VoxEU Column Global crisis International trade

Upstream sovereigns

With all the focus on Europe, it is easy to ignore the argument that global imbalances remain a drag on economic recovery. This column decomposes international capital flows into public and private components and claims that upstream flows from emerging to advanced economies and global imbalances in general are the result of the same underlying factor.

The key policy concern preceding the 2007–09 crisis was global imbalances. The extensive policy intervention in the aftermath of the crisis did not bring any resolution to the issue.

  • Capital seems to be flowing from fast-growing emerging markets to slow-growing countries.
  • These high-growth emerging markets also accumulate a vast amount of reserves.

"How long will the growing China finance the slumping US?" is the reoccurring question in headlines across the globe.

As Barry Eichengreen noted on this site earlier this year (Eichengreen 2011), global imbalances remain a key issue for world leaders since these imbalances continue to place the recovery and the stability of the global economy at risk.

Uphill capital flows: Evidence

A common explanation for ‘upstream’ capital flows from fast-growing developing nations to stagnant countries is the relatively higher saving rates in emerging markets. The recent theoretical literature is mainly concerned with why these savings are high and why they are being invested in low growth countries.1

It is not possible, however, to gauge the relative importance of different theoretical models in the absence of robust empirical evidence. From a policy perspective, it is essential to know the underlying causes of upstream flows and imbalances since the prescription will differ widely depending on the answer.

  • If imbalances are caused by domestic distortions, such as high private saving and low investment given lack of social insurance and financial markets, then exchange-rate policies might be justified.
  • If, on the other hand, export-led growth strategies and self-insurance motives are leading to excess reserve accumulation, then we should worry about systemic distortions.

The former requires strengthening social infrastructure and financial intermediation in emerging markets. The latter necessitates global-level intervention through international institutions.

At the February 2011 meeting of G20, although finance ministers agreed to assess the sustainability of national policies based on three types of indictors – public debts and deficits, private savings and debts, and current-account balances – it is still unknown which one of these aggregates are mainly responsible for upstream flows and global imbalances.

In recent work (Alfaro et al 2011), we decompose international capital flows into public and private components and show that upstream flows and global imbalances are manifestations of the same underlying phenomenon – the central role of official flows in determining the international allocation of capital.

International capital flows net of government debt and/or aid are positively correlated with growth. Government debt flows are negatively correlated with growth only if government debt is financed by another sovereign and not by private lenders. It is not trading in debt instruments per se that has shaped the puzzling patterns of international capital, but sovereign-to-sovereign transactions being in the form of debt, reserve accumulation, and aid (debt-concessional loans and grants). We complement this finding by showing that public savings are robustly positively correlated with growth as opposed to private savings. Our results hold not only for 1970–04 period but also during the 1990s and 2000s.

Official flows and distorted facts

Official flows can distort the stylised facts regarding capital flows for a small group of emerging countries when a few important big players, such as China, behave differently than the average emerging economy. On average, China had a CA surplus of 1.1% of GDP and hence a net lender vis-à-vis the rest of the world during 1980–2004. The size of the surplus grew to 1.9% of GDP over 1990-2004 period. During the same period China was simultaneously a net borrower in terms of FDI and equity flows (net flows of FDI and equity capital amounted to 2.5% of GDP). China, with its huge reserve accumulation, together with financial centres such as Singapore and Hong Kong, can easily shape the general picture for Asia when we focus on a small sample of developing countries in a relatively short time span. Figure 1 shows the strong positive correlation between net equity flows and reserve accumulation for such Asian countries but not for other emerging markets; the relationship between equity flows and reserve accumulation is negative for African countries, and there is no relation between these two variables for the rest of the developing countries. For many African countries, capital flows are mostly in the form of development aid. Given the fact that African countries constitute a big fraction of the developing country sample, once aid flows are subtracted from the total capital flows, the puzzling negative relationship between productivity growth and capital flows – upstream flows – turns out to be positive as expected from the theory, as shown in Figure 2. So it is really the ‘sovereign’ that is flowing upstream.

Figure 1. Equity flows and reserve accumulation in developing countries, 1980–2004

Notes: The flows are computed as the average over 1980–2004 of the annual flows in current US dollars, normalized by nominal GDP in US dollars. “Equity Net Flows" represents the annual net flows of foreign liabilities minus net flows of foreign assets. “Reserve Accumulation" is the changes in stock of foreign reserves (excluding gold) as a percentage of GDP

Figure 2. Net capital flows and growth in developing countries, 1980–2004

a) Dependent variable is Net capital flows (-CA/GDP)

b) Dependent variable is Aid-adjusted net capital flows ([-CA-Aid]/GDP)

Notes: The graphs represent cross-sectional partial regression plots for regressing net capital flows (current account with reverse sign) on real GDP per capita growth relative to the U.S. and controls for the period 1980–2004.

Several recent papers explore capital outflows from high productivity countries. While there is truth in many of the theoretical mechanisms that have been proposed to explain uphill capital flows and global imbalances, the most common theoretical references have been the models in which domestic financial frictions and/or precautionary motives lead to oversaving in emerging markets. In such papers, the private sector is behind the observed patterns of capital mobility reacting to various frictions in the economy (political and/or financial). However, as we document, there is much more nuance to the direction of capital flows than is commonly appreciated. We find that not only FDI and portfolio equity but also private debt flows to high-return countries, ie, all private capital flows downstream. High-growth emerging markets are net borrowers of private capital but net lenders overall through public debt and reserves. Complementing these findings, as Figure 3 shows, public savings are robustly positively correlated with growth as opposed to private savings; there is no correlation between private savings and growth once China is dropped from the sample as shown by red dashed line.

Figure 3. Public and private saving and growth in developing countries: 1990–2004

a) Public Saving and Growth

b) Private Saving and Growth

An alternative set of explanations focusing on governments' ‘neo-mercantilist’ policies to increase net exports and enhance growth via reserve accumulation seem to better fit the pattern of capital mobility displayed by China and a handful of countries.2 Figure 4 shows the relationship between reserve accumulation and real exchange rate. There is a negative relation between the two for the countries in Asia and in particular for China. As Calvo and Reinhart (2002) have noted, there seems to be an epidemic case of ‘fear of floating’ despite the emergence of a system of floating regimes in the 1970s.

Figure 4. Real exchange rate and reserves in developing countries




Notes: The graphs represent cross-sectional averages of annual Real Effective Exchange Rate Index versus Foreign Exchange reserves, excluding gold, by geographical regions. China is reported separately from the rest of Asia.


Our findings emphasise that the failure to consider official flows as the main driver of uphill flows and global imbalances is an important shortcoming of the recent literature. Sovereigns and official donors invest in low-return countries for other considerations. Not taking this behaviour into account can easily lead to misleading conclusions about the general facts regarding capital flows and misguided policy implications. Sovereign-to-sovereign transactions can fully account for upstream capital flows and global imbalances.

Our results have strong policy implications pointing to the importance of public savings and governments' behaviour as opposed to private saving as key underlying factors of upstream flows and global imbalances. These results imply that systemic distortions that require international cooperation are more important than the domestic distortions in fast-growing emerging markets.


Aguiar, M and M Amador (2011), "Growth in the Shadow of Expropriation", Quarterly Journal of Economics,126:651-697.

Aizenman, J and J Lee (2006), "Financial Versus Monetary Mercantilism: Long-Run View of the Large International Reserves Hoarding", IMF Working Paper 06/280, International Monetary Fund.

Alfaro, L, S Kalemli-Ozcan, and V Volosovych (2011), "Sovereigns, Upstream Capital Flows and Global Imbalances", NBER Working Paper No. 17396.

Caballero, RJ, E Farhi, and PO Gourinchas (2008), "An Equilibrium Model of `Global Imbalances' and Low Interest Rates", American Economic Review,98:358-393.

Calvo, G, and C Reinhart (2002), "Fear of Floating", Quarterly Journal of Economics,107:379-408.

Carroll, CD, and O Jeanne (2009), "A Tractable Model of Precautionary Reserves, Net Foreign Assets, or Sovereign Wealth Funds", NBER Working Paper 15228, National Bureau of Economic Research, Inc.

Dooley, M, D Folkerts-Landau, and P Garber (2003), "An Essay on the Revived Bretton Woods System", NBER Working Paper 9971, National Bureau of Economic Research, Inc.

Eichengreen, B (2011), "The G20 and global imbalances”, VoxEU.org, 26 June.

Gourinchas, P and O Jeanne (2009), "Capital Flows to Developing Countries: The Allocation Puzzle", NBER Working Paper 13602.

Ju, J and SJ Wei (2010), "Domestic Institutions and the Bypass Effect of Financial Globalisation", American Economic Journal: Economic Policy, 2:173-204.

Song, Z, K Storesletten and F Zilibotti (2011), "Growing Like China", American Economic Review, 101:196-233.


1 See Caballero et al. (2008), Gourinchas and Jeanne (2009), Carroll and Jeanne (2009), Song et al (2011) among others.

2 Only five countries were net lenders during 1980–2004 and seven during 1990–2004, all of which are in Asia. Models that describe the behaviour of such few countries based on official outflows are advanced by Dooley et al. (2003), Aizenman and Lee (2006), Ju and Wei (2010), and Aguiar and Amador (2011).

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