According to Jiandong Ju, the low movement of capital inflow from rich countries to poor countries can be explained using the assumption of one sector in the economy. He came up with three major propositions as to why there is little capital outflow from the rich countries to the poor countries. According to Lucas, the capital flow is determined by the marginal product of capital. The first factor he proposed for the low capital outflow was the sovereign risk assumption. Sovereign risk is the assumption that the government bills and bonds are risk free. He explains that the sovereign risk does not provide any incentive for the movement of capital between the rich and poor countries.
The second proposition is based on the assumption of the missing factor in the economy. He explained that the differences in the capital outflow were brought about by the differences in the factors in, the two countries. He gave an example of U.S and India. It was expected that capital would move from the United States to India. However, this was not the case as the United States had an abundance of labor as compared to India. The factors under consideration include human capital, labor and capital. Countries with the same number of factors of production were likely to have price equalization. This explains why there was no capital outflow from the United States to India.
The third proposition is based on effective labor in the two countries. It is expected that if the American worker is 5 times more skilled than the Indian worker, then the expected difference in the return to capital would be five. This is not the case because an increase in productivity increases wages but does not have any effect on the return of capital hence the low capital movement. According to Pierre-Olivier, the flow of capital does not move towards countries which have higher productivity and investment. The article bases its argument of the little capital outflow on one country against the whole world. The capital flows in the developing countries are determined by the productivity in the respective country as compared to the rest of the world.
The first explanation of the little capital movement can be explained by the relationship between savings and growth. It is known that the level of savings increases with the level of growth. There is a direct relationship between the level of savings and the rate of growth in a country. The Lifecycle model, which was suggested by Modigliani in 1970, shows that a higher growth rate in a country increases the level of savings among the young population as compared to the older population. The growth rate leads to increased productivity in the country. Lucas argued that there is higher capital movement in the countries with higher productivity as compared to those countries with low productivity. There are more capital inflows into America as compared to Africa due to differences in the growth and productivity.
The level of income of a country is also used to explain the little capital movement between the rich and the poor countries. According to Corollary, Poor countries have a lower level of productivity and should, therefore, export more capital. There is a negative relationship between per capita income and the capital inflows. The capital flow decreases as the level per capita income increases. Poor countries have low per capita income and hence are going to export capital. As per capita income so does the level of capital flows decrease..
According to Eswar S. Prasad, one of the major factors contributing to low capital inflow from rich countries to poor countries is the relationship between financial integration and growth. In this article, the capital inflows are referred to as the current account balances. The capital inflows may include FDI, debt and equity. The different types of capital inflows have different impacts on the country under consideration. Debt and equity may affect the macroeconomic policies of a country while FDI is considered to be an important source of technology. From the analysis carried out, it was concluded that countries, which did not rely heavily on foreign financing, had a higher growth rate. Rich countries have less current account deficits than the poor countries. This means that there are low capital inflows from the rich countries to poorer countries.
The relationship between the growth rate and the net foreign fixed and current assets also contributes to failure of capital movement between the rich and poor countries. Gross assets are positively related to the growth rate while there is a negative relationship between gross liabilities and the rate of growth. Countries with many assets grow faster as compared to those with few assets. The level of stock affects the current accounts. A country that has high stock has a high growth rate. Most poor countries have accumulated gross liabilities in foreign countries. This is because of the high level of borrowings and loans advanced to them. This implies there is no capital movement from the rich countries to the poor countries. On the other hand, rich countries have accumulated net assets in poor countries. This is as a result of investment made by the rich countries in the developing countries. The returns on investment thus move from the poor countries to the rich countries..
According to Steger, the paradox of capital movement is explained by the capital mobility between the rich and the poor countries. Obstfeld and Taylor, 2004, argued that the distribution of foreign assets is mainly among the rich countries. They referred to the situation as asset swapping diversification by the developed countries. Before the World War 1, there was a massive movement of capital from the rich countries to the poor countries. This is, however, not the case today. There is limited net capital inflow from the rich countries to the poor countries.
Lucas explained the change was as a result of differences in the rate of return on investments from the rich countries and the poor countries. He argues that physical capital is non-productive unless it is accompanied by human capital. However, human capital is missing in the poor countries and hence there are no capital flows between the poor and rich countries. Failure in the capital market also contributed significantly to minimal capital flows between the rich countries and the poor countries. The failure may be as a result of lack of information on how to invest the capital received and poor policies on the selection and identification of investment projects to undertake. Protection of accounts payable and property rights is important elements in facilitating capital inflows. The capital providers have to be certain that their interest is well protected, but this is not the case in poor countries.
Weak legal and political institutions contribute to the poor capital inflow between the rich and poor countries. There have been cases of failure by the government to breach the contractual agreement made during capital inflow. Cases of mismanagement and corruption in the institutions have weakened the rate of capital flows from the rich countries to the poor countries.. According to Laura Alfaro, minimal capital inflows into poorer countries are as a result of various issues. The issues include corruption in the poor countries, an insecurity which acts as a threat to investment by foreigners and poor policies in protection of patent property rights. The main inflows into the country are FDI in which may involve construction of manufacturing factories, equity capital, financial derivatives and debt capital.
Imperfections in the international capital markets are a source of capital diversion from the poor countries. The imperfections are in the form of poor information on the best investment decisions or projects. In the poor countries, investment decisions are poorly made. The government may decide to invest in a particular country, but they do not have any information regarding the economic conditions of the country. For instance, deciding to invest in China. The decision to invest there may be made because we think that there are higher returns. Differences in the quality of the institutions and weak institutions between the rich countries and the poor countries are a major factor leading to low capital inflows into the poor countries. The institutional qualities include the availability of human capital and market for the products. Rich countries have been relocating their operations to other developed countries where there is availability of labor and high technology. Poor countries have low quality institutions, and hence capital inflows into these countries are limited. A high quality institution requires high investment.
Lucas recommended certain policies to be implemented in order to encourage the inflow of capital to the poor countries. The policies included minimizing cases of corruption, establishing policies to help in the protection of property rights and improving the security system in the country.. According to Eswar Prasad, the paradox of capital highlights various reasons why the capital does not flow from the rich countries to the poor countries. The issues discussed include poor and undeveloped infrastructure, low labor force which consists mainly of unskilled people, low returns on investment and the failure to pay the amount granted in a country. The return on investment is low as compared to investing the same amount of capital in developed countries. This is the main reason why the rich countries prefer to invest in the developed countries as compared to poor countries.
Eswar Prasad focuses also on the relationship between the current account balances and the growth rate of a country. The current account balances are the external financing from borrowing. The current account balances affects the balance between the savings and investments of a nation. A country, which relies heavily on external financing, should have many investments in order to be able to repay the loan. Poor countries are, however, not able to balance savings and investment. They borrow more and invest less. This means that the capital inflows from the rich countries into the poor countries are minimal. This explains why there have been changes in the movement of capital from the rich countries to the poor countries. A country with high capital account balances grows at a slower rate than companies with low capital balances. The factors affecting movement of capital from rich countries to poor countries among the six articles discussed above are almost similar. The argument is based mainly on the current account balances, growth rate and imperfections in the market..
Works Cited
Eswar Prasad, R. R. (March 2007). The Paradox of Capital. The Paradox of Capital , 2-8.
Eswar S. Prasad, R. G. (April 2007). Foreign Capital and Economic Growth. Foreign Capital and Economic Growth , 9-11.
Jiandong Ju, S.-J. W. (APRIL 13, 2006). A Solution to Two Paradoxes of International Capital Flows. A SOLUTION TO TWO PARADOXES OF INTERNATIONAL CAPITAL FLOWS , 9-12.
Laura Alfaro, S. K.-O. (September 9, 2004). WHY DOESN’T CAPITAL FLOW FROM RICH TO POOR COUNTRIES? AN EMPIRICAL INVESTIGATION. CAPITAL FLOW FROM RICH TO POOR COUNTRIES? AN EMPIRICAL INVESTIGATION , 15-20.
Pierre-Olivier Gourinchas, O. J. (October 2011). The Allocation Puzzle. Capital Flows to Developing Countries: , 27-30.
Steger, M. S. (2008). The Lucas Paradox and the Quality of Institutions: Then and Now. The Lucas Paradox and the Quality of Institutions: Then and Now , 4-7.
