World Bank Blogs IBRD and IDA: Working for a World Free of Poverty. en Why isn't financial deepening happening in the poor countries? <p>While global financial integration has been progressing well, financial deepening is not.&nbsp; Only a handful of emerging market economies are benefiting from large capital inflows in the form of FDI.&nbsp;&nbsp; In countries like Kenya where the capital account is open and foreign bank entry has long been allowed, capital market remains shallow and real interest rate remains high, hindering the private sector development.&nbsp; </p> <p>&nbsp;</p> <p>Why is there a weak association between financial openness and financial deepening in the poor countries?&nbsp; In a November conference, Professors Ju and Wei seemed to have provided an answer.&nbsp; In their paper &quot;<a href="" target="_blank">A Solution to Two Paradoxes of International Capital Flows</a>&quot;, they provide a framework to study the role of financial and property right institutions in determining patterns of capital flows.&nbsp; Their two-sector model features differentiating returns to financial investment and physical investment, as financial investors have to share the return to capital with entrepreneurs.&nbsp; The more developed a financial system is, the greater the slice that goes to the financial investors.&nbsp; As an implication, a poor country with an inefficient financial sector may experience a large outflow of financial capital, but together with inward FDI, resulting in a small net inflow.&nbsp; The model also incorporates property rights protection as another institution.&nbsp; Countries with poor property rights protection may well experience an outflow of financial capital without a compensating inflow of FDI.</p> <p>&nbsp;</p> <p>First, the quality of the financial system and expropriation risk play crucial roles in the patterns of capital flows.&nbsp; Second, financial capital flows and FDI can move in either the same or the opposite directions.&nbsp; And last, in a world of frictionless capital markets and identical expropriation risks,&nbsp; the less developed financial system is completely <strong>bypassed</strong>,&nbsp; and that is, all capital owned by the country with the less developed financial system will leave the country in the form of financial capital outflows, but physical capital (and projects) re-enters the country in the form of FDI.&nbsp; That implies, the less developed financial system serves no financial intermediation at all in the equilibrium. </p> <p>&nbsp;</p> <p>This and other crucial issues will be discussed in <strong>WBI's Global Senior Policy Seminar on &quot;Capital Flows, Financial Integration and Stability&quot;</strong> to be held on April 23-26, Paris France.&nbsp; For information and registration, please click <a href="" target="_blank">here</a>. </p> Tue, 20 Feb 2007 16:30:15 -0500 Yan Wang Why doesn't capital flow from rich to poor countries? <p>While global cross border capital flows have risen to reach nearly $6 trillion in 2004, only a small fraction (about 10%) flows to developing countries.&nbsp; People cannot help but ask, Why doesn't capital flow from rich to poor countries?&nbsp; In a recent conference, Prof Enrique G. Mendoza and his co-authors seemed to have provided an answer.&nbsp; In their paper &quot;<a href="" target="_blank">Financial Integration, Financial Deepness and Global Imbalances</a>&quot;, they argue that in the last decade, financial integration was a global phenomenon, but financial development was not.&nbsp; Capital market liberalization may lead to global imbalances when countries are vastly different (heterogeneous) in their levels of financial development.&nbsp; </p> <p>&nbsp;</p> <p>Their model shows that first, countries with deeper financial markets have lower savings and accumulate net foreign liabilities.&nbsp; Conversely, countries with shallow financial markets may have higher savings (due to the lack of insurance, for example) but higher capital outflows (out of desire to seek more secure&nbsp; returns).&nbsp; Second, financial market differences also affect the composition of the international portfolio.&nbsp; Countries with deeper financial markets invest in high return assets. As a result, they may receive positive factor payments even if the net foreign asset (NFA) position is negative (e.g. the US).&nbsp; The authors conclude that this has some welfare implications to developing countries:&nbsp; Low income countries with low levels of financial development will be worse off in such an environment because their savings may bypass their domestic financial sector and flow to developed countries with highly sophisticated financial markets, at least in the short run.&nbsp; (Considering learning by doing, the long run effect may be different, in my view ).</p> Mon, 13 Nov 2006 11:02:20 -0500 Yan Wang China in the Age of Globalization <p>In a little over a quarter of a century, economic reforms and openness have let to rapid economic growth and poverty reduction in China with her international trade soaring to reach $1.1 trillion in 2004 when China became the world&rsquo;s third largest trading economy (WTO 2005, 16).&nbsp; Policymakers and development practitioners the world over are wondering how.&nbsp; In a recent NBER paper &ldquo;<a href="" target="_blank">China&rsquo;s Embrace of Globalization</a>&rdquo;, Lee Branstetter and Nick Lardy (2006) provided an excellent overview of China&rsquo;s pre-WTO and post-WTO reforms, encompassing reforms in trade, investment and foreign exchange regimes.&nbsp; </p> <p>&nbsp;</p> <p>Several main themes in this paper are inspirational: first, prior to WTO accession, China had achieved a greater degree of openness to foreign trade in manufactures than is generally acknowledged; and the reforms accelerated in the late 1990s.&nbsp; Second, to date, China has made reasonable progress toward meeting her WTO obligations, which will likely to make China the most open of large developing countries.&nbsp; Third, the patterns of China&rsquo;s trade have conformed to patterns of her comparative advantage, benefiting China and her trading partners. In particular, multinational corporations (MNCs / FIEs) are using China as an export platform, and the biggest exporters in China are foreign invested firms. As a result of this displacement effect, the combined shares of the US global trade deficit accounted for by China, Japan, Hong Kong, Taiwan and South Korea actually fell. So it is misleading to just focus on the US-China bilateral trade deficit which is rising rapidly causing so much concern. </p> <p>&nbsp;</p> <p>One particular point got me thinking. The authors eluted to the possibility that &ldquo;an overdevelopment of the export sector was a function of a long undervalued exchange rate&rdquo;.&nbsp; &ldquo;The longer a currency&rsquo;s undervaluation encourages an overexpansion of the export sector, the greater the power of the lobbying groups that could seek to halt or limit the adjustment &hellip;.&rdquo; To which I might add, the overexpansion of goods exporting sector is in sharp contrast with an inefficient service sector: even though progress has been made, China&rsquo;s service sector has been largely sheltered from international competition until recently, and many subsectors are under state monopoly. FDI in these areas has been limited and the budgetary allocation to social services (0.6 percent of GDP on health and 2.4 percent on education) has been lower than other developing countries.&nbsp; The imbalances between the manufacturing and the service sector (accounting for only 40 percent of GDP and declining) are more pronounced in China than elsewhere. It is now the time for rebalancing the pattern of growth to shift the focus on the reform and <a href="" target="_blank">trade in services</a>. (<a href="files/Services%20in%20China.doc" target="_blank">detailed program</a>)</p> Tue, 03 Oct 2006 10:55:22 -0400 Yan Wang Global Imbalances and Adjustment Scenarios <p>How will global external imbalances adjust? Economists have vastly diverse views. The <a href="" target="_blank">IMF</a> presented two adjustment scenarios using its Global Economic Model, a benign baseline and a more abrupt adjustment. Depending on views regarding the probabilities of various adjustment scenarios, proposed policy responses differ. This note provides a survey of recent literature and summarizes diverse views on various assessment of the probability of a hard landing, and the proposed policy responses. </p> <p>The <strong>benign adjustment scenario</strong> presented by the IMF requires a gradual reduction of current account surplus in emerging Asia, and a gradual rise in real interest rates in the US leading to an increase in savings rate, a slowdown in GDP growth and a reduction in the CA deficit to 3.5 percent of GDP by 2010. However, this scenario depends critically on the willingness of foreigners to accommodate a further buildup in US foreign liabilities without demanding a large risk premium. (<a href="" target="_blank">IMF, 2005, WEO</a>)</p> <p>The second scenario looks at the impact of <strong>a more abrupt and disorderly adjustment</strong> &ndash;a hard landing. Assuming a combination of a rise in protectionism and a sudden decline in demand for US assets including an abandonment of pegs in emerging Asia, this will lead to a sharp contraction in the US economy.&nbsp; The sudden shift in portfolio preference away from US assets forces a large real depreciation of the dollar, and a sharp correction of the trade balance. Together with the rise in protectionism, this leads to rising inflationary pressure, requiring a significant monetary tightening in the short term, which amplifies the contraction in GDP growth. The emerging Asia experiences a sharp real appreciation, a deterioration in trade and current account balances and a slowdown in growth. Similar impact will be felt in Japan, euro area countries, and other developing regions. The hard landing will lead to a global slowdown with severe consequences to the poor.&nbsp;&nbsp;</p> <p><a href="" target="_blank">Professor Roubini</a>, among others,&nbsp;argued that the probability of a hard landing has increased for the following reasons.</p> <ul> <li> <p><u>First</u>, there is a great deal of complacency in the US, and it is quite apparent that the government is not doing anything to resume its fiscal discipline by cutting spending or increasing taxes.&nbsp; About 100 percent of US fiscal deficit has been financed abroad.</p> </li> <li> <p><u>Second</u>, China may be forced to allow more exchange rate flexibility and adjust its portfolio allocation due to economic reasons. &nbsp;China&rsquo;s economy is becoming increasingly imbalanced &ndash;with a large CA surplus and partially sterilized capital flows, there has been a rising money supply and abundant liquidity which feeds into a lending boom. With limited investment opportunities, this leads to overinvestment and declining returns from investment which exacerbate the NPL problems of the banking system. The asset /real estate bubbles and regional and sectoral imbalances may force the government to abandon the tightly managed exchange rate and allow the currency to appreciate. Recently, the State Administration of Foreign Exchange (SAFE) has indicated their intension of diversifying its asset holding.</p> </li> <li> <p><u>Third</u>, if China does not adjust its exchange rate, the rest of emerging Asia is not likely to do anything for the fear of losing competitiveness.&nbsp; However, in his view, if China adjusts its exchange rate and asset holding, the rest of emerging Asia may follow suit. If a group of central banks takes similar actions, this may in turn lead to a sudden change in the investor sentiment, resulting in a sharp contraction in the global economy and a greater risk of financial market disruption. </p> </li> </ul> <p>Jury is still out as to which of these different views and scenarios turns out to be correct. However, the severity of the current global imbalances calls for concerted actions by all, including:</p> <ul> <li>A rapid fiscal consolidation to raise savings rate in the US;</li> <li>Greater exchange rate flexibility in Emerging Asia; and </li> <li>Structural reforms in Japan and the Euro area to boost growth and domestic demand through increasing labor market flexibility and competition.</li> </ul> <p>This&nbsp;note provides a non-technical background briefing to policymakers and practitioners in developing countries. In particular, this will be useful as background for our Global Seminar on <a href="" target="_blank">Capital Flows and Global External Imbalances</a>, to be held in Paris, April 3-6, 2006. </p> Tue, 14 Mar 2006 07:11:12 -0500 Yan Wang The Sources of Global External Imbalances <p>Although the world economy has been growing at a decent rate in the last three years, the global current account imbalances have reached unprecedented levels.&nbsp; On one hand, the US current account deficit rose from $665 billion in 2004, to $820 billion or 6 percent of GDP in 2005, and is expected to reach $900 billion in 2006. On the other hand, there is a rapid accumulation of foreign exchange reserves in Emerging Asia as well as in oil exporting countries.&nbsp; As global current account imbalances have grown, the dispersion in net foreign asset positions has also correspondingly increased.&nbsp; The US net foreign asset position steadily deteriorated between 1996 and 2002, while Japan, emerging Asia and oil exporters have built up significant creditor positions.</p> <p>Economists have vastly diverse views on the causes and implications of the global external imbalances as well as their proposed policy responses.&nbsp; This note provides a survey of recent literature and summarizes those views.</p> <p><strong>Three Different Views on the Causes of the Global Imbalances</strong></p> <ol> <li> <p>The <strong>optimistic view</strong> <strong>is that we have entered a new golden age</strong> where the current international monetary and financial system is the Bretton Woods system reborn.&nbsp; Today, like 40 years ago, the international system is composed of a core, which has the privilege of issuing the currency used as international reserves, and a periphery, which is committed to export-led growth based on the maintenance of an undervalued exchange rate (emerging Asia and in particular China). Defying all economic theories, the large current account deficit in the US has not let to a depreciation of the dollar, as 50 percent of this deficit has been financed by foreign central banks and another 50 percent by private investors.&nbsp; As a result, US interest rate has been kept low, and consumer spending has been resilient and corporate profitability has been strong even in the face of a roaring oil price, escalating budget deficit and the detrimental impact of Katrina. Some argued there is an overly optimistic expectation about future investment returns in the US based on the high productivity growth in the 1990s. Thus, a large amount of oil revenue has been recycled back to the US which is one of the reasons that the US dollar remains strong.&nbsp; According to this view, there is no real reason for concerns as long as foreign central banks and investors are willing to hold dollar and finance the US Current Account deficits.&nbsp; In this view, the current international settlement system can be maintained indefinitely, and there is little need for policy adjustment. </p> </li> <li> <p><strong>The second group considers the global imbalances as mainly due to a &ldquo;global saving glut&rdquo;</strong> where the swing in the saving-investment gap from deficit to a large surplus in emerging Asia has resulted in an excess global supply of saving (a global saving &ldquo;glut&rdquo;) that has been channeled to the US to finance its large current account imbalances (Bernanke 2005, also Chapter II, IMF&rsquo;s WEO). This would also explain the low level of long-term interest rate in the face of a low and declining rate of savings in the US and other industrial countries. According to this view, consumers in emerging Asia seem to have saved too much as compared to investment opportunities in their own economies. Several structural and policy issues in China have kept savings rate high and investment returns low including, e.g. inadequate provision of health and social insurance, and an inefficient banking system. A variant of this group focuses only on the exchange rate regime in China and emerging Asia as the main source of imbalances. According to this view, it is China and the rest of emerging Asia who need to adjust/reform their policies. Others, however, have argued that the US is the biggest beneficiary of high savings rate in China and other Asian countries, and that US economy has been riding on the high savings rates in these countries (Fehr, Jokisch, and Kotlikoff 2005). Using the overlapping generations model they predict that in the long term interest rates will continue to be kept low and the real wage rates will rise, rather than fall, thanks to the high savings rate in China. &ldquo;China eventually becomes the world&rsquo;s saver and the developed world&rsquo;s savoir with respect to its long term supply of capital and its long-run general equilibrium prospects.&rdquo; (Fehr, Jokisch, and Kotlikoff 2005, p.1).&nbsp; </p> </li> <li> <p><strong>The third group has argued that the sharp drop in the national saving in the US --reflecting the deterioration in the fiscal position and the increase in housing wealth-- and the recent rebound in investment are at the root of current account imbalances</strong> (see, for example, Roubini and Setser 2005). Indeed, the CA deficit was widened by 2 percentage points, and fiscal deficit worsened by 6 percentage points, but dollar remained strong in 2005. The increase in saving in China and other Asian economies has contributed to keeping the interest rate low. But this &ldquo;ideal&rdquo; world of Bretton Woods 2 system will not last long. <a href="" target="_blank">Roubini</a> argues that it will unravel &ldquo;in less than 5 years&rdquo;. Sooner or later, the willingness of central banks and private investors of holding dollar denominate asset will decline. And many worry that Bretton Woods 2 will unravel in a disorderly fashion, resulting in a hard landing. Why? &ldquo;Because the global imbalances have been worsening and currently no one is doing anything about it. The US is not doing much on its twin deficits and China is not likely to budge on exchange rate appreciation.&rdquo; Therefore, Roubini argues that the probability of a hard landing is rising. </p> </li> </ol> Thu, 09 Mar 2006 06:26:47 -0500 Yan Wang