3  Foreign capital and national income: theoretical foundations

This section presents a simple international flow of funds framework that relates saving, investment, rates of return, foreign borrowing and economic growth. Consistent with the intertemporal approach to the open economy, external imbalances and international borrowing are primarily related to domestic saving and investment behaviour and hence we abstract from trade flows and exchange rates.

Figure 5 - Saving, Investment, International Borrowing and National Income

Under autarky conditions, total investment spending must be funded from domestic saving, the residual between domestic output and consumption. Let the demand schedule for loanable funds as a function of the real interest rate be depicted by the schedule I in Figure 5. The market for loanable funds clears at the equilibrium real interest rate, i_A given a fixed supply (S_A). In contrast, with perfect capital mobility, a small economy’s domestic borrowing requirement over and above available domestic saving can be satisfied by foreign lenders (investors) lending[5] at the exogenous real world interest rate, i^*.

Domestic investment therefore exceeds domestic saving at i^* to the extent of foreign borrowing. This ex ante foreign borrowing requirement is shown by distance fc in Figure 5. Hence, if external debt is initially nil, it reaches level fc by period end. As the real world interest rate is lower than the real autarky interest rate, investment under autarky is always lower than when international borrowing is permitted.

Figure 5 also reveals how foreign borrowing raises national income. The marginal product of capital determines the slope of the investment demand schedule, so that given i^*, the extra units of foreign financed capital, times their marginal product, add to GDP to the extent of the area abcd. However, of that, the rectangular area afcd is paid to foreign lenders, leaving a net national income gain equivalent to the triangular area fbc. International capital mobility therefore enables lower domestic interest rates and higher national income, provided the productivity of the extra foreign-financed capital exceeds its cost.[6]

If foreign lenders perceive high foreign debt as a sign of heightened country risk and diminished creditworthiness, they may demand an interest premium (ρ), to compensate.[7] This explains the convex foreign lending schedule rising from the world interest rate, i^* in Figure 5. The more averse foreign investors are to rising foreign debt, the steeper the slope of the schedule and the higher the risk premium. At some point, foreigners could judge the level of lending risk prohibitive, equivalent to the foreign lending schedule becoming vertical.

In the presence of a risk premium, the foreign lending schedule is no longer perfectly elastic. The risk premium is the difference between the interest rate foreign lenders demand under imperfect capital mobility and the interest rate i^* under perfect capital mobility. Hence,

i_d - i^* + ρ    (3.1)

where i_d is the equilibrium domestic interest rate and ρ is measured by the distance gf in Figure 5.

Foreign debt related risk therefore causes macroeconomic welfare losses since potential national income gains from foreign borrowing are not realised. With reference to Figure 5, the welfare loss is area fgec. Note however that foreign borrowing still confers a net welfare gain of gbe, provided the equilibrium interest rate allowing for risk is less than the autarky rate. Although interest risk premia limit potential growth, it also follows that the higher the risk premium, the slower foreign debt accumulates, suggesting that rising risk premia act to stabilise foreign debt levels.

The main qualification to the argument about the benefits of allowing unrestricted flows of funds across borders is that reversals of inflows make emerging economies vulnerable to crises. Capital flight in response to new information about exchange rate risk, default risk or deteriorating fiscal and monetary policy settings can impose substantial short term economic, social and political costs on borrower economies. These costs are transmitted in the first instance through higher domestic interest rates and lost output, as well as through large exchange rate depreciations and the associated higher inflation. While we recognise that these are legitimate concerns, the purpose of this paper is to estimate the real income gains from foreign capital flows; we therefore abstract from the broader issues of risk management.