TWN Info Service on Finance and Development (Sep08/05)
10 September 2008
Third World Network


The capital-poor developing world is lately exporting more capital to developed countries than it receives, a “puzzle” that  approach for financing development, the UN  Conference on Trade and Development (UNCTAD) has found.

In its Trade and Development Report 2008, UNCTAD said that the puzzle is all the more intriguing because many of these capital-exporting countries have been achieving higher rates of investment and growth than those that rely on the standard economic model of net capital imports.

The report questioned the traditional theoretical framework and suggested a new

approach to the financing of development, focussing less on capital imports and on increasing household savings, and more on the financing of investment from enterprise profits and from domestic bank credit.

Below is a summary of UNCTAD’s findings. It was published in SUNS #6544, Monday, 8 September 2008.

This article is reproduced here with the permission of the SUNS.  Reproduction or recirculation requires permission of SUNS (

With best wishes
Martin Khor

The Paradox of Capital Flows from South to North
By Kanaga Raja, Geneva, 5 September 2008*

The capital-poor developing world is lately exporting more capital to developed countries than it receives, a “puzzle” that  approach for financing development, the UN  Conference on Trade and Development (UNCTAD) has found.

In its Trade and Development Report 2008, UNCTAD said that the puzzle is all the more intriguing because many of these capital-exporting countries have been achieving higher rates of investment and growth than those that rely on the standard economic model of net capital imports.

The report questioned the traditional theoretical framework and suggested a new

approach to the financing of development, focussing less on capital imports and on increasing household savings, and more on the financing of investment from enterprise profits and from domestic bank credit.

Using this approach, said UNCTAD, developing countries in many cases can avoid dependence on foreign capital inflows by applying appropriate macroeconomic and exchange-rate policies. A strong increase in official development assistance (ODA) is nevertheless required to help poor, commodity-dependent countries meet the  millennium Development Goals set by the United Nations.

According to the report, the beginning of the Millennium saw the shift of developing countries as a group from net capital importers to net capital exporters. Indeed, since the Asian financial crisis in 1997-1998, capital has increasingly been flowing “uphill” -- from poor to rich countries. The magnitude of this new phenomenon has caused some observers to conclude that some developing countries have been creating a global “savings glut”.

The emergence of developing countries as net capital exporters contrasts with expectations derived from standard growth theories. These theories postulate that with open capital markets, capital will flow from rich to poor countries in order to exploit the higher expected rates of return on capital and bridge the “savings gap” in capital-scarce countries. The theories also predict that capital inflows will spur economic growth.

However, said the report, these predictions are not supported by developments over the past few years. Not only is capital flowing “uphill”, but net capital-exporting developing countries also tend to grow faster and invest more than those developing countries that receive net capital inflows.

Thus, higher rates of investment for diversification and structural change do not always require current-account deficits or net capital inflows, as suggested by standard economic models. Indeed, many developing countries, particularly in Latin America, failed to achieve higher productive investment under the mainstream approach because the monetary and financial policies that attracted waves of capital inflows also led to high domestic financing costs and to currency appreciation.

These developments also call into question another hypothesis of standard economic theory, namely that there is a close and positive relationship between capital account liberalization and economic growth.

The divergence between these expectations and empirical findings has been described as a “puzzle”. However, this divergence is puzzling only if viewed from the perspective of the basic tenets of neoclassical economic theory, particularly the idea that the evolution of the current account is driven by the behaviour of a representative agent that has perfect foresight and maximizes an inter-temporal utility function. It is not puzzling once it is recognized that these assumptions do not reflect what actually happens in the real world.

According to the report, a main finding is that in countries which are heavily dependent on primary commodities, swings in the current account are driven to a large extent by changes in commodity prices, and that in countries with more diversified export and production structures, the real exchange rate plays the key role in determining changes in the current-account balance. Particularly, the latter finding is in line with recent research that has shown not only that an overvalued exchange rate has detrimental effects on the external balance, but also that a competitive real exchange rate is a key factor for  achieving growth of aggregate demand in the short run and of employment in the long run.

Out of 113 developing countries and transition economies, 42 were net exporters

of capital in 2002-2006. And 60 saw improvements in their current account balances in this period compared with 1992-1996.

The reversal of the current-account balances of developing countries started around 1998, probably largely in response to the wave of financial crises that hit the developing world in the second half of the 1990s. The reversal was driven mainly by emerging-market economies. The observation that the overall improvement in the current-account balances is mainly attributable to emerging-market economies can be explained by the fact that the other countries had only limited access to international capital markets and were only marginally affected by the financial crises of the last 10 years.

This observation is even more perplexing from the perspective of mainstream economic theory, because it is the emerging-market economies that, due to their greater openness to the international financial markets, would be expected to benefit the most from net capital inflows (or inflows of “foreign savings”), and thus have greater current-account deficits. Yet, it was in the Asian emerging-market economies in particular that greater gross inflows were more than offset by gross outflows.

Evidence shows that current account reversals are typically preceded by positive terms-of-trade shocks and real depreciations, and that the subsequent improvement in the current-account balance enables implementation of a more investment and growth-friendly monetary policy stance, said the report.

It noted that a significant number of empirical findings call into question the predictions of neoclassical growth models. While both the structure of these models and the econometric techniques designed to test the validity of their predictions have been developed further with a view to reconciling the differences between these empirical findings with the model's predictions, the remaining difference is often interpreted in a somewhat ad hoc fashion as pointing to structural problems of developing countries -- such as imperfections of their financial markets -- or policy failures.

Movements in the real exchange rate and commodity prices are the most frequent shocks for developing countries, and they have immediate and quantitatively significant consequences for trade and current-account balances. An increase in the current-account deficit as a result of an appreciation of the real exchange rate and a concomitant loss of competitiveness of domestic producers may be temporarily financed by a net capital inflow, but it will sooner or later require some form of adjustment -- normally a real depreciation. Indeed, exchange-rate over-valuation has been the most frequent and the most “reliable” predictor of the financial crises that have characterized the developing world over the past 15 years.

One of the outstanding features of the economic process is its proneness to shocks and cyclicality. It is of the utmost importance for sustained growth and catching up that macroeconomic policies effectively absorb shocks, allow a quick resolution of cyclical disturbances and provide enterprises with a stable environment conducive to investment in productive capacity, said the report.

Monetary instability, periods of hyperinflation and frequent financial crises have often  forced many developing countries to adopt economic policies that generate the exact opposite of what would be favourable investment conditions. “Sound macroeconomic policies” as prescribed by the Washington Consensus, combined with financial liberalization, seldom led to the desired result of higher investment and faster growth, whereas the alternative policy approaches helped the newly industrializing economies of East and South-East Asia to accelerate their catch-up process.

In Asia, accommodative and stimulating monetary policies, with low policy interest rates and government intervention in the financial markets, have been accompanied by undervalued exchange rates since the financial crisis in 1997-1998. Fiscal policy has been used pragmatically to stimulate demand whenever that was required to respond to cyclical developments. In South, East and South-East Asia, the policy interest rate (in real and nominal terms) has been, on average, consistently lower than the growth rate (in real and nominal terms) over the past 20 years, except during the Asian financial crisis.

By contrast, said the report, policy interest rates have been considerably higher in Latin America, where monetary policy has focused entirely on avoiding inflation, with the result that investment ratios and growth rates remained low. It is only since 2003 that more accommodative monetary policies and an overall good growth performance have prevailed in the majority of the countries in that region.

In pursuing the agenda of the Washington Consensus, which aimed at “getting the prices right”, many countries got two of the most important prices -- the exchange rate and the interest rate -- wrong. To be sure, a stable environment conducive to investment in productive capacity must include price stability. Countries that are prone to high and accelerating inflation may find it more difficult to start and sustain a process of development and catching up than countries with a history of price stability.

It is mainly international speculation searching for interest arbitrage and gains from exchange-rate appreciation that makes it difficult to prevent currency over-valuation and financial crises. Revaluation of currencies as a result of speculative capital flows undermines the normal functioning of the exchange-rate mechanism that would prevent the emergence of large and persistent current-account deficits.

The report stressed that strengthened international cooperation in macroeconomic and financial policy may be required to contain speculative capital flows and reduce their damaging impact on the stability of the world economy. Such cooperation could also help prevent governments from manipulating exchange rates to improve the international competitiveness of their economies. A framework of international rules governing international monetary and financial relations similar to those governing the use of trade policy measures in agreements of the World Trade Organization could lend greater coherence to the system of global economic governance.

The report noted that the UNCTAD Secretary-General has suggested the adoption of a code of conduct aimed at preventing the manipulation of exchange rates, wage rates, taxes or subsidies in the competition for higher market shares and at preventing the financial markets from driving the competitive positions of nations in the wrong direction. For example, major changes in the nominal exchange rate should be subject to multilateral oversight and negotiations. Only if such rules were to apply could all trading parties avoid unjustified overall loss or gains of

competitiveness, and developing countries could systematically avoid the trap of over-valuation that has been one of the greatest impediments to prosperity in the past.

The report also featured another fundamental departure from mainstream theory: an increase in household savings, which is difficult or even impossible because of low per capita incomes in developing countries, is not necessary to raise investment. It proposes an alternative view on the savings-investment relationship where the financing of investment depends primarily on savings from corporate profits and on the potential of the banking system to create credit. In this view, the prerequisites for higher investment are no longer households “putting more money aside” or the availability of “foreign savings,” but improved conditions for reinvestment of company profits and for an enhanced role for credit created by the banking sector as it seeks to provide long-term investment financing.

An influential strand of economic thought views investment as being financed from a savings pool created mainly by household savings. According to this view, entrepreneurial investment will be maximized by increasing national savings and the efficiency of financial intermediation. Policy recommendations stemming from this view include lowering fiscal expenditure to improve government fiscal accounts, and increasing household savings rates and capital imports (“foreign savings”) through higher interest rates.

The report said that an alternative approach to the financing of investment -- associated with Keynes and in particular Schumpeter   suggests that capital accumulation in industry is financed primarily by savings from corporate profits, while the contribution of voluntary household savings to productive investment is considered relatively less important.

The report recalled that in examining the successful economic catch-up of the East Asian economies in the post-Second World War period, UNCTAD had emphasized the importance of the link between corporate profits and savings and a dynamic profit-investment nexus. It attributed high national savings rates to high corporate savings, rather than to high household savings. From a macroeconomic perspective, domestic sources of finance are more appropriate and quantitatively more important than foreign ones. From the perspective of firms, self-financing from retained earnings is the most important and most reliable source for financing investment, with bank loans playing an important complementary role.

The report suggested that financing instruments out of retained profits could be promoted by a range of fiscal incentives, such as preferential tax treatment for reinvested or retained profits, or special depreciation allowances. Noting that bank credit is the second most important source of financing for enterprises, particularly for new businesses and small and medium-sized firms, the report emphasized that the power of banking systems to create credit based on liquidity provided by central banks has to be combined with strong institutional arrangements and additional policy instruments to maintain price stability.

UNCTAD recommended a stronger role for governments in influencing the direction of credit to strategically important sectors and activities. This can take, for example, the form of direct provision of credit by public financial institutions or interest subsidies for selected projects. Stricter control of lending for consumption or speculative purposes could also encourage credit allocation to investment projects. In instances where high lending rates reflect high perceived risks, government guarantees might be considered for loans to finance promising investment projects of firms that otherwise might have limited or no access to longer term bank credit.

Adequate regulation and supervision of the financial sector, particularly the effective  monitoring of foreign-currency-denominated debt, is essential for maintaining sound balance sheets of financial institutions, said the report, adding that strict standards of corporate transparency and clear and consistent rules for access to overseas borrowing would help prevent speculative currency positions also in balance sheets in the non-financial sector.

Governance structures of public financial institutions should be designed in such a way that the direct and indirect benefits arising from their activities accrue to the economy as a whole (and over a longer time horizon than the one usually considered by the private sector for profit maximization).

Without proactive public intervention, it is highly unlikely that the undesired consequences of market failures and segmentation of the financial system can be overcome. A proactive policy, rather than ignoring the persistent financial market imperfections and segmentation, could develop new channels for financing economically and socially important activities (such as manufacturing, agriculture and infrastructure) and actors (such as small and innovative firms) which tend otherwise to be marginalised.

The report also noted that although more and more developing countries have significantly reduced dependence on foreign capital flows and have even become net exporters of capital, most poor, commodity-dependent nations with insufficiently diversified production structures continue to rely on foreign capital inflows to finance imports of essential capital goods.

For a realistic chance of meeting the Millennium Development Goals, which include halving extreme poverty by 2015, overseas development assistance to poor nations would need to be increased by $50-$60 billion a year above current levels, the report concluded.

* This is the second part of a two-part article on the Trade and Development Report 2008. The first part was published in SUNS #6543 dated 5 September 2008.