The portfolio approach of Benhima (2013) explains the allocation puzzle — the tendency of net international capital to flow away from fast-growing developing countries — through portfolio composition: in a neoclassical growth model with internationally traded riskless bonds and uninsurable idiosyncratic investment risk, riskier countries self-insure by accumulating foreign bonds, and a country-specific capital wedge shapes the direction of flows. The framework, however, overpredicts the magnitudes of capital flows and net external positions by several orders of magnitude, because it effectively allows the totality of human wealth to be pledged to foreign creditors, and it is silent on the composition of capital flows, even though foreign direct investment flows toward fast-growing countries while portfolio securities flows do not. The open problem is to extend the portfolio approach to at least partial trade in equity claims (and foreign direct investment) and to determine whether the extended model can account for the observed composition of capital flows without destroying the portfolio mechanism that explains the allocation puzzle.

Background

The allocation puzzle is the empirical finding, emphasized by Prasad, Rajan and Subramanian (2007) and Gourinchas and Jeanne (2013), that international capital does not on net flow toward developing countries with fast productivity growth, contrary to the neoclassical prediction that capital should seek its highest marginal return; in the 1980–2003 sample studied by Benhima (2013), high-growth, high-investment developing countries tend instead to experience capital outflows. Benhima (2013) proposes a 'portfolio approach' to this puzzle: a neoclassical growth model in which countries trade only riskless bonds internationally and in which domestic investment bears uninsurable idiosyncratic investment risk — risk that individual investors cannot diversify away, in the tradition of precautionary-saving models with incomplete markets. Because labor income (human wealth, the present value of future labor income) is relatively safe and fully pledgeable to creditors in the model, countries with high idiosyncratic risk σ\sigma self-insure by tilting their portfolios toward foreign bonds, generating outflows. The model also incorporates a capital wedge τ\tau, a wedge between the private and the social return to capital arising from institutional failures, expropriation risk, or the relative price of capital, which suppresses the desired capital stock and reinforces bond accumulation. With these ingredients the model matches the direction of capital flows — total factor productivity (TFP) catch-up correlates with outflows among creditor countries, outflows correlate negatively with the capital wedge — and explains why Asia, with its relatively low capital wedge, dominates global imbalances (the persistent current-account surpluses of emerging Asia). The paper itself acknowledges two quantitative shortcomings. First, the model overpredicts the magnitudes of capital flows and of net external positions (a country's foreign assets minus its foreign liabilities) by several orders of magnitude — a deficiency of bond-only portfolio models already noted by Kraay, Loayza, Servén and Ventura (2005) that is accentuated by the full pledgeability of human wealth; Benhima notes in passing that transaction costs, home bias in asset holdings, sovereign risk, or limits on the pledgeability of human wealth could dampen the magnitudes, but does not incorporate them. Second, the model is silent about the composition of capital flows, whereas the data show that foreign direct investment (FDI, cross-border investment establishing a lasting controlling interest) is directed toward fast-growing developing countries while portfolio securities flows are not (Prasad, Rajan and Subramanian, 2007; MacDonald, 2015). The paper's conclusion states the next step for this research program explicitly: extend the model to allow at least partial trade in equity claims and check whether the portfolio approach can then account for the composition of flows.

Problem Statement

Within the portfolio approach of Benhima (2013) — a neoclassical growth model with internationally traded riskless bonds, uninsurable idiosyncratic investment risk, and a country-specific capital wedge — extend the framework to allow at least partial trade in equity claims, including foreign direct investment, and evaluate whether the extended model can account for the composition of capital flows without destroying the portfolio mechanism that explains the allocation puzzle, in particular for the facts that FDI inflows are positively correlated with growth across developing countries while portfolio securities flows are not, and that net capital outflows coexist with FDI inflows in fast-growing countries. The target is a quantitative extension: an extended model whose predictions are compared with data on the composition of capital flows across instruments (debt, portfolio equity, FDI). A related refinement discussed but not incorporated in the source is whether the extended framework can also reproduce realistic magnitudes of capital flows and net external positions, which the bond-only, full-pledgeability version overpredicts by orders of magnitude, with the source expecting that matching these magnitudes would leave the allocation-puzzle mechanism intact, since the effects of TFP growth and the capital wedge depend on the structure rather than the magnitude of the portfolio.

References

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