Why is capital so often flowing out of emerging economies?

Sam asks me:

I was struck by something that Peter Thiel has talked a bit about in recent months, namely that capital is flowing ‘uphill’ from China to the U.S., which is not what the neoclassical model would predict. I’ve read a few of the general objections to this “Lucas Paradox” (e.g. differences in human capital, credit risks etc.), but would love to know what your take on this phenomenon is.

I would cite a few factors:

1. China is a high-savings country with high political risk.  In general savings don’t have that many safe outlets, noting the third largest government debt market in the world is that of Italy.  So of course much of this money flows into the United States.  And China is hardly the only high-savings emerging economy.

2. China makes it costly or impossible for many kinds of American firms and individuals to invest directly in China, this now being a familiar story.  The Chinese stock market also is limited and unrepresentative of the Chinese economy as a whole.

3. American capital will not flow to Russia the way British capital once sopped up opportunities in Argentina and elsewhere in the late 19th and early 20th centuries.  The end of gunboat diplomacy is one but not the only reason for this.

4. State-owned industry is a bigger factor today than in earlier times.  For instance, if Aramco is privatized, plenty of private Western capital will invest in the company.  But so far it is not.

5. Savings rates are often especially high during times of rapid income growth, because preferences have not yet caught up with income (an underrated mechanism, which perhaps someday will get its own blog post).  Emerging economies in much earlier times did not have such rapid growth, and therefore they did not have comparable huge savings surpluses to dispose of.

6. The United States has issued a lot of debt, whereas the earlier Great Britain ran a balanced budget at least intertemporally.

7. America has accumulated enough wealth so that flows of household savings can be relatively low.  Plus we are irresponsible — so good at marketing and spending! — and thus we do not save enough either.

8. If you counted holdings of American dollars, as a reserve currency, as “America exporting its rule of law,” the flow of funds would look less strange.

Which other reasons?


On China specifically, the government has done a U-turn and is slowly making it harder and harder for foreign firms and individuals to get their money out. Nobody wants to wait and become a slowly boiled frog.

I just had lunch with a former VP of a large Chinese bank. He retired early and moved all of his savings and assets holdings to the US (he lives in Seattle). When I asked why, he said he use to know where the line was and how to never cross it. But now with Xi, you never know where you'll end up. Especially with the economy slowing down (much more than reported he assured me) and the government gets a bit desperate, the future is too uncertain to keep your capital there.

Good comment.

Obviously, not me, too logical.

" the government gets a bit desperate, the future is too uncertain to keep your capital there ..."

I think this may increasingly become an issue in the US, for the states and cities (e.g. Illinois) with the most egregiously underfunded pension plans.

I don't like the government of Illinois, but it ain't the government of China.


There's a substantial difference between failing to pay out pensions at full value versus confiscating the money (and lives) of people you don't like.

Illinois won't be able to afford it's pension plans, but it's unlikely to start seizing private assets to come up with the money. It certainly won't execute people to enforce its rule.

Illinois won't be seizing private property because they won't need to. The federal government can and will seize private property and use that to bail them out.

Would a red Congress bail out a blue state?

Will Congress always be red?

I agree that there's some ideological aspect to the idea, but I wouldn't discount the geographical aspect of it. Not sure that voters (and Congress critters) from states that have reasonably well-funded state pension systems would be all that keen for an overt federal bailout that looks like it specifically helps Illinois.

So, political reality may be that federal action depends on a critical mass of states having bad enough pension problems that any federal bailout legislation helps out a really big number of states. Sadly, I think it's conceivable that overall state pension funding deteriorates to that degree. Illinois is far from the only state with problems currently.

I could also see something that centers around bankruptcy law changes and therefore sticks state bondholders with a lot of the losses. States can't currently file for federal bankruptcy. Whether or not it would be constitutional for Congress to allow states to file for bankruptcy is an open question ( https://www.csg.org/pubs/capitolideas/enews/issue65_3.aspx ). I could see, however, something like federal legislation allowing states to file for bankruptcy and setting up a pecking order in bankruptcy that is favorable to state employee pensions relative to other creditors (e.g., bondholders). Maybe that would be paired with federal financing for bankrupt states on favorable terms for the states that looks less like an overt bailout because the financing is structured as loans, even if said loans are very low interest.

The USA blue state exodus has begun.

5 Feb 2019: NY Gov. Andrew Cuomo announced Monday that state income tax revenues plummeted by $2.3 billion. Cuomo had planned to spend $176 billion — including about $100 billion in federal funds — in the new fiscal year that starts on April 1. The federal law approved by President Trump and the then-GOP controlled Congress limited SALT deductions to $10,000. The loss of revenue from New York’s wealthiest puts New York in a bind because the state relies on a progressive income tax system that taxes the rich at a higher rate. One percent of the state’s top income earners provide 46 percent of the state’s personal income tax revenues, officials said.

Taxes are too damned high. It is not the SALT tax deduction limitation.

It's beautiful! It couldn't happen to nicer bunch of baby killers.

The problem is neither Thug-in-Chief Cuomo or the Democrat majorities in both houses of state legislature can print money like President Donald J. Trump can.

NY is The Infanticide Capital Of The World: the state's absolute rulers are arrogant, evil and ignorant, and burden us with too many dependents, regulations, and taxes.

That which is unsustainable will collapse.


SALT limitation was a work of art!

And I say that as a blue-state Never Trumper.

If China ever becomes a rule of law type of country instead of what it is now, money and people would be pouring in. They just need to follow Singapore's model or even closer to home, Hong Kong's. Is the theory that China becoming more middle class leads to democracy still on?

This at least suggests that China is on a trend of becoming less corrupt, though of course that is not the same thing:


If that lowered corruption is heavily related to more strictly enforcing the various CCP crackdowns. Let us remember that the early reforms came about in the 1980s when formal property rights did not exist. Many investments would not have been possible without wink-wink non-enforcement of many rules tolerated and abetted by local and regional leaders.

+1 I keep some money invested there now but would invest more if not for political risk.

Could one issue be that much of the EM capital growth comes from reinvested profits of highly profitable subsidiaries of foreign firms, so it doesn't get measured as an international flow, even though it is an increase in capital from foreign savers?

US government FDI statistics include reinvested profits of US owned foreign subsidiaries as an FDI outflow.

Interesting. Maybe it's slightly more subtle. Could it be that the equity value of foreign subsidiaries is rising, separate from investment? For instance, if foreign savers owned Amazon, they would own an increasing amount of American capital, but not because of capital flows. It seems like a Deirdre McCloskey story. Most value growth is innovation rather than brute force capital. Maybe developed economy savers are investing in high return innovation and developing economy savers are investing in brute force capital. Does that make sense?

I thought there was evidence for this decades ago in terms of US vs. Japan.

It makes sense to me. To the high-saving Chinese, the ability to salt away money that earns a modest real return (like US Treasury bonds) backed by the full faith and credit of The United States Navy seems pretty attractive. We take that shit for granted.

That does make sense. The United States is not suffering from a capital shortage in the way it did during the 19th century. There is a dearth of desired, productive investment opportunities in the real economy (e.g., startups), and a surfeit of money looking for high returns. The result is the excess capital flows into speculative investments, inflating asset bubbles.

Thus, the foreign capital surplus (the obverse of the trade deficit) exacerbates this problem, further inflating asset bubbles. In fact, although it makes for great headlines, but foreign investment in greenfield manufacturing in the US is less than 1% of the total foreign net capital inflow. Here is good site with lots of data on this stuff:


China runs a trade surplus with the US and what else are they going to do with the extra US Dollars from that if they don't want to spend them right now?

"Why is capital so often flowing out of emerging economies?"

Here is an answer:

The US Current Account Deficit and Economic Development: Collateral for a Total Return Swap
Michael P. Dooley, David Folkerts-Landau, Peter M. Garber
NBER Working Paper No. 10727
Issued in September 2004
NBER Program(s):International Finance and Macroeconomics

We argue that a chronic US current account deficit is an integral and sustainable feature of a successful international monetary system. The US deficit supplies international collateral to the periphery. International collateral in turn supports two-way trade in financial assets that liberates capital formation in poor countries from inefficient domestic financial markets. The implicit international contract is analogous to a total return swap in domestic financial markets. Using market-determined collateral arrangements from these transactions we compute the collateral requirements consistent with recent foreign direct investment in China. The data are remarkably consistent with such calculations. The analysis helps explain why net capital flows from poor to rich countries and recent evidence that net outflows of capital are associated with relatively high growth rates in emerging markets. It also clarifies the role of the reserve currency in the system.

Ricardo Hausmann and Frederico Sturzenegger theme. Here's another nugget: McKinnon (1973) and Shaw (1973) anticipated that deregulation and financial liberalisation would lead to significantly higher levels of national saving. Most of the countries of the region have made considerable progress in financial liberalisation and the deregulation of most prices — but despite these reforms, the average rate of national saving in the region has remained close to its historical level of 20 per cent of GDP, with an evident tendency for foreign savings to crowd out national savings. This suggests that financial deepening accompanied by an inflow of external savings does not suffice to raise saving rates and sometimes may operate in the opposite direction.

So China is an exception that proves the rule. Most of the time, international capital flows make savings superfluous, even though the Solow equation implies savings rates should be much higher around the world, probably close to 50%, for optimal GDP trendline growth.

Obvious. Savings seek safety. English investments in say Venezuela were guaranteed by the British Navy's gunboats. That system ("imperialism") is not working anymore.

Are you sure? Let's watch what happens with all the Chinese B&R and it's Pearls investments -- which seem to be more and more associated with getting various military footholds.

Indeed. But China doesn't yet have nearly enough gunboats to enforce that, even if it would otherwise be possible in the modern world to confiscate assets from poor countries through dirty clauses in deals with corrupt leaders.

"China doesn't yet have nearly enough gunboats to enforce that"

England ruled the waves without significant competition. Any Chinese gunboat diplomicy runs the risk of the US interference.

China lack force projection in any event. Maybe one day they will have it, not now.

The UK couldn't even stop Iceland from stealing its bank deposits during the last crisis.

Is that what happened? My limited understanding is that UK investors bought ice save bonds that became worthless during the collapse. I wouldnt call that stealing, if that is what happened.

The Icelandic government changed the law after the crisis and essentially screwed over foreign depositors.

" On 6 October, the Icelandic legislature instituted an emergency law which enabled the Financial Supervisory Authority (FME) to take control over financial institutions and made domestic deposits in the banks priority claims."


That's presumably roughly what the US will do in the next few years: default on debt held by foreigners.

My understanding is that the average maturity on US debt is too short to enable a massive default.

"My understanding is that the average maturity on US debt is too short to enable a massive default."

Well if the US doesn't pay back the principal, then it doesn't matter how short the terms are. That being said, the US is nowhere near that state. Japan has higher debt and slower growth and it hasn't defaulted.

I do think the US should balance the books. Taxes should go up and spending should go down in equal measures until the US has a zero yearly deficit. Then let that ride at close to zero for a decade or two.

In the last crisis, even the money market funds teetered and had to be thrown a lifeline. Were within a heartbeat of mandated redemption freeze.

It's a little more complicated than that


This Guardian piece is a shit article. Spending 5-10 minutes reading it, I had no idea why the Icelandic banks collapsed.

On the other hand, looking at the wikipedia article, the first paragraph gives a strong indication that the Icelandic banks gambled on the carry trade. Which means the crisis was preventable, and the result of greed, picking up pennies in front of a steamroller.


That's because the guardian piece did not intend to explain the collapse. Only why there were differential bailouts.

"The United States has issued a lot of debt, whereas the earlier Great Britain ran a balanced budget at least intertemporally."

That's the answer, isn'it? A hollowed up America needs Red China's money. Americans are not masters in their own homes anymore! https://www.dailymail.co.uk/news/article-2237717/Red-Dawn-remake-swapped-Chinese-flags-insignia-North-Korean-ones-fear-losing-billion-dollar-box-office.html

Americans have sold their first-born right for a mess of trinkets.


And what are we buying from Brasil? Why are Brazilians the 3rd largest foreign holders of U.S. Treasury securities?

It is different. We respect freedom of speech. We do not censor artistic and intellectual activity. We do not try to silence criticism. Brazil and America are allies.

We are just building a egg nest to fund duture projects.

"We are just building a egg nest to fund duture projects."

So it's Bernake's Global Savings Glut Hypothesis.

Exactly. There is no place where we can park our resources.

Corruption and other forms of illicit income are an important explanation for flows of private capital out of developing countries. Someone who has received millions of dollars via bribery, appropriating assets from the state or organized crime needs to get much or all of that money out of the country (so as to keep control of it if they fall out of favour at home).

Usually they want to park the money in a safe destination (eg with a stable political system, an efficient financial services industry, and a stable economy so assets won't lose their value). Favorite investments include property in London, Paris or New York, as they're also nice places to visit and do business. Once someone has built up a property portfolio they'll be looking for other investments which will generate a cash return.

Bingo!! Being in Africa I see this all the time. Huge sums!!

So, while we wring our hands here in the US (and UK, etc) and argue about whether we are a socialist hell hole or a communist totalitarian state, successful wealthy people around the rest of the world look towards us and think: "how do I get in on that"?

Yes. We are not perfect but we don’t have to be. We have merely to be better than most others. And we easily are.

Or, to paraphrase Bill Gross, "The cleanest dirty shirt."

This could be part of it:
Caselli and Feyrer (2007), “The Marginal Product of Capital”, QJE


Chinese demographics is another factor.

Ah yes, the long-awaited Guns'n'Roses album....

What is the effect of demographics?

Good blog post and several good comments. The system works (equilibrium) only if a minimum level of stability in the international order can be maintained; the symbiotic relationship between China (or any EM) and the United States depends on trust, which in turn creates the necessary condition for order and stability. Order and stability, very much a conservative priority; disruption, not so much. I suppose the downside of order and stability is that it can mask an inefficiency (and lurking chaos) lying beneath the surface. The financial crisis may only be a taste of the chaos yet to come. The international order reminds me of what Hemingway said about bankruptcy: “How did you go bankrupt?" Two ways. Gradually, then suddenly.”

For those who believe disruption is best for the international order, here's a promising development: https://www.nytimes.com/2019/02/04/business/world-bank-david-malpass.html

Fantastic news!

From the link:

Mr. Malpass, like Mr. Trump, has cited the World Bank’s continuing loans to China as an example of its outdated approach to financing developing countries. “The World Bank’s biggest borrower is China,” Mr. Malpass said in a 2017 forum sponsored by the Council on Foreign Relations. “Well, China has plenty of resources.”

During that same session, Mr. Malpass denied that the president’s “America First” approach to international institutions amounted to isolationism.

I want to make a clear distinction between isolation, which we oppose, and our view that multilateralism has gone substantially too far — to the point where it is hurting U.S. and global growth,” he said. “This viewpoint is sometimes mislabeled populism, but I think it is a pragmatic, realistic response to a multilateral system that often drifts away from our values of limited government, freedom, and the rule of law.”

During congressional testimony in 2017, he said those benefiting from the World Bank’s lending practices were “the people who fly in on a first-class ticket to give advice to governments.”

One of the little economic advantages that the Chinese enjoy is the prevalence of so much pearl-clutching in the West, arguing that stability is the only goal worth pursuing, such that therefore we must avoid irritating the Chinese, no matter the cost to ourselves.

Is China's savings rate so high ?
For one thing, the official savings rate includes government-mandated social-security contributions. Other government surveys show that Chinese households only save about 29 percent of their actual income. After accounting for the fact that Chinese household income is equal to 44 percent of GDP — compared to 70 percent to 80 percent in other countries — that suggests Chinese are saving closer to 13 percent of GDP, which would be less than a third of the headline national savings rate. Even if the situation isn’t quite so dire, it seems clear that households have less socked away than one might think...

It seems to me both Jerry Brown and WD40's comments are on the right track (see Jörg Bibow's work here on USD CA deficits to supply reserve currency).
In any case, this issue cannnot be discussed without the contextual understanding of the internation monetary system and USD as world reserve currency in a credit money system, where credit money is created both onshore and offshore (ie Eurodollar markets). I would point to resources like Perry Merhling here (http://www.perrymehrling.com/current/).

For fun, you may glance at a scenario-based paper I co-published in 2018 as part of an EU funded project: The Future of Offshore Dollar Creation: Four Scenarios for the International Monetary System by 2040 (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3191786)

Capital flows out for the same reason it concentrates in markets in the first place:

- higher foreign returns than domestic returns
- greater security (not prone to grift, corruption)
- better diversification
- exchange rate stability

US taxes and sanctions that discourage investing in emerging markets play a role too. For example, only 49% of the dividends from Vanguard's emerging markets ETF are eligible for lower tax treatment as a qualified dividend, compared to 81% of the dividends for the developed markets ETF and 100% for the S&P 500 (https://advisors.vanguard.com/VGApp/iip/advisor/csa/investments/taxcenter/yearendfigures). US sanctions (all against emerging market countries) also directly prohibit investment, and the US does not grant foreign tax credit for some emerging market countries' taxes, making investment uneconomical. On the margin, these sanctions and taxes make Americans invest less in emerging markets.

It's not in my sphere of factual knowledge, but here's my short list:
1. Transparency (of US vs PRC companies as well as the other (often more important) local, regional, and national conditions; can anyone really believe what the government says over there?)
2. Rule of Law. The *relative* risk of an investment going side-ways due to corruption in either the government or with its "owned/controlled" competitors.
3. I have no idea what the tax situation is there for capital gains, etc. Worth a look.
4. Status.

>"Any other reasons?"

Yes. Here is the big one. Capital flows "uphill" from surplus countries to the USA because we let it happen. Moreover, the tax structure here actually encourages it. US investors must pay capital gains taxes. Non-resident aliens (who own 35% of the US equities market last I checked) do not have to pay US capital gains taxes.

That is why tariffs alone will never close the trade deficit. As long as we allow the capital surplus, there must be a trade deficit as a matter of accounting. China and Germany have high savings rates not because their citizens are especially thrifty compared to spendthrift Americans. They have high savings rates due to specific government policies that artificially force up savings.

Since the global economy is an autarky, those excess savings have to flow to deficit countries that allow such inflows. Trade imbalances necessarily result.

"US investors must pay capital gains taxes. Non-resident aliens (who own 35% of the US equities market last I checked) do not have to pay US capital gains taxes."

Yet, it is written: "It is not meet to take the children's bread, and to cast it to dogs."

It is not meet?

I guess whoever wrote that down was stoned at the time?

Or is it just you?

The cod-Brazilian understands English better than you do.

I am being impersonated.

"meet adjective
Definition of meet (Entry 3 of 3)
: precisely adapted to a particular situation, need, or circumstance : very proper" -Websters

It is the Lord's salvation Word.

"They have high savings rates due to specific government policies that artificially force up savings."

What explicit policies does Germany have?

I was thinking of the Hartz reforms that lowered wages and reduced the household share of GDP, thus forcing down consumption and thus forcing up savings.

Then there is the euro, of course, that results in an undervalued currency compared to what the German mark would otherwise be.

The Hartz reforms would be a tangential effect at best. The Euro on the other hand does fulfill the role of a currency that's intentionally weaker than the market would determine for a pure German currency and which would tend to benefit a merchantilist economic policy. Of course, it has the exact opposite effect for Poland or Greece.

Is it really any different than the US having the same dollar for Michigan as it does for Mississippi?

It would be more like if we had the "Amero" that was once talked about in the early NAFTA debate. The Mexican peso and Canadian loonie would drag down the US dollar, making US exports more competitive.

Apparently, capital prefers locations with high taxes and onerous regulations

Another way to put it is that the high returns earned by Chinese capital are not available to the typical foreign investor at all or only with much higher transactions costs and risks not borne by those privileged to earn those high returns. And as others have noted even the winners in China don't want to keep their assets in China. So limits on investment keep money from flowing in and lowering their returns but also slow China's ability to grow and develop high per capita income.
Conversely politicians in rich countries abuse their high income by raising taxes without providing corresponding benefits to promote still higher growth well aware that most countries in high growth, low income countries don't have the institutions to draw away all their business. Instead Western businesses stagnate or grow at below their potential as well.

Imagine that investors decide to invest 70% of their capital in countries with an average return of 10% and 30% in countires with an average return of 5%; 82% of their profits wil be in "10% countries" and 18% in "5% countries". If they want to mantain the 70/30 ratio of investments, part of the profits of the investments in "10% countires" will be invested in "5% countries".

In addition to simply being very difficult climates to do business in, it's almost impossible to realize any profits. My organization has pulled out of China (and Russia) because we aren't able to pay any dividends out of those organizations.
Money goes in, is nominally profitable, but never comes out.

China creates this with its export promotion policies. Domestic consumption is greatly discouraged. Domestic investment in real estate was large, and I dont know the current state (no one does, because records dont exist) but I suspect wealth concentration of real property is high and unchanging.

China follows the "Hotel California" model with respect to capital.


On China only.

The first four or five items all apply to China, mostly, and cover the bulk of the problem.

If you need a name, the cause is a tendency to over aggregate in large populous nations, resulting in unstable finance and constant government intervention.

There has been some research on this specific topic, taking a closer look at the data. I think a couple important points should be emphasized here:

-This is common to emerging markets, not just China.

-Institutional quality (economist speak for stuff like the rule of law, risk of expropriation by the government, etc.) explains the flows of capital to rich countries more than other macroeconomic fundamentals (Alfaro et al., 2008 ReStat).

-Flows between the private sectors behave much as we would expect from the neoclassical model, going from rich to poor (low return to high return). The uphill capital flow is mainly due to sovereign to sovereign flows (Alfaro et al., 2014 JEEA).

-Much of the uphill capital flow can be explained by reserve accumulation by emerging market economies (Gourinchas and Jeanne, 2013 ReStud).

-The capital flowing into the US goes relatively more into safer assets like Treasuries, whereas the capital that flows out of the US goes relatively more into riskier assets with a higher return. So, even if there is a net inflow into the US, the asset return properties are quite different between capital flowing in and capital flowing out.

These points do not necessarily invalidate the other factors cited, but based on the data, the bulk of the explanation seems to revolve around the accumulation of safe assets by EM governments. Explanations of this reserve accumulation may be more useful to understand/explain the uphill flow.

Tyler's question refers to emerging economies in general, not mainly China. A major reason for capital exporting instead of domestic investment in these economies is that risk adjusted rates of return are not very high. Institutions are weak, state owned enterprises dominate these economies and infrastructure is poor. This does not add up to a business environment conducive to risk taking. It also shortens pay back periods that investors require to make an investment.

Potential 9th & 10th factors

9) the demographics of developed economies discourage long term risk investments. In the United States and elsewhere, the wealth is concentrated in near retirees and retirees. This group of investors is risk-averse and therefore shies from the intermediate term risk / reward profile of EM investments. One need only look at the glide path of an target date strategies to see how asset allocation changes over time.

10) The last quarter century of developed economy capital markets encouraged de-risking over the past 2-3 years. Investors remember the tech boom & bust, the bush-era market & subsequent sub-prime crash, and expect that this unusually long bull market will suffer the same fate. (This is not to assign credit or blame to 43’s policies, just to put a time period on it). If My previous point is true, then this would its impact.

Neither are sufficient to fully explain this trend, but are likely to be contributing factors.


Neither of these are sufficient

"8. If you counted holdings of American dollars, as a reserve currency, as “America exporting its rule of law,” the flow of funds would look less strange."

This makes sense and it just feels right. Keeping our political system intact and functioning would be a priority then.

sufficient statistic for the relative returns tot capital for countries with same weight on capital in the production function in a AK setting is the capital/output ratio.
see https://voxeu.org/article/why-does-capital-flow-poor-rich-countries

so you have an easy answer for China where there has been overinvestment... obviously not all the emerging economies have high K/Y ratios.

Seems like the simplest story is increasing returns to capital. Of course this breaks the neoclassical growth model, but that doesn't mean it isn't true. Calling Doctor Romer.

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