International Capital Flows and Capital Account Liberalization Thorvaldur

International Capital Flows and Capital Account Liberalization Thorvaldur Gylfason

Two Parts Part One: International Capital Movements Part Two: External Debt Dynamics

1 Goods and Capital The argument 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, know -how, technology

Symmetry between Trade in Goods and Capital The balance of payments R = X – Z + F where X = exports of goods and services Z = imports of goods and services F = net exports of capital ü ü ü Foreign direct investment Portfolio investment Foreign borrowing

Determinants of Foreign 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

Two Views of Trade The current account of the balance of payments is defined as B = X – Z National income is Y = E + X – Z Therefore, current account is B=X–Z=Y–E Two sides of the same coin: Deficit means that Z > X and E > Y Surplus means that X > Z and Y > E

Foreign Investment Capital flows Foreign borrowing, portfolio investment, foreign direct investment Trade in equities 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

Exports 1990 -2000 (% of GDP)

Transition Countries: Exports 2000 (% of GDP) World average

Growth in Trade Less Growth in GDP 1990 -2000 (%)

FDI 1990 -2000 (Net, % of Gross Investment)

FDI 1990 -2000 (Gross, % of GDP)

Transition Countries: FDI 2000 (Net, % of Gross Investment) World average

Transition Countries: FDI 2000 (Gross, % of GDP) World average

Capital Flows Facilitate borrowing abroad to smooth consumption over time Dampen business cycles Reduce vulnerability to domestic economic disturbances Increase risk-adjusted rates of return Encourage saving, investment, and growth

Openness to FDI and 85 ies Growth 1965 -98 r t n cou r = 0. 62 r = rank correlati on Botswana An increase in openness to FDI by 2% of GDP is associated with an increase in per capita growth by more than 1% per year.

Openness to Trade and 87 ies Growth 1965 -98 r t n cou r = 0. 42 An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year.

Tariffs and Growth 82 ies 1965 -98 r t n cou Botswana An increase in tariffs by 10% of imports is associated with a decrease in per capita growth by 1% per year. India Cote d'Ivoire r = -0. 52

Pitfalls: Incomplete Information Capital account liberalization, if well managed, stimulates saving and investment, efficiency, and economic growth But information may be asymmetric Adverse selection Moral hazard Herding

Capital Account Liberalization Needs to be orderly, gradual, wellsequenced Effective prudential regulation To encourage banks to recognize risks To enable authorities to monitor threats to stability of the financial system Sound macroeconomic policies Sequencing Put bank supervision and sound policies in place first, then liberalize

2 External Debt Dynamics and Sustainability Many countries have developed rapidly with the aid of external loans (US, Korea) But many other countries have fared less well with their external debt strategies because they borrowed abroad to finance consumption, not investment Consumption does not increase the ability of indebted countries to service their debts, nor does low-quality investment But high-quality investment does

External Debt: Key Concepts Debt burden Also called debt service ratio Equals the ratio of amortization and interest payments to exports q = debt service ratio A = amortization r = interest rate DF = foreign debt X = exports

External Debt: Key Concepts Interest burden Ratio of interest payments to exports Amortization burden Also called repayment burden Ratio of amortization to exports q=a+b

External Debt: Numbers How can we figure out a country’s debt burden? Divide through definition of q by income Now we have expressed the debt service ratio in terms of familiar quantities: the interest rate r, the debt ratio DF/Y, and the export ratio X/Y as well as the repayment ratio A/Y

Numerical Example Suppose that r = 0. 08 DF/Y = 0. 50 A/Y = 0. 06 X/Y = 0. 20 Here we have a country that has to use a half of its export earnings to service its external debt n! e d r u b Heavy

Transition Countries: External Debt 2000 (PDV, % of GDP)

Transition Countries: External Debt 2000 (% of Exports)

Transition Countries: External Debt Service 2000 (% of Exports)

External Debt Dynamics Debt accumulation is, by its nature, a dynamic phenomenon A large stock of debt involves high interest payments which, in turn, add to the external deficit, which calls for further borrowing, and so on Debt accumulation can develop into a vicious circle How do we know whether a given debt strategy will spin out of control or not? To answer this, we need a little arithmetic

External Debt Dynamics Recall balance of payments equation: BOP = X – Z + F where F = capital inflow = DF where DF = foreign debt Capital inflow, F, thus involves an increase in the stock of foreign debt, DF, or a decrease in the stock of foreign claims (assets) So, F is a flow and DF is a stock

External Debt Dynamics Now assume Then, it follows that BOP = X – Z + DF = 0 so that DF = r. DF Z = Z N + r DF Z = total imports ZN = non-interest imports r. DF = interest payments Further, assume X = ZN BOP = 0 In other words: A flexible exchange rate maintains equilibrium in the balance of payments at all times

External Debt Dynamics So, now we have: Now subtract growth rate of output from both sides:

External Debt Dynamics But what is ? This is the proportional change of the debt ratio: This is an application of a simple rule of arithmetic: % (x/y) = % x - % y

Proof z = x/y log(z) = log(x) – log(y) log(z) = log(x) - log(y) But what is log(z) ? So, we obtain Q. E. D.

Debt, Interest, and Growth We have shown that Debt ratio Need economic growth to keep the debt ratio under control r g where r=g r g Time

What Can We Learn from This? It is important to keep economic growth at home above – or at least not far below – the world rate of interest Otherwise, the debt ratio keeps rising over time External deficits can be OK, even over long periods, as long as the external debt does not increase faster than output and the debt burden is manageable to begin with A rising debt ratio may also be OK as long as the borrowed funds are used efficiently Once again, high-quality investment is key

Debt Dynamics: Another Look Let us now study the interaction between trade deficits, debt, and growth Two simplifying assumptions: Dt = a. Yt (omit the superscript F, so D = DF) Trade deficit is a constant fraction a of output Y Yt = Y 0 egt Output grows at a constant rate g each year Exponential growth t

Pictures of Growth Y log(Y) g 1 time Exponential growth implies a linear logarithmic growth path whose slope equals the growth rate

Debt as the Sum of Past Deficits at time T

Debt as the Sum of Past Deficits at time T

Debt as the Sum of Past Deficits at time T Evaluate this integral between 0 and T

Debt as the Sum of Past Deficits at time T So, as T goes to infinity, Dt becomes infinitely large. But that may be quite OK in a growing economy! Evaluate this integral between 0 and T

Debt as the Sum of Past Deficits

Debt as the Sum of Past Deficits

Debt as the Sum of Past Deficits

Debt as the Sum of Past Deficits So, as T goes to infinity, DT/YT approaches the ratio a/g

Numerical Example Suppose Debt ratio 3 Trade deficit is 6% of GNP a = 0. 06 Growth rate is 2% per year Time g = 0. 02 Then the debt ratio approaches d = a/g = 0. 06/0. 02 = 3 This point will be reached regardless of the initial position. . . as long as a and g remain unchanged

Numerical Example, Again Suppose that r = 0. 08 (as before) D/Y = 3 (our new number) A/Y = 0. 06 (as before) X/Y = 0. 20 (as before) Here we have a country that has to use one and a half of its export earnings to service its debts n, e d r u b Heavy ! ! ! d e e d in

Numerical Example, Again Suppose that r = 0. 08 (as before) D/Y = 2 (our new number) A/Y = 0. 06 (as before) X/Y = 0. 20 (as before) Here we have a country that has to use one and a half of its export earnings to service its debts n, e d r u b Heavy ! ! d e e d in

Numerical Example, Again Suppose that r = 0. 08 (as before) D/Y = 1 (our new number) A/Y = 0. 06 (as before) X/Y = 0. 20 (as before) Here we have a country that has to use one and a half of its export earnings to service its debts n, e d r u b Heavy indeed!

Numerical Example, Again Suppose that r = 0. 08 (as before) D/Y = 1 (our new number) A/Y = 0. 06 (as before) X/Y = 0. 40 (as before) Here we have a country that has to use one and a half of its export earnings to service its debts n, e d r u b Heavy e l b a e g a n a m t u b

What to Conclude? Must adjust policies Must either üReduce trade deficit by stimulating exports or by reducing imports, or üIncrease economic growth Otherwise, the debt ratio will reach unmanageable levels, automatically No country can afford external debt equivalent to 2 -3 times annual output

And Why Not? Because, after a while, the debt burden becomes unbearable Korea avoided this Its export-oriented growth strategy reduced the numerator and increased the denominator of the debt ratio, thereby reducing its debt burden An import-substitution strategy would reduce both numerator and denominator, with an ambiguous effect on the debt burden

Recap Transition Countries: External Debt Service 2000 (% of Exports) but , K O l l i t S ! l u f e r a c be

Debt Renegotiations and Forgiveness Borrowers often renegotiate the terms of their loans in mid-stream in order to delay repayments, that is, extend the maturity of the loans, or to ü reduce interest payments by replacing highinterest loans by loans with lower interest ü Sometimes, outright debt forgiveness may be called for But debt forgiveness is no substitute for sound economic policies Remember: our formula d = a/g holds in the long run regardless of initial conditions

The Bottom Line External borrowing is a necessary and natural part of economic development This requires countries that borrow to invest the funds borrowed in high-quality capital, including health and education This is necessary to be able to service the debt If the debt burden becomes too heavy, must either reduce deficit or stimulate growth It is always desirable anyway to do everything possible to encourage economic growth Rapid growth allows more foreign borrowing without making the debt burden unmanageable