Financial capital is like a lifeline to an economy; driving an economy by higher growth rates becomes possible only when a country has adequate capital invested at the right time and place. It is very much similar to water in its use and nature. Water is the elixir of life while financial capital is the panacea for under developed and developing countries. Just like water flows from high areas to low areas, similarly capital also moves from rich countries to poor countries (after all, well, they are rich! They sure must have some bucks to spare)
But who said that life is fair? The actual scenario turns out to be quite the contrary; the capital tends to flow up hill, i.e. it flows from poor nations to rich nations. This makes the poor nations exporters of capital and rich nations, the importers of capital. This is precisely the question raised by the famed economist Robert E. Lucas, Jr. (“Why doesn’t capital flow from rich to poor countries?”)
Theoretically speaking, the capital ought to move downhill –from capital rich countries to capital deficit countries. In this case the capital exported to poor nations would be more productive because these countries have large amounts of labour relative to the capital available at home country. Therefore when adequate capital is available per unit of labour, the productivity is high and consequently the returns on investments are high. This would also increase the demand for labour at home country so the employment would also increase which further pushes the economic growth of that country. As a result of this, the parties would be left better off. It is not some hypothetical situation but in fact had been witnessed in 1990s when rich countries invested in poor nations with hopes of higher returns to their investments. This increased the financial flows to many developing countries of Asia and Latin America, mostly in the form debts (foreign purchase of government and corporate issued bonds and debts extended by foreign banks). Unfortunately, these countries went overboard with their consumption expenditure and spent very little on improving their productive capacities. Further, weak financial systems and corruption prevented the capital from being put to optimal use. This made the foreign investors skeptical about the returns on their investment and started pulling out.
It could be said that since then, the roles have been reversed, i.e. the poor countries are capital exporters while the rich nations are capital importers. A country is said to be a capital exporter if the investments made abroad exceed the flows coming in the country. A country becomes a capital importer when the incoming flows exceeds its foreign investments. To be able to invest more, availability of funds is a must. This implies that a capital exporter should have large savings to finance its investments (in other words, it should produce more than it consumes) Poor/developing economies generally have higher saving rates and as result are able to generate funds for investments.
China and US are the classic example of this reversed direction of flows. US is the biggest economy in the world yet it has been running current account deficit for many years (consumption> production). One of the main reason for this deficit is that overall savings in the US is very small; both the government and citizens save very little. Hence to finance its excess consumption, it is forced to borrow from other countries having surplus. On the other hand China, a (rapidly) developing economy, has been witnessing a current account surplus since 2000 (production > consumption). Since people, corporations and government all save a lot, their national savings are very high; more than enough to finance all its consumption requirements and to plough back a lot of it in home industries as well as in foreign countries.
So why does capital move uphill?
To put it simply, it is for safer investments. As seen above, most developing countries have the required funds for investment due to their tendency to save more. However, they have a difficulty in channelizing those funds in productive investment projects. This is mainly due to inefficient financial market and corruption. This holds true even for China, in spite of its high investment rate. Its inefficient banking sector may have unable to allocate all the funds in productive investments. With other developing countries, the problem remains the same. As a result, they may export capital to rich countries like US to compensate for their incompetent financial market in hopes that those funds are invested back in the country in good projects. U.S, in spite, of running a current account deficit for many years, continues to attract foreign investment because of its robust financial and public institutions. Investors have faith that they will be fairly treated on investing in the country and that their investment would be safe because of the transparency in procedures and strict rules of law. So even if, the investors are not receiving very high returns than they would have obtained otherwise, they prefer the safety of their investment which advanced economies can offer (Another instance of loss aversion in action!)
By Arushi Sharma
Image source: National center for the middle market