Foreign Capital Flows and Growth: Is Europe Different? -- A Commentary by Ashoka Mody
June 19, 2008
Published in Expansión (Spain)
June 10, 2008
Capital, in the last decade, has tended to flow "uphill" from relatively poor, mainly Asian, countries to the United States. The most vivid example is the flow of Chinese savings to finance the U.S. current account deficit. For some, the apparent incongruity of poorer world citizens financing profligate American consumers has ceased to be an anomaly. Indeed, they have come to view this as the norm. The reasoning is that the poorer nations transferring their capital benefit because by doing so they weaken their exchange rates, which, in turn, spurs the development of their exports. The bargain is that lower consumption today will pay back in future riches. A grander purpose served is the stabilization of the international financial system by containing either a free fall of the dollar or the risk of a U.S. and, hence, world recession.
Within Europe, however, the behavior of capital flows is strikingly different. There the flow of capital is "downhill" from rich to poor countries, allowing for the possibility that the emerging nations of Europe can simultaneously increase their consumption and investment. The tighter financial integration within Europe—reflected in more intense cross-border flows within Europe than in any other region of the world—apparently allows for greater diversification of financial risks. Hence, investors and lenders are much more willing to move capital to productive, but possibly more risky opportunities, into the countries of emerging Europe.
As financial integration has increased, the richer nations have tended to run larger current account surpluses (transferring capital) while the poorer countries have run larger deficits (receiving capital). In other words, financial integration leads countries to borrow more from abroad if they are poorer, and rich countries to lend more abroad if they are richer. This process is still ongoing. To take an example, my estimates suggest that, all else equal, an increase in financial integration by 100 percent of GDP would increase Lithuania's current account deficit by 3.5 percent of GDP, and would raise the Netherlands's surplus by 2.1 percent of GDP.
These capital flows have helped growth in the emerging nations of Europe—the poorer the country, the greater the contribution of capital inflows to growth. But as countries become richer, current account deficits (capital inflows) decline (for given levels of international financial integration) as does the growth dividend from foreign capital flows. External finance, therefore, has a self-limiting and transitory influence, though the transition can be drawn out.
This benign process carries at least two risks. First, the "downhill" flow of capital brings risks that are all too familiar from the emerging market crises of the 1990s. Capital flows can be fickle and may reverse at inopportune moments, with costly consequences. Deeper financial integration may imply that investors are better diversified and hence willing to take a longer view, reducing the risk of a "sudden stop" in capital flows. Nevertheless, these risks must be monitored and managed. Second, the gush of capital inflows can hurt if it leads to overvaluation of the exchange rate and a loss of international competitiveness. This possibility depends on whether the inflows are channeled to raising productivity. The evidence so far is that gains in productivity have accompanied in particular foreign direct investment. Other evidence shows that the new member states of the European Union, as substantial recipients of international capital, have also achieved significant transformation of their production structures, raising the technology content and quality of their products. Again, such a favorable outcome is not a given and the risks of exchange rate overvaluation cannot be ruled out.
Does the European experience hold relevance for other regions? Europe's experience may reflect historical and geographical linkages that have facilitated both financial integration and income convergence. Thus it may be that European-style financial integration and its implications apply only for middle-income and advanced economies, with no bearing for a wide range of poorer countries.
There is, however, a more intriguing possibility. The Asian-U.S. pattern of capital flows may reflect a unique response to the crises of the late 1990s. In protecting themselves against a repeat of financial crises, Asian governments have sought to raise their international reserves to unprecedented level, pushing capital "uphill." In a more financially-integrated world, such high levels of protection may not be needed. If so, the patterns we see in a tightly-integrated Europe may well be the leading edge, the bellwether. As global financial integration proceeds apace, it may draw a wider circle of countries within its fold, changing the direction and effects of international capital flows.
Ashoka Mody is an Assistant Director in the European Department of the International Monetary Fund
1 Ashoka Mody is an Assistant Director in the European Department of the International Monetary Fund. This op-ed draws on "International Finance and Income Convergence: Europe is Different," IMF Working Paper No.WP/07/64 by Abdul Abiad, Daniel Leigh, and Ashoka Mody.