1.

Introduction World financial integration has taken great strides over the last fifteen years, as confirmed by both de jure and defacto measures of integration. 2 Among industrial countries, the trend towards integration had been present since the mid1970s, but its pace quickened after 1990, as legal and regulatory barriers to international financial flows were lifted, and rich countries holdings of foreign assets and liabilities, relative to GDP, rose more than fivefold from the levels of the early1980s. Among developing countries, a similar trend of increasing integration became apparent since the early 1990s, as many countries opened up their economies to private financial transactions,3 and private flows from industrial countries experienced a boom that, in spite of major short-run fluctuations and episodes of international financial turbulence, has not been reversed to date. Conceptually, international financial integration plays a dual development role. First, it supplies much needed financing for profitable investment opportunities in poor countries, helping speed up the growth of their real income and employment. Second, it provides the means to diversify country-specific idiosyncratic risks. This in turn helps reduce the variability of consumption, especially in poor and highly volatile countries, thereby increasing the welfare of their residents. The two effects are in fact inter-related e.g., access to risk diversification can make it possible for risk-averse investors to undertake high return/high risk projects that would otherwise not be implemented. Indeed, lack of access to risk diversification opportunities has been stressed as a key mechanism that could prevent low-income countries from adopting investment projects that would help them overcome poverty.4 From this perspective, rapidly rising capital flows and deepening financial integration represent enhanced development opportunities for poor countries. But the process of financial integration and the changing composition of international capital flows have also cast the external financing of developing countries under a new light. In the past, their financing was dominated by official flows grants and loans from industrialcountry governments and multilateral institutions. Indeed, until the early 1990s these flows accounted for the bulk of external financing to the developing world. Moreover, they left little room for recipient countries risksharing, in that repayment obligations were largely unrelated to debtors economic

performance -- other than for ex-post debt forgiveness and grants given in response to unanticipated shocks. Since the early 1990s, however, official flows to developing countries have been dwarfed by private flows. This means that the external financing of developing countries is increasingly dominated by world investors portfolio diversification decisions and thus guided by the key variables that govern such decisions, namely anticipated returns and perceived risks. Furthermore, the upward trend in private capital flows to developing countries has been led by booming foreign direct investment (henceforth FDI), which unlike conventional debt -- offers risk-sharing possibilities to recipient economies as well as potential indirect growth-enhancing effects through technological spillovers. Of course, these global trends conceal a considerable degree of cross-country heterogeneity. Some countries, especially poorer ones, have not benefited from the rise in private capital flows, and their external financing continues to be dominated by official sources. Likewise, the FDI boom has not reached all developing countries to the same extent. In some regions, it has been more closely associated with the privatization of public utilities than with the adoption of new investment projects.5 But, more fundamentally, capital flows to developing countries remain small in spite of the boom. They account for only one-seventh of total international capital movements (excluding official reserves). And relative to the total capital stock of poor countries, capital flows from rich countries are far smaller today than they were in the first age of globalization, during the late nineteenth and early twentieth centuries.6 This situation is seemingly at odds with conventional economic theory, which would predict massive North-South flows to take advantage of a huge return differential arising from the Souths relative scarcity of capital.7 In this view, vast amounts of capital should flow from rich countries (where the returns on capital should be relatively low) to poor countries (where they should be far higher). But in reality capital flows primarily from one rich country to another, where the returns on capital are roughly similar at least in terms of orders of magnitude.

Thus the puzzle is why capital flows to developing countries are so small, rather than so large. And the puzzle has become even more challenging in recent years, as world net flows have turned around, so that since 2000 the South has been investing in the North, rather than the other way round. That countries in the South may acquire assets on the North is in itself hardly surprising it can be viewed as a natural step in the process of portfolio diversification of Southern investors, facilitated by the global decline of barriers to international investment. But in the last few years, developing countries have accumulated vast amounts of short-term assets on industrial countries. This portfolio redeployment seems hard to justify in light of its large opportunity costs in terms of foregone returns from (socially and financially) profitable investment alternatives in the South. This paper offers a selective overview of key facts and recent trends in the international portfolios of North and South. The purpose of the paper is twofold: first, to document the main stylized facts, and second, to assess whether, and how, they can be reconciled with first principles. The overriding objective is to understand better the forces shaping the international financial integration of developing countries, to draw lessons for these countries to extract the full development potential of international financial flows. To do this, the paper draws selectively from recent analytical and empirical research on the determinants of international portfolio diversification. The rest of the paper is organized as follows. Section 2 describes the main features of the allocation of foreign assets across developed and developing countries from a historical perspective. It then presents the main elements of a portfolio diversification framework that combines the forces of diminishing returns, idiosyncratic risk, and sovereign risk in order to explain these features. Section 3 discusses the remarkable changes --in volume and composition-- that capital flows to developing countries have undergone in the last two decades. Then, it uses the framework introduced in Section 2 to understand these recent trends, complementing this explanation with additional theoretical and empirical results that highlight the relevance of market integration. Using a similar framework, Section 4 discusses the even more recent trends of capital flows from developing countries, reviewing the changes in their volume and composition. Section 5 offers some concluding remarks.

2. Country Portfolios from a Historical Perspective A convenient summary of the main features of international capital flows of developing and industrial countries over the long term is provided by their respective country portfolios. The term country portfolios denotes the allocation of national and international investors wealth across domestic and foreign assets. As a stock position, it represents the accumulation of flows over extended periods of time and, as such, is the proper subject for the long-run analysis of capital flows. The facts From a historical perspective, capital flows to developing countries exhibit three main features: they are positive on balance, are relatively small, and are financed mainly through lending rather than equity. The bold line in Figure 2.1 shows the combined net foreign asset position of 47 non-OECD countries as a share of their combined wealth from 1970 to 1997.8 Throughout this period these countries have been net recipients of capital. This has occurred, however, in a context of rather limited flows with rich nations. The well known home-bias effect -- that is, the tendency of investors to their assets invested in their own country in excess of the dictates of portfolio diversification9 -has been particularly pronounced in the way developed countries interact with developing countries, leading Robert Lucas to wonder in his influential 1990 article why capital does not flow massively from rich to poor countries despite the likely existence of large return differentials. As Figure 2.1 shows, developing countries net capital imports average only about 10 percent of their wealth, fluctuating moderately between 8 and 12 percent. Moreover, since foreign investment by poor countries in rich countries is negligible (less than 0.5% of their wealth on average), not only net but also gross flows have been small, relative to what would be expected in a world of active risk sharing.

Figure 2.1 also shows that loans are the preferred asset to instrument capital flows to poor countries. This stylized fact is now changing, as we will see in the next section, but historically about three-quarters of net capital flows to developing countries have taken the form of net lending, with the remainder consisting primarily of foreign investment.

Understanding country portfolios These features of country portfolios can be reconciled with the predictions of standard portfolio theory with the help of three key ingredients: diminishing returns, production risk and sovereign risk. In Kraay, Loayza, Servn and Ventura (2005) we show how the interplay of these factors generates a set of North-South country portfolios and a world distribution of capital stocks that resemble those in the data. Here we present the main arguments, leaving out the technical details of the mathematical model. A theory of North-South capital flows requires at least two ingredients to explain these empirical observations. The first one is one or more incentives for capital to low from rich to poor countries. Natural candidates for this role are diminishing returns at the country level and/or country-specific production risk. If either of these two forces are present, the risk-adjusted rate of return on capital declines as more capital is invested in a country, creating an incentive to invest in countries that have little capital. In the absence of a countervailing force, this incentive would only be eliminated if capital stocks per person were equalized across countries. Since the set of developing countries considered in Figure 2.1 accounts for about four-fifths of the world population and owns about one- fifth of the worlds wealth, equalization of capital stocks per person would require a net foreign asset position of 300 percent of their wealth! The theory clearly needs a second ingredient to explain why capital flows are so small relative to that benchmark. A popular view is that the theory just needs to recognize that rich countries possess better technologies and human capital, and this is why investors keep most of their capital in rich countries even in the presence of diminishing returns and production risk (this is in fact the thrust of the argument offered by Lucas 1980). However, this explanation only begs the question, since it is not clear why technologies and human capital do not flow to poor countries together with physical capital. But even if one is willing to take this for granted, it cannot be the whole story. While better technology and human capital in rich countries can explain why net foreign asset positions are small, it cannot explain how they are financed. To the extent that countries have some desire to diversify production risk, standard portfolio theory would lead to the prediction that countries should hold large gross foreign investment positions that are roughly balanced, and they should have no incentive to lend. Yet, Figure 2.1 has

already shown that most capital flows are financed through loans, and that gross foreign investment positions are small.

The alternative hypothesis is that sovereign risk might be the second ingredient that the theory needs. The notion that foreign investments and loans are subject to sovereign risk is hardly novel or controversial.10 Figure 2.2 shows that over the past 200 years there have been four episodes of widespread systemic default by poor countries. These episodes lasted around 20 years, and were interspersed by 30-40 year periods during which defaults were relatively rare. The interesting question is whether the presence of sovereign risk can help account for the main empirical features of capital flows to developing countries. To explore this, in Kraay, Loayza, Servn and Ventura (2005) we build a simple North-South model of international capital flows. The production technology exhibits diminishing returns at the country level and country-specific risk. In this model, the world economy experiences periods with active North-South capital flows, which culminate in the South defaulting on its foreign obligations. This initiates a crisis

period in which international financial markets shut down. Eventually, North- South capital flows resume and the cycle starts again. As a result of these recurrent crises, domestic capital offers a country not only the value of its production flow, but also a hedge against the risk of foreign default. This creates a home bias in the demand for capital that might explain why capital flows to developing countries are small.

Whether sovereign risk can also explain how capital flows to developing countries are financed depends crucially on how the consequences of a default are modeled. Assume first that if a country defaults on its foreign obligations, foreign countries respond by seizing the assets that this country owns abroad and then using these assets to (partially) compensate the loss. Assume also that the process by which assets are seized and transferred to creditors is not costly. Or, if this transfer is costly, assume this cost is always avoided through efficient renegotiation of claims after the default. Under either of these assumptions, default is just a transfer of the net foreign asset position to the defaulting country. To minimize exposure to sovereign risk, countries then choose small net foreign asset positions; but they do not have to hold small gross foreign investment positions. Once again, to the extent that countries have a desire to diversify production risk they would again choose large gross foreign investment positions that are roughly balanced, and they would have no incentives to lend. Assume instead that transferring ownership of foreign investments is costlier than transferring ownership of loans. This can be the case if, for example, foreign investors have specialized knowledge, or operate the assets with a superior skill that cannot be appropriated an assumption that is not unrealistic. Moreover, assume also that renegotiation of claims is inefficient and sometimes defaulting countries seize loans and foreign investments despite the costs. An implication of these assumptions is that the costs of default rise with the share of capital flows that are financed through foreign investments. If the desire to avoid diminishing returns creates an incentive to transfer capital from rich to poor countries, foreign loans will be a more attractive asset if sovereign risk is high relative to production risk. Thus, sovereign risk has also the potential to explain why loans are the preferred asset to finance capital flows, and why gross foreign investment positions are small.

To summarize, it is possible to show quantitatively that the standard portfolio diversification framework can go a long way towards reconciling the theory with the data provided it is modified along two dimensions.11 The first one is to recognize that the world economy experiences recurrent episodes of systemic default, and that this creates an impediment to capital flows. In fact, an empirically reasonable dose of sovereign risk is sufficient to reduce predicted flows to levels that start to resemble those we see in the data. The second modification is to recognize that, during default episodes, renegotiations are likely to be more inefficient for foreign investments than for loans, and this introduces a bias against the former and towards the latter. Although it is admittedly difficult to calibrate this effect, a relatively modest amount of inefficiency is consistent with loans being the preferred vehicle to finance capital flows to developing countries. Although this amended framework is designed to address the basic distribution of wealth across holdings of domestic capital and various foreign assets, it can also be used to understand specific changes in historical patterns. In particular, it can shed some light on the developments that have taken place since the 1980s regarding capital flows to and from developing countries. To this issue we turn our attention in the following section.

3. Capital Flows to Developing Countries in the Last Two Decades The facts Over the last two decades, the configuration of country portfolios across the world has undergone important changes resulting from a remarkable transformation in international capital flows. The main features of this transformation are that capital flows to developing countries have become mostly private, have increased manifold, and consist now substantially of foreign direct investment (FDI).

Figure 3.1 summarizes these trends. The total volume of capital inflows has increased from about 100 billion dollars in the mid 1980s to over 400 billion dollars in 2005 (in 2000 constant prices). This change amounts to a rise from an average of 2% to around

5% of the combined gross national income of developing countries. The increase in capital flows was particularly strong in the early and mid 1990s. It then slowed down and was even temporarily reversed, following the consecutive international financial crises of the second half of the decade. However, the expansion resumed in 2003, with capital flows reaching record highs by 2005. Along with the increase in their volume, capital flows have undergone a sharp change in composition. In the second half of the 1980s, the average share of private capital flows in total flows was only 17%.12 By the first years of the 2000s, it had risen to 81% (see bottom portion of Figure 3.1). Moreover, in this transformation, FDI has become the most important type of capital flow, with its share in the total raising from 20% to 70% in just over a decade. Naturally, there is some heterogeneity across regions regarding these trends, as Figure 3.2 shows. The expansion in the volume of capital inflows was particularly strong for East Asia and Pacific (which seems to have recovered completely from the 1997-98 financial crisis), Europe and Central Asia, and Latin America and the Caribbean (which also shows signs of steady recovery in the last few years). To a lesser extent, the expansion also occurred for South Asia and SubSaharan Africa; and only the Middle East and North Africa seem to have escaped the rapid increase in capital inflows.

The importance of private flows has increased noticeably in the last two decades across all regions, and only in Sub- Saharan Africa they have yet to overcome public flows.13 Likewise, FDI has become the prime capital flow in the majority of regions, including East Asia and Pacific, Latin America and Caribbean, Sub-Saharan Africa, and even the Middle East and North Africa. In Europe and Central Asia and in South Asia, FDI has also grown rapidly, but its expansion has been accompanied by a simultaneous increase in other types of private capital flows such as long-term debt and portfolio equity.

Explanations (and Limitations) from Portfolio Theory The conceptual framework presented in the previous section can help understand these changes in the behavior of capital flows over the last two decades, and to this we devote the first part of the discussion that follows. But we also point out certain limitations of the framework, and in order to address them we present additional analytical and empirical results. The first fact highlighted above is that capital flows have become mostly private. In the analytical framework outlined earlier, the transition from public to private flows can be understood as a reflection of lower sovereign (expropriation) risk. According to this perspective, public, official flows were more prevalent under high sovereign risk because they made retaliation in the case of default more credible, thus facilitating renegotiation of claims as opposed to outright expropriation. Despite the notoriety of some recent sovereign defaults, such as those of Argentina and Russia, there is some evidence of a decline in the perceived likelihood of default of emerging countries on their obligations towards foreign investors, as attested for example by the downward trend in sovereign spreads from the mid 1990s to a decade later. This is also consistent with the widespread investor-friendly, market-oriented reforms undertaken by many developing countries since the late 1980s, which should likewise lead to declining expropriation risk for foreign investors (although episodes of expropriatory changes in regulation and outright nationalization have recently occurred in some Latin American countries, for example).14

As a result of these trends in expropriation risk, official flows likely lost some of their edge vis--vis private flows. This interpretation, however, stretches a little the applicability of the framework described above, because the latter does not consider directly the distinction between public and private flows. In fact, in the model the allocation of capital across countries responds exclusively to economic incentives, whereas in reality official (especially bilateral) lending has reflected also other motives such as geopolitical concerns and poverty and crisis relief. Thus, consistent with the increasing integration of financial markets since the 1980s, another explanation for the increasing importance of private flows is that economic incentives are being allowed to operate more freely as capital restrictions are reduced. We return to this issue below. The second fact stressed above is that capital flows to developing countries have increased manifold. In the context of the model outlined earlier, this can be explained by an increase in the productivity of developing countries and hence the return differential from investing in them -- or by the already-mentioned decrease in sovereign risk. Both developments can be credibly associated to the process of market-oriented reforms introduced in the late 1980s in many developing countries. However, to give more credence to this explanation, we need to examine whether in fact capital flows have responded to changes in risk and return across countries. We address this issue below. In explaining the increase in capital flows to developing countries, however, a limitation of the conceptual framework described earlier is that it assumes a world without barriers to capital flows. In fact, an alternative explanation for the rising flows since the late 1980s is that, since then, there has been a relaxation of capital controls and a process of increasing international market integration. We return to this issue below, where we offer evidence supporting this complementary explanation. The third fact is that capital flows to developing countries consist substantially of FDI. Naturally, the explanations given above for the rise of capital flows apply also to FDI. However, what is remarkable is not only that FDI has increased in absolute terms but also that its share vis--vis other types of capital flows (and lending in particular) has risen enormously. In the stylized portfolio framework described earlier, this composition change can be explained by improvements in the perceived ability to renegotiate successfully in the event of default. It can be argued that this improvement is an important result of the policy and institutional reforms that took place in many developing countries starting

in the 1990s. As with the other two stylized facts, the limitation of the conceptual framework lies in not accounting for the role of capital restrictions. In fact, the increase in the absolute and relative importance of FDI in developing countries can also be explained by the lifting of the restrictions that many of these countries had imposed on direct investment and foreign majority ownership in domestic firms (out of fears of foreign economic dominance or simply excessive protectionism). This relaxation of capital restrictions was accompanied in a number of countries by massive privatization of state enterprises, thus creating the conditions for an explosion of FDI to emerging economies. We return to the connection between FDI and market integration below.

When Do Capital Flows Respond to Risk and Return?

A key element for this explanation of the rise in private capital flows to be valid is that they in fact respond to the investment opportunities arising in various countries when capital restrictions are reduced. This is the subject studied by Caldern, Loayza, and Servn (2006), who explore empirically the role of risk and return factors in the observed evolution of the net foreign asset positions of a large number of industrial and developing economies. The studys objective is to examine whether international capital flows respond to market incentives and, if so, whether this conclusion can be generalized to all countries in the world or only particular subsets of them. The paper does not attempt to reconcile the observed extent of diversification with theoretical predictions, but instead tries to assess empirically the role of changing fundamentals in the actual evolution of international portfolios, taking implicitly as given their home bias. In this sense this study is complementary to that of Kraay, Loayza, Servn and Ventura (2005), which addresses the issue of home bias directly. From first principles of portfolio diversification, the ratio of net foreign assets (henceforth NFA) to the total wealth of domestic residents depends on four factors: investment returns in the home country relative to the rest of the world, investment risk in the home country relative to the rest of the world, the degree of co-movement between investment returns at home and abroad, and the ratio of foreign-owned to

domestic-owned wealth. We can view this as a characterization of investors desired portfolio allocation, which is also the one that effectively prevails in the long run. However, frictions and adjustment costs can make short-run portfolios differ from their long-run counterparts. The paper focuses on the empirical estimation of this long-run equilibrium condition, using data on foreign asset and liability stocks for a large number of industrial and developing countries spanning the period from the 1960s to the 1990s, and adding estimates of domestic capital stocks to the foreign asset data to calculate each countrys financial wealth. 15 In addition, the paper develops empirical measures of country returns and risks in three versions: composite indices constructed using a comprehensive set of macroeconomic, policy, and institutional variables; indices based on the rate of economic growth only; and indices based on stock market returns.16 Table 3.1 presents estimates of the empirical models long-run parameters characterizing investors desired portfolios. The short-run (or dynamic) parameters are estimated jointly with the long-run coefficients but, since they are not essential here, they are not presented in the table. Portfolio diversification would indicate that the ratio of net foreign assets to wealth varies inversely with domestic rates of return and directly with domestic risk and comovement rates. Improved returns and reduced risks raise the perceived profitability of investment and attract capital into the country by foreign and domestic investors (implying a reduction in the NFA position). Likewise, a decrease in comovement with the rest of the world raises the value of domestic assets for hedging purposes and draws more capital into the domestic economy (reducing its NFA position). Finally, an increase in domestic residents wealth relative to the rest of the world implies, for given portfolio shares, larger participation of domestic residents in foreign assets (increasing the countrys NFA position). A pattern of signs on the estimated coefficients that is consistent with these expected effects indicates that net foreign assets respond to portfolio diversification motives as predicted by theory.

The results for those groups of countries characterized by, respectively, high capital controls and lower income levels indicate that capital flows are not quite responsive to risk and return differentials. For the group of countries possessing burdensome capital restrictions, this evidence indicates that capital controls achieve some degree of

success they dampen the effects of risk and return factors on portfolio decisions. For the group of very poor countries, the likely reason is the limited role that optimal diversification decisions play in the observed evolution of their net foreign assets. To a large extent, these consist of official concessional debt, whose pattern across countries and over time may be dominated instead by non-market considerations related to geopolitical interests, humanitarian aid, and development purposes. In contrast, the estimation results indicate that capital flows do respond to economic incentives (in the form of return, risk, and wealth changes) as predicted by theory in the samples of, respectively, high and upper-middle income countries and countries with moderate capital account restrictions. The estimated long-run parameters on relative wealth and the two alternative measures of risk and return are correctly signed and always significant. Thus, as predicted by the portfolio diversification model, net foreign assets (as a ratio to total wealth) are negatively related to the measures of domestic investment returns and the ratio of foreign to domestic wealth, and positively to the measures of investment risk. Our measure of co-movement also shows an association with the NFA/wealth ratio, but not as robust as with the other explanatory variables. In summary, capital flows seem to respond to market incentives in some but not all groups of countries. Specifically, in countries where market forces are likely to dominate other considerations, international capital flows behave in accordance with the principles of portfolio diversification. FDI and Market Integration In order to explain the increasing importance of FDI in the volume and composition of flows to developing countries, it is essential to show its connection with the process of international market liberalization and integration. It is through this process that lower expropriation risk, improvements in the renegotiation of equity claims, and the lifting of capital restrictions are reflected. In Albuquerque, Loayza, and Servn (2005), we analyze the dynamics of foreign direct investment in response to increased integration of capital markets. In what follows we present its main arguments and results. The first step in our analysis is to identify the determinants of foreign direct investment. We separate these determinants into global and local factors. Global factors explain foreign direct investment into and from several countries. Local factors are country-specific and have no direct or indirect impact on foreign direct investment across other countries. Having identified these factors, we use them as explanatory

variables to estimate an empirical model of foreign direct investment using a large cross section and time series dataset of developing and developed countries. The estimation results of the basic model are presented in Table 3.2. First, consider the results on the global variables in the table, which are chosen for their quality as indicators of international economic activity and global financial conditions. The G-3 average bond rate, the slope of the US yield curve, and the world per capita GDP growth rate carry significantly negative coefficients. An increase in any of these three variables denotes an improvement in the performance of international assets. The fact that both the G-3 bond rate and the slope of the US yield curve carry negative and significant coefficients indicates that the opportunity cost for direct investment is driven by the return on both short and long-run global assets. In turn, neither the index of global stock market returns nor the US credit spread carries a statistically significant coefficient. Turning to the local variables, improvements in overall productivity (as reflected in higher economic growth), larger trade openness, and deeper financial markets serve to attract foreign direct investment into the country. Conversely, a rise in the burden of government (which can be interpreted as reflecting higher taxation) and an increase in macroeconomic volatility (represented by the standard deviation of per capita GDP growth) act as deterrents for foreign direct investment inflows. The other measures of volatility (of the real exchange rate and the terms of trade) do not have an independent significant effect on foreign direct investment inflows. Their effect seems to be captured by the volatility of economic growth. The rate of real exchange rate depreciation and the proxy of civil liberties do not seem to affect FDI inflows (beyond their possible effect through the other local factors).

On the whole, we can take these results as confirming the view that FDI inflows respond positively to anticipated returns and negatively to perceived volatility in the destination economy. They also respond negatively to higher returns on alternative global assets. In the next step, we use these empirical estimates to get a measure of the exposure of countries to global factors. This we call the globalization measure. The globalization measure is given by the fraction of explained foreign direct investment variance that is due to variation in global factors. Given our perspective on the effects of global factors, to construct the globalization measure we make the identifying assumption that any component of local variables that is correlated with the global factors is itself a global factor. We re-estimate the investment model over moving windows of 16 years of data and use the re-estimated model to compute the globalization measure. Figure 3.3 presents the globalization measure for the full sample of countries, as well as for the samples of developed and developing countries, for the period 1985-99. The analysis reveals that global factors have increased in importance in explaining the dynamics of the cross section of foreign direct investment over time for developing and developed countries. For the full sample of countries in 1999, the globalization measure increased over ten-fold since 1985. Furthermore, developing countries exposure to global factors has increased faster than that of developed countries, and the gap between both has narrowed at the end of the 1990s. The third and last step of our analysis relates the driving factors of foreign direct investment to the observed increased liberalization of capital markets. We expect stronger financial liberalization to increase the relative importance of global factors as drivers of foreign investment, because local factors whose risk can be traded away with financial liberalization no longer impact asset allocation decisions and because new global factors emerge which before had only a local dimension.17 Consistent with the hypothesis of increased world capital market integration, we show that our globalization measure is explained to a significant extent by the level of financial liberalization. In Table 3.3 we report the results of regressing the globalization measure on four different indices of liberalization. The first three are the liberalization variables in Bekaert, Harvey and Lumsdaine (2003) -- official liberalization, first sign, and investability -- and the fourth is a measure of balance-of-payments restrictions reported by the International Monetary Fund.18 Each of these liberalization variables is country

specific while our globalization measure applies to groups of countries. To come up with a proxy for the extent of liberalization in a particular group of countries we compute a GDPweighted average of each liberalization variable. As expected, the signs of the coefficients are positive for the first three measures and negative for balance of payments restrictions (a high value for balance of payments restrictions indicates low liberalization). All coefficients are highly statistically significant and the regression fit is strong, particularly in developing countries. These results indicate that a substantial portion of the time series variation of our globalization measure is due to the liberalization of capital markets.

On the whole, this evidence suggests that the remarkable growth of foreign direct investment flows in the last two decades is closely related to the outstanding integration of world capital markets following the economic reforms and liberalization programs of the mid 1980s and 1990s. The effect of market integration on the behavior of FDI is manifest in the increasing role of global factors for capital flows in both industrial and developing countries. 4. Capital outflows from the South

Perhaps the most recent reflection of the rising world financial integration is the rapid increase in financial flows from developing countries. These have risen from virtually negligible levels at the beginning of the 1990s when they totalled less than 100 billion in 2000 U.S. dollars -- to over 450 billion in 2004 (Figure 4.1).19 In fact, since 2000 outflows have exceeded inflows,20 so that developing countries as a whole have become capital exporters.

The stock counterpart of this increase in capital outflows is the rising trend in developing countries gross and net foreign asset positions. As we saw earlier, developing countries have historically been net debtors vis--vis the rest of the world and their net debtor position actually widened over the 1980s. Since the mid 1990s, however, an incipient turnaround has taken place, and the median net foreign asset position of the developing countries for which information is available21 has been rising slowly but steadily, by some 15 percentage points of GDP i.e., from around 65 percent of GDP in 1995, to about 50 percent in 2004. Further inspection reveals some heterogeneity across income groups of developing countries. Among middleincome countries, the rising trend started earlier, in the late 1980s, while low income

countries saw their net foreign asset positions deteriorate further, to reach a minimum of 95 percent of GDP in 1994, and then experienced a marked reversal over the ensuing decade, for a cumulative total rise of nearly 30 percentage points of GDP by 2004 (Figure 4.2).

This increase in developing-country investment abroad is hardly surprising in the light of the portfolio diversification framework outlined earlier. From this perspective, the rise in capital outflows is a natural result of the rising trend in developing countries overall income and wealth, and hence in the size of their overall portfolio. With a given risk-return configuration, this leads to an increase in the desired gross foreign asset holdings of developing country investors. Moreover, as already noted in the previous section, theory also suggests that increasing relative wealth -- that is, rises in a countrys overall wealth at a faster pace than that rises in the wealth of the rest of the world should be associated with an increasing net foreign asset stock position, again with a given risk-return configuration. The reason is that as the wealth of domestic residents outpaces that of foreigners, the gross foreign asset holdings of the former should also expand more rapidly than foreigners gross claims on the home economy. This, however, is only part of the story. The dismantling of barriers to outward capital movements in many developing economies, and thereby the reduced implicit and explicit transaction costs associated with acquiring and holding foreign assets, has surely been another contributing factor, as it tends to raise investors desired holdings of foreign assets for any given size of the overall portfolio. Finally, decreasing marginal investment returns at home in the face of a growing domestic capital stock

may have been also an ingredient in prompting capital outflows from growing developing countries. However, these aggregate trends conceal a great degree of heterogeneity across countries. Indeed, the biggest outward investors are middle-income developing economies that have grown rapidly over the last decade the case of China, India and Korea, for example or have experienced a persistent terms of trade windfall over that period the case of oilexporting economies of the Middle East and North Africa (Figure 4.3). This is in accordance with the arguments given above about the key role of rising wealth, and perhaps also decreasing marginal returns on domestic capital, for foreign asset holdings.

The increase in capital outflows from developing countries has been accompanied by changes in their composition, in two dimensions. The first one concerns the geographical destination of flows. Traditionally, outflows from the South have gone to rich countries often as a means for wealthy developing-country residents to place their assets beyond the reach of their governments. In recent years, however, SouthSouth capital flows have become increasingly large, although accurate estimates of their total volume are hard to construct. In the case of FDI inflows to developing countries for which estimates are more readily available -- the share of flows originating in other developing countries has risen from some 15 percent of the total in 1995 to around 40 percent at present.22 The biggest investors include large middle income developing economies that are themselves major recipients of FDI inflows. Indeed, seven of the ten top developing countries by their holdings of FDI assets (shown in Figure 4.4) are also among the top then issuers of FDI liabilities.

The second dimension regards the increasing role of official flows, and in particular reserve accumulation, in total capital flows from developing countries. In fact, as Figure 4.1 shows, reserve accumulation has accounted for a growing share of outflows since 2000, rising up to exceed 300 billion dollars in 2004. Commodity-exporting countries experiencing a termsof- trade boom, along with China, have been responsible for much of this accumulation of reserve assets (Figure 4.5). But the phenomenon has been quite general. Indeed, since 1997-98, reserve holdings have risen steadily in all developing regions, including lower income ones such as South Asia and Sub-Saharan Africa (Figure 4.6). Among poor countries, median reserve holdings rose to 15 percent of GDP in 2003-2004, up from les than 9 percent in 1999-2000.

Along with adjustment costs and lags in disposing of the terms of trade windfall from high commodity prices, this process also reflects developing countries precautionary liquidity hoarding to self-insure against the volatility of private capital inflows, and prevent the repetition of episodes of global instability similar to those witnessed in 1996-1998 in connection with the East Asian and Russian crises. Those events highlighted the risks posed, in particular, by short-term foreign debt, which makes countries external accounts vulnerable to unexpected shocks and changes in investor sentiment. For many countries, the lesson was that net short-term debt should be kept in check, possibly through the accumulation of sufficient short-term liquidity.23

However, many observers have argued that the stock of short-term foreign assets has grown out of proportion in a number of developing economies. At the end of 2005, several developing countries (notably China) held reserve stocks in excess of 100 billion US dollars. Not only oil exporters, but also countries like India and Brazil were among the top foreign reserve holders (Figure 4.7). By September 2006 it was estimated that developing countries reserve holdings exceeded by 2 trillion dollars (or, equivalently, by close to 20 percent of their combined GDP) their short-term foreign debt obligations (Summers 2006). In fact, the accumulation of reserves by developing countries as a group has turned Lucas paradox on its head: not only are North-South capital flows small, they are actually smaller than South-North flows. As a result, capital is being reallocated from poor countries to rich countries and, in particular, to the worlds richest nation, whose currency accounts for the bulk of developing countries reserve holdings (Summers 2006).

The economic rationality of this situation for developing countries is clearly open to question. Foreign reserves typically earn very low returns, and holding them in vast amounts entails huge opportunity costs for countries in dire need of additional investments in infrastructure and human capital. In other words, reserve accumulation provides very rudimentary risk hedging at a very high price in terms of foregone returns. This fact has given momentum to a number of proposals to improve developing countries ability to diversify their aggregate risks. Some of these proposals are concerned with the policies of multilateral institutions which on occasion have been a source of instability rather than a solution to it but others rely on the use by developing countries of new financial instruments with superior risk characteristics, be it on the liability side or the asset side. On the liability side, the focus has been on the design of debt contracts with risk-sharing features i.e., offering a higher return to creditors when debtor countries resources are plentiful than when they are scarce. This is the case, for example, of GDP-linked debt (Borensztein and Mauro 2004) or commodity price-indexed debt.

On the asset side, recent proposals stress the advantages of contingent reserve management over conventional reserve accumulation (e.g., Caballero and Panageas 2005). The former makes use of financial assets, and especially financial derivatives, with the right covariance with the ultimate sources of risk so that resources automatically rise in bad times, when they are most needed, and shrink in good times when the situation is the opposite. Quantitative studies show that, under plausible assumptions, this strategy can yield rather large welfare improvements over the nave strategy of liquidity hoarding that most countries follow. These ideas hare hardly new, however,24 and the question is why they have failed to gather momentum in international financial markets. To a large extent, the main obstacle is the need for coordination. Successful introduction of new financial instruments requires sufficient critical mass of traders on both the supply and demand side --to generate liquidity. In turn, adoption of innovative reserve management strategies runs against established standard practice, and the political and reputational cost of failure while implementing an unorthodox strategy is arguably larger than that of failing while following the standard recipe. On these two fronts, multilateral institutions may have a key role to play in coordinating the introduction and use of new financial assets, and bringing up to date their advice on standard risk management practices.

Concluding Remarks This paper has reviewed the historical experience and recent trends of capital flows in developing countries, presenting some theoretical arguments to understand them and consider them as facets of the larger process of economic development. Poor countries have historically received capital from the developed world -- but only in small amounts and mostly in the form of public loans and grants. This has long puzzled academics and disappointed policy makers in developing countries, who view the chronic scarcity of capital as a key obstacle to realizing the growth potential of their economies. However, low foreign investment in poor countries has had much to do with the unfavorable configuration of risks and returns for investors from abroad i.e., the difficulties in enforcing international contracts, the unbecoming domestic business

environment, and the risk of expropriation. Even more, an economic model based on state intervention, through directed credit and controlled prices, imposed in effect the financial isolation of many a developing country. Capital account restrictions meant to maximize the availability of low-cost financial resources to the domestic country really promoted -- aside from gross investment inefficiencies -- capital flight by domestic residents and reluctance in the provision of fresh capital by foreign investors. The recent process of financial integration must be viewed against this background. As the development model changed in many developing countries to a more market-oriented approach with strengthened property rights and diminished risks, capital flow restrictions were lifted and new profitable investment opportunities emerged. After that, it was only natural that capital flows to developing countries multiplied, became largely private, and took the form of foreign direct investment, the type of capital that best captures long-run horizons and risk diversification. In the process, the flows from developing countries are also growing as domestic investors are looking to optimize their portfolio and, in some notable cases, take best advantage of their newly acquired wealth. As any other facet of economic development, integration to international financial markets offers new opportunities but also poses its own risks. The main one is the volatility of international financial flows and their role in the global propagation of financial turbulence. Developing countries have had to face sudden stops, current account reversals, and other traumatic episodes financial turmoil. In truth, many of these episodes resulted from a combination of global shocks and ill-conceived domestic macroeconomic and financial policies. But in view of past experience, it is hardly surprising that many countries are acting cautiously in the current era of capital flow buoyancy. The large accumulation of official reserves that a number of countries have avidly pursued in recent years is a symptom of this prudence. But it involves very large opportunity costs that could be greatly reduced through the use of alternative risk diversification strategies and instruments, whose adoption could be speeded up through concerted international action. The risks that capital flow volatility poses for developing countries largely result from the weakness of their financial links with world markets that can be easily severed by a sudden flow turnaround -- and the shallowness of their domestic financial markets, rather than from excessive financial integration. Deepening financial markets are likely

to prove the best insurance against those risks. Institutional reforms strengthening creditors and investors rights can go a long way towards encouraging the development of domestic financial markets allowing better risk management, as well as towards strengthening the links with world financial markets. These are likely to deepen also as investment risks are reduced by improved governance and contract enforcement, and by reforms to tackle domestic sources of volatility such as the instability of macroeconomic and financial policies that still characterize many developing countries that can greatly amplify the uncertainty faced by investors.

WHY DOESNT CAPITAL FLOW FROM RICH TO POOR COUNTRIES?????

INTRODUCTION One of the most hotly debated issues in international economics has centred on the flow of capital between nations. Standard neoclassical theory makes some strong predictions regarding the origin and destination of capital flows; however this prediction has been ineffective at explaining the data for large spans of economic history. Moreover, capital flows today are equally of out sync with theory. It is therefore crucial to ask whether this is due to a market failure, or can be accounted for by extending the theory to account for more the more nuanced behaviour of international capital markets. Therefore, this essay provides a survey of literature in order to examine this puzzling inconsistency between theory and reality. In particular, this essay will explore why capital does not flow from rich to poor countries.

WHY SHOULD CAPITAL FLOW FROM RICH TO POOR COUNTRIES?

First off, it is essential to establish why capital should flow from rich to poor countries. Suppose two economies display the following Cobb-Douglas production function, where q = and k = . In this model is a measure of the contribution of capital to production. In order to explain why capital should flow from rich to poor countries, it is necessary to consider the Marginal Product of Capital (MPK). This is defined as the additional out per unit of capital and so can be quantified as The implication is that if output is higher in some countries than others, then this must be due to different levels of capital per worker (i.e. k). However, diminishing returns to scale implies that (assuming capital can flow freely) investment should only occur in poorer nations where output is lower, and thus the MPK is higher lower. Indeed, in his classic paper, Lucas (1990) calculates that the difference in output between the US and India implies that the MPK in India is 58 times that of the US (setting = ). Similarly, Feenstra and Taylor (2008) have calculated that the output differential between the US and Mexico implies a MPK in Mexico four times the US level (though Feenstra and Taylor (2008) set = 0.33). Given return differentials of this magnitude, one would expect capital to flow from rich countries to poor ones until the higher returns were arbitraged away. Of course, capital is not perfectly mobile and there can be significant barriers to capital flows. However, given the proximity of the US and Mexico, and the relative ease of mobility of capital between the two nations, it is even more difficult to resolve the fact that capital does not flow from rich to poor countries. The very existence of output gaps between rich and poor nations implies that capital markets are not behaving how theory would predict. This has become known as the Lucas paradox and accounting for its pervasive presence in international capital markets will be the subject of the remainder of this essay.

IS THE PARADOX WORSE THAN LUCAS IMAGINED?

Prasad et al. (2007) have produced even more puzzling results. Not only does capital not flow from rich to poor countries, but rather, the opposite appears to be true; capital tends to flow uphill from capital scarce to capital rich countries. Using the Current Account (CA) as a summary measure of the total inflow or outflow of capital, they find that capital is indeed flowing uphill. Many industrial economies are now running current account deficits, whereas a large number of emerging market economies are running surpluses. Moreover this is not purely the result of the policies of the US and China. Removing these countries from the analysis produces a similar result demonstrating the prevalence of this trend. Moreover, Gourinchas and Jeanne (2008) found that capital seems to flow more to countries that invest and grow less; a result they coined, the allocation puzzle. Therefore, it seems the paradox is even deeper than Lucas first suggested.

EXPLAINING THE PARADOX: FUNDAMENTALIST VIEW

Ideas, knowledge, science, hospitality, travelthese are the things which should of their nature be international. But let goods be homespun whenever it is reasonably and conveniently possible... - Keynes, 1933 Having identified the paradox, Lucas (1990) went to great lengths to explain it. First off, Lucass original analysis assumed that effective labour per person was equal across countries. However, clearly the level of human capital will vary across countries, with more developed countries tending to have higher stocks of human capital than developing nations. Using Kruegers (1968) estimates of human capital to correct for effective labour, Lucas recalculates the MPK for India as 5 times the US level. This is substantially below the original 58 multiple, but it still leaves a puzzle.

To account for the remainder of the difference in the MPK between, Lucas attributes it to differences in Total Factor Productivity (TFP), (or A as it is more affectionately known). Specifically, he treats differences in technology as the external benefits of human capital. This is modelled as the average level of workers human capital raised to a power in the Cobb-Douglas production function. In order words, assuming the production function, and using an estimate for of 0.36, Lucas recalculates the Indian MPK as 1.04. However, this explanation is troubling in the sense that it assumes that the knowledge spill overs from capital inflows are zero. Lucass explanation for differences in A is very narrowly defined. At the time of his writing A was considered to be technology, however more recently it has been more broadly defined as social efficiency. In the context of the Lucas paradox, A therefore represents the ability of a nation to absorb capital flows. For example, Prasad et al. (2007) argue that a part of the paradox is the difficulty the financial systems in less developed economies have in allocating capital to productive uses. Hall and Jones (1999) used the broadest possible measure of A (Total Factor Productivity) to examine the Lucas paradox. Backing out the implied A in the US, and assuming it was equal across countries implies that there are huge GDP gains to be had from capital flows from rich to poor countries. While the authors look more broadly at financial globalisation, capital flows are in essence the mechanism through financial globalisation occurs and so ample comparisons can be drawn. The results are striking; if developing countries had the TFP levels of the US, financial globalisation could produce output gains of over 3,000% in some countries. For example, the gains would be dramatic in China (1,569%), India (1,064%) and Nigeria (2,259%). For the poorest 20% of countries in the world, the average output gain would be 2,474%. However, with actual productivity levels that gain is a mere 46%. This is a profound result because it implies a long run divergence between rich and poor countries. Therefore in the developing world, global capital markets may not be failing. Rather, low levels of productivity it in developing countries make investment unprofitable. Attributing differences in the MPK to TFP might be theoretically parsimonious, but it lacks a clear explanation for why these differences exist. Lucas suggested this was due to human capital externalities. Alfaro, Kalemli-Ozcan and Volosovych (2008) also find that that during the period 1970 2000 differences in TFP is the primary explanation for the Lucas paradox, but more specifically, they isolate low institutional quality as

the leading cause. OLS estimates imply that improving Turkeys institutions to the quality of those in the UK implies a 60% increase in foreign investment. Furthermore, Instrumental Variables (IV) estimates (using log European settler mortality rates as an instrument for institutions) implies an even greater effect: improving Peru's institutional quality to Australia's level, implies a fourfold increase in foreign investment. Another explanation for the paradox which may be grouped under a differences in A heading has been advanced by Greg Clark (1987). The author has proposed a more controversial, but nonetheless insightful explanation for why capital doesnt flow from poor to rich countries. In his article Why Isn't the Whole World Developed? Clark examines underdevelopment through a detailed study of the cotton textiles industry in the early 20th century. He argues that the failure of certain countries to dominate in this industry in a way that their labour cost advantage would suggest is due to inefficient labour, rather than differences in TFP or market failures. Indeed, when the Industrial Revolution swept the cotton textile industry in the 1770s, technological advancements were rapidly diffused throughout continent and North America. In particular, the continental countries enjoyed much lower labour costs (often well below 50% of wages in Manchester). Accounting for all other input costs, Clark finds that the magnitude of the cost advantage is quite large in Asian economies such as China and India if labour efficiency is equal across countries. For example, the Chinese wage was only $0.54 per 55 hours, or 10.8 percent of the British wage. But given the costs of their non-labour inputs, they should have been able to pay $4.30 per week, or 86 percent of the British wage. Yet despite the cost advantages continental Europe had, (and the even greater labour cost advantages of the Asiatic countries), none could compete with the British before WWI. Therefore Clark (1987) argues that the British remained competitive despite its high labour costs because worker efficiency corresponded closely with the real wage. Specifically, he refers to worker efficiency and not skill because skill implies a learned ability (i.e. differences in human capital). Clark (1987) is arguing something much different: local culture determines worker performance. He concludes that, in 1910 one New England cotton textile operative performed as much work as 1.5 British, 2.3 German, and nearly 6 Greek, Japanese, Indian, or Chinese workers. Such a stark difference in labour efficiency implies that the only countries which should have been able to compete with the British on international

markets were India, Japan, and China - the only countries which did actually compete. Furthermore, he finds that input substitution, differences in technology, management, and workers training or inherent abilities do not explain these apparent differences in labour efficiency. Its worth noting that the variable A used in Hall and Jones (1999) should theoretically capture differences in culture, but Clarks argument offers more substance in this regard. Celemens and Williamson (2000) have also put forward an alternative explanation of the Lucas paradox. Again they argue that fundamentals matter; however unlike Lucas (1990), they examine the first great global capital market boom after 1870. They argue that had Lucas used a less contemporary example in his analysis, he might have been less surprised by the results. They build upon the arguments of ORourke and Williamson (1999) who posit that this apparent paradox is due to British capital chasing after European emigrants, with both were seeking cheap land and other natural resources. This explanation implies that it is land, or natural resources, that are missing from the production function originally specified by Lucas, and not human capital. However, Celemens and Williamson (2000: 2) argue that the Lucas paradox deserves more serious attention than that offered by some mono-causal natural resource or human capital endowment explanation. Their central thesis is that the Lucas paradox was greatly lacking in empirical evidence. Therefore they use the period 1870 1913 to test for the presence and determinants of the paradox. The authors find that the paradox was alive and well during the first great era of globalisation. More crucially, they find that after accounting for the significant capital attraction of natural resource abundance and (after the turn of the century) education, population growth and immigration, the Paradox disappears. Therefore they reject the capital market failure view as the above fundamentals fully account for the paradox. Their analysis suggests that the fundamentals that mattered most were good endowments of education, skills and schooling plus natural resources. That said demographic forces were also at place, captured in this model by immigration and population grow.

INTERNATIONAL CAPITAL MARKET IMPERFECTIONS

So far this essay has examined arguments that have focused differences in fundamentals across countries as explanations of the Lucas paradox. There is a large literature that has focused on alternative explanations that can be broadly classified under the heading international capital market imperfections. Essentially, such arguments take the view that although capital has a high return in developing countries, it does not go there because of the market failures. It is important to note that Lucas rejected this idea in his classic paper, arguing that capital market imperfections, such as political risk, was not an issue due to the control Britain and other nations were able to exert of its colonies. Indeed, Celemens and Williamson (2000) reject the role of imperialism in explaining the paradox between 1870 and 1914. However there are a number of other capital market imperfections that may lead to market failures, thereby accounting for the paradox. Asymmetric information can be particularly problematic to capital markets. It can manifest itself ex-ante (adverse selection), interim (moral hazard) or ex-post (costly state verification). Under such conditions, underinvestment tends to result offering an apparent explanation of the paradox. Specifically, adverse selection implies that investors will not accept the high returns to capital on offer in developing countries because the very presence of that capital may attract high-risk borrowers. Indeed, Moreover, Gertler and Rogoff (1990) develop a model of intertemporal trade under asymmetric information. They find that capital market imperfections are endogenous and capital flows are dampened (possibly reversed) under these conditions. However, Celemens and Williamson (2000: 14) find that no other capital market failure indicator matterednot the Gold Standard, not the height of tariffs, and not colonialism. Indeed, their results support this finding for the 1870 1914. This includes the role of adverse selection and information asymmetries. However, they do find that transport costs mattered, indicating the presence of a market failure. This not surprising as transport prices spiked over this period, but as it only accounts for an eight of the variation, they reject it as a significant factor. Interestingly, despite the numerous advancements in shipping and aviation, transport costs have been relatively constant over the past 100 years due to rising input prices. Furthermore, a number of studies that have looked at more contemporary examples have found evidence for the

role of market imperfections in explaining why capital doesnt flow from poor to rich countries. Taken together, these could help explain the Lucas paradox. A home bias in trade, consumption and investment has all been well documented. For example, McCallum (1995) used a gravity equation to examine the trade between the US and Canada. What is interesting about this analysis is that these are two countries very similar in terms of culture, language, and institutions. However, the author finds that the very existence of a border (despite NAFTA) has a decisive effect on trade patterns. Moreover, this result holds for capital flows. French and Poterba (1991) demonstrated than when it comes to equity decision, investors display an extreme home bias. More than 98% of the equity portfolio of Japanese investors is held domestically, which compares to 94% in the US and 82% in Britain. This implies that investors expect domestic returns that are several hundred times that in international markets. This over optimism is just one of a number of pervasive behavioural biases that traders frequently display and it has striking economic implications: capital may not flow to poor countries because of irrational investor behaviour. Furthermore, this bias is not just an international phenomenon. Coval and Moskowitz (1999) found that portfolio managers over invest in local companies such that the risk to return profiles are not efficient. While the home bias has been declining over time (Srensen et al, 2007), it is still very much a part of international capital markets. So far, the analysis has been neglecting one crucial factor in determining the flow of capital between countries risk premiums. There are a number of uncertainties that present themselves when making an international investment regulatory, taxation, expropriation. If risk premiums are high enough, then it is not surprising that capital does not flow from rich to poor countries. In fact, if premiums are high enough, it may account for why capital flows uphill from poor to rich countries. Feenstra and Taylor (2008) calculate that the risk premium on certain countries is high, particularly for emerging market economies. On average, developing countries have to compensate investors an additional 6.4% compared with domestic US investments. Indeed, capital has been flowing to the US from the developing world due to the dollars safe-haven status. Between 1994 and 2006 Mexican holdings of US assets rose from $5 billion to $95 billion, (while US holdings of Mexican assets grew from $50 to $60 billion). Similarly, China has invested over half its national output in US treasuries over the last decade. Capital has been flowing uphill in pursuit of security. (In fact, the home bias

may be due to overestimating the risk premium involved with international investment). It is worth noting that Lucas (1990) rejected the notion that risk premiums were behind the paradox, pointing to the fact that before World War II many of todays developing countries were colonies and subject to rich-country laws. However, since WWII the world has become inhabited by smaller, independent nations and so the issue of sovereign risk is widespread in international finance. Alfaro, Kalemli-Ozcan and Volosovych (2008: 7) define sovereign risk as any situation where a sovereign default on loan contracts with foreigners, seizes foreign assets located within its borders, or prevents domestic residents from fully meeting obligations to foreign contracts. It is particularly problematic because there is no international enforcement of debt contracts between nations (though gunboat diplomacy was popular in the 19th century). Reinhart and Rogoff (2004) have argued that while there are a number of plausible explanations for the Lucas Paradox, some are more relevant than others. In particular, they place inefficient credit markets are the centre of their explanation. They argue that credit risk is a far more compelling reason for the paucity of capital flows from rich to poor countries, noting that only 12 percent of low income countries issued any equity during 1983- 2003, and only a third of middle income countries did so. All OECD countries by comparison issued equity during this period. Reinhart and Rogoff (2004) note that corruption, volatile weather and commodity prices in developing nations are leading causes of this risk. The key explanation to the Lucas paradox according to these authors may be quite simple: countries that fail to repay their debts have a difficult time borrowing from the rest of the world. In particular, they calculate that if the odds of default are as high as 65 percent for some low income countries, credit risk seems like a far more compelling reason for the lack of capital flows to poor countries.

WHAT IS LEFT OF THE PARADOX?

Caselli and Feyrer (2007) have shown that the return to capital is remarkably similar across countries once properly measured in a development accounting framework. The authors attribute lower capital ratios in developing countries to lower endowments of complementary factors and lower efficiency, as well as to lower prices of output goods relative to capital. Furthermore, they find that may not be equal across countries. The evidence suggests that the contribution of capital to output is much lower in developing countries where a large part of GDP is derived from natural resources. Given that any number of the above factors is capable of explaining the apparent Paradox of capital flows, the true paradox may be that too much capital makes its way developing nations, in particular serial defaulters (Reinhart and Rogoff, 2004). Furthermore, the results of Caselli and Feyrer (2007) call into question the effectiveness of aid intervention in developing nations. Their analysis implies that foreign aid is no better at promoting growth than foreign investment as both will result in divergent result with poorer nations simply converging to a lower equilibrium level of output. Indeed, Rajan and Subramanain (2008) find little robust evidence of a positive (or negative) relationship between aid inflows into a country and its economic growth. Batista & Potin (2009) find that in a Heckscher-Ohlin framework, factor prices do not equalise with the returns to capital in higher in poorer countries. This prediction provides a good description of what happened to the 44 developing and developed countries in their dataset over the period 1976-2000. However, the authors also offer an explanation for the anaemic flow of capital from poor to rich countries during this period: the cost of capital when adjusted for quality differences is significantly higher in developing economies. Adjusting for differences in human capital using the estimates of Barro and Lee (2001), and quality-equivalent stocks of capital based on the results of Eaton and Kortum (2001), they find that countries can grow by beating the curse of diminishing returns. Therefore, despite taking a radically different approach, the authors confirmed the results of Caselli and Feyrer (2007): the rates of return of investing in manufacturing abroad are remarkably similar across country.

EXCEPTIONS TO THE PARADOX

There are certain exceptions when it comes to capital flows. Most studies look at the current account balance as a bottom line measure of growth. However, many emerging economies have tended to build up huge reserves of US treasuries in order to promote themselves from the volatility associated with rapid growth. However, if we look at a more specific type, mainly Foreign Direct Investment (FDI), the paradox becomes less apparent. FDI investment does appear flow the right way, that is, from rich to poor countries (Prasad et al., 2007). High growth emerging economies, China, and India have received huge FDI over the period 1970-2004 as a percent of GDP and in absolute terms. Not all types of capital are the same, either in terms of their allocation or their effects on growth. FDI investment is flowing in exactly the direction predicted by classical economic theory; from rich to poor countries in pursuit of a higher return on capital.

Figure 1: The Allocation of FDI Flows (Net) to Non-Industrial Countries Source: Prasad et al., 2007 So it may simply be the case that the Lucas paradox is merely the result of using broad measures of capital flows such as the current account, that include government reserves, which are motivated by factors other than maximising the return on capital. The difficulty with the above analysis is that it the flow of FDI to emerging economies occurred in parallel with institutional change in these economies. So this does not necessarily contradict the fundamentalist view. In many ways, FDI investment is more important for development. Javorcik (2004) found a number of positive productivity spillovers due FDI taking place through contacts between foreign affiliates and their local suppliers in upstream sectors. Of particular interest was the finding that such spillovers are associated with projects with shared domestic and foreign ownership but not with fully owned foreign investments. Many emerging economies legally require a certain percent domestic ownership of the enterprise. Therefore, it is quite plausible that FDI flows have improved many of the fundamentals in emerging economies, thus

creating a virtuous cycle of improving returns to capital and FDI. Indeed, the exceptions may prove to be more important that the rule. CONCLUSION Since Lucass (1990) seminal work, the debate surrounding this apparent paradox has raged for over two decades. However, a myriad of explanations have been advanced from both fundamentalists and those who emphasis capital market imperfections. When the findings from both camps are taken into account, it is not surprising that capital tends to flow uphill from poor to rich countries. Indeed, the true paradox may well be why any capital flows to poor countries at all given the adjusted real return on capital. However, looking at broad capital flows tends to miss the subtle mechanisms through which capital flows improve economic development. FDI investment does tend to flow from rich to poor countries in pursuit of higher returns. The major of capital flows from poor to rich countries, is composed of low-risk investments such a treasury bills. The positive spill over effects of this investment are minimal, but the spillover effects from FDI in developing nations can in fact create the golden eggs Marx was referring to. Indeed, if you measure capital flows in absolute terms, then it seems that capital outflows, rather than inflows, as the real source of such golden eggs. Prasad et al (2007) found a positive correlation between surpluses and growth between 1970 and 2004. Moreover, they find that countries that had high investment ratios and lower reliance on foreign capital (lower current account deficits) grew faster - by about 1 percent a year - compared with countries that had high investment but a greater degree of reliance on foreign capital. The rapid growth of emerging economies such as China and India is evidence of that fact, but such aggregate correlates miss the point. If one considers specific types of capital flows, such as FDI, then the positive externalities, such as boosting TFP through the diffusion of best practices, may be sufficient to ignite a virtuous cycle of increasing returns to capital and inward investment References Albuquerque, R., N. Loayza, and L. Servn (2005): World Market Integration through the Lens of Foreign Direct Investors, Journal of International Economics 66: 267 295.

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