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«Barcelona GSE Working Paper Series Working Paper nº 664 Financial reforms and capital flows: insights from general equilibrium Alberto Martin and ...»

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Financial Reforms and Capital Flows:

Insights from General Equilibrium

Alberto Martin

Jaume Ventura

September 2012

Barcelona GSE Working Paper Series

Working Paper nº 664

Financial reforms and capital flows:

insights from general equilibrium

Alberto Martin and Jaume Ventura∗

September 2012

Abstract: As a result of debt enforcement problems, many high-productivity firms in emerging

economies are unable to pledge enough future profits to their creditors and this constrains the financing they can raise. Many have argued that, by relaxing these credit constraints, reforms that strengthen enforcement institutions would increase capital flows to emerging economies. This argument is based on a partial equilibrium intuition though, which does not take into account the origin of any additional resources that flow to high-productivity firms after the reforms. We show that some of these resources do not come from abroad, but instead from domestic low-productivity firms that are driven out of business as a result of the reforms. Indeed, the resources released by these low-productivity firms could exceed those absorbed by high-productivity ones so that capital flows to emerging economies might actually decrease following successful reforms. This result provides a new perspective on some recent patterns of capital flows in industrial and emerging economies.

JEL classification: F34, F36, G15, O19, O43 Keywords: capital flows, financial reforms, productivity, economic growth, financial globalization ∗ This paper has been written for the conference in honor of Vittorio Corbo “Economic Policy in Emerging Economies”. We thank Gonçalo Pina and Jagdish Tripathy for excellent research assistance. Martin: CREI, Universitat Pompeu Fabra and Barcelona GSE, amartin@crei.cat. Ventura: CREI, Universitat Pompeu Fabra and Barcelona GSE, jventura@crei.cat. CREI, Universitat Pompeu Fabra, Ramon Trias Fargas 25-27, 08005-Barcelona, Spain. We acknowledge support from the Spanish Ministry of Economics and Competitiveness (grant ECO2011-23192), the Generalitat de Catalunya-AGAUR (grant 2009SGR1157), and the Barcelona GSE Research Network. In addition, Ventura acknowledges support from the ERC (Advanced Grant FP7-249588), and Martin from the Spanish Ministry of Science and Innovation (grant Ramon y Cajal RYC-2009-04624).

1 Introduction How are capital flows affected by financial reforms that relax credit constraints and raise the ability of domestic firms to borrow? At first sight, one might be tempted to dismiss this question as trivial. If some domestic firms are credit constrained (which we assume to be the case!), relaxing their constraints will allow them to borrow more and increase their investment. If domestic savings are not affected by this relaxation of credit constraints (which we also assume to be the case!), this increased investment must be financed with foreign savings. This line of reasoning leads naturally to the conclusion that financial reforms raise capital inflows. Indeed, this reasoning has led many to argue that emerging economies should reform their financial systems if they want to absorb more foreign savings and speed up investment and economic growth.

Of course, things are never so simple. The first point of this paper is to show that this line of reasoning is at best incomplete and, possibly, misleading. The reason is that it does not take into account that any additional borrowing and investment by some domestic firms crowds-out investment by other domestic firms. This is far from an innocent oversight, as we prove here. The second point of this paper is that recognizing this crowding-out effect might shed light on some real-world questions regarding capital flows into and out of emerging economies. For instance, it might be the case that financial reforms in emerging economies raise rather than reduce global imbalances.

Let us start by revisiting the line of reasoning above and consider the effects of a financial reform that relaxes credit constraints and allows domestic firms to borrow more. In a closed economy, this newfound ability to borrow leads high-productivity firms to expand their investments. The resources needed for this expansion come from low-productivity firms, which are no longer able to compete and are forced to shut down. Although the savings and labor available within the economy might both be fixed in the short run, the relaxation of credit constraints leads to a better allocation of these scarce resources. In the short run, the reform does not affect the quantity of investment, but it still raises its quality. In the long run, the reform raises the capital stock, wages and savings and it therefore also raises the quantity of investment.

It is useful to think more carefully about the role of the domestic interest rate in this process.

A key observation is that, if the reform is successful in raising the quality of investment, future wages will be high and this reduces the return to all types of investment today. This reduction in profitability leads marginal or low-productivity firms to close and stop investing, releasing some domestic savings that can be used by high-productivity firms. Are these savings large enough to accommodate the increased investment demand by high-productivity firms? The answer depends on the distribution of firm productivities within the economy. If there is only a small pool of marginal or low-productivity firms, the reduction in their investments does not free enough savings and the interest rate must increase to equilibrate domestic savings and investment. If, instead, there is a large pool of marginal or low-productivity firms, the reduction in their investments frees savings in excess of those demanded by high-productivity firms and the interest rate must fall. Somewhat surprisingly, then, the effects of a financial reform that relaxes credit constraints and directly raises investment demand does not necessarily lead to an increase in the interest rate.

There is a countervailing general equilibrium effect that works through wages and indirectly reduces investment demand. The size of this effect depends on the distribution of firm productivities, and it is pivotal in determining whether aggregate investment increases or decreases after a financial reform.

How does this picture change in the open economy? Consider, for simplicity, the case of the small open economy in which the interest rate is not affected by changes in the domestic demand for credit. If the domestic demand for credit increases, the reform leads to capital inflows. This is what one would expect if there is only a small pool of marginal or low-productivity firms in the economy. If instead this pool is large, the reform reduces the domestic demand for credit and leads to capital outflows. Moving away from the small open economy and allowing the financial reform to have effects on the world interest rate does not affect this result.

This theoretical insight has important implications for two real-world developments that have attracted substantial interest from academics and policymakers alike: the appearance of large global imbalances in the world economy and the puzzling observation that capital tends to flow to those emerging economies that exhibit lowest growth in productivity and output. We discuss each of these developments in turn.

A first striking development of the past two decades has been the emergence of large and persistent current account surpluses and deficits in the world economy, a phenomenon referred to as “global imbalances”. The lion’s share of these deficits has been concentrated in the United States, which began experiencing an increasing current account deficit in the mid 1990s. This deficit exceeded 1% of world GDP after 1999, and it peaked at more than 1.5% of world GDP in 2006.

In the late 1990s, the main counterparts to this deficit were surpluses in emerging Asia (excluding China) and Japan. In the 2000s, however, the largest surpluses became those of China and of the oil-producing countries. These current account deficits and surpluses have had a tremendous influence on the evolution of international asset positions. The net foreign liabilities of the United States quadrupled in size between 1998 and 2008, for instance, rising to $3.5 trillion in 2008. In the same period, Chinese net foreign assets rose to $1.5 trillion, which represented a third of the country’s GDP in 2008.1 There is one aspect of global imbalances that has drawn the attention of economists: the deficits have been largely concentrated in industrial economies while the surpluses have been concentrated in emerging economies. This is contrary to the prediction of conventional economic theory that capital should flow towards emerging economies, where it is relatively scarce. This discrepancy between facts and theory has prompted a substantial amount of research that, broadly speaking, can be grouped into one of two categories. The first category views global imbalances as the result of unsustainable behavior by economic agents (particularly governments), which must therefore be eventually reversed. We do not comment on this view here, except for noting that no formal models of it have yet been developed. A second, and more interesting, category views global imbalances as the result of equilibrium behavior by rational agents, which might therefore persist far into the future. This literature has largely adopted the view that underdeveloped financial markets prevent capital to flow towards fast-growing, capital-scarce emerging economies. This is the narrative that, details aside, emerges from the theories recently laid forth in Caballero et al. (2008) and Song et al. (2011).2 This view has also been in the mind of some important policymakers.3 The theoretical results in this paper indicate that this view needs to be qualified, since financial sector reform might increase rather than decrease global imbalances. This seems especially likely if, as Song et al. (2011) argue, the Chinese economy is characterized by a large pool of lowproductivity public enterprises that are not credit constrained. These firms coexist with a smaller Since the onset of the financial crisis, the magnitude of global imbalances has been reduced. At the time of writing, it is unclear whether this reduction is temporary or permanent. See Blanchard and Milesi-Ferretti (2009) and Servén and Nguyen (2010) for a discussion of this point.

Mendoza et al. (2007) also portray global imbalances as the result of financial underdevelopment in emerging economies. In their view, it is the lack of insurance markets in emerging economies that fosters precautionary savings, lowering domestic interest rates and causing capital to flow out of these economies.

In a well-known speech of 2005, Federal Reserve Chairman Ben Bernanke concluded that “... (S)ome of the key reasons for the large U.S. current account deficit are external to the United States, implying that purely inwardlooking policies are unlikely to resolve this issue. Thus a more direct approach is to help and encourage developing countries to re-enter international capital markets in their more natural role as borrowers, rather than as lenders...

Providing assistance to developing countries in strengthening their financial institutions... could... increase both the willingness of those countries to accept capital inflows and the willingness of foreigners to invest there.” Raghuram Rajan expressed himself in a similar vein in 2006 when, as Economic Counselor and Director of Research at the IMF, he noted that: “I will focus on a familiar issue, the problem of global current account imbalances, and will describe how financial sector reform can help narrow them...”.

pool of high-productivity private firms that are severely constrained. Under these circumstances, the model developed in this paper suggests that financial reform is likely to reduce the demand for credit in China, leading to larger global imbalances and even lower interest rates around the world.

A second striking development is that, among emerging economies, surpluses tend to be concentrated in those economies that exhibit highest growth in productivity and output. Gourinchas and Jeanne (forthcoming), for instance, examined a large sample of emerging economies and found that the cross-country correlation between productivity growth and capital inflows is negative.

That is, emerging economies with high productivity growth tend to export capital, while emerging economies with low productivity growth tend to import capital. This surprising empirical regularity cannot be explained easily within standard theory and led Gourinchas and Jeanne to coin the term “the allocation puzzle” to refer to it. In a related paper, Prasad et al. (2011) examined two samples containing industrial countries and emerging economies, respectively. In the sample of industrial countries, they found a positive correlation between economic growth and capital inflows.

As textbook theory suggests, in industrial countries capital flows to those countries that are capital scarce (relative to the steady state) and converge fast towards their steady state. In the sample of emerging markets, however, they found a negative correlation between economic growth and capital inflows. Contrary to textbook theory, in emerging economies capital flows to those countries that are less capital scarce (relative to the steady state) and are close to their steady states.

The theoretical results in this paper suggest that these puzzling observations could be the result of asymmetric financial development. The model developed in this paper suggests that, if there is a large pool of low-productivity firms in emerging economies, asymmetric reforms among these economies could lead to the allocation puzzle. Emerging economies that implement successful financial reforms see that many of these low-productivity firms shut down and this has two simultaneous effects: (i) increases in productivity and in the capital stock; and (ii) capital outflows. Emerging economies that implement failed financial reforms see that many of these low-productivity firms expand and this has two simultaneous effects: (i) reductions in productivity and the capital stock;

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