FRBSF Economic Letter
2000-18; June 2, 2000
 Economic
Letter Index
The Composition of International Capital Flows
Although currency crises may not be predictable, what is predictable
is that after each one there will be calls to reform the "international
financial architecture." One proposal currently making the rounds is to
stabilize capital flows with policies that either encourage "long-term"
capital flows or discourage "short-term" capital flows. Examples might
be tax or regulatory policies that provide incentives to issue equity
rather than debt or, if debt is issued, policies that encourage long maturities
or the rolling over of short maturities. Before the costs and benefits
of these policies can be assessed, we need to have a theoretical benchmark
that allows us to judge whether in fact this goal is desirable and, if
so, whether a given policy is likely to be effective in meeting it. This
Economic Letter addresses these questions. It starts by reviewing
a few basic facts about recent international capital flows. It then discusses
theories that attempt to account for these facts.
Some facts
Figures 1 and 2 display data on net capital flows to a group of 138 developing
countries for the years 1980 and 1991 through 1998 (the data for 1998
are preliminary). These countries essentially make up the entire world
economy exclusive of the original 23 rich OECD economies. Although for
some issues, like risk-pooling and diversification, it is important to
consider gross (two-way) flows, net flows measure the overall resources
that are being transferred from rich to poor countries in support of their
development. Hence, these data capture a crucial aspect of the functioning
of international capital markets.
Three major changes are apparent in these figures. First, capital flows
have grown dramatically since 1980, with most of the growth taking place
during the 1990s. Total net flows (i.e., equity as well as short- and
long-term debt) more than doubled between 1991 and 1998, even accounting
for a slowdown after the 1997 Asian financial crises. Second, Figure
1 shows that there has been a significant increase in the share of
private flows, which has come at the expense of official and government
lending. Net private capital flows were about 50% of total net flows at
the beginning of the 1990s. By the end of the decade they were about 85%
of the total. Third, as seen in Figure
2, there has been a major shift toward equity financing, in the form
of either Foreign Direct Investment (FDI) or portfolio (i.e., non-controlling)
investment. For example, in 1980 equity accounted for only 3.5% of total
net flows. By 1991 its share had risen to 29%. By 1998, equity accounted
for about 60% of total net capital flows.
Of course, what people are concerned about is not the growth in capital
flows per se, but the volatility of these flows. Wide swings in capital
flows can wreak havoc in small open economies. Accordingly, recent research
has focused on whether some types of capital flows are inherently more
stable than others. If so, then policies that alter their composition
could perhaps stabilize them without adversely affecting their overall
level.
The presumption has always been that FDI is the most stable type of capital,
since it is related to specific investment projects that to a degree are
irreversible. Next in line is supposedly long-term debt, followed by short-term
debt and portfolio investment. (This ranking is not as obvious as it seems,
since short-term debts can always be rolled over.)
Perhaps surprisingly, it is not clear from the data that this presumed
volatility ordering exists. For one thing, capital flows were relatively
volatile during the 1990s, while the share of FDI was increasing. In addition,
simple statistical measures of volatility, like coefficients of variation
and autocorrelation, do not reliably indicate that FDI is more stable
than long-term debt, or that long-term debt is more stable than short-term
debt and portfolio investment. For example, Claessens, Dooley, and Warner
(1995) computed statistical measures of volatility for a group of five
developed economies (France, Germany, Japan, Great Britain, and the United
States) and five developing economies (Argentina, Brazil, Indonesia, Korea,
and Mexico). They did not find any systematic pattern or ranking in the
volatilities of the various types of capital flows.
Although simple measures of volatility do not confirm the conventional
wisdom, a more refined analysis reveals a sense in which it might be true.
Specifically, Chuhan, Perez-Quiros, and Popper (1997) point out that it
could be misleading to look at capital flows individually. This is because
there could be causal or feedback relations among them. In addition, there
could be spillovers across countries. Hence, they conduct a multivariate
cross-sectional analysis and discover two ways in which the conventional
wisdom is true. First, they find that shocks to short-term capital flows
are transmitted between countries far more readily than shocks to FDI
or long-term debt. Second, they find that short-term capital flows respond
strongly to other capital flows, while FDI does not.
Overall, the evidence suggests there might be some differences in the
statistical properties of different kinds of capital flows. Unfortunately,
it is not at all clear what this means. Deciding whether this evidence
provides the basis for policy requires a theoretical understanding of
the underlying determinants of capital flows. Otherwise, we might end
up treating symptoms rather than causes.
Some theory
From a theoretical standpoint, it is important to keep in mind that all
these various capital flows are just alternative ways of financing the
same underlying economic activities. A basic result in economics says
that with perfect capital markets, where there are no taxes or other frictions,
the way projects are financed is irrelevant. This is the famous Modigliani-Miller
Theorem. It says that what matters to the value of a firm (or, in this
case, a country) is the size of its pie (i.e., its cash flows), not how
the pie is sliced up. In addition to this, it is also important to keep
in mind that capital flows must satisfy certain accounting, or adding-up,
restrictions. For a given total flow, the only way equity can rise is
if debt falls. All else equal then, there should be a tendency for broad
categories of capital flows to be negatively correlated. Of course, all
else might not be equal, and advocates of policies to alter the composition
of international capital flows presumably believe that changing the composition
will change (i.e., stabilize) the level.
Although international capital markets are much improved, they are not
perfect. So while the Modigliani-Miller Theorem provides a useful benchmark,
there is little reason to believe that financing is irrelevant. Perhaps
the most important friction in real world capital markets arises from
asymmetric information. Firms often know more about their projects than
investors, and investors know this. Researchers who have studied the effects
of asymmetric information on capital structure generally conclude that
it gives rise to a "pecking order." All else equal, firms would like to
finance their activities using internally generated funds (i.e., retained
earnings). If these are insufficient, then "safe" securities, like debt,
are issued next. Only as a last resort, when not enough safe debt can
be issued, do firms use equity to finance their investments.
Since the pecking order hypothesis is based on asymmetric information,
it would seem to be especially relevant to international capital flows.
In a recent paper, Razin, Sadka, and Yuen (1998) extend the pecking order
theory to an international context. They point out that FDI is like retained
earnings. Since funds are being transferred internally within an organization,
problems of asymmetric information should be less severe for FDI. Hence,
we should observe a predominance of FDI flows, followed by debt, and then
portfolio investment.
Although this theory is consistent with the growing share of FDI, it
has a couple of drawbacks. First, it is based on an inherently unobservable
variable, viz., the degree of asymmetric information. This makes it difficult
to explain, in a noncircular way at least, why capital structures differ
across countries, and why they change over time. Second, the explosive
growth in portfolio equity flows seems inconsistent with the pecking order
hypothesis, which ranks this financing method last. These drawbacks call
for alternative theories of international capital flows.
In some preliminary work, Glick and Kasa (1997) develop and test a theory
that links the composition of international capital flows to the properties
of national output shocks. We abstract from problems of asymmetric information
and assume that risks are efficiently pooled across countries. We then
work backwards to construct portfolios that deliver this efficient risk-sharing
arrangement. The crucial idea is that while transitory idiosyncratic shocks
can be effectively diversified by bonds, permanent shocks must be diversified
via equity trade. Unlike equity, bonds must be paid back or rolled over,
so permanent reductions in a country's income cannot be offset by borrowing.
However, to the extent that a permanent shock is specific to a given country,
its adverse consequences can be mitigated by exchanging equity shares.
Consequently, if there are any cost advantages to issuing debt rather
than equity, this approach suggests that national debt/equity ratios should
be positively related to the relative importance of transitory output
shocks.
In contrast to the pecking order hypothesis, a risk-sharing approach
is in principle easily tested, since it is based on observable data. The
problem is getting data on the stocks of each country's (gross) equity
holdings and (net) debt. So far, we have obtained these data for seven
wealthy OECD countries. Our preliminary results indicate that there is
indeed a positive relationship between the relative importance of transitory
output shocks and national debt/equity ratios. This suggests that risk-sharing
plays a role in determining the composition of international capital flows.
Conclusion
Do these theories provide enough understanding to predict confidently
the costs and benefits of recent policy proposals? Despite being a co-author
of one of the studies, I would say the answer is a resounding no. Current
pecking order theories are static and untested. A risk-sharing approach
is more easily tested, but suffers the drawback of assuming from the outset
that capital markets are efficient. This makes it unsuitable to address
policies that are designed to improve the functioning of capital
markets. Hence, besides the proverbial call for more research, this Letter
suggests a note of caution concerning recent proposals to change the composition
of international capital flows.
Kenneth Kasa
Senior Economist
References
Chuhan, Punham, Gabriel Perez-Quiros, and Helen Popper. 1997. "The Capital
Flow Mix: Foreign Direct Investment, Short-term Investment, and Other
Ingredients." Mimeo. Santa Clara University.
Claessens, Stijn, Michael P. Dooley, and Andrew Warner. 1995. "Portfolio
Capital Flows: Hot or Cold?" World Bank Economic Review 9, pp.
153-174.
Glick, Reuven, and Kenneth Kasa. 1997. "The Composition of International
Capital Flows: Theory and Evidence." Mimeo. Federal Reserve Bank of San
Francisco.
Razin, Assaf, Efraim Sadka, and Chi-Wa Yuen. 1998. "A Pecking Order of
Capital Inflows and International Tax Principles." Journal of International
Economics 44, pp. 45-68.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
