The mixed effects of foreign capital

The Economist piece poses the question, Is foreign capital a luxury that developing countries can live without? Have a read if you care to:

WHEN Hank Paulson, America's treasury secretary, urged China to liberalise its capital markets earlier this month, he sensed a hardened reluctance in his hosts. “There's no doubt that what is happening in the US markets is clearly giving the Chinese pause,” he said. America's subprime meltdown is not, it seems, the best advertisement for unfettered finance elsewhere.

Against this backdrop, Dani Rodrik of Harvard University and Arvind Subramanian of the Peterson Institute, in Washington, have published a timely reappraisal of financial globalisation. They conclude that it is far from obvious that developing countries benefit much from opening up to global capital. In principle, the free flow of capital across borders makes funds available more cheaply to poor countries and, by lifting investment, boosts and raises living standards. The trouble is, economists have struggled to establish a strong link between freer capital flows and speedier economic development.

That has not stopped researchers from looking, and many believe a tangible connection will soon be found. Perhaps the effect is not picked up in studies because capital flows are hard to measure accurately, argue the optimists. Messrs Rodrik and Subramanian are not convinced: measurement error bedevils many studies, but that has not barred researchers from establishing that policies to improve education or trade are good for growth.

Perhaps foreign capital helps indirectly—by disciplining policymakers or by promoting reforms that improve the financial system. The authors say it is possible to make the opposite argument and find indirect costs. Plausibly, lifting restrictions on capital flows could undermine the domestic financial system because spendthrift governments can tap a larger pool of funds abroad. Also, the well-off have less incentive to lobby for reforms at home if they are free to store their wealth overseas.

Perhaps, then, the gains from globalised finance are latent and will be unleashed once catalysing reforms are in place? Maybe they will. But the wish list of complementary measures is difficult to tick off. Economies might reap the benefits of foreign capital more fully if property rights were stronger, contracts were more enforceable, and if there were less corruption and financial cronyism. But the authors point out that if poor countries could carry out such ambitious reforms “they would no longer be poor” and financial globalisation would be “a clearly dispensable sideshow”. With so much else to do first, liberalising capital flows would not be an obvious policy priority.

Foreign capital ought to be good for countries that have profitable ventures that lack funding because of low savings at home. But Messrs Rodrik and Subramanian argue that for many countries, it is not low savings but a shortage of good investments that is the binding constraint. Weak property rights, poorly enforced contracts and the fear that profits will be siphoned away make it hard to conceive of ventures that might generate a reliable return. When investment opportunities are scarce, capital inflows simply displace domestic savings and encourage consumption.

Read more here.