The Return to Capital in Capital-Scarce Countries

The recent resolution of the Lucas paradox has been that the marginal product of capital is not actually higher in poor countries once measurement is done properly, so there was never much incentive for capital to flow there. This paper reopens the question by measuring both quantities that the neoclassical first-order condition links – the marginal product of capital and the financial return – on the same firms, using Worldscope accounting and stock-market data for listed firms in MSCI developed and emerging countries from 1997 to 2014 (334,471 firm-years across 42 countries). The marginal product is proxied by earnings before interest, tax, depreciation and amortisation over the previous year’s market value of assets (debt at book plus equity at market); the financial return is that plus the capital gain net of new investment, following Fama and French’s internal-rate-of-return-on-value construction; both are inflation-adjusted. The results split the two apart. Consistent with the neoclassical prediction, firm-level return on assets is significantly negatively related to GDP per capita, and this holds after firm, industry and time controls, in 40 of 44 non-financial Fama-French industries, in every single year of the sample, in the post-crisis window, among IFRS adopters, in the EU subsample, using output per worker or per hour instead of per capita, and after adjusting income for corporate tax. The internal rate of return shows nothing of the kind: the coefficient on GDP per capita is statistically insignificant in the main specification and in every robustness variant, insignificant in 42 of 44 industries, and insignificant or positive in 10 of 18 years. Averaged across the sample, return on assets is 9.2 percent and the internal rate of return 8.3 percent, with emerging markets showing higher return on assets but lower internal rates of return than developed markets, in means and medians alike. Quantile regressions sharpen the point: the negative relation with income is strongest for the most profitable firms, yet even those firms show no corresponding advantage in realised returns – “even the best-performing firms within emerging countries cannot successfully translate their higher marginal products of capital to higher investment returns.” The proposed mechanism is a capital accumulation friction: adding a quadratic adjustment term to the accumulation equation breaks the constant-depreciation link, and a firm-level test finds the squared investment-to-capital ratio significantly related to the growth of capital at market prices, so the linear accumulation process implicit in perpetual-inventory capital stocks needs modification. The implication the paper draws is a redirection rather than a solution: “a key explanation for the pattern of international capital flows may indeed be domestic rather than international frictions.” Its own stated limits are firm: the sample is listed firms only, so “our conclusions about the Lucas paradox are restricted to the sample of public firms,” and firm data say nothing about the self-employed or informal sector that “make up a large part of the economy in developing countries.”

Jennifer Rhee | Macro Paper Warehouse

The Return to Capital in Capital-Scarce Countries