RDP 2002-03: International Financial Liberalisation and Economic Growth 3. How Does Financial Liberalisation Affect Economic Growth? A Review of the Theoretical Literature

Theory suggests different channels through which increased capital mobility can enhance economic growth. Capital flows can enhance economic growth by augmenting the domestic investment rate. In open-economy versions of neoclassical growth models, capital flows from capital-rich to capital-poor countries where the marginal product of capital is higher. This results in an increase in the rate of capital accumulation and growth in the latter. This channel emphasises the role of net capital flows. In these models, for capital flows to have a positive influence on growth, they must augment domestically financed investment, rather than crowd it out.

Barro, Mankiw and Sala-i-Martin (1995) present an open-economy version of a simple neoclassical growth model. In this model domestic residents own the physical capital stock but may obtain part or all of the financing for this stock by issuing bonds to foreigners. By relaxing the constraint that domestic savings finance domestic investment, the availability of foreign savings increases the rate of physical capital accumulation. This in turn increases the country's speed of convergence to its steady state level of output.^[5]

Gains from capital account liberalisation could also come from better utilisation of available domestic savings rather than from net inflows of foreign savings. This channel highlights the role of gross capital flows. These benefits are typically associated with foreign direct investment, but could also arise with other types of capital flows. For example, foreign investment could increase competition in the host economy, thereby making domestic firms more efficient. It could also lead to transfers of technology and/or skills. Wang (1990) develops a model in which technology is assumed to be transferred via international capital movements from the developed North to the developing South. The rate of technological change is an increasing function of the amount of foreign capital operating in the South and of the extent to which technology in the advanced country exceeds that in the less developed country. It is shown that when the South shifts from autarky to free capital mobility, its steady state growth rate of per capita income also increases.^[6]

Another channel through which financial liberalisation could positively influence economic growth is through the benefits of portfolio diversification. Increased opportunity to diversify risk can enhance growth by inducing a shift toward investment in projects with higher expected returns. In turn, higher rates of return can deliver faster economic growth by encouraging higher savings and investment. Obstfeld (1994) presents a simple model of global portfolio diversification that links growth and financial openness. The set up is a stylised rendition of the idea, developed by Romer (1990) and by Grossman and Helpman (1991), that ongoing growth depends on investments that supply specialised and hence inherently risky production inputs. Because risky technologies in the model have higher expected returns than safe ones, international asset trade, which allows each country to hold a globally diversified portfolio of risky investments, encourages all countries to shift from low-return safe investments toward high-return risky investments. Provided risky returns are imperfectly correlated across countries, and provided some risk-free assets are initially held, a small rise in diversification opportunities always raises expected growth as well as national welfare. The key here is that financial liberalisation can enhance growth even in the absence of net capital inflow.

The theoretical case for free capital mobility is based on the assumption that capital markets are efficient, and does not take into consideration the presence of distortions such as information asymmetry, moral hazard and herding on the part of foreign investors. Experience of both developed and developing countries suggests that when these distortions are present, capital flows can be destabilising. Indeed, a number of studies have identified these distortions as the key factor behind the boom and bust cycles of capital flows in emerging markets. Guttentag and Herring (1985), for example, argue that international commercial banks lent to Latin America in the late 1970s and early 1980s with insufficient attention to borrower credibility due to incomplete information and official support in the event of adverse outcomes. Likewise, Dooley (1994) claims that the resurgence of capital flows to emerging markets in the early 1990s did not necessarily reflect renewed confidence in the investment climates in these countries, but rather, were motivated by moral hazard associated with fixed exchange rate regimes and lender of last resort facilities.

The destabilising effect of capital flows in the presence of these distortions has been further highlighted by the Asian crisis. This has motivated a growing body of work that highlights the role of moral hazard and explicit or implicit government guarantees in increasing countries' vulnerability to financial crises.^[7] In a typical framework, firms borrow from non-residents in foreign currency and lend domestically in local currency. Their investment decisions incorporate the expectation that relatively stable exchange rates will be maintained and, as governments are unable to credibly commit not to do so, that the government will bail them out in the event of a run. As lenders share this expectation, they have little incentive to monitor the quality of bank lending. This results in a level of investment that is higher than the optimal level obtained in the absence of credible implicit or explicit guarantees. However, foreign creditors stop lending when the government's contingent liabilities exceed foreign reserves. The resulting devaluation in turn causes widespread bankruptcies of institutions with unhedged foreign currency exposures. Capital flows in this framework would not enhance growth, and can in fact impede growth by making countries more vulnerable to financial crises.

In this section we examined the different channels through which capital flows can promote economic growth. We also discussed some of the risks associated with financial openness. Whether the growth-enhancing attributes of capital flows outweigh the potential risks is an empirical question, which we address in the next section.

Footnotes

The results would be the same if foreigners were allowed to own part of the physical capital through foreign direct investment or equity investment rather than bonds. [5]

For a more recent contribution see Borensztein, De Gregorio and Lee (1998). [6]

See for example, McKinnon and Pill (1998). [7]