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Capital accumulation in open economies

Capital accumulation increases the amount of machinery, equipment, and structures available to workers in the economy, thus raising their productivity. Moreover, new capital often embodies technological progress. Hence capital accumulation can be viewed as the most direct way of raising the standard of living.
An open economy enjoys opportunities for capital accumulation that are not available in the absence of international transactions. For one, it does not have to produce all the equipment employed in that country. Importing capital equipment allows a country to take advantage of international specialization in the manufacture of capital goods. For example, East and Southeast Asia produce the bulk of semiconductors and computers, while North America and Europe make most of the airplanes. More generally, a country does not have to specialize in capital goods at all, as trade gives it opportunities to acquiremachinery and equipment in exchange for commodities or consumption goods. China is perhaps the most prominent current example of the latter case.Although some researchers have suggested that specialization according to comparative advantage in, say, agriculture, may deprive an economy of the benefits associated with learning by doing, it should be noted that importing capital goods gives a country access to sophisticated technologies, helping it to advance its own technological frontier and learn by imitation.
In addition to the classical static gains from trade, opportunities for trade over time are also important. In a closed economy capital goods have to be manufactured domestically, and resources for their production have to be diverted from other uses, in particular from making consumption goods. This constraint is relaxed in an open economy, where first, capital goods can be purchased from abroad, and second, current consumption does not necessarily have to be sacrificed to make room for investment, since foreign borrowing can partially finance both.

Canonical View

Traditionally, the relaxation of the intertemporal budget constraint has been viewed as a great benefit of openness. This is particularly true of emerging markets. A prototypical emerging market country is onewhere current output perworker is relatively low because there is not enough capital. The diminishing marginal productivity of capital means that if such a country has access to the same technology as industrial countries, the rates of return on investment in the emerging market will be high. The country will be poised for growth, but it faces a dilemma.On the one hand, investment todaywould raise productivity and therefore the standard of living tomorrow. On the other hand, impatience and intergenerational equity considerations create pressures to bring some of that future prosperity into the present, generating high consumption demand today. Since both consumption and investment goods have to be produced from current resources, however, it is impossible to manufacture more of both, and hard choices have to be made.
The trade-off is much less stark in an open economy. Either consumption or investment goods or both can be imported.Moreover, the total value of everything that the country produces does not have to equal the value of its absorption (the sum of consumption and investment), as long as the country can finance its trade deficit by borrowing or selling its assets abroad. Of course, debts have to be serviced, and opportunities offered by openness are not unlimited. What happens is that the autarkic requirement that domestic output equal absorption at every point in time is replaced with just one intertemporal constraint that the present discounted value of output equal that of absorption. Hence when new investment opportunities arise and the future looks bright, it is possible to increase both investment and consumption, thus laying the foundation of future prosperity and at the same time enjoying some of its fruits in the present.
Foreign financing of trade deficits can take many forms, all of which, being manifestations of intertemporal trade, involve a gain today for a loss tomorrow. The country’s residents can take out foreign loans. They can also sell bonds or shares in their enterprises to foreign portfolio investors. A form of foreign financing particularly important for capital accumulation is foreign direct investment, whereby a foreign investor either builds a new plant in the host country or purchases a substantial enough share in a host country enterprise to participate in its management. In any case, some degree of openness in the capital account is required to realize this benefit, which relies on exchanging not only different goods, but also goods delivered at different points in time and thus can be viewed as a generalization of gains from trade.
Of course, intertemporal trade requires the existence of willing partners. In the canonical view, the counterparts of capital-hungry emerging market countries are advanced economies, where capitallabor ratios are high and, because of diminishing returns, the marginal product of capital may be low. These countries (Japan being one example) may not have enough profitable investment opportunities at home, and they may seek opportunities for investment abroad, particularly as aging residents of these countries save for retirement.
To recapitulate, in the canonical view, when a low-income country has in place conditions for high return on investment and rapid growth and opens up to international trade and capital flows, it will experience an investment boom while also increasing consumption. This is possible because the country is able to finance the resulting trade deficit by borrowing abroad or selling its assets to foreigners.Over time, as its productivity catches up with that in advanced countries and returns to investment decline, its growth decelerates, and trade surpluses replace trade deficits. This description fits broadly the experiences of many countries that experienced rapid growth, including Japan and continental Europe after World War II, South Korea from the mid-1960s through the mid-1980s, and the Central European economies during post communism transition.

Dynamics of Growth and Capital Accumulation in an Open Economy

Abstracting from technological progress, the rate of growth of output per worker is determined by the pace of ‘‘capital deepening,’’ or increases in capital per worker. In a closed economy, that rate depends on available investment opportunities and the residents’ preferences regarding the choice between investing and consuming their income. Capital accumulation is gradual, and the standard of living,measured by consumption per capita, converges slowly to a steady-state value determined by available technology. Greater impatience an unwillingness to sacrifice current consumption for the sake of investment implies slower convergence. The presence of technological progress does not alter the essence of this progression, except that the economy converges to a steady-state growth rate rather than a steady-state level of output.
As discussed in the previous section, openness relaxes the budget constraint and could accelerate capital accumulation dramatically. Exactly how much is a contentious question in the open-economy macroeconomic literature. If one extends the classical growth model the Ramsey-Cass-Koopmans model, where rational, forward-looking households and profitmaximizing firms operate in a perfectly competitive environment to an open-economy setting by assuming free trade and perfect capital mobility, the result will be instantaneous convergence. Perfect capital mobility implies unlimited borrowing at a constant interest rate, so domestic residents will immediately borrow enough money and install enough capital equipment to equalize the domestic rate of return on new investment with that available in the advanced economies they are borrowing from. Assuming they have access to the same technology, output per worker wouldimmediately jumpto its steady-state level, equal to that in themost advanced countries. Consumption per capita would permanently remain below the level of advanced countries, reflecting the need to service the debt, but itwould also stay constant after amomentary upward transition (or grow at a constant rate in the presence of technological progress).
Needless to say, instantaneous income convergence is not observed in practice. In reality, countries cannot borrow unlimited amounts at a constant interest rate, purchase unlimited amounts of capital equipment, and install it costlessly and instantaneously. Many things get in theway. Borrowing over a certain limit may raise the probability of default or result in too much concentration in the lender’s portfolio. Lenders may respond by charging the borrowing country a higher interest rate or by cutting off additional funding. Poor legal systems and the risk of government intervention give rise to doubt about the enforcement of contracts and make lending institutions in advanced economies hesitant to commit overly large sums to emerging market borrowers. Lack of information about local investment opportunities also hinders flows of external finance, and underdeveloped financial systems in emerging markets have a limited capacity to process these flows. In addition, some types of capital, such as buildings, may not be tradable internationally, or at least require some local nontradable inputs, such as construction labor, for their installation. Therefore, if some items in the consumption basket (e.g., services) are also nontradable, the trade-off between consumption and investment is still relaxed by openness, but less than amodelwith a single tradable good would imply.
These and other obstacles have been incorporated into open-economy macroeconomic models to moderate the rate of convergence. Details of these frictions and other model assumptions have implications for the evolution of other macroeconomic variables, such as domestic interest rates and the exchange rate. For example, combined with the assumption that production in the tradable sector is more capital intensive than in the nontradable sector, friction in the financialmarkets such that the interest rate charged on foreign borrowing increases with the amount borrowed in a given period results in gradual convergence of interest rates in emerging and advanced countries and in gradual real exchange rate appreciation in the former, a phenomenon known as the Balassa-Samuelson effect.

Recent Experience

The canonical view suggests that capital should flow from advanced countries to emerging markets, where returns are higher.Over the first decade of the 21st century, however, a new pattern has emerged, where trade surpluses in China and some other fast-growing emerging economies are financing trade deficits in a number of advanced economies, most notably the United States. The investment rates are very high in the surplus economies, exceeding 40 percent of gross domestic product (GDP) in China, but national saving is even higher, reflecting the relatively low share of consumption in GDP. While China has attracted a lot of foreign direct investment, it has been purchasing foreign financial assets on a grand scale.
Several explanations have been offered for this reversal of the traditional pattern. Among the factors cited are the relatively weak social safety net in China and some other emerging economies, creating the need for high precautionary private saving; the relatively underdeveloped financial systems in these countries, resulting in the flow of these savings abroad, particularly to the United States, whose innovative financial system has been able to generate attractive assets; and government policy of preventing the exchange rate from appreciating despite the trade surpluses in order to promote exports and to accumulate international reserves as insurance against external shocks.
The canonical view still holds in many instances. Many advanced economies, for example Germany and Japan, are running current account surpluses, and many emerging market countries, including Central and Eastern European economies andmany Latin American economies, are running deficits. High commodity prices, which boost the incomes of many developing countries and reduce their reliance on external finance, may have disrupted the traditional pattern, although this explanation clearly does not pertain to China. On the other hand, the fact that capital does not flow to the poorest developing countries does not really contradict the canonical view, as these countries, for many reasons, do not promise high return on investment despite having little capital. See also capital flows to developing countries; economic development; foreign direct investment (FDI); growth in open economies, neoclassical models; international income convergence


2 июля 2011 21:08

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