A Solution to Two Paradoxes of International Capital Flow

1. A Solution to Two Paradoxes of International Capital Flow Jiandong Ju and Shang-Jin Wei * Personal views, not those of the IMF

2. Motivation Cross-border capital flow reached nearly $6 trillion in 2004. Less than 10% goes to developing countries. The paradox of too little capital flow: in a one-sector model, marginal product of capital is lower in rich country, but the amount of capital from rich to poor countries is too small (the Lucas Paradox) Example: India vs the U.S. (5800% difference in MPK) The paradox of too much capital flow: in a 2-sector, 2-factor model, factor prices are equalized in a free trade world (FPE due to Samuelson). So there is no incentive for any capital to flow.

3. Objectives of the paper Existing explanations of the Lucas paradox do not survive in a generalization to a 2X2 model To build a micro-founded non-neo-classical theory to solve the two paradoxes To highlight (possibly different) roles of financial development and property rights institutions in international capital flows

4. Existing explanation of the Lucas paradox within a neo-classical framework Difference in effective labor Missing factor (e.g. human capital) Sovereign risk (Reinhart and Rogoff) Trade cost (Obstfeld and Rogoff) Difference in TFP (of which institution is a special case) Common problem: They do not survive in a generalization to a neo-classical two sector, two factor model

5. Chain rule of FPE Lemma 1: Let # factors = m. All other neo-classical assumptions apply. For any two countries, factor prices are equalized if the countries can be linked by a sequence of country pairs, and if the countries within each pair produce a common set of m products. Example: Two factors (land and capital) US and India may not produce anything in common, and may not even trade with each other. But FPE could hold if US-Greece (apple & apricot) Greece-Thailand (beer and bottle) Thailand-India (cabbage and carriage)

6. If existing explanations of the Lucas paradox don�t work, what about textbook reasons that break the FPE in the 2X2X2 model? Difference in technology No eqbm in general (Panagariya) We are NOT saying that FPE is realistic, but that it is much more difficult to escape from the tyranny of FPE that the existing literature may have realized.

7. Intuitive outline of our model We work with a two-sector model but with two twists To resolve the Lucas paradox, we introduce a financial contract between entrepreneurs and investors: Each only gets a slice of the marginal product of physical capital. To move away from FPE, we introduce heterogeneous entrepreneurs, which result in sector- level DRS (despite firm-level CRS).

8. Re-do Lucas� example: India vs the U.S. India�s K/L ratio is only 1/15 of the U.S. Its financial system is also much less efficient In the absence of capital flow, the return to financial investment is lower in India than in the U.S. India experiences an outflow of financial capital At the same time, because Indian�s return to physical capital is higher -> Inflow of FDI Inflow of FDI is bigger than it would have been if its financial system had been more efficient Return differential is smaller than Lucas� calculation Much smaller friction can stop the capital flows

9. Roadmap The Model Two key parameters Financial development Control of expropriation risk (property rights protection) Comparative Statics Free trade in goods Financial capital flow FDI World capital market equilibrium Some very preliminary/suggestive evidence

10. Model Description Within an economy (2 sectors, 2 factors) For a given sector: Labor Capitalists (each endowed w one unit of capital) Entrepreneurs + financial investors Linked by financial contracts 2-period production; Liquidity shock in 2nd period Moral hazard problem Two country world economy Various scenarios of capital flows

11. Time line of the model

12. The Model

14. Financial Contract:

15. Solution

16. Allocation of Capital within and across Sectors Lemma 2: The more productive entrepreneurs enter the heterogeneous sector, while the less productive ones enter the homogeneous sector. In the heterogeneous sector, relatively more productive entrepreneurs manage more capital.