International Capital Flows:
By Assaf Razin*
Sustainability, Sudden Reversals, and Market Failures
*Razin is an NBER Research Associate in the Programs in International Finance
and Macroeconomics and International Trade and Investment and is the Mario
Henrique Simonsen Professor of Public Economics at Tel Aviv University.
The Mexican peso debacle and, most recently, the balance-of-payments
crises in Thailand, Malaysia, the Philippines, and Indonesia show how changes
in the direction of capital flows after a period of large current account deficits
can force the adoption of drastic adjustment measures designed to reduce
external imbalances and meet external obligations. Much of my recent
research has focused on the issue of balance of payments dynamics with
potential capital flow reversals. I have also investigated the related topic of
market failures associated with international capital flows and their implications
for capital accumulation and capital income tax policies. This summary briefly
reviews my work in these two areas . First I describe my research on external
sustainability  and my joint work with Gian-Maria Milesi-Ferretti [1996a,b
and 1997]. Then I summarize my research on the composition of international
capital flows between portfolio debt investment, portfolio equity investment,
and foreign direct investment (FDI) under asymmetric information between the
owners-managers of the corporation and other portfolio stakeholders, and
between the domestic and portfolio stakeholders [Razin, Sadka, and Yuen,
1996 and 1997]. The information-based framework, which gives rise to
inadequate domestic savings and foreign underinvestment, has important
implications for the domestic accumulation of capital and for international
Capital Flows Reversals
Three related questions often are asked about an economy's external
balances: Is a debtor country solvent? Is the current account deficit excessive?
Are current account imbalances sustainable?
An economy is solvent if the present value of present and future trade
surpluses is equal to the country's external indebtedness. The question of
whether particular current account deficits are excessive could be answered in
the context of the consumption smoothing model of the current account,
which yields predictions for the intertemporal equilibrium path of external
balances, based on the assumption of perfect capital mobility. This has been
demonstrated by Reuven, Glick and Kenneth Rogoff(1) as well as myself, working
independently(2) and with Leonardo Liederman.(3) When foreign investors are
uncertain about a country's willingness to meet its debt obligations, or about
its ability to do so in the face of external or domestic shocks, there are
constraints on the sustainability of current account imbalances in addition to
those imposed by pure intertemporal solvency.
In the context of a cross-country episodic analysis, Milesi-Ferretti and I
[1996a,b] consider potential indicators of sustainability and examine their
performance in signaling external crises.(4),(5) The episodes fall into three broad
categories of outcomes: 1) those in which sustained current account
imbalances did not trigger sharp policy reversals; 2) those in which external
and/or domestic factors caused a sharp policy reversal, but without external
crises; and 3) those in which persistent current account imbalances were
followed by an external crisis, resulting in debt rescheduling, renegotiations or
a massive bailout. We characterize these different experiences in terms of such
factors as the macroeconomic policy stance, the economy's structural
characteristics, and external shocks. Our aim was to determine whether (and
identify which of) the sustainability indicators help to discriminate among the
three groups of country episodes, in particular, between countries that did or
did not experience external crises . In order to interpret the contribution of
these indicators to explaining sustainability, it was important to ascertain
whether differences in the intensity of external shocks were not the
predominant reason for the range of country experiences. We find that various
indicators of sustainability help us to discriminate among the three possible
outcomes, including: the ratio of exports to GDP (a measure of trade
openness), the degree of real exchange rate misalignment, and the level of
Milesi-Ferretti and I interpret the role of trade openness as follows : In
order to service and reduce external indebtedness, a country needs to rely on
the production of exports as a source of foreign exchange. Clearly, a country
with a large exports sector can service external debts more easily, because
debt service will absorb a smaller fraction of its total export proceeds. In order
to generate the foreign exchange required to service external debt in case of an
interruption in capital flows, a country needs to engineer a resource shift
towards the exports sector. Since this shift cannot occur instantly, sharp import
compression may become necessary, with adverse consequences on domestic
industries that rely on imported inputs. This import compression may be more
costly in a relatively closed economy, because it is more likely to entail cuts of
"essential" imported inputs. Although the evidence from the sample of
episodes does not suggest that large fiscal imbalances ex ante imply that
current account deficits are unsustainable, in most of the episodes an ex post
improvement in the current account balance, after a prolonged period of
deficits, was associated with a fiscal consolidation.
My 1997 work with Milesi-Ferretti more systematically looks at the
determinants and consequences of reversals in current account imbalances.
Using a sample of 86 developing countries over the period 1971-92, we ask:
What triggers sharp reductions in current account deficits? And what factors
explain the costliness of such reductions?(6) A sharp reversal in external
imbalances can originate in a change in macroeconomic policy stance
undertaken by the country in question -- for example, the implementation of a
stabilization plan -- or it can be forced upon the country by external
developments, such as a sudden reversal in international capital flows that
forces the country to reduce its external imbalances.
In our sample of low- and middle-income countries, reversal events have
to satisfy two requirements: First, an average reduction in the current account
deficit of at least 3 percentage points of GDP over a three-year period. This
requirement captures the idea that a reversal is characterized by a large and
sustained reduction in current account imbalances. Second, the maximum
current account deficit after the reversal must be no larger than the minimum
deficit in the three years preceding the reversal. This requirement should insure
that we capture only reductions of sustained current account deficits, rather
than reversals of a temporary nature.
Our probit analysis identifies a number of "robust" predictors of reversals
in current account imbalances:
1) current account deficit. Not surprisingly, reversals are more likely in
countries with large current account deficits. This result is consistent with
solvency and willingness to lend arguments.
2) openness. Reversals are less likely in more open economies. This result is
consistent with our previous work(7) and with theories of current account
sustainability that emphasize how more open economies have fewer difficulties
in servicing external liabilities, and less incentive to renege on external debt,
thereby making a turnaround in capital flows less likely.
3) reserves. Countries with lower reserves (as a fraction of imports) are more
likely to experience a reversal. This result is consistent with a "reserves
adequacy" approach and, on the capital account side, with a willingness-to-lend
argument. The ratio of reserves to M2, which Calvo and others have identified
as a key predictor of recent balance-of-payments crises, does not appear to
signal reversals ahead of time in our sample. It is negatively correlated with our
event measure, but is "dominated," in terms of statistical significance, by the
4) investment. For a given size of the current account deficit, a high share
of savings and investment increases the likelihood of a reversal. High
investment and savings can increase future exports and output growth,
thereby contributing to narrowing current account imbalances.
5) concessional debt. As expected, the higher the share of concessional debt in
total debt, the less likely is a current account reversal. There can be two
reasons for this: concessional debt flows are less likely to be reversed; and,
they are likely to be higher in countries that have more difficulty reducing their
external imbalances and servicing their external obligations.
6) terms of trade before the reversal. Reversals are more likely in countries with
diminished terms of trade. One interpretation is that countries that have
suffered terms-of-trade deterioration are more likely to experience a reversal of
capital flows, and therefore may be forced to adjust. We also find that reversals
are more likely in years in which the terms of trade improve.
7) public deficit. The lower the public sector deficit, the higher is the probability
of a reversal. This result, somewhat difficult to interpret, can be caused by the
effects of fiscal consolidation on the current account.
Pecking Order of International Capital Flows
Even though financial markets today show a high degree of integration,
with large amounts of capital flowing across international borders to take
advantage of rates of return and the benefits of risk diversification, the world
capital market is still far from the textbook story of perfect capital mobility.
International capital immobility has been explained not only by capital controls,
but also by informational problems associated with international investments.
Because of adverse selection and moral hazard problems, real rates of return
across countries are not equal. Applying capital market regulations and better
rules of disclosure to information about domestic firm profitability alleviates
some of these problems of asymmetric information, but such rules and
regulations are not adequate in most developing countries. Adverse selection
problems give rise to a pecking order among types of international capital
flows: foreign portfolio debt investment (FPDI); foreign portfolio equity
investment (FPEI); and FDI. This ranking originates from the "home court
advantage" that domestic savers have over their foreign counterparts, and is
somewhat similar to the pecking order hypothesis of corporate finance.
In corporate finance, the hypothesis maintains that firms prefer internal finance
(retained earnings) to external finance. In the international capital market, FDI
comes first, FPDI second, and FPEI third. My 1997 analysis with Sadka and
Yuen considers three tax instruments, which together can level the playing
field and restore efficiency: a tax on the capital income of nonresidents , a tax
on capital income of residents; and a corporate income tax.(8)
Typically, though, there is also significant asymmetry in information between
the managing stockholders (owner-managers) and other portfolio equity- and
debt-holders. This asymmetry of information causes severe market failures,
which can be devastating in the case of equity-financed capital investment. We
show that the equity market may collapse to a "lemon" market, as in Akerlof,
and that little financing is provided for capital investment. We show that in this
case, FDI has an essential role in restoring the function of the capital market
and the financing of capital investment. However, such financing is still not
fully efficient, because it leads to foreign overinvestment and domestic
undersavings. A corrective tax package, with a tax on the capital income of
nonresidents and a subsidy to corporate income, will restore efficiency. Non-uniform taxation of capital income from various sources is crucial for the
efficiency of the international capital market in the presence of information-based market failures.
1. G. Akerlof, "The Market for 'Lemons': Qualitative Uncertainty and the Market
Mechanism," Quarterly Journal of Economics, 89, (1970) pp. 488-500.
2. R. Glick and K. Rogoff, "Global versus Country-Specific Productivity Shocks and
the Current Account," Journal of Monetary Economics, 35 (February 1995), pp.
3. L. Leiderman and A. Razin, "Determinants of External Imbalances: The Role of
Taxes, Government Spending, and Productivity," Journal of the Japanese and
International Economics, 5 (December 1991), pp. 421-50.
4. G. Milesi-Feretti, and A. Razin, "Sustainability of Persistent Current Account
Deficits," NBER Reprint No. 2100, December 1996. [1996a]
5. "Current Account Sustainability: Selected East Asian and Latin American
Experiences," NBER Reprint No. 2111, March 1997. [1996b]
6. "Origins of Sharp Reductions in Current Account Deficits: An Empirical Study,"
forthcoming as an NBER Working Paper 
7. A. Razin, "The Dynamic-Optimizing Approach to the Current Account: Theory
and Evidence," NBER Reprint No. 1984, July 1995. 
8. A. Razin, E. Sadka, and C. Yuen, "A Pecking Order Theory of International
Capital Flows," NBER Reprint No. 5513, March 1996. 
9. "An Information-Based Model of FDI and Capital Flows," forthcoming as an
NBER Working Paper.