F21 | Macro Paper Warehouse

Capital Account Liberalization: Theory, Evidence, and Speculation

Two decades of cross-country regressions found no relationship between capital account openness and economic growth, which earlier surveys read as a verdict against the textbook case for liberalization. This survey argues those regressions never tested the theory. In the neoclassical growth model, liberalizing a capital-poor country’s capital account permanently lowers its cost of capital and permanently raises the level of GDP per capita, but raises the growth rate only temporarily, because capital accumulation – subject to diminishing returns – is the only channel available and long-run growth differences come solely from total factor productivity, which the capital account regime does not touch. So a regression of average growth on the fraction of years a country was judged open “do[es] not provide a test of any causal theory”; Henry adds a worked example in which a country that liberalizes halfway through a twenty-year window genuinely gets a temporary growth boost yet, because its openness share is 0.5 against an always-open comparator’s 1.0, the regression returns a negative coefficient. Reoriented to what theory predicts – do the cost of capital, investment and growth move in the years right after a country opens? – the evidence lines up: across 18 developing countries that opened their stock markets between 1986 and 1993, stock markets revalue by roughly 26 to 30 percent in real dollar terms, dividend yields fall by 5 to 75 basis points, the growth rate of the capital stock rises from 5.4 to 6.5 percent a year between the five years before and after, real private investment growth rises by 22 percentage points in an eleven-country sample, and GDP-per-capita growth rises about a percentage point a year. Henry then turns the same scepticism on these results. The revaluation is small relative to what large capital-labour gaps should imply, and he canvasses three explanations – incremental rather than one-shot liberalization (which he rejects, since later openings move prices little and continuous investability measures give a cumulative dividend-yield fall of only about 140 basis points), genuinely lower returns in developing countries because weak institutions depress total factor productivity, and persistent return differentials from capital market imperfections and weak investor protection. He shows the aggregate investment response cannot be financed by the initial country fund (Chile’s 37.7 million dollar Toronto Trust fund accounts for under 5 percent of the extra capital implied by its subsequent 2.2 percentage points of abnormal annual capital-stock growth), and argues the country-fund date is a proxy for a broader opening rather than the whole inflow. He is blunter still about growth: with capital growth up about one percentage point and an output elasticity of capital near one-third, liberalization “cannot raise the growth rate of GDP per capita by much more than one-third of a percentage point,” so the one-point estimate “is implausibly large,” and the measured jump in TFP growth from 0.19 to 1.82 percent a year cannot be attributed to liberalization within the model, because contemporaneous inflation stabilizations, trade liberalizations, privatizations and Brady debt relief supply an accounting for it that the theory does not. Firm-level work resolves some of this and complicates the rest: firm revaluations do track firm-specific changes in systematic risk, and the average firm’s capital stock growth exceeds its pre-liberalization mean by 3.8 percentage points a year, but investment does not respond to firm-specific changes in the equity premium at all – which Henry calls “a powerful blow to the Allocative Efficiency view.” On crises, he insists the answer depends on which liberalization is meant: crises also occur under capital controls and are positively correlated with them, the median stock market liberalization predates the Mexican crisis by five years and the Asian crisis by nearly ten, and the proximate cause was short-term dollar-denominated bank debt, whose reversal in the five Asian crisis countries amounted to nearly 80 billion dollars in a single year while portfolio flows fell by about half and stayed positive. His bottom line is that debt-flow liberalization – especially short-term and dollar-denominated – “can cause problems,” while “all the evidence we have indicates that countries derive substantial benefits from opening their equity markets to foreign investors,” and that the profession’s attachment to cross-sectional growth regressions reflects tradition and “a professional obsession” with policies that raise steady-state growth rather than anything the theory supports.

Capital flow waves: Surges, stops, flight, and retrenchment

Almost all earlier work on extreme international capital-flow episodes was built on proxies for net capital flows, which cannot tell a change in foreign behaviour from a change in domestic behaviour. This paper rebuilds the measurement from gross flows and dates four distinct episode types: “surges” and “stops” (sharp increases and decreases in gross inflows, driven by foreigners) and “flight” and “retrenchment” (sharp increases and decreases in gross outflows, driven by domestic residents). Using quarterly IMF data on gross inflows and outflows for 58 emerging and developed economies from 1980 (at the earliest) through 2009 – a sample that captures $10.8 trillion of gross inflows in 2007, or 97% of global inflows recorded by the IMF, and excludes China for want of quarterly data – it identifies 167 surge, 221 stop, 196 flight and 214 retrenchment episodes, each lasting roughly a year on average. Switching from net to gross flows changes the picture sharply: at the height of the crisis (2008Q4-2009Q1) the net-flow method finds 13 surges and 22 stops where the gross-flow method finds 1 surge and 47 stops, because in country after country a stop of foreign inflows coincided with domestic residents bringing money home, and the net measure read that combination as a “surge”. Estimating the conditional probability of each episode type on lagged global, contagion and domestic variables (a complementary log-log model on 54 countries, 1985-2009, with errors correlated across episode types and clustered by country), the paper finds global risk – proxied by the VXO – is the only variable significantly associated with all four types: positively with stops and retrenchment, negatively with surges and flight. Contagion through trade linkages, banking linkages or simple regional proximity is strongly associated with stops and retrenchment. Domestic characteristics are generally much weaker and often not robust, and there is no significant association between capital controls and the probability of a surge or a stop. The authors are explicit that they do not assess causation, that flight episodes are the most idiosyncratic and hardest to explain, and that the results are correlations between lagged conditioning variables and episode incidence rather than estimated policy effects.

Capital Flows in Risky Times: Risk-on/Risk-off and Emerging Market Tail Risk

Research on cross-border capital flows has concentrated on the first moment – what moves average flows and average returns. This paper asks instead how shifts in global risk appetite reshape the whole distribution of emerging-market portfolio flows and asset returns, and in particular the left tail. It measures “risk-on/risk-off” (RORO) two ways: a statistical index built as the first principal component of daily changes across advanced-economy credit spreads, equity returns and implied volatility, funding-liquidity spreads, and the dollar and gold; and, to separate the price of risk from the quantity of risk, the model-based risk aversion series of Bekaert, Engstrom and Xu (2020). Both measures are right-skewed and fat-tailed, spiking in the global financial crisis, the European debt crisis, the taper tantrum and COVID-19. Outcomes are weekly EPFR country flows (scaled by the previous week’s allocation) and daily total returns from the EMBI, a local-currency bond index, and MSCI local-currency and dollar equity indices, for 22 emerging markets, beginning 7 January 2004 and running to April 2020, with push and pull controls and country and time fixed effects. Estimating panel quantile regressions in the manner of Machado and Santos Silva (2019), the paper finds that a risk-off shock lowers flows and returns across the distribution, and that “in nearly every case we consider” the fifth-percentile realisation moves more than the median while the ninety-fifth moves less – so the distribution shifts left and lengthens. The exceptions and the asymmetries are the interesting part. Bond-fund flows shift left with tails pulled apart; equity-fund flows shift left with tails modestly pulled in, a pattern the paper traces specifically to sensitivity to risk aversion rather than to physical risk. Among returns, equity is far more sensitive than fixed income – more than fivefold on the statistical measure – and within each asset class dollar-denominated indices react more than local-currency ones. Decomposing the index, corporate spreads supply much of the leftward shift and funding liquidity much of the bond funds’ tail-lengthening; the risk-aversion component dominated the global financial crisis while the quantity of risk dominated COVID-19. The paper’s conclusion is methodological as much as substantive: a focus on central tendency is “incomplete,” because the tail responses it documents would be masked by conditional means and variances.

Chapter 34 The intertemporal approach to the current account

The intertemporal approach treats the current-account balance as the outcome of forward-looking saving and investment decisions rather than as a residual determined by relative prices, and this chapter surveys the theory and the evidence for it as developed since the early 1980s. The authors trace its origins to two pressures: Lucas’s critique, which suggested that open-economy models “might yield more reliable policy conclusions if demand and supply functions were derived from the optimization problems of households and firms rather than specified to match reduced-form estimates,” and the large, divergent current-account adjustments that followed the oil shocks of 1973-74 and 1979-80, on which “[n]either the classical monetary models nor the Keynesian models in vogue at the time offered reliable guidance.” Before any theory they flag a measurement problem that “plague[s] all of the empirical literature”: reported current accounts omit net capital gains on foreign assets and are not corrected for inflationary erosion of their real value, so that for the United States in 1991 the economically meaningful deficit is “probably much closer to” minus 108.7 billion dollars than to the national-accounts figure. The theory is then built up in stages. From time-separable isoelastic preferences and the economy’s intertemporal budget constraint comes a characterisation in which the current account responds to deviations of interest income, output, government consumption and investment from their permanent levels, plus a consumption-tilting term reflecting any gap between world real interest rates and domestic impatience – each prediction stated with an explicit ceteris paribus clause. The model’s quantitative failure is displayed rather than hidden: with a world real interest rate of 8 percent, growth of 4 percent and an intertemporal elasticity of 0.4, the implied steady-state net foreign asset position is minus twenty times annual output and “the economy’s trade balance surplus each period must be 80 percent of GDP” – levels “never observed in practice.” Successive sections add comparative advantage, investment with adjustment costs, nontradables, consumer durables, terms-of-trade and transfer effects, demographic structure and fiscal policy, then uncertainty under complete markets, bonds only, partially complete markets and endogenous incompleteness. On the evidence, the authors first take on Feldstein and Horioka, reproducing the original 16-country OECD regression for 1960-74 (a saving coefficient of 0.887 with a standard error of 0.074, R-squared 0.91) and reporting a weakened but still highly significant coefficient of 0.622 for 1982-91; they also note that the average OECD time-series correlation between saving and investment rates over 1974-90 is 0.495 after linear detrending and 0.512 in first differences. Their conclusion is that these correlations “provide[] no basis at all for dismissing the basic premises of the intertemporal approach,” offering four reconciling mechanisms – current-account targeting by governments, OECD countries sitting near stochastic steady states for external debt, retained earnings raising investment through the Gertler-Rogoff channel, and demographic structure – while conceding that “no single one fully explains the behavior of all countries.” Formal structural tests are treated much more sceptically. Constructing permanent values is “perhaps the most problematic issue of all”: with a real rate of 3 percent, moving the persistence parameter from 1 to 0.97, “an amount generally too small to detect empirically,” halves permanent output, and the discount rates that would remove this sensitivity “appear implausible.” The Campbell-Shiller present-value tests reject the model’s exact restriction for most countries – Sheffrin and Woo reject for Canada, Denmark and the UK but not Belgium; Ghosh does not reject for the US but rejects for Canada, Germany, Japan and the UK; and even the weaker Granger-causality implication is passed only by the US in Ghosh’s full sample – while the actual current account is generally more volatile than the predicted one, six times more so for Canada on Otto’s estimate, which Ghosh reads as evidence of “’too much’ capital mobility, in contrast to the Feldstein-Horioka claim of too little.” Extending Britain’s sample back to 1870 improves the visual fit “dramatically” yet still fails the formal restriction. Distinguishing global from country-specific shocks helps substantially: global shocks are about half of G-7 productivity shocks, and once separated “the coefficients on the global shocks are invariably much smaller than those on the country-specific shocks, and are usually insignificant.” The chapter’s closing claim is comparative rather than triumphal: the models “provide only a starting point,” but the complete-markets alternative makes the current account “little more than an accounting convention” in a world the authors judge far from complete, while Mundell-Fleming “offers no valid benchmark for evaluating external balance” and “has no clear, much less testable, predictions about current-account dynamics.”

Do finite horizons matter? The welfare consequences of capital account liberalization

Cross-sectional regressions have repeatedly failed to find robust effects of capital account liberalization on investment or GDP per capita, and Gourinchas and Jeanne (2006) found that the welfare gain from integration, measured over an infinite consumption stream, is small. This paper argues both findings are what the neo-classical model should predict and that neither settles whether liberalization is worth doing, because the theory predicts a temporary growth effect with a permanent level effect, and because the standard welfare measure spreads a gain concentrated in the first years over an infinite horizon on which the two consumption paths eventually coincide. Working in a calibrated infinite-horizon Ramsey model with Cobb-Douglas production (beta = 0.96, capital share 0.3, depreciation 0.06, output growth 1.012, population growth 1.022, log utility), the authors assume the liberalizing economy faces the world interest rate immediately and so jumps to the integrated steady state at once – an assumption made explicitly “to abstract from speed of convergence issues” – while the autarkic economy climbs there gradually from the same starting point, the population-weighted capital stock of 1995 (1.96, against a steady state of 3.97). They then compute the Hicksian consumption-equivalent gain over horizons from five years to infinity for 81 non-OECD countries. The timing result is the paper’s core empirical claim: “95% of the increase in annual consumption from capital account liberalization accrues in the first 10-15 years after the opening.” Consequently the same welfare difference reads very differently depending on the normalising horizon. In the baseline, where the economy pays interest on the inflow in perpetuity and never repays principal, the average infinite-horizon gain is minus 3.46 percent of annual consumption – financing costs outweigh the gain – while the five-year figure is 19.02 percent, and the numbers decline monotonically with the horizon, crossing zero around 35 to 40 years. The gain scales with initial capital scarcity: 51.47 percent at five years for the most capital-scarce quartile of countries, against minus 0.90 percent for the most capital-abundant quartile. The robustness exercises mostly preserve the horizon result while showing how sensitive the level is to the debt contract: allowing conditional convergence with country-specific earnings-price ratios gives 9.89 percent at five years and minus 8.35 percent at infinity; imposing the Obstfeld-Rogoff transversality condition, so principal and interest are settled only at infinity, gives 29.32 percent at five years and a positive 4.97 percent at infinity; a 50-year amortising contract gives 18.22 percent and minus 4.12 percent; starting from 1960 rather than 1995 capital stocks, when gaps were wider, gives 32.03 percent at five years. Adding a normally distributed technology shock (mean 1, standard deviation 0.03, described by the authors as “not a realistic shock … used for illustrative purposes”) makes the contract form decisive: with a non-contingent debt contract the computed gains turn sharply negative at every horizon, whereas an equity-like contract that suspends payments in bad states “comes close to the case of an economy that liberalizes and does not need to make repayment.” The authors’ conclusion is methodological and carefully bounded: they “do not claim that policies that lead to permanent effects on TFP and growth are not important,” only that finite-horizon evaluation “may be more appropriate and policy-relevant” for policies with temporary growth and permanent level effects.

Domestic Saving and International Capital Flows

How much of the saving generated inside a country actually stays there? Feldstein and Horioka set two extreme answers against each other – a world capital market in which capital flows until net-of-tax yields are equalised, so that a nation’s saving joins a common pool and its domestic investment is financed from that pool, versus a world in which portfolio preferences and institutional rigidities keep long-term capital where it originates – and note that under the first view the cross-country association between a country’s saving rate and its investment rate should be close to zero (the authors put the implied coefficient at “less than 0.10” on average across their sample, and at zero for an infinitesimally small country), while under the second it should be close to one. They then regress the ratio of gross domestic investment to GDP on the ratio of gross domestic saving to GDP across 16 OECD countries, using averages over 1960-74 so that the estimate reflects long-run rather than cyclical variation. The coefficient is 0.887 with a standard error of 0.074 for gross flows and 0.938 (0.091) for net flows – neither significantly different from one, both plainly incompatible with zero – and the five-year subperiods give 0.909, 0.872 and 0.871. The result survives the checks the authors run: a quadratic term is insignificant, adding population growth barely moves the coefficient, and letting the slope vary with trade openness or with the logarithm of GDP produces interaction terms that are negative but very small. Disaggregating saving for the nine countries with sectoral data, total gross investment responds with a coefficient of 0.957 to aggregate saving, and the household (1.17), government (1.12) and corporate (0.55) coefficients cannot be shown to differ (F = 4.5 against a 5 percent critical value of 5.8). Annual time-series regressions country by country give a much lower average coefficient, 0.64, which the authors are careful to call a short-run response “not comparable” to the cross-section estimate. Their conclusion is stated as a comparative judgement rather than a structural estimate – “the truth lies closer to the second view than to the first” – and they explicitly acknowledge that a high coefficient could in principle reflect some third factor moving saving and investment together, arguing only that the burden of naming such a factor now falls on defenders of perfect mobility. They also insist the finding is compatible with the obvious rapid arbitrage of short-term liquid capital and with large flows of direct investment undertaken to serve markets or exploit production knowledge rather than to chase yield.

Globalization and Capital Markets

Written as the financial-globalization backlash of the late 1990s was at its height, this chapter asks whether the integration of world capital markets at the turn of the twenty-first century was unprecedented, and what governed its rise and fall. The received narrative is a U – high mobility under the classical gold standard, destruction between 1914 and 1945, slow reconstruction under Bretton Woods, and a renewed rise after the early 1970s – and the authors are explicit that this is a hypothesis to be tested rather than a result, labelling their own stylised figure of it “Conjecture?” with the source listed as “Introspection.” The explanation they propose is the open-economy policy trilemma: since a government can have at most two of free capital movement, a fixed exchange rate, and a monetary policy oriented to domestic goals, capital mobility survived wherever politics supported one of the corner solutions and was suppressed wherever governments tried to occupy the middle ground. Because no single measure of market integration is decisive – price convergence and flow volumes both fail as criteria, and “all such tests may be able to evaluate market integration, but only as a joint hypothesis test where some auxiliary assumptions are needed” – the paper runs a battery. On quantities, foreign assets were about 7 percent of world GDP in 1870, just under 20 percent at the 1900-14 zenith of the gold standard, 8 percent in 1930, 11 percent in 1938, 5 percent in 1945, 6 percent in 1960, 25 percent in 1980 and 62 percent in 1995 – so “the 1900-14 ratio of foreign investment to output in the world economy was not equaled again until 1980, but has now been approximately doubled,” with liabilities tracing the same path (21 percent in 1914, 11 percent in 1938, 2 percent in 1960, 30 percent in 1980, 79 percent in 1995). Measured against the GDP only of countries with data, however, the seven great creditors exceeded 50 percent from 1870 to 1914, a level “we only surpassed … as recently as 1990, and only narrowly even then.” On prices, long-term real interest differentials against the United States for Britain, France and Germany are stationary over the whole 1890-2000 span and in most subperiods, with the unit-root null rejected at 1 percent almost everywhere except the recent float; covered and quasi-covered nominal differentials since 1870 widen in exactly the periods the U predicts, and threshold estimates of the no-arbitrage band – roughly 19 basis points for New York-London and 35 for London-Berlin before 1914, against 60 and 91 in the interwar years and about 6 in the mid-1980s – put pre-1914 integration “truly impressive compared to conditions over the following half-century or more.” Cross-country dispersion of dollar equity returns follows the same U for the G7. The authors then argue that only policy can account for the mid-century collapse, since “technology is a poor candidate” – financial techniques were not forgotten in the 1930s, and some, such as foreign exchange futures, matured then. The political-economy section supplies supporting evidence from bond spreads: on a consistent 1870-1940 London panel, being on gold lowered spreads by about 57 basis points before 1914 and only peripheral countries were punished for public debt (7.2 basis points per 10 percentage points of debt to GDP), whereas for 1925-30 the gold dummy is insignificant or wrongly signed, core and periphery are no longer distinguished, debt sensitivity is roughly five times larger, and estimated reputational persistence falls from 0.68 to 0.30. Finally the paper insists on one large difference between the two globalizations. Pre-1914 flows were long-term and nearly one-way, so gross and net positions nearly coincided; today the same rich countries top both the asset and liability rankings, net positions have stayed very low since 1980, and the developing-country share of global liabilities has fallen from 33 percent in 1900 to 11 percent in the 1990s. Today’s integration is therefore “mostly a rich-rich affair, a process of ‘diversification finance’ rather than ‘development finance’,” and the Lucas paradox of capital failing to reach capital-poor countries is, if anything, sharper now than a century ago.

Home country interest rates and international investment in U.S. bonds

This paper asks where money goes when interest rates at home fall, and answers it with an unusually direct measurement: the holdings of U.S. bonds by private investors in 31 countries, taken from the confidential security-level data underlying the annual U.S. Treasury International Capital (TIC) surveys, for 2003 through 2016. Because the TIC data separate private from official holdings, the authors can strip out central bank reserve managers, whose reasons for owning U.S. securities differ; and because they use face rather than market value, year-to-year changes reflect new investment rather than price moves. The home-country variable is each investor country’s own local-currency sovereign yield – 5-year in the baseline, 1-year in robustness checks – and the panel regressions carry both country and time fixed effects, so the estimates come from within-country movements in home yields relative to a common U.S. and global backdrop. The finding is twofold. First, lower home rates go with more total investment in the United States relative to home GDP, and the effect runs through corporate bonds rather than Treasuries: a home rate 100 basis points lower is associated with U.S. corporate bond holdings higher by 3.6 to 5.3 percent of GDP, against roughly 0.2 percent of GDP for Treasuries and only in the post-crisis years. Second, and more tellingly, lower home rates raise the corporate share within a country’s U.S. bond portfolio by an estimated 2.3 to 2.7 percentage points per 100 basis points – a composition shift toward credit risk that the authors read as search-for-yield, and that is muted or absent during the 2008-2012 crisis window when investors instead tilted toward Treasuries in a pattern they label flight-home. A third result sharpens the interpretation: when the home yield is converted into a synthetic dollar yield by netting out the 12-month forward premium, that hedged rate is statistically insignificant while the unhedged local-currency rate keeps its effect – so “investors do not appear to take hedging costs into account. Rather, they appear to compare nominal promised rates of return among investment choices.” The scope conditions are explicit and limiting. These are panel associations with fixed effects, not an identified causal experiment; the authors argue reverse causality is implausible in direction and magnitude rather than ruling it out by design. And because only the U.S. slice of each country’s portfolio is observed, the paper says plainly that it cannot tell whether these investors’ overall portfolios became riskier: “It could be that these investors invest more aggressively abroad and more conservatively at home, and as such their overall portfolio need not be more risky.”

Investor Diversification and International Equity Markets

Investors in every major market hold almost all of their equity wealth at home, even though returns across national markets are far from perfectly correlated – the average pairwise correlation between quarterly real returns on the US, Japanese, UK, French, German and Canadian markets over 1975-89 is 0.502, which the authors say “suggests that nontrivial risk reduction is available from cross-border holdings.” This paper measures how large a belief it takes to sustain that concentration. Using estimated portfolio weights for December 1989 – Japanese investors held only 1.9 percent of their equity in foreign stocks, US investors 6.2 percent, and British investors 18 percent, the last split roughly evenly among the United States, continental Europe and Japan – the authors take the covariance matrix of returns as estimable, assume a representative investor in each country with the utility function printed as U(W) = -exp(-AW/W0) and A = 3 holding only the equity of the six largest markets, and invert the first-order condition for optimal weights to recover the expected returns that would make the observed holdings optimal. Against a benchmark of equal expected returns everywhere, the implied home-market premia are large: British investors must expect UK returns more than 500 basis points a year above US returns to justify holding 82 percent domestically, a differential the authors attribute to the substantially higher standard deviation of British returns; US investors must expect US stocks to beat Japanese stocks by 250 basis points; Japanese investors must expect the reverse ranking by 350 basis points. The same numbers imply that investors of different nationalities disagree sharply about the same market, with Japanese investors expecting more than 300 basis points more from Japanese stocks than US investors do. The authors are careful that equal expected returns “may not be an appropriate benchmark,” so they recompute the deviation against an international value-weighted strategy: on that comparison US investors need only about 90 basis points of home-market optimism and about 110 basis points of pessimism about Japan, while Japanese investors still need 250 basis points and British investors over 400. They then argue institutional explanations do not fit – tax burdens on foreign and domestic equity income are similar for most investors once withholding taxes are credited at home (worth only about 50 basis points even for tax-exempt investors who cannot claim the credit), transaction costs should push everyone toward the most liquid market rather than toward their own, and the identified legal limits are not binding, as shown by foreigners being substantial net sellers of Japanese shares in the mid-1980s and of US equities in 1988. Their conclusion is stated as an inference about where the explanation must lie rather than a demonstration of a specific mechanism: incomplete diversification “is the result of investor choices,” with systematically differing return expectations (documented directly in a 1990 survey of Japanese and US portfolio managers) and familiarity-driven perceptions of risk the leading candidates – and they add that the level of cross-border investment, though low, “is growing and with time the international diversification puzzle may recede.”

Misallocation and Capital Market Integration: Evidence From India

Misallocation is a leading explanation for income differences across countries, but the literature has two problems: measures built on cross-sectional dispersion in marginal revenue products are inflated by measurement error and model misspecification, and dispersion measures are largely silent about which policies would reduce misallocation. India’s staggered liberalisation of foreign equity investment addresses both. Over the 2000s the Indian government granted automatic approval of foreign direct investment up to at least 51 percent of domestic firms’ equity, industry by industry, in two waves (2001 and 2006), coded at the 5-digit NIC level. Combining that policy variation with a 1995-2015 panel of 5,013 large and medium-sized manufacturing firms across 337 industries from the Prowess database, the paper runs a difference-in-differences with heterogeneous effects: does the reform raise capital differentially for firms that had high marginal revenue products of capital before it? The identifying requirement is weaker than what cross-sectional work needs – not random assignment, nor balanced pre-reform levels, only that the high-versus-low-MRPK gap would have evolved similarly in treated and untreated industries. For the average firm, capital rose 32 percent and MRPK fell 18.7 percent, with revenues and wage bills positive but not significant. The heterogeneity is the result: relative to low-MRPK firms, high-MRPK firms raised physical capital by 53 percent, revenues by 23 percent and wage bills by 28 percent, and cut MRPK by 33 percent, while low-MRPK firms were essentially unaffected – so dispersion in MRPK narrowed without shrinking anyone, and at least some of India’s observed MRPK dispersion is real misallocation rather than noise. Effects build slowly: they take three to four years to reach those magnitudes and reach +79 percent capital and -46 percent MRPK by ten years. The same pattern holds for labour, with high-MRPL firms raising wage bills 24 percent and cutting MRPL 28 percent, closing about a fifth of the MRPL gap. Effects are largest where the pre-reform state banking sector was least developed, which the paper reads as evidence that domestic banking inefficiency is part of the source. Product-level data show prices falling 17 percent on average and 21 percent for high-MRPK firms, with output up and product portfolios expanding for those firms. Aggregating with a first-order Solow-residual decomposition that avoids the usual lognormality and returns-to-scale assumptions, the treated industries’ Solow residual rises by at least 3.4 percent, 6.2 percent once the policy’s growing effects over five years are cumulated, and 16.3 percent under the conventional cross-sectional way of inferring baseline wedges – the range the paper reports as 3 to 16 percent, with the low end its deliberate lower bound.

The determinants of cross-border equity flows

Very little was established about what determines international trade in securities, partly for want of data. This paper assembles a panel of annual bilateral gross cross-border portfolio equity transactions – purchases plus sales – among 14 countries from 1989 to 1996, 1456 observations in all, whose distinguishing feature is that it records country pairs that exclude the United States, so the US’s special status as the largest economy, a leading financial centre and the issuer of the main international currency can be controlled for rather than assumed away. Deriving the estimating equation from a micro-founded model of asset trade with imperfectly substitutable assets, transaction and information costs, and endogenous asset supply, the authors regress log transactions on the two countries’ equity market capitalisations, an index of financial-market sophistication, and distance. The elasticities on market capitalisation are close to and never statistically distinguishable from the theoretical value of one; adding distance gives a coefficient of -0.881 with a standard error of 0.031 and raises the R-squared from 0.555 to 0.693, so that “with five independent variables, this straightforward, simple ‘gravity’ regression captures almost 70% of the variance,” and 84 percent in a between-estimator cross-section. That distance matters so much is the puzzle the paper is built around, since “unlike goods, assets are ‘weightless’, and distance cannot proxy transportation costs,” and a diversification motive would give distance a positive sign because business-cycle correlations fall with distance. The authors’ answer is that distance inversely proxies information, which they test with variables that represent information more directly: bilateral telephone call traffic (normalised by country size, and exogenous to financial activity by construction), the number of branches in the destination country of banks headquartered in the source country, trading-hours overlap, and a survey index of insider trading in the destination market. Telephone traffic and bank branches are consistently significant with the expected positive signs and reduce but do not eliminate the distance coefficient; insider trading is the least stable, insignificant in the full panel but correctly signed and significant (-0.398, standard error 0.117) within Europe, where perceived insider trading varies far more. Six explanatory variables capture 45 percent of the variance of bilateral flows and 65 percent of the cross-sectional variance. The results survive a long list of robustness checks – full source- and destination-country dummy sets, adjacency and common-language dummies, regional and currency-bloc dummies, financial-centre dummies, dropping the US and then the UK (distance elasticities of -0.721 and -0.856), restricting to intra-European flows (-0.727) or excluding them (-0.632), year-by-year and country-by-country estimation, instrumenting market capitalisation, and controlling for bilateral goods trade (distance falls to -0.529 but stays strongly significant). On diversification the paper is deliberately cautious: the return-covariance term enters positively (0.346, standard error 0.136) when the information variables are omitted, takes its theoretically predicted negative sign only once distance and the information variables are included, and the authors conclude there is “weak evidence for a diversification motive for asset trade in our annual data, but only when we control for the informational friction,” explicitly less robust than the information results. Two extensions widen the claim. Running the same information variables through a matched panel of manufactures trade cuts the goods-trade distance elasticity from -0.547 to -0.279, suggesting distance proxies information in the goods gravity equation too. And on a separate US-centred dataset built from the 1994 and 1997 Treasury benchmark surveys, the elasticity of US transactions with respect to US holdings is 1.05 (standard error 0.053, R-squared 0.87) and a holdings regression reproduces a distance elasticity of -0.71 – results the authors call “illustrative” given only 80 observations. The paper’s summary verdict is that “[i]nternational capital markets are not frictionless: they are segmented by informational asymmetries or familiarity effects,” a claim about segmentation rather than about the welfare cost of it.

The external wealth of nations: measures of foreign assets and liabilities for industrial and developing countries

Capital flows were tracked continuously, yet the stocks of foreign assets and liabilities those flows accumulate into were essentially unmeasured outside a small group of industrial countries – a gap the authors call “a severe empirical constraint,” because net foreign assets are a state variable in open-economy growth and business-cycle models, because the gains from financial integration attach to gross rather than net positions, and because the equity-versus-debt composition of a country’s balance sheet bears on its vulnerability to shocks and its degree of risk sharing. This paper builds such estimates for 67 industrial and developing countries over 1970-1998, disaggregated into direct investment, portfolio equity, debt and foreign exchange reserves. Its methodological contribution is an accounting framework showing exactly how balance-of-payments flows relate to the underlying stocks, and therefore where naive cumulation goes wrong: capital transfers (Canada received 58 billion dollars of them over 1988-97, close to 10 percent of 1997 GDP, against a cumulative current account deficit of 146 billion), debt reduction and forgiveness (Chile’s external debt fell by over 8 billion dollars, more than 25 percent of 1990 GDP, over 1987-90 while its cumulative current account deficit was only about 2 billion), exchange-rate revaluation of debt (the yen’s appreciation added 4.4 billion dollars to the dollar value of Indonesia’s external debt in 1994, against a current account deficit of 2.8 billion), and equity-market valuation (a 1996 UK portfolio equity inflow of about 9 billion dollars corresponds to an estimated 66 billion dollar rise in the stock of equity liabilities, close to the 59 billion officially reported). The authors construct three distinct measures – an adjusted cumulative current account available for all countries and all years, an adjusted cumulative-flows measure used for developing countries, and the officially reported International Investment Position, available for around 30 countries and typically only from 1980 – and use the overlap as a validation test rather than assuming their method works: the adjusted measures track both the levels and, in Table 2, the short-run year-to-year variability of the official positions more closely than the current account does, including for Australia, the Netherlands, Switzerland, the UK and the US, where the current account tracks the official position poorly or negatively. Where the measures diverge, the divergence is itself informative: the gap between the cumulated-current-account estimate and the official position correlates 0.75 with cumulative errors and omissions across industrial countries, consistent with the paper’s identifying assumption that errors and omissions represent unrecorded capital outflows. Two valuation choices are stated openly as compromises – FDI at book value rather than market value, because market-value data exist for almost no country, even though the US case shows a 1998 gap of 119 billion dollars at current cost against 356 billion at market value; and debt for industrial countries unadjusted for cross-currency fluctuations for want of comparable data. The stylized facts drawn from the resulting dataset are presented as a “first cut”: gross stocks of FDI and portfolio equity relative to GDP rose substantially from the mid-1980s in industrial countries and especially after 1990 in developing ones; among developing countries GDP per capita is positively correlated with the net external position, consistent with the “stages” hypothesis, though the weaker industrial-country relationship “suggests that the true relationship may be nonlinear”; country size raises net foreign assets across subsamples; and trade openness is strongly associated with a shift in the composition of developing countries’ external liabilities away from debt and towards equity. The authors close by listing the margins for error in their own estimates before claiming only that they are “constructed on a consistent basis across countries, they match existing stock data quite closely and they fill an important gap.”

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.”

Why Doesn't Capital Flow from Rich to Poor Countries?

The simplest neoclassical models of trade and growth make an egalitarian prediction that follows from assumptions about technology alone: if two countries produce the same good with the same constant-returns production function in capital and homogeneous labour, then differences in output per worker must come from differences in capital per worker, diminishing returns put the marginal product of capital higher in the poorer country, and free competitive trade in capital goods sends all new investment to the poorer economy until returns and wages equalise. Lucas puts numbers on it. Taking production per person in the United States as about fifteen times India’s (Summers and Heston, 1988) and a Cobb-Douglas capital share of 0.4 – an average of US and Indian capital shares – the marginal product of capital in India must be about 58 times that in the United States. The point of working the arithmetic is that “there is nothing at all delicate about this standard neoclassical prediction on capital flows”: the observed flows fall so far short that the assumptions must be “drastically wrong,” and the question is which. Four candidates follow. Correcting labour for quality using Anne Krueger’s (1968) estimates – which imply each American or Canadian worker is the productive equivalent of about five Indians or Ghanaians – cuts the US-India income ratio per effective worker from 15 to 3 and the predicted return ratio from 58 to about 5, “a substantial revision” that nonetheless “leaves the original paradox very much alive.” Adding external benefits of human capital, with the spillover exponent estimated at 0.36 from Denison’s US 1909-1959 data, brings the predicted India-US return ratio to 1.04 – eliminating the differential entirely, though Lucas flags as “important and troublesome” that this calculation assumes knowledge spillovers across national borders are exactly zero. The third candidate, political risk, faces a historical objection: contracts in colonial India were enforced as reliably as domestic ones, so why were returns not equalised in the two centuries before 1945? The fourth is a colonial monopoly model in which an imperial power with exclusive control of the colony’s trade and monopsony power over its wages finds it optimal to retard capital flows, implying a colonial return about 2.5 times the European one at a capital share of 0.4 – although Lucas’s own footnote reports contrary evidence from Davis and Huttenback (1989). The conclusion is where the stakes sit: under either human-capital hypothesis, or under the monopoly hypothesis, official capital transfers to poor countries are fully offset by reductions in private investment; only insofar as political risk binds can transfers speed the equalisation of factor prices.