Capital exports drive development

Conventional economic wisdom has it that poor countries develop by importing capital from rich countries to acquire the extra resources needed for investment. But according to a study authored by David Folkerts-Landau and Peter Garber of Deutsche Bank's global research group together with consultant Michael Dooley, that theory is not borne out by what happens in real life. Successful emerging economies like China have not, on balance, been importing capital; they have been exporting it. Instead of investing income from exports (not least to the United States) at home, they amass for-ex reserves in US dollars and invest them predominantly in US Treasury Bonds. Emerging nations thus put money into the world’s richest industrialised nation – not vice versa.

Established theory sees an untenable imbalance here. But even on that point the three authors beg to differ: they regard huge US deficits in both trade and capital flows – notably with emerging Asian economies – as anything but a sign of dangerous instability in the global economy. On the contrary, they consider it a necessary side-effect of the international capital flows that have underpinned growth in countries like China. According to Folkerts-Landau et al emerging nations’ investment in US dollars is a kind of collateral for foreign investment in those counties.

Unlike in industrialised countries, with their established legal systems, investors in emerging economies face the risk of political constraint, even expropriation. As a consequence – the authors explain – developing countries receive private loans and investment only if they provide some form of security. And that, the study points out, is effectively what happens when a country buys US Treasury Bonds. The US Administration has the legal power to confiscate the US assets of a government that, for example, expropriates foreigners. And Washington has exercised that power in the past. So a country with a great deal of money invested in the United States is unlikely to break rules in its treatment of foreign investors. The authors refer to this unspoken condition for access to the international capital market as an “implicit contract”.

That contract, they say, is the reason that emerging economies like China hold massive amounts of US bonds – even though they are a relatively low-yield investment. According to the study, the foreign-exchange reserves of China and a group of 49 other emerging economies have for years mirrored the level of collateral that would be required for a particular form of private investment equal to the total volume of foreign direct investment in those countries. The Deutsche Bank researchers see this as evidence of the countries complying with the implicit contract. The study shows that they increase their dollar reserves in line with the rise in value of the foreign investment they receive. To do that, they have had to keep on buying US Treasury Bonds and that makes the system stable.

This new model, like the conventional one, attributes a crucial role in development to the international capital market – but not because it provides a net capital flow to poor countries, but because it brokers access to technology and management expertise. This, the authors explain, is why investment banks like the one they work for promote development. They do not claim the system is commendable, just that it works.

Their objections to established development theory are compelling. What is less clear is how tenable their alternative model is. What happens if conditions for investors in countries like China stabilise, for example, making collateral superfluous? And do governments really invest in the United States just because of the “implicit contract”? Imputing such motives from the mere fact that global statistics tally with the model is problematic from a methodological viewpoint. For example, there is evidence that a number of Asian countries have increased their foreign-exchange reserves as a hedge against financial crises or – as in the case of Taiwan – for reasons of national security. (bl)