Two‐Way Capital Flows and Global Imbalances

Abstract

Financial capital and …xed capital tend to ‡ow in opposite directions between poor and rich countries. This paper introduces frictions into a standard two-country neoclassical growth model to explain the pattern of two-way capital ‡ows between emerging economies (such as China) and the developed world (such as the United States). We show how underdeveloped …nancial markets in China can lead to abnormally high rates of return to …xed capital but excessively low rates of return to …nancial capital relative to the U.S., hence driving out household savings (…nancial 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, our model is able to account for China’s rising …nancial capital out‡ows and FDI in‡ows as well as its massive trade imbalances in the past decades. Our model yields two additional implications that stand in sharp contrast to the existing literature: (i) Global trade imbalances between emerging economies and the developed world may be sustainable even in the long run; and (ii) the conventional wisdom that the saving glut of emerging economies is responsible for the global low world interest rate may be wrong.