The Paradox of Capital

AuthorEswar Prasad, Raghuram Rajan, and Arvind Subramanian
PositionNandlal P. Tolani Senior Professor/Eric Gleacher Distinguished Service Professor/Director in the Research Department of the IMF.

Is foreign capital associated with economic growth and, if not, why does it flow "uphill"?

Standard economic theory tells us that financial capital should, on net, flow from richer to poorer countries. That is, it should flow from countries that have more physical capital per worker-and hence where the returns to capital are lower-to those that have relatively less capital-and hence greater unexploited investment opportunities. In principle, this movement of capital should make poorer countries better off by giving them access to more financial resources that they can then invest in physical capital, such as equipment, machinery, and infrastructure. Such investment should improve their levels of employment and income.

It is natural to expect that as financial globalization-cross-border flows of various forms of financial capital-picks up steam, these flows from industrial to developing countries will increase, making all countries better off. A rosy scenario, indeed, but what is the reality? In a famous article written in 1990, Robert Lucas pointed out that capital flows from rich to poor countries were very modest, and nowhere near the levels predicted by theory. Financial globalization has, of course, surged in the past decade and a half. What then has become of the empirical paradox that Lucas identified? Has increasing financial integration resolved it?

Remarkably, this paradox has, if anything, intensified over time. As Chart 1 shows, the average income, relative to the United States, of capital-exporting countries has fallen well below that of capital-importing countries. In other words, capital has been flowing from poor to rich countries!

Recent U.S. current account deficits and Chinese current account surpluses are, of course, a big part of the reason why capital is flowing "uphill." But they are hardly the full story. Many industrial economies are now running current account deficits, whereas a large number of emerging market economies are running surpluses. Chart 1 also indicates that uphill flows are not entirely a new phenomenon; a similar pattern can be seen in the mid-1980s.

[GRAPHICS ARE NOT INCLUDED]

Capital flows to and from developing economies include official flows, such as inflows of foreign aid and outflows in the form of accumulated international reserves. These flows may be driven by factors other than the basic rate-of-return considerations discussed earlier. Do private capital flows behave more in accord with economic theory? Foreign direct investment (FDI) does flow from richer to poorer countries, which is comforting. But FDI, while rising in importance over time, still accounts for only about 40 percent of private flows to developing countries and a smaller fraction of total flows. Moreover, the pattern of overall flows is ultimately what is relevant in terms of resources available for financing investment in a country. This article examines how capital is allocated around the world and whether foreign capital really promotes growth in developing countries.

Examining the paradox

Perhaps the Lucas paradox isn't such a paradox if one digs deeper. After all, many developing countries are beset by a variety of problems-inadequate infrastructure, a poorly educated labor force, corruption, and a tendency to default on debt from abroad, among other factors-that reduce the risk-adjusted returns to investment. These problems could explain why capital does not flow to developing countries in the quantities one would expect. The...

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