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TRANSCRIPT
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A Solution to Two Paradoxes of
International Capital Flow
Jiandong Ju and Shang-Jin Wei
* Personal views, not those of the IMF
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Motivation
Cross-border capital flow reached nearly $6 trillion in2004. Less than 10% goes to developing countries.
The paradox of too little capital flow: in a one-sectormodel, marginal product of capital is lower in rich
country, but the amount of capital from rich to poorcountries is too small (the Lucas Paradox)
Example: India vs the U.S. (5800% difference in MPK)
The paradox of too much capital flow: in a 2-sector,2-factor model, factor prices are equalized in a freetrade world (FPE due to Samuelson). So there is noincentive for any capital to flow.
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Objectives ofthe paper
Existing explanationsofthe Lucasparadox do
notsurvive in a generalization to a 2X2 model
To build a micro-founded non-neo-classicaltheory tosolve the twoparadoxes
Tohighlight (possibly different) rolesoffinancial
development and property rightsinstitutionsin
international capitalflows
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Existing explanationofthe Lucas paradox
withinaneo-classical framework
Difference in effective labor
Missing factor (e.g. human capital)
Sovereign risk (Reinhart and Rogoff)
Trade cost (Obstfeld and Rogoff) Difference in TFP (ofwhichinstitution is a special
case)
Common problem:They do notsurvive in a generalization to a neo-
classicaltwosector, twofactor model
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Chain rule ofFPE
Lemma 1:Let # factors = m. Allother neo-classicalassumptions apply. For any two countries, factorprices are equalized ifthe countries can be linked by
a sequence ofcountry pairs, and ifthe countrieswithin eachpairproduce a common setofmproducts. Example: Twofactors (land and capital)
US and India may notproduce anything in common, and
may not even trade with eachother. ButFPE could hold if US-Greece (apple & apricot)
Greece-Thailand (beer and bottle)
Thailand-India (cabbage and carriage)
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Ifexisting explanationsofthe Lucasparadox dontwork,
what abouttextbook reasonsthat breakthe FPEin the2X2X2 model?
Difference in technology
No eqbm in general (Panagariya)
We are NOTsaying thatFPEis realistic,
butthatitis much more difficultto escape from the
tyranny ofFPEthatthe existing literature may haverealized.
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Intuitive outline ofour model
We work with a two-sector model but with two twists
To resolve the Lucas paradox, we introduce a
financial contract between entrepreneurs andinvestors: Each only gets a slice of the marginalproduct of physical capital.
To move away from FPE, we introduceheterogeneous entrepreneurs, which result insector- level DRS (despite firm-level CRS).
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Re-do Lucas example: India vs the U.S.
Indias K/L ratioisonly 1/15 ofthe U.S.
Itsfinancialsystem is also muchless efficient
In the absence ofcapitalflow, the return tofinancialinvestmentislowerin India than in the U.S.
India experiences an outflowoffinancial capital Atthe same time, because Indians return to
physical capitalishigher-> InflowofFDIInflowofFDI is biggerthan itwould have been ifits
financialsystem had been more efficient Return differentialissmallerthan Lucas calculation
Muchsmallerfriction can stopthe capitalflows
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Roadmap
The Model Two key parameters
Financial development
Control of expropriation risk (property rights protection)
Comparative Statics Free trade in goods
Financial capital flow
FDI World capital market equilibrium
Some very preliminary/suggestive evidence
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Model Description
Within an economy (2 sectors, 2 factors)
For a given sector:
Labor
Capitalists (each endowed wone unitofcapital) Entrepreneurs + financialinvestors
Linked by financial contracts
2-period production; Liquidity shockin 2nd period
Moralhazard problem
Two country world economy
Variousscenariosofcapitalflows
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Time line of the model
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The Model
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Financial Contract:
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Solution
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AllocationofCapital withinandacross Sectors
Lemma 2: The more productive entrepreneurs enter
the heterogeneous sector, while the less productiveones enter the homogeneous sector. In theheterogeneous sector, relatively more productiveentrepreneurs manage more capital.
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Free Entry Conditions
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A Stolper-Samuelson Plustheorem holds:
(Prop 1)
When p r butw
When r butw
When r but no change in w When N1 r butw
ButFPE does nothold!
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DeterminationofFactor Prices
Proposition 1: An increase in N1 will decrease r but increase w.An improvement in the level of financial development willincrease r but has no effect on w. Lower expropriation riskincreases r but decrease w.
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EquilibriumConditions
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A RybczynskiPlustheorem holds:
(Prop 2)(under a modified non-reversaloffactorintensity)
When K (or L) N1, y1 more than y2,and p
When y1 and y2 proportionately, but
no change in p (or N1) When N1&N2 , y1& y2 proportionately,
but no change in p
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Comparative Statics
Proposition 2: The increase in K will increase N1, and
decrease the relative price of good 1. The improvement inthe level of financial development, however, has no effect onoutputs and the commodity price. Lower risk expropriationdecreases N1 and N2, but has no effect on p.
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Combining Propositions 1 and 2
When K/L N1 (prop 2)
r butw (prop 1)
The intuition from a one-sector modelis restored inthistwo-sector, two-factor model!
Question: Isthe LucasParadox also restored?
No! The differentialin returnsto capital dependsonc1f/(1+f), which can be very small
Evidence: Caselli and Feyrer (2005)
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Moving from closed to open economy
Four-step discussion
Free trade in goods Justfinancial capitalflow (+ free trade)
JustFDI (+ free trade)
Bothtypesofcapitalflows (free trade)
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Free Trade in Goods
Two countries differin factor endowments and levelsof
financial development and property rightsprotection.
Prop 3: The Heckscher-Ohlin theorem stillholds: Eachcountry exportsthe good that usesits more abundant
factorintensively.
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Financial Capital Flow
Proposition 4: If the two countries have the samelevel of property rights protection and financial
development, financial capital will flow out of the
capital abundant country, and into the capital scarce
one. If the two countries have the same capital-labor
ratio, financial capital will flow out of the country
with lower financial development or poorer property
rights protection and into the other one.
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ForeignDirectInvestment
Proposition 5: Suppose trade in goods is free and expropriation
risk in the two countries are the same, FDI will flow out of the
capital abundant country to the labor abundant country. If thetwo countries have the same K/L ratio, then FDI will go from the
country with poor property rights protection to the other.
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Free capital mobility + free goodstrade
Ifa country haslow K/L and low , then itexperiencestwoway grossflows (outflowoffinancial capital butinflowofFDI), and a smallnetflow
e.g. China
Ifa country has a low K/L and low , thenoutflowoffinancial capital + outflowofFDI
e.g. Zimbabwe
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Contrasting effects ofpoor financial development vs.
poor property rights protection
A lower level of financial development results in alower r, which generates an outflow of financialcapital. As a result, w becomes lower, which
attracts more FDI th
an oth
erwise. Worse property rights protection results in both a
lower profit, leading to less FDI, and a lower r,leading to outflow of financial capital
Empirical evidence: Wei 2006
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Property rights protection,financial development,
and compositionofcapital flow (Wei, 2006,connectingtwo
views onfinancial globalization)IV Regression
FDI/total
foreign
liability
Portolio equity
/total foreign
liability
Portolio debt
/total foreign
liability
Loan/total
foreign liability
Institutional Quality 0.67** -0.11 0.38** -0.81*(0.29) (0.11) (0.17) (0.40)
Financialdevelopment
-0.88* 0.31* -0.40 0.65
(0.46) (0.18) (0.27) (0.66)
Resourcea
0.13 0.04 0.05 -0.15(0.13) (0.05) (0.08) (0.18)
Openness a 0.12* 0.01 -0.08* -0.23(0.07) (0.03) (0.04) (0.14)
Observations 34 34 34 33
R-squared 0.36 0.40 0.47 0.56
Measure of Institutions Average ofSix World Bank Indicators
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Capital Bypass Circulation,or transfusion
Proposition 6:A unique equilibrium: Inefficient
financial system is completely bypassed.
In the transition to the eqbm, the country with a higher initialK/L always exports capital on net (i.e. running a CA deficit)
So a scenario in which the US runs a current account (CA)
deficit, China CA surplus can in principle be rationalized w/o Exchange rate policy
Mercantilist trade strategy
Fiscal deficit
Free capital mobility + free trade + free mobility ofentrepreneurs
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Capital Bypass Circulation
FDIFCF
Y2
O
K
K+K*
A
B
B*
A*
L L+L*
F O*
E
CH
Y1
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Capital Bypass Circulation,or transfusion
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Capital MarketEquilibrium:Different
ExpropriationRisk
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DifferentExpropriationRisk
In equilibrium, wage is always higher in the country with better financialinstitution or lower expropriation risk.
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Prop 5:
Suppose the two countries are diversified in the
equilibrium withfree trade and free capital
mobility, then the wage rate is always (atleast
weakly)higherin the country with betterproperty
rightsprotection orwith betterfinancial
development
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Conclusions
Existing explanationsofthe Lucasparadox dontsurvivein a modelwithtwosectors and twofactors. Itis difficulttosimultaneously resolve Lucasparadox and FPEin aneo-classicalframework
We build a micro-founded non-neoclassical model
Key twists:
Financial contracts
Heterogeneousfirms
The modelhighlights (potentially different) rolesoffinancial development and property rightsprotection
It generatespredictions aboutgross aswell asnetcapitalflows. It avoids boththe Lucasparadox and FPE.
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Future Work (I)
Solution tootherpuzzlesin intlfinance?
Feldstein-Horioka puzzle
Shutting down risk-sharing motivation
Smallfriction to capital mobility
investment = saving
Home biasin equity holdings
Equity instead ofdirectfinancing contracts
Smallfriction to capital mobility
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Future Work (II)
Empirics
Dynamics
Welfare analysis /conflictofinterest
Alternative financial contracts
Frictionsto capitalflow
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Financial development, corruption,and composition
ofcapital flows: Preliminary evidence
Challenge:
measuresofinstitutions may be endogenous
Instrumental variable for government corruption:
Initial costto colonizers mortality rate ofEuropean
settlers before 1850
Acemoglu, Johnson, and Robinson (AER 2001)
Alternative: initialpopulation density in 1500
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Instrumental variablesforfinancial
development:
Legalorigins: La Porta, Lopez-de-silanes,
Shleifer, and Vishny (JPE 1998)
Settler mortality
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(History-based) instrumental variables
Corruption is mostly affected by settler
mortality but not by legalorigin
Financial developmentis affected by both
legalorigins and settler mortality.
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The basic specification:
(1) Composition(j) = 1 Corruption(j)
+ 2 FinDev(j) + Z(j) + e(j)
Zj is a vectorofcontrol variables,
1, 2, and are parameters
ej is a random error.
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Table 7:Addingmore control variables (IVRegressions)
FDI/total foreign
liability
Portolio
equity/totalforeign liability
Portolio debt
/total foreignliability
Loan/total
foreign liability
(1) (2) (3) (4) (5) (6) (7) (8)
Corruption(GCR/WDR) -0.55** -0.42* 0.09 0.17* -0.34** -0.27* 0.69* 0.29
(0.24) (0.25) (0.10) (0.09) (0.14) (0.13) (0.34) (0.28)
Financial development -0.87* -0.76 0.31* 0.38** -0.48* -0.42* 0.72 0.28
(0.48) (0.46) (0.19) (0.16) (0.26) (0.25) (0.68) (0.54)
Resourcea
0.13 0.12 0.04 0.04 0.05 0.05 -0.15 -0.16
(0.13) (0.13) (0.05) (0.04) (0.07) (0.07) (0.18) (0.14)
Opennessa
0.13* 0.17** 0.01 0.04 -0.09** -0.07* -0.22 -0.39**
(0.07) (0.07) (0.03) (0.02) (0.04) (0.04) (0.15) (0.12)
FDI restrition Dummy -0.01 -0.06 -0.00 -0.03* 0.05* 0.02 -0.04 0.09
(0.05) (0.06) (0.02) (0.02) (0.03) (0.03) (0.07) (0.06)
Log(GDP) 0.04* 0.03** 0.02* -0.10**
(0.02) (0.01) (0.01) (0.02)
Observations 34 34 34 34 34 34 33 33
R-squared 0.36 0.43 0.40 0.58 0.53 0.59 0.57 0.74
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Explainingthe RatioofFDI/Total Foreign Liabilities in 2003
IV regressions
Corruption(GCR/WDR) -0.10** -0.65** -0.56**
(0.04) (0.23) (0.24)
Financial development 0.17* -1.07** -0.88*
(0.09) (0.44) (0.46)
Resourcea
0.13(0.13)
Openness a 0.12*
(0.07)
Observations 40 34 34 34
R-squared 0.15 0.09 0.28 0.36
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FirstStage Regressions:
Using Histories toInstrumentModern-day Institutions
Corruption(GCR/WDR) Financial development Institutional Quality
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Log(settler
mortality)
0.46** 0.31** -0.21** -0.38** -0.29**
(0.08) (0.08) (0.03) (0.07) (0.07)
Log(Population 0.27** 0.10 -0.07**
density in 1500) (0.07) (0.08) (0.03)
Legal origin 0.37 0.62** -0.18** -0.14* -0.18** -0.06
(French) (0.23) (0.22) (0.08) (0.08) (0.08) (0.17)
Legal origin 0.00 0.00 0.74* 0.00 0.00 0.00
(German) (0.00) (0.00) (0.38) (0.00) (0.00) (0.00)
Legal origin 0.00 0.00 0.70* 0.00 0.00 0.00
(Scandivanian) (0.00) (0.00) (0.38) (0.00) (0.00) (0.00)
Legal origin 0.71 0.79 -0.25** -0.29 -0.14 -0.98**
(Socialist) (0.66) (0.72) (0.10) (0.21) (0.25) (0.45)
Observations 44 48 40 44 120 60 73 70 61
R-squared 0.44 0.24 0.36 0.20 0.14 0.47 0.14 0.33 0.29
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Evidence isstillpreliminary, butintriguing
More needsto be done
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Welfare Impacts: Financial Capital flow
The welfare effect of financial capital outflow isdetermined by the trade off between investors' gain
and entrepreneurs' loss. If the later dominates theformer, welfare is reduced at home due to financialcapital outflow.