Should Capital Flow to Poor Countries?

Authors: Uri Dadush, Bennett Stancil
Originally published by the Carnegie Endowment for International Peace

Economists tend to assume that capital should move from advanced economies—those with abundant capital—to developing ones—those with little capital and abundant labor. However, this line of thinking is not only simplistic and empirically unverified, but it is also dangerous. It can, for instance, encourage developing countries to attract capital they cannot absorb and is ultimately destabilizing.

• Numerous considerations beyond relative labor and capital stocks (factor endowments) affect the profitability and risk associated with international investment. These forces frequently work to retain capital in advanced countries and to encourage capital outflows from developing ones. In comparison with advanced countries, developing economies have higher start-up costs, weaker institutions, more sovereign risk, less-skilled workers, and shallower capital markets, all of which discourage investment. Moreover, important forces also cause capital to flow out of developing countries—including political and expropriation risk, limited investment opportunities, the need for diversification, and relatively high savings rates.
• Governments play a big role in capital flows through their accumulation of reserves. From 2000 through 2010, developing countries added $5.5 trillion to their stock of foreign exchange reserves and had an aggregate current account surplus of only $3.8 trillion. The official acquisition of reserves more than offset the net flow of private capital to developing countries. Some of this reserve accumulation is clearly excessive, but it is difficult to say how much.
• Developing countries that run large current account deficits should not assume that doing so is fine because they are poor. They can clearly benefit from inflows of foreign capital, especially in the form of foreign direct investment, provided they are deployed for productive purposes and are not overly prone to sudden stops or reversals. Likewise, advanced countries should not assume that large current account surpluses are natural because they are rich.
• Above all, the recent global financial crisis has shown that even in the most capable environments, the potential for misallocating capital is immense. Thus, the presumption that large amounts of capital should flow from rich to poor nations, whose institutions are even weaker, should always be treated with skepticism.

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