows. The responsiveness of private capital to opportunities in emerging markets started to improve in the 1990s because of both internal and external factors. Internal factors improved private risk-return characteristics for foreign investors through three main channels. First, creditworthiness improved as a result of external debt restructuring in a wide range of countries. Second, productivity gains were obtained from structural reform and the establishment of confidence in macroeconomic management in several developing countries that had undertaken successful stabilization programs. Third, countries adopting fixed exchange rate regimes became increasingly attractive to investors owing to the transfer of the risk of exchange rate volatility—at least in the short run—from investors to the government.

Consequences of capital inflows

Investors' interest in developing countries has led to their increased financial integration. Large capital inflows, however, might also imply an excessive expansion of aggregate demand and have negative effects on the financial sector. In addition, microeconomic distortions can amplify capital flows and their impact on the economy.

Overheating. Capital inflows may lead to excessive expansion of aggregate demand or macroeconomic overheating. This expansion is likely to be reflected in inflationary pressures, real exchange rate appreciation, and widening current account deficits.

A widening current account deficit was the symptom of overheating that most countries in the sample experienced. As predicted by open-economy models, the current account deteriorated owing to increases in the ratios of both investment and consumption to GDP. In this regard, the Asian crisis has shown that overconsumption is as problematic as overinvestment. Low-quality investment causes severe economic vulnerabilities because it does not contribute to future productive capacity or repayments of external debt. The low productivity of investment resulted from weakly supervised and regulated financial sectors characterized by poor risk management and lending problems. In these circumstances—and because of weak corporate governance and moral hazard in the financial and corporate sectors—capital inflows and high domestic savings were not invested and managed efficiently (Adams and others, 1998).

Effects of capital inflows on financial sector and boom-bust cycles.Capital inflows affect the financial system that intermediates them. They have two major effects on the domestic banking system. First, under a pegged exchange rate regime, the quasi-fiscal deficit—which includes financial transactions undertaken by central banks and other public financial institutions that play the same roles as taxes and subsidies—increases as a result of a sterilization policy that sells high-yielding domestic bonds and buys foreign exchange holdings earning lower interest rates. Second, the financial system might become more vulnerable because of a rise in lending that exacerbates the maturity mismatch between bank assets and liabilities and reduces loan quality. The increases in bank credit were a generalized outcome of capital inflows, and the vulnerability of the financial sector was usually heightened by a surge in asset prices that, in the end, proved unsustainable.

Microeconomic distortions can exacerbate the negative impacts of capital flows on the economy, implying that a developing country can shift from a path of reasonable economic growth before a financial crisis to one of sharply declining activity after a crisis. In particular, the boom-bust cycle can be amplified by price and wage rigidities, asymmetric information in the domestic banking sector or internationally, inadequate supervision and regulation of financial institutions, shallow capital markets, and reforms, whether or not they are credible.

Finally, it should be stressed that some countries have been able to avoid most of the symptoms of macroeconomic overheating; not all countries that experienced a credit boom ended up with weaker financial systems; and the size of the boom-bust cycle has differed in each country. It is thus important to analyze how these countries avoided the alleged consequences of capital inflows.

WHile earlier, capital flow to emerging markets was limited, in modern era, emerging markets giving high rates of return see large volumes of capital flow.

Next, we know that,

In an open economy, saving rate does not depend on interest rate.

However, Investment is still a downward-sloping function of the interest rate. Yet, the exogenous world interest rate determines the country’s level of investment. Here, interest rate would adjust to equate investment and saving:

Hence, the exogenous world interest rate determines investment and the difference between saving and investment determines net capital outflows and net exports