International Capital Flows: Sustainability, Sudden Reversals, and Market Failures

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 [1993] 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 taxation. 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 national savings. …