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Let’s solve the puzzles

india Updated: Jun 11, 2013 22:20 IST
Apoorva Javadekar

Globalisation is a broad term but it basically means two things; increased trade links and increased financial flows across borders.

When globalisation started in the 1980s, the expectation was that capital would flow from rich countries to poor but efficient countries, that domestic investments will be financed less and less by domestic savings, that investors would diversify their asset portfolios globally and that countries would hedge away the country-specific economic risks.

This has not materialised to the extent it should have over the last two decades.

In 1990, Robert Lucas pointed out that capital does not flow from rich to poor countries to the extent it should. After two decades we are left with two puzzles to solve: the ‘Direction Puzzle’ and the ‘Allocation Puzzle’. South Korea liberalised its capital account after the Asian crises.

At that time, Korea was running a current account deficit of around 2.5% of its GDP. Though FDI inflows increased over last decade, more capital has flown out of Korea than what came in, barring 2003 and 2004 — this is the ‘Direction Puzzle’ (when capital flows in the opposite direction than predicted).

The ‘Allocation Puzzle’ is that capital is not necessarily flowing to productive economies.

With globalisation, one would expect that more of the domestic investments are financed by international savings. But that is not happening. In many open economies like China, Singapore and Indonesia, the average foreign ownership is less that 30%.

The next puzzle in line is the ‘Risk Sharing Puzzle’. The idea of risk-sharing is that countries can invest abroad and borrow internationally, thereby hedging against domestic recessions.

Economists found that exactly the opposite is true in data; output or GDP growth is more highly correlated than consumption growth. The mirror image of this puzzle, ‘The Home Bias Puzzle’ explains it. Even after two decades of capital markets development, investors do not diversify their portfolios globally.

The idea of risk sharing works only if your insurer does not sink with you. Recent crises have showed how recession can transmit across the borders as it did from the US to Europe.

Hence, if the economic shocks are global in nature or if domestic shocks spread to other countries, opportunities to share risk are drastically reduced.

Why are these puzzles important? The way capital moves around the world is important because it can create ‘global imbalances’ — a term which refers to the massive built up of deficits by large economies and surpluses by emerging economies.

After the Asian crises in 1997, emerging economies like China and South Korea invested their current account surplus in safe assets in the developed world.

This kept the interest rates in the US well below where they would have been and that in turn led to the house and asset price bubble from 2003 till the crisis in 2007.

This shows that capital movements play an important role in global economy. In addition, if consumption risk cannot be shared effectively, then the major motivation for globalisation is at stake.

Hence, the gains to globalisation may not be as high as perceived by many in the light of the risks it poses, unless bottlenecks which create the puzzles are removed.

Apoorva Javadekar is a doctoral student in economics at Boston University The views expressed by the author are personal.