InternationInternational Capital al Capital Flows and Flows and Capital Capital Account Account LiberalizatiLiberalizationon Thorvaldur Gylfason
Two PartsTwo Parts
Part One: Part One:
International Capital International Capital MovementsMovements
Part Part TwoTwo::
External Debt DynamicsExternal Debt Dynamics
Goods and CapitalGoods and Capital
The argument for free trade in goods The argument for free trade in goods and services applies also to capitaland services applies also to capital
Trade in capital helps countries to Trade in capital helps countries to specialize according to specialize according to comparative comparative advantageadvantage, exploit , exploit economies of economies of scalescale, and promote , and promote competitioncompetition
Exporting equity in domestic firms not Exporting equity in domestic firms not only earns foreign exchange, but also only earns foreign exchange, but also secures access to capital, ideas, secures access to capital, ideas, know-how, technologyknow-how, technology
11
Symmetry between Symmetry between Trade in Goods and Trade in Goods and CapitalCapital
The balance of payments The balance of payments
R = X – Z + FR = X – Z + Fwherewhere
X X = exports of goods and services= exports of goods and services
Z Z = imports of goods and services= imports of goods and services
F F = net exports of capital= net exports of capital Foreign direct investmentForeign direct investment Portfolio investmentPortfolio investment Foreign borrowingForeign borrowing
Determinants of Determinants of Foreign TradeForeign Trade
Trade in goods and services Trade in goods and services depends ondepends on
Relative pricesRelative prices at home and abroad at home and abroad
Exchange rates Exchange rates (elasticity models)(elasticity models)
National incomesNational incomes at home and abroad at home and abroad
Geographical Geographical distancedistance from trading from trading partners (gravity models)partners (gravity models)
Trade policyTrade policy regime regimeTariffs and other barriers to tradeTariffs and other barriers to trade
Two Views of TradeTwo Views of Trade
The current account of the balance The current account of the balance of payments is defined as of payments is defined as B = X B = X – Z– Z
National income is National income is Y = E + X – ZY = E + X – Z
Therefore, current account is Therefore, current account is
B = X – Z = Y – EB = X – Z = Y – E
Two sides of the same coin:Two sides of the same coin:Deficit means that Deficit means that Z > XZ > X and and E > YE > Y
Surplus means that Surplus means that X > ZX > Z and and Y > EY > E
Foreign InvestmentForeign InvestmentCapital flowsCapital flows
Foreign borrowing, portfolio investment, Foreign borrowing, portfolio investment, foreign direct investmentforeign direct investment
Trade in equities depends onTrade in equities depends onInterest ratesInterest rates at home and abroad at home and abroad
Exchange rate expectationsExchange rate expectations
Geographical Geographical distancedistance from trading partners from trading partners
Capital account Capital account policy regimepolicy regimeCapital controls and other barriers to free flowsCapital controls and other barriers to free flows
Exports 1990-Exports 1990-20002000 (% of GDP) (% of GDP)
05
101520253035
World Low- and middle-income countries
High-incomecountries
1990
2000
Transition Countries: Transition Countries: Exports 2000 (% of Exports 2000 (% of GDP)GDP)
0 20 40 60 80 100
AlbaniaArmenia
ChinaRomaniaGeorgia
AzerbaijanKyrgyz Republic
UzbekistanLithuaniaRussian
LatviaMoldovaBulgaria
KazakhstanSloveniaUkraine
TurkmenistanHungaryBelarus
Czech RepublicSlovak Republic
TajikistanEstonia
World average
Growth in Trade Less Growth in Trade Less Growth in GDP 1990-2000 Growth in GDP 1990-2000 (%)(%)
-10 0 10 20 30
BelarusKazakhstan
ChinaKyrgyz Republic
UzbekistanSlovenia
Russian FederationTurkmenistan
BulgariaLatvia
UkraineAlbania
RomaniaHungary
Slovak RepublicCzech Republic
EstoniaLithuaniaMoldova
AzerbaijanVietnamGeorgia
FDI 1990-2000 (Net, FDI 1990-2000 (Net, % of Gross % of Gross Investment) Investment)
02468
10121416
World Low- and middle-income countries
High-incomecountries
1990
2000
FDI 1990-2000 (Gross, FDI 1990-2000 (Gross, % of GDP) % of GDP)
0
2
4
6
8
10
12
World Low- and middle-income countries
High-incomecountries
1990
2000
Transition Countries: FDI Transition Countries: FDI 2000 (Net, % of Gross 2000 (Net, % of Gross Investment)Investment)
-10 0 10 20 30 40 50 60
Kyrgyz RepublicBelarus
SloveniaRussian
ChinaAzerbaijan
UkraineTurkmenistan
UzbekistanHungaryTajikistanRomaniaVietnam
LithuaniaAlbania
LatviaCambodia
GeorgiaEstonia
Czech RepublicSlovak Republic
ArmeniaMoldova
KazakhstanBulgaria
World average
Transition Countries: FDI Transition Countries: FDI 2000 (Gross, % of GDP)2000 (Gross, % of GDP)
0 5 10 15
BelarusSloveniaUkraineRussian
AzerbaijanRomaniaLithuania
AlbaniaCambodia
VietnamGeorgia
ChinaKyrgyz Republic
HungaryLatvia
ArmeniaKazakhstan
BulgariaCzech Republic
MoldovaEstonia
Slovak Republic
World average
Capital FlowsCapital Flows
Facilitate borrowing abroad to Facilitate borrowing abroad to smooth consumption over timesmooth consumption over time
Dampen business cyclesDampen business cycles
Reduce vulnerability to domestic Reduce vulnerability to domestic economic disturbanceseconomic disturbances
Increase risk-adjusted rates of returnIncrease risk-adjusted rates of return
Encourage saving, investment, and Encourage saving, investment, and growthgrowth
Openness to Openness to FDIFDI and Growth 1965-98and Growth 1965-98
-8
-6
-4
-2
0
2
4
6
-4 -2 0 2 4 6 8
Actual less predicted FDI 1975-1998 (% of GDP, ppp)
An
nu
al g
row
th o
f G
NP
per
cap
ita
1965
-98,
ad
just
ed f
or
init
ial
inco
me
(%)
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.
r = 0.62
85
countrie
s
r = r = rank rank correlatcorrelationion
Openness to Trade and Growth 1965-98
-8
-6
-4
-2
0
2
4
6
-40 -30 -20 -10 0 10 20 30 40
Actual less predicted exports 1965-98 (% of GDP)
An
nu
al
gro
wth
of
GN
P p
er
cap
ita
196
5-98
, a
dju
ste
d f
or
init
ial
inco
me
(%
)
Malaysia
Korea
Guinea Bissau
Belgium
87
countrie
s
An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year.
r = 0.42
Tariffs and Growth 1965-9882
countrie
s
-8
-6
-4
-2
0
2
4
6
0 10 20 30 40
Import duties (% of imports 1970-98)
An
nu
al g
row
th o
f G
NP
pe
r c
ap
ita
19
65
-98
, ad
jus
ted
fo
r in
itia
l in
co
me
(%
)
An increase in tariffs by 10% of imports is associated with a decrease in per capita growth by 1% per year.
r = -0.52
India
Cote d'Ivoire
Botswana
Pitfalls: Incomplete Pitfalls: Incomplete InformationInformation
Capital account liberalization, if Capital account liberalization, if well managed, stimulates saving well managed, stimulates saving and investment, efficiency, and and investment, efficiency, and economic growtheconomic growth
But information may be But information may be asymmetricasymmetricAdverse selectionAdverse selection
Moral hazardMoral hazard
HerdingHerding
Capital Account Capital Account LiberalizationLiberalizationNeeds to be orderly, gradual, well-Needs to be orderly, gradual, well-
sequencedsequenced
Effective prudential regulationEffective prudential regulationTo encourage banks to recognize risksTo encourage banks to recognize risks
To enable authorities to monitor threats to To enable authorities to monitor threats to stability of the financial system stability of the financial system
Sound macroeconomic policiesSound macroeconomic policies
SequencingSequencingPut bank supervision and sound policies in Put bank supervision and sound policies in
place first, then liberalizeplace first, then liberalize
External Debt External Debt Dynamics and Dynamics and SustainabilitySustainability22
Many countries have developed rapidly with the aid of external loans (US, Korea)
But many other countries have fared But many other countries have fared less well with their external debt less well with their external debt strategies because they borrowed strategies because they borrowed abroad to abroad to finance consumption, not finance consumption, not investmentinvestment
Consumption does not increase the Consumption does not increase the ability of indebted countries to ability of indebted countries to service their debts, nor does low-service their debts, nor does low-quality investmentquality investment
But But high-quality investmenthigh-quality investment doesdoes
External Debt: External Debt: Key ConceptsKey Concepts
Debt burdenDebt burdenAlso called Also called debt service ratiodebt service ratio
Equals the ratio of amortization Equals the ratio of amortization and interest payments to exportsand interest payments to exports
q = debt service ratioA = amortizationr = interest rate DF = foreign debtX = exports
X
rDAq
F
Interest burdenInterest burdenRatio of interest payments to Ratio of interest payments to
exportsexports
X
Aa q = a + bq = a + b
Amortization burdenAmortization burdenAlso called Also called repaymentrepayment burden burden
Ratio of amortization to exportsRatio of amortization to exports
X
rDb
F
External Debt: External Debt: Key ConceptsKey Concepts
How can we figure out a How can we figure out a country’s debt burden?country’s debt burden?Divide through definition of Divide through definition of qq by by
incomeincomeNow we have expressed Now we have expressed the debt service ratio in the debt service ratio in terms of familiar terms of familiar quantities: the interest quantities: the interest rate rate rr, the debt ratio , the debt ratio DDFF/Y/Y, and the export , and the export ratio ratio X/YX/Y as well as the as well as the repayment ratio repayment ratio A/YA/Y
Y
XY
Dr
Y
A
q
F
External Debt: External Debt: NumbersNumbers
Suppose that Suppose that r = 0.08r = 0.08
DDFF/Y = 0.50/Y = 0.50
A/Y = 0.06A/Y = 0.06
X/Y = 0.20X/Y = 0.20
5.02.0
1.0
0.2
5.008.006.0q
Here we have a Here we have a country that has to country that has to use use a half of its a half of its export earningsexport earnings to to service its external service its external debtdebt
Heavy burden!Heavy burden!
Y
XY
Dr
Y
A
q
F
Numerical ExampleNumerical Example
Transition Countries:Transition Countries: External Debt 2000 (PDV, External Debt 2000 (PDV, % of GDP)% of GDP)
0 20 40 60 80 100 120
BelarusChina
AlbaniaAzerbaijan
RomaniaArmeniaVietnamUkraine
KazakhstanGeorgia
LithuaniaCzech Republic
LatviaSlovak Republic
UzbekistanRussian
CambodiaHungaryEstonia
BulgariaMoldova
TajikistanKyrgyz Republic
Transition Countries: Transition Countries: External Debt 2000 (% of External Debt 2000 (% of ExportsExports))
0 50 100 150 200 250
BelarusAlbania
AzerbaijanChina
Czech RepublicUkraine
KazakhstanEstonia
Slovak RepublicVietnamRomaniaHungaryLithuania
LatviaGeorgiaArmenia
TajikistanUzbekistanCambodia
RussianBulgariaMoldova
Kyrgyz Republic
Transition Countries: External Transition Countries: External Debt ServiceDebt Service 2000 (% of 2000 (% of ExportsExports))
0 10 20 30 40
CambodiaAlbaniaBelarus
ChinaVietnamArmenia
AzerbaijanEstoniaGeorgiaRussian
TajikistanCzech Republic
LatviaBulgariaMoldova
KazakhstanLithuania
Slovak RepublicUkraine
RomaniaHungary
UzbekistanKyrgyz Republic
Debt accumulation is, by its nature, a Debt accumulation is, by its nature, a dynamicdynamic phenomenon phenomenonA large stock of debt involves high A large stock of debt involves high
interest payments which, in turn, add interest payments which, in turn, add to the external deficit, which calls for to the external deficit, which calls for further borrowing, and so on further borrowing, and so on Debt accumulation can develop into a Debt accumulation can develop into a
vicious circlevicious circle
How do we know whether a given debt How do we know whether a given debt strategy will spin out of control or not?strategy will spin out of control or not?To answer this, we need a little arithmetic To answer this, we need a little arithmetic
External Debt External Debt Dynamics Dynamics
Recall balance of payments Recall balance of payments equation:equation:BOP = X – Z + FBOP = X – Z + F
wherewhere
FF = capital inflow = capital inflow = = DDFF where where
DDFF = foreign debt = foreign debtCapital inflow, F, thus involves an Capital inflow, F, thus involves an
increase in the stock of foreign debt, increase in the stock of foreign debt, DDFF, or a decrease in the stock of , or a decrease in the stock of foreign claims (assets)foreign claims (assets)
So, F is a So, F is a flowflow and D and DF F is a is a stockstock
External External DebtDebt Dynamics Dynamics
Now assumeNow assumeZ = ZZ = ZNN + r + rDDFF
ZZ = total imports= total importsZZNN = non-interest imports = non-interest importsrrDDFF = interest payments = interest payments
Further, assumeFurther, assumeX = ZX = ZNN
BOP = 0BOP = 0 A flexible exchange rate maintains A flexible exchange rate maintains equilibrium in the balance of payments at equilibrium in the balance of payments at
all times all times
Then, it follows thatBOP = X – Z + BOP = X – Z + DDFF = = 00so that
DDFF = = rDrDFF
In other words:
rD
ΔDF
F
External External Debt Debt DynamicsDynamics
So, now we have:
rD
ΔDF
F
Now subtract growth rate of output from both sides:
g-rY
ΔY
D
ΔDF
F
Y
Yg
External Debt External Debt DynamicsDynamics
But what is
This is the proportional change of the debt ratio:
Y
ΔY
D
ΔDF
F
??
Y
D
Y
DΔ
Y
ΔY
D
ΔDF
F
F
F
This is an application of a simple rule of arithmetic:
%%(x/y) = (x/y) = %%x - x - %%yy
External Debt External Debt Dynamics Dynamics
z = x/yz = x/y
log(z) = log(x) – log(y)log(z) = log(x) – log(y)
log(z) = log(z) = log(x) - log(x) - log(y)log(y)
But what is But what is log(z) log(z) ??
So, we obtain
z
Δz
z
1
dt
dz
dt
dlog(z)Δlog(z)
y
Δy
x
Δx
z
Δz
Q.E.D.
Proof Proof
We have shown thatWe have shown that
grd
Δd
where
Debt ratio
Time
r r g g
r = gr = g
r r g g
Need economic Need economic growth to keep growth to keep the debt ratio the debt ratio under controlunder control
Y
Dd
F
Debt, Interest, and Debt, Interest, and Growth Growth
It is important to keep It is important to keep economic growtheconomic growth at home at home aboveabove – or at least not far – or at least not far below – the below – the world rate of interestworld rate of interest
Otherwise, the debt ratio keeps rising over Otherwise, the debt ratio keeps rising over timetime
External deficits can be OK, even over External deficits can be OK, even over long periods, as long as the external long periods, as long as the external debt does not increase faster than debt does not increase faster than output and the debt burden is output and the debt burden is manageable to begin with manageable to begin with
A rising debt ratio may also be OK as A rising debt ratio may also be OK as long as the borrowed funds are used long as the borrowed funds are used efficientlyefficiently
Once again, Once again, high-quality investment high-quality investment is keyis key
What Can We Learn What Can We Learn from This? from This?
Let us now study the interaction Let us now study the interaction between trade deficits, debt, and between trade deficits, debt, and growthgrowth
Two simplifying assumptions:Two simplifying assumptions:DDtt = aY = aYt t (omit the superscript F, so D = (omit the superscript F, so D =
DDFF))
Trade deficit is a constant fraction Trade deficit is a constant fraction aa of of outputoutput
YYtt = Y = Y00eegtgt
Output grows at a constant rate Output grows at a constant rate gg each yeareach year
Y
tExponential growth
Debt Dynamics: Debt Dynamics: Another Look Another Look
Y
time
Exponential growth implies a linear logarithmic growth path whose slope equals the growth rate
log(Y)
time
1
g
Pictures of Growth Pictures of Growth
T
0
tT dtΔDD at time T
Debt as the Sum of Debt as the Sum of Past Deficits Past Deficits
dteaYdtΔDDT
0
gt0
T
0
tT
T
0
tT dtΔDD at time T
DebtDebt as the Sum of as the Sum of Past Deficits Past Deficits
dteaYdtΔDDT
0
gt0
T
0
tT
gt0
T
0
gt0
T
0
tT eg
1aYdteaYdtΔDD
Evaluate this Evaluate this integral integral between 0 and between 0 and TT
T
0
tT dtΔDD at time T
DebtDebt as the Sum of as the Sum of Past Past DeficitsDeficits
dteaYdtΔDDT
0
gt0
T
0
tT
gt0
T
0
gt0
T
0
tT eg
1aYdteaYdtΔDD
Evaluate this integral between 0 and T
1eg
1aYe
g
1aYdteaYdtΔDD gT
0gt
0
T
0
gt0
T
0
tT
T
0
tT dtΔDDSo, as T goes to So, as T goes to infinity, Dinfinity, Dtt becomes becomes infinitely large.infinitely large.But that may be quite But that may be quite OK in a growing OK in a growing economy!economy!
at time T
Debt as the Sum of Debt as the Sum of Past DeficitsPast Deficits
T
0gt
0
T
T
Y
YeY
g
a
Y
D
Debt as the Sum of Debt as the Sum of Past Deficits Past Deficits
T
0gt
0
T
T
Y
YeY
g
a
Y
D
T
0
T
0gt
0
T
T
Y
Y1
g
a
Y
YeY
g
a
Y
D
Debt as the Sum of Debt as the Sum of Past Deficits Past Deficits
T
0gt
0
T
T
Y
YeY
g
a
Y
D
T
0
T
0gt
0
T
T
Y
Y1
g
a
Y
YeY
g
a
Y
D
gT
T
0
T
0gt
0
T
T e1g
a
Y
Y1
g
a
Y
YeY
g
a
Y
D
Debt as the Sum of Debt as the Sum of Past Deficits Past Deficits
So, as T goes to So, as T goes to infinity, Dinfinity, DTT/Y/YTT approaches the approaches the ratio ratio a/ga/g
T
0gt
0
T
T
Y
YeY
g
a
Y
D
T
0
T
0gt
0
T
T
Y
Y1
g
a
Y
YeY
g
a
Y
D
gT
T
0
T
0gt
0
T
T e1g
a
Y
Y1
g
a
Y
YeY
g
a
Y
D
g
a
Y
D
T
Tlim T
Debt as the Sum of Debt as the Sum of Past Deficits Past Deficits
SupposeSupposeTrade deficit is 6% of GNPTrade deficit is 6% of GNP
a = 0.06a = 0.06
Growth rate is 2% per yearGrowth rate is 2% per yearg = 0.02g = 0.02
Then the debt ratio approachesThen the debt ratio approachesd = a/g = 0.06/0.02 = 3d = a/g = 0.06/0.02 = 3
This point will be reachedThis point will be reached regardless regardless of the initial position ...of the initial position ...... as long as ... as long as aa and and gg remain remain
unchangedunchanged
Debt ratio
Time
3
Numerical Numerical Example Example
Suppose that r = 0.08 (as before)
D/Y = 3D/Y = 3 (our new number)
A/Y = 0.06 (as before)
X/Y = 0.20 (as before)
Here we have Here we have a country that a country that has to use has to use one one and a halfand a half of of its export its export earnings to earnings to service its service its debtsdebtsHeavy Heavy
burden, burden,
indeed!!!indeed!!!
5.10.2
30.080.06q
Y
XY
Dr
Y
A
q
F
Numerical Example, Numerical Example, AgainAgain
Suppose that r = 0.08 (as before)
D/Y = 2D/Y = 2 (our new number)
A/Y = 0.06 (as before)
X/Y = 0.20 (as before)
Here we have Here we have a country that a country that has to use has to use one one and a halfand a half of of its export its export earnings to earnings to service its service its debtsdebtsHeavy Heavy
burden, burden,
indeed!!indeed!!
1.10.2
20.080.06q
Y
XY
Dr
Y
A
q
F
Numerical Example, Numerical Example, AgainAgain
Suppose that r = 0.08 (as before)
D/Y = 1D/Y = 1 (our new number)
A/Y = 0.06 (as before)
X/Y = 0.20 (as before)
Here we have Here we have a country that a country that has to use has to use one one and a halfand a half of of its export its export earnings to earnings to service its service its debtsdebtsHeavy Heavy
burden, burden,
indeed!indeed!
7.00.2
10.080.06q
Y
XY
Dr
Y
A
q
F
Numerical Example, Numerical Example, AgainAgain
Suppose that r = 0.08 (as before)
D/Y = 1D/Y = 1 (our new number)
A/Y = 0.06 (as before)
X/Y = 0.40 (as before)
Here we have Here we have a country that a country that has to use has to use one one and a halfand a half of of its export its export earnings to earnings to service its service its debtsdebtsHeavy burden, Heavy burden,
but but
manageablemanageable
35.00.4
10.080.06q
Y
XY
Dr
Y
A
q
F
Numerical Example, Numerical Example, AgainAgain
Must adjust policiesMust adjust policies
Must eitherMust eitherReduce trade deficitReduce trade deficit by stimulating by stimulating
exports or by reducing imports, orexports or by reducing imports, orIncrease economic growthIncrease economic growth
Otherwise, the debt ratio will reach Otherwise, the debt ratio will reach unmanageable levels, unmanageable levels, automaticallyautomaticallyNo country can afford external debt No country can afford external debt
equivalent to 2-3 times annual outputequivalent to 2-3 times annual output
What to Conclude?What to Conclude?
Because, after a while, the debt Because, after a while, the debt burden becomes burden becomes unbearable unbearable
Korea avoided thisKorea avoided thisIts Its export-oriented growth strategyexport-oriented growth strategy
reduced the numerator and reduced the numerator and increased the denominator of the increased the denominator of the debt ratio, thereby reducing its debt debt ratio, thereby reducing its debt burdenburden
An An import-substitution strategyimport-substitution strategy would would reduce both numerator and reduce both numerator and denominator, with an ambiguous denominator, with an ambiguous effect on the debt burdeneffect on the debt burden
And Why Not?And Why Not?
Transition Countries: External Transition Countries: External Debt ServiceDebt Service 2000 (% of 2000 (% of ExportsExports))
0 10 20 30 40
CambodiaAlbaniaBelarus
ChinaVietnamArmenia
AzerbaijanEstoniaGeorgiaRussian
TajikistanCzech Republic
LatviaBulgariaMoldova
KazakhstanLithuania
Slovak RepublicUkraine
RomaniaHungary
UzbekistanKyrgyz Republic
Still OK, but Still OK, but
be careful!be careful!
RecapRecap
Borrowers often renegotiate the terms of Borrowers often renegotiate the terms of their loans in mid-stream in order to their loans in mid-stream in order to delay repayments, that is, extend the delay repayments, that is, extend the
maturity of the loans, or tomaturity of the loans, or to reduce interest payments by replacing reduce interest payments by replacing
high-interest loans by loans with lower high-interest loans by loans with lower interestinterest
Sometimes, outright Sometimes, outright debt forgivenessdebt forgiveness may be called formay be called forBut debt forgiveness is But debt forgiveness is no substitute for no substitute for
sound economic policiessound economic policies Remember: our formula Remember: our formula d = a/g d = a/g holds in holds in
the long run regardless of initial the long run regardless of initial conditions conditions
Debt Renegotiations Debt Renegotiations and Forgiveness and Forgiveness
External borrowing is a necessary and External borrowing is a necessary and natural part of economic developmentnatural part of economic developmentThis requires countries that borrow to invest This requires countries that borrow to invest
the funds borrowed in the funds borrowed in high-quality capitalhigh-quality capital, , including health and educationincluding health and education
This is necessary to be able to service the This is necessary to be able to service the debtdebt
If the debt burden becomes too heavy, If the debt burden becomes too heavy, must either must either reduce deficitreduce deficit or or stimulate stimulate growthgrowthIt is always desirable anyway to do It is always desirable anyway to do
everything possible to encourage economic everything possible to encourage economic growthgrowth
Rapid growth allows more foreign borrowing Rapid growth allows more foreign borrowing without making the debt burden without making the debt burden unmanageable unmanageable
The Bottom Line