Capital inflows and recipient economies
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
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.
Benigno, G, N Converse, and L Fornaro (2015), “Large capital inflows, sectoral allocation, and economic performance”, Journal of International Money and Finance. Volume 55, Pages 60–87
Benigno, G, and L Fornaro (2014), “The financial resource curse”, The Scandinavian Journal of Economics 116 (1), 58–86.
Caballero, J A (2014), “Do surges in international capital inflows influence the likelihood of banking crises?” The Economic Journal. Forthcoming.
Calvo, G and C Reinhart (2000), "When Capital Infows Come to a Sudden Stop: Consequences and Policy Options" in P Kenen and A Swoboda, Key Issues in Reform of the International Monetary and Financial System, (Washington DC: International Monetary Fund,), 175-201
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Duarte, M and D Restuccia (2010), “The role of the structural transformation in aggregate productivity”, The Quarterly Journal of Economics, 125(1), 129-173.
Gertler, M, S Gilchrist and F Massimo Natalucci (2007), “External Constraints on Monetary Policy and the Financial Accelerator”, Journal of Money Credit and Banking, Vol. 39, No. 2–3.
Ghosh, A R, M S Qureshi, J I Kim, and J Zalduendo (2014), “Surges”, Journal of International Economics 92 (2), 266 – 285.
Gopinath, G, S Kalemli-Ozcan, L Karabarbounis, and C Villegas-Sanchez (2015), “Capital Allocation and Productivity in South Europe”, NBER working paper 21453
Gourinchas, P-O, R Valdes, O Landerretche (2001), “Lending booms: Latin America and the world”, Economía 1 (2), 47-99.
Kalantzis, Y (2015), “Financial fragility in small open economies: firm balance sheets and the sectoral structure”, Review of Economic Studies 83(3): 1194-1222.
Mendoza, E G (2010), “Sudden stops, Fiancial crises, and leverage”, American Economic Review 100(5), 1941-66.
Mendoza, E G, M E Terrones (2008), “An Anatomy of Credit Booms: Evidence from Macro Aggregates and Micro Data”, NBER Working Paper 14049.
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Reinhart, C, and V Reinhart (2009), “Capital flow bonanzas: An encompassing view of the past and present” In: Frankel, J, C Pissarides, (Eds.), NBER International Seminar on Macroeconomics 2008. University of Chicago Press, pp. 9–62.
Reis, R (2013), “The Portuguese Slump and Crash and the Euro-crisis”, Brookings Papers on Economic Activity 46, 143-193.
Schmitt-Grohe, S and M Uribe (2015), “Downward Nominal Wage Rigidity, Currency Pegs, and Involuntary Unemployment”, Journal of Political Economy, Forthcoming.
Van der Ploeg, F (2011), “Natural Resources: Curse or Blessing?” Journal of Economic Literature 49, 366–420.
The IMF's inclusion of capital controls in its recommended policy toolbox epitomises the shift in thinking (Ostry2010, IMF World Economic Outlook 2011).
To see why capital inflows trigger a reallocation of production toward the non-tradable sectors, consider a standard small open economy model (as in Obstfeld and Rogoff 1996, chapter Chapter 2). Increased access to foreign capital, for instance, due to a fall in the interest rate on foreign borrowing, sparks a consumption boom. The increase in consumption of tradables is attained through a rise in imports, but greater consumption of non-tradables requires an increase in domestic production. As a result, the non-tradable sectors expand at the expense of sectors producing tradable goods. See Benigno and Fornaro (2014) for a detailed exposition of this argument.
For instance, De Gregorio et al. (1994) and Duarte and Restuccia (2010) use cross-countries analyses to show that productivity grows faster in tradable sectors than in non-tradable ones.
The low interest rates available to Spanish borrowers during these years were part of a more general convergence in interest rates across members of the European Monetary Union (EMU). Many authors have linked the convergence in interest rates with the process of financial integration and harmonisation of financial market rules within the EU, as well as with the elimination of exchange rate risk due to the creation of the single currency (see, for example, Blanchard 2002).
We also find that larger credit booms and larger inflows of foreign capital are associated with a deeper fall in GDP, consumption, investment, employment and TFP at the end of the episode, while a rise in foreign reserves during the inflows episode appears to dampen the severity of the post-inflows slump. This is consistent with research on lending booms by Gourinchas et al. (2001) and research on surges in capital inflows by Reinhart and Reinhart (2009) and Kalantzis (2014).
These estimates are calculated using the coefficients from regressions of macroeconomic performance in the three years after large capital inflows end on resource reallocation during the episode of large inflows (as well as a broad set of controls).
Our research is complementary to work by Reis (2013) and Gopinath et al. (2015), who explore how capital inflows affect the allocation of resources within the manufacturing sector in the Eurozone periphery.