Why Capital Flows Uphill

LONDON – At first, it seems difficult to grasp: global capital is flowing from poor to rich countries. Emerging-market countries run current-account surpluses, while advanced economies have deficits. One would expect fast-growing, capital-scarce (and young) developing countries to be importing capital from the rest of world to finance consumption and investment. So, why are they sending capital to richer countries, instead? China is a case in point. With its current-account surplus averaging 5.5% of GDP in 2000-2008, China has become one of the world’s largest lenders. Despite its rapid growth and promising investment opportunities, the country has persistently been sending a significant portion of its savings overseas. And China is not alone. Other emerging markets – including Brazil, Russia, India, Mexico, Argentina, Thailand, Indonesia, Malaysia, and the Middle Eastern oil exporters – have all increased their current-account surpluses significantly since the early 1990’s. Collectively, capital-scarce developing countries are lending to capital-abundant advanced economies. Many observers believe that these global imbalances reflect developing economies’ financial integration, coupled with underdevelopment of domestic financial markets. According to this view, these countries’ demand for assets cannot be met – in terms of both quantity and quality – at home, so they deploy part of their savings to countries like the US, which can offer a more diverse array of quality assets. While plausible, this argument suggests that, as financial markets improve over time in developing countries, the global imbalances are bound to shrink. But such a reversal is nowhere in sight. Why? A crucial dimension of globalization has been trade liberalization. For China, foreign trade as a percentage of GDP soared from 25% in 1989 to 66% in 2006, largely owing to its admission to the World Trade Organization in 2001. Most of what China and other developing countries produce and export are labor-intensive goods such as textiles and apparel. This has allowed advanced economies, in turn, to produce and export more capital-intensive, higher-value-added products. Globalization of trade enabled countries to tap the efficiency gains that specialization in their sectors of comparative advantage has brought about. With a slight mental stretch, one can imagine that what a country produces and trades may affect its savings and investment decisions. An economy in which the main productive activity is berry picking, for example, has little need for investment and capital accumulation. Its laborers earn wages, consume, and save part of that income. Since the production process requires little capital, there is no demand for domestic investment – and thus no savings vehicles. Instead, the only way to save is by purchasing capital abroad – in economies with capital-intensive production and demand for investment. This economy will always export its savings. That may be an extreme example, but it illustrates a more general point about how merchandise trade can influence financial flows. Countries that produce and export more labor-intensive goods – perhaps owing to increased trade openness, or faster labor-force and productivity growth, all of which are true of China – may experience a rise in saving, but a less-than-equivalent increase in demand for capital. Rich countries, by contrast, are able to export more capital-intensive goods, and thus have a greater need for investment. So they may be importing more capital – resulting in a greater current-account deficit – simply because they are producing more capital-intensive goods. With developing countries – in particular, China, India, and the ex-Soviet bloc – bringing almost 1.5 billion workers into the world economy since the early 1990’s, it is not difficult to understand the potential impact of this effect. After all, much of this labor force was absorbed by labor-intensive industries that eventually churned out products exported to the rest of the world. Indeed, that massive addition of labor helped to drive down the relative price of labor-intensive goods, which fell by roughly 15% between 1989 and 2008. As developing countries increased their labor-intensive production and exports, their current-account surpluses rose – by almost 3.6 percentage points, on average, between 1989-1993 and 2002-2006. China’s current-account surplus increased by almost 11 percentage points over the same period, India’s by 2.5 percentage points, and Russia’s by seven percentage points. These countries, as well as other large surplus economies, such as Brazil, Saudi Arabia, and Iran, all experienced a simultaneous increase in the labor content of exports. This pattern contrasts with that of the United States and many other advanced countries, which have experienced a deterioration of their current-account balances as their production and exports have become more capital-intensive. Many might doubt the view that China is exporting more labor-intensive goods, rather than upgrading its exports on the capital- and skill-intensity ladder. But trade data suggest the opposite, perhaps because China’s accession to the WTO led to tariff reductions that released more labor-intensive production. In fact, trade data may underestimate the true extent of China’s labor intensity and overstate the capital and skill intensity of China’s exports. China has witnessed rapid growth in the processing trade: assembling intermediate inputs – imported from countries like the US and Japan – that have high capital and skill content. So, while the exports of these final goods may count towards China’s own capital and skill content, the country’s real role was only in the labor-intensive process of assembly. A country’s production structure may very well determine how much capital it supplies and how much it needs. So the fact that capital may flow towards rich countries that produce and export more capital-intensive goods should not be so puzzling, after all. Keyu Jin is Lecturer in Economics at the London School of Economics. Copyright: Project Syndicate, 2012.