Sovereigns, Upstream Capital Flows and Global Imbalances
Executive Summary — Uphill capital flows and global imbalances have been at central stage in debates among academics and policymakers for quite some time. Many have argued that capital has been ﬂowing upstream from fast-growing developing nations to stagnant countries in the last decade. At the same time, these emerging countries accumulate a vast amount of reserves. HBS Professor Laura Alfaro and coauthors dissect capital flows between 1970 and 2004 into private and public components for every type of capital, namely FDI, equity and debt. The authors show that upstream ﬂows and global imbalances are manifestations of the same underlying phenomenon: the central role of official ﬂows in determining the international allocation of capital. Private capital does not flow on average uphill from emerging market countries and total capital flows uphill only out of five Asian countries including China due to reserve accumulation which completely dwarfs the net inflows of private capital. Key concepts include:
- There is much more nuance to the direction of capital ﬂows than is commonly appreciated.
- Current account deﬁcits of low-productivity developing countries have been driven by government debt/aid. Once aid ﬂows are subtracted, there is capital ﬂight out of these countries.
- Total capital does not ﬂow uphill for an average emerging market economy, and the regional patterns for current account behavior in Asia are driven by few outliers who happen to be big players in reserve accumulation, such as China.
- This paper has important policy implications. Addressing systemic distortions in the international financial system that require international cooperation, such as intentional undervaluation of exchange rates, should come before fixing domestic distortions in fast-growing emerging markets.
- The paper sheds light on the relevant theories. The most common theoretical references in understanding the uphill flows and global imbalances are models in which domestic financial frictions and/or precautionary motives lead to over-saving in emerging markets. However, as the paper shows, any explanation for uphill flows and global imbalances must take into account the fact that private capital flows downhill. The failure to consider official flows as the main driver of uphill flows and global imbalances is an important shortcoming of the recent literature.
We decompose capital flows—both debt and equity—into public and private components and study their relationship with productivity growth. This exercise reveals that international capital flows are mainly shaped by government decisions and sovereign to sovereign transactions. Specifically, we show: (i) international capital flows net of government debt are positively correlated with growth and allocated according to the neoclassical predictions; (ii) international capital flows net of official aid flows, which are mostly accounted as debt, are also positively correlated with productivity growth consistent with the predictions of the neoclassical model; (iii) public debt flows are negatively correlated with growth only if government debt is financed by another sovereign and not by private lenders. Our results show that the failure to consider official flows as the main driver of uphill flows and global imbalances is an important shortcoming of the recent literature.