# **<mark>Box 2.  Why Capital Flows Diverge From Their Predicted Direction and Volumes</mark>**

<mark>Theory says capital should flow from capital-abundant, rich countries to capital-scarce, poor countries. In practice, however, capital flows among rich countries dwarf those from rich to poor countries in volume. Why? Because of factors reducing risk-adjusted returns in poor countries, the default problem, and the</mark> limited range of instruments available in international financial markets.

- <mark>Risk-adjusted returns to capital in poor countries may be lower than in rich countries, contradicting the law of diminishing returns.  Factors such as human capital, the quality of institutions and political and policy predictability may operate to lower returns and raise risks notwithstanding relative capital</mark> capital-scarcity.<sup>1/</sup> Practice highlights the key role of institutions, incentives and productivity.

- <mark>Default risk, and the difficulty of securing legal redress against both foreign private and especially sovereign borrowers for enforcement of property rights, might also explain the home bias in lending</mark> and portfolio allocations of rich countries.

- <mark>The virtual absence of debt instruments that would adjust payments to shocks stemming from the terms-of-trade or world interest rates might appear surprising in view of the high levels of sophistication in world financial markets today.  GDP-indexed bonds do not as yet exist while currency risk is typically borne by the borrower.  One impediment might be moral hazard stemming from the ability of sovereign borrowers to influence the indexation variable, although this can be overcome by</mark> appropriate choice of an exogenous variable.   Yet such instruments do not exist.

1/ See, for example, Lucas (1988) and Mankiw, Romer and Weil (1992). _<mark>Source</mark>_ <mark>: Sturzenegger and Wolf (2004).</mark> Moreover, even the spurt of capital flows into MACs following the Brady Plan resolution of the 1980s debt crisis, and subsequent widespread liberalization of capital markets during the 1990s, may not have boosted investment and growth. Using a sample of 60 developing countries, one study found that, while the growing financial integration with the rest of the world has increased access to foreign private capital, the relationship between foreign capital and domestic investment has weakened, reflecting changes in the composition of inflows, offsetting outflows, and increased foreign currency reserve requirements.<sup>10</sup> Another study found that a substantial share of the surge in capital inflows has been channeled into reserve accumulation, and that an equal share found its way back out of the country. Using investment regressions, this study found that FDI shows the strongest link with aggregate investment, with a coefficient close to one.<sup>11</sup> A third study fails to find persuasive evidence of a “growth bonus” associated with an increased share of foreign saving in financing the domestic capital stock in a wide range of developing countries. The evidence suggests the opposite: in a sample of 47 countries, those which relied more on national savings (a higher “self-financing ratio”) grew much faster throughout the 1990s.<sup>12</sup> This result persists even when the impact of the quality of institutions on growth is allowed for. These findings are consistent with the idea that financial integration may have facilitated diversification of assets and liabilities, but failed to offer net new sources of financing capital in developing countries.<sup>13</sup>

> 10 Mody and Murshid (2002).

> 11 Bosworth and Collins (1999).

> 12 Aizenman, Pinto and Radziwill (2004).  See also Aizenman (2005), which contains a comparison of Korea and Chile.

> 13 Based on a regression of average per capita growth rates during the 1990s on the level, square and cube of the average self-financing ratio and its standard deviation.

8