Föhrenbergkreis Finanzwirtschaft

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International capital flows, sectoral resource allocation, and the financial resource curse

Posted by hkarner - 12. Oktober 2015

Gianluca Benigno, Nathan Converse, Luca Fornaro 11 October 2015, voxeu

The last 30 years have seen a sustained process of financial globalisation, with countries around the world opening their capital accounts and joining international financial markets. At the same time, both in academic and policy circles an initially benign view toward openness to international capital flows has given way to a more sceptical approach.1 Indeed, in response to the wave of capital flowing toward emerging economies in the aftermath of the 2008 Crisis, governments in countries ranging from Brazil to South Korea adopted policies to limit or manage capital inflows. More recently, attention has shifted to the risk that policy tightening by the US Federal Reserve might provoke a halt to or even a reversal of capital flows to emerging economies. Now more than ever these concerns highlight the need for a clear understanding of the effects of capital inflows on recipient economies.

The academic literature has analysed several key aspects of international capital flows. Most of the existing research focuses on the economic dislocation that occurs once the capital inflows subside. Numerous empirical studies have shown that episodes of large capital inflows tend to be followed by sharp reversals of capital flows, known as sudden stops, associated with deep recessions (Calvo and Reinhart 2000, Mendoza and Terrones 2008, Caballero 2014). Others have used theory to understand the channels through which a sudden stop can hurt the real economy, for instance, by disrupting firms’ access to credit (Gertler et al. 2007, Mendoza 2010).

The financial resource curse: New evidence

In recent research (Benigno and Fornaro 2014, Benigno et al. 2015), we explore the notion of financial resource curse, another channel through which a surge in capital inflows can have a negative impact on economic performance. Our idea is that sustained current-account deficits driven by cheap access to foreign capital can produce a shift of productive resources toward non-tradable sectors such as construction.2 The resulting allocation of resources can hinder the development of a dynamic export sector and dampen long-run competitiveness, since the scope for productivity gains in the non-tradable sectors is relatively limited.3 Inspired by the literature on the natural resource curse (e.g. Van der Ploeg 2011), we refer to the link between cheap access to abundant foreign capital and weak productivity growth as the financial resource curse.

We view Spain as a case of the financial resource curse. From Spain’s adoption of the euro in 1999 until 2007, the country financed its large external imbalances by borrowing abroad at low interest rates. As Figure 1 shows, Spain went from an almost balanced current-account position at the inception of the euro to a deficit close to 10% of GDP in 2007.4 These capital inflows helped to finance a housing boom, resulting in a steady rise of employment in the construction sector, from 9% of total employment in 1995 to almost 13% in 2007. Interestingly, although Spain enjoyed a spectacular economic boom during this period, productivity growth was stagnant (Figure 2).

Figure 1. Current account balance, Spain

Figure 2. Total factor productivity, Spain

Is this pattern specific to Spain? Or does it characterise periods of large capital inflows more generally? To answer this question, we examine 155 episodes of large capital inflows occurring in a sample of 70 countries over the last 35 years (Benigno et al. 2015). Figure 3 makes clear that episodes of large capital inflows have been a regular feature of the post-Bretton Woods era, affecting advanced, emerging, and developing countries. On average, private capital inflows peak at around eight percent of GDP during these episodes, and episodes typically last three and a half years (see Figure 4).

Figure 3. Episodes of large capital inflows

Figure 4. Average private capital inflows during episodes of large inflows

In line with previous studies (Reinhart and Reinhart 2009, Ghosh et al. 2014), as well as with the Spanish experience, we find that these episodes coincide with an economic boom in which output, consumption, investment, employment, and domestic credit rise. However, as Figure 5 illustrates, once capital inflows subside and credit contracts, the boom gives way to a recession. We also find that the boom is concentrated in sectors producing non-tradable goods, such as services and construction, at the expense of the sectors producing tradable goods, including agricultural products and manufactured goods.

Figure 5. Average GDP during episodes of large inflows

Studying the manufacturing sector in detail, we find that the share of both employment and investment allocated to manufacturing drops during episodes of large capital inflows (Figure 6). However, while the reallocation of investment is a general phenomenon in our sample, we find that the reallocation of labour occurs specifically during episodes that begin when international liquidity is abundant. This is illustrated in Figure 7, with manufacturing employment dropping only during those episodes that began when US interest rates were low. In this sense, Spain in the 2000s represents a typical case of an economy receiving large capital inflows— – a drop in the interest rates at which Spanish banks, firms, and government could borrow from abroad was followed by large capital inflows and a shift of resources out of manufacturing.

Figure 6. Reallocation during episodes of large inflows

Figure 7. Reallocation and international interest rates

We also explore whether the sectoral allocation of factors of production help to predict the severity of the post-boom slump that occurs once capital inflows abate. We find that the reallocation of labour out of manufacturing is robustly and significantly related to economic performance after large capital inflows come to an end, with a stronger shift of labour out of manufacturing during the inflows episode associated with a sharper contraction in the aftermath of the episode.5

  • Our findings suggest that, ceteris paribus, the reallocation of labour out of manufacturing in the Eurozone periphery during the 2000s may account for a reduction in growth of around 0.3 percentage points per year between 2009 and 2011, and of investment by 1.1 percentage points per year.6

Policy implications

We conclude by discussing briefly the policy implications of our findings. In just over half of the episodes we study, policymakers responded to large inflows by accumulating foreign exchange reserves. We find that offsetting the capital inflows through substantial purchases of foreign assets by the government appears to limit the fall in productive resources allocated to manufacturing. In this sense, foreign reserve intervention can be used successfully to prevent an excessive shrinkage of the export sector (Benigno and Fornaro 2012). More broadly, our research points toward the importance of monitoring not only the size of capital inflows, but also their allocation across different sectors of the economy.7 It would then be interesting to consider policy interventions that aim at affecting the flow of resources across sectors, a task that we leave for future research.

Disclaimer: The views expressed here are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System.

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