Why Capital Flows Uphill

Trillions of dollars in capital now cross borders each year in search of profit. And since more is flowing out of developing countries than coming in, the return must be higher in the rich industrialized economies.

Wait; that can’t be right. The low-hanging fruit in the United States, Western Europe, and Japan was presumably picked long ago. Shouldn’t capital now be sucked into places where labor’s cheap and opportunities abound? Indeed, isn’t that what global economic integration is about?

It’s more complicated than that. (Bet that caught you by surprise.) But there’s an important truth underlying this paradox: In a world in which financial market integration lags far behind the integration of trade and technology, flows of financial capital are playing a surprisingly limited role in driving growth in developing economies. In fact, there seems to be a negative correlation between growth and imports of financial capital: The fastest growing emerging-market economies typically save more than they invest at home, with the difference spilling into foreign securities.

To understand what’s been happening, look closely at capital flows between the U.S. and China — the iconic example of the aforementioned paradox. Each year, hundreds of billions of dollars more flow from China (where the productivity of capital is very high) to the United States (where the potential return is lower) than vice-versa. One reason is that Beijing is eager to support job-creating, politically wired exporters, and is thus willing to accept foreigners’ IOUs in order to induce them to buy all those laptops and dining sets and designer jeans. To put it another way, if the China’s central bank didn’t buy humongous quantities of dollars (mostly in the form of U.S. Treasury securities) as a means for holding down the value of China’s currency, Walmart and friends might well find it cheaper to buy goods in, say, Thailand or Mexico.

That’s not the only reason, though, that Beijing pushes international capital "uphill." It fears currency exchange volatility if it lets private interests determine financial flows in and out of China. This fear, moreover, hardly springs from thin air. Back in 1997-98, surges of "hot" money (short-term liquid investments) from abroad shattered the stability of currencies from Thailand to Indonesia to Korea — and then went on to wreak havoc in Russia and Brazil. Even Hong Kong, arguably the best-run economy on the planet, was badly shaken in the tumult.

China, by contrast, escaped relatively unscathed because capital controls kept its currency, the renminbi, out of global play. That is, for the most part, Beijing limited foreigners’ holdings of renminbi to the amounts needed to do business in China.

Oh, you say: We’ve learned from the mistakes of the Asian currency crisis; now it’s safe to go back in the water of global financial capitalism. Dream on. After all, it was the integration of international capital markets that meant that the American mortgage-backed securities collapse quickly spread to Europe and beyond. Why should China risk infection from global financial viruses?

Actually, China has yet another reason to brush aside the reality that it is investing hundreds of billions annually in U.S. Treasury bills while hundreds of millions of Chinese still lack the capital needed to earn a decent living. The Chinese, who save a higher proportion of their income than any other people in the world, already have more capital than they can make good use of. The real constraint on (even faster) economic development is that China lacks the efficient, well-developed banking and securities markets needed to allocate even more capital into investments that would eventually make the Chinese as productive as their North American or European counterparts.

Indeed, by this reckoning, opening the door to more financial capital would only lead to an asset bubble. The whole point of allowing capital to flow downhill would be to generate more investment in technical education, health care, more efficient transportation, and pollution control (not to mention more factories). But the result might just be more empty apartments and office buildings in the already overbuilt real estate markets of China’s booming coastal cities.

Note an important distinction here. In contrast to purely financial investments –say, the purchase of bonds issued by Chinese companies — the government welcomes foreign direct investment in businesses, especially those that come with new technology and highly skilled management. Foreigners have invested close to $800 billion in Chinese production facilities; the stock of foreign direct investment in China now far exceeds that in Australia, Switzerland or Canada. But it isn’t the capital that China wants or thinks it needs, but the productivity spillovers from foreign technology and training.

It’s pretty easy, then, to see why China is reluctant to conform to what is often called the "Washington Consensus," which includes the diktat that developing countries should open their economies to global market forces as fast as it is practical. China has done very well by doing things its own way. And (with reason), Chinese leaders suspect that the pressure to conform is in part motivated by ideology, along with rich countries’ perceived interest in seeing Chinese exports become less competitive in world markets.

But before buying entirely into the Chinese view, consider this. The reality that China can’t make good use of savings from rich countries — that it chooses to invest in U.S. Treasury securities rather than education or infrastructure or whatever at home — is not solely a consequence of the Chinese people’s extraordinary thrift. It also is a symptom of institutional weakness, of China’s well-founded fear that it lacks the management and regulation to operate stable, efficient private capital markets that could funnel more resources into building a modern economy.

It’s not clear, moreover, that what is working now will work indefinitely. For one thing, the bigger the Chinese economy becomes, the more difficult it will be to sustain high growth without sophisticated domestic capital markets. And once that becomes painfully clear, China will have to play a dangerous game of catch-up.

For another, the success of China’s strategy of export-led growth facilitated by recycling huge quantities of dollars ironically depends on Americans’ inclination to save very little. Eventually, this delicate dance of co-dependence must end. More to the point, unless it ends in a coordinated fashion, with America becoming thriftier as the Chinese find satisfactory ways to invest and consume more, there will be hell to pay. And that smooth transition will be next to impossible if China does not speed the development of efficient private capital markets.

China isn’t the only relatively poor country that is saving more than it invests at home — that, in effect, is exporting capital to rich countries and adding to the stresses on an unbalanced global economy. While the particulars vary, these countries generally share the problem of being unable to absorb more capital because they lack efficient capital markets.

But as Eswar Prasad of Cornell (and, not coincidentally, the former head of the IMF’s China Division) argues, change is slowed by an inherent tension. International financial integration will eventually serve developing countries’ interests, helping to manage the complexity of associated with greater productivity. But the process of getting from here to there will be perilous, giving high-saving countries ample reason to think thrice before opening their doors to financial integration. Pretending otherwise won’t make it any easier.