Two-Way Capital Flows and Global Imbalances: A Neoclassical Approach

Abstract

Financial capital and fixed capital tend to flow in opposite directions between poor and rich countries. Why? What are the implications of such two-way capital flows for global trade imbalances and welfare in the long run? This paper introduces frictions into a standard two- country neoclassical growth model to explain the pattern of two-way capital flows between emerging economies (such as China) and the developed world (such as the United States). We show how underdeveloped credit markets in China can lead to abnormally high rate of returns to fixed capital but excessively low rate of returns to financial capital relative to the U.S., hence driving out household savings (financial capital) on the one hand while simultaneously attracting foreign direct investment (FDI) on the other. When calibrated to match China’s high marginal product of capital and low real interest rate, the model is able to account for the observed rising trends of China’s financial capital outflows and FDI inflows as well as its massive trade imbalances. Despite double heterogeneity in households and firms and a less than 100% capital depreciation rate, our two-country model is analytically tractable with closed form solutions at the micro level, which permits exact aggregation by the law of large numbers, so the general equilibrium of the model can be solved by standard log-linearization or higher order perturbation methods without the need of using numerical computation methods. Our model yield, among other things, three implications that stand in sharp contrast with the existing literature: (i) Global trade imbalances between emerging economies and the developed world are sustainable even in the steady state. (ii) There exists an immiserization effect of FDI --- namely, FDI is beneficial for the sourcing country but harmful to the recipient country under financial frictions. (iii) Our quantitative results cast doubts on the conventional wisdom that the "saving glut" of emerging economies is responsible for the low world interest rate.>