Productivity Growth and Capital Outflow: The Case of a Small Opening Economy

The standard economic theory suggests that capital should flow from rich to poor countries, unless the poor countries have lower overall productivity (Lucas, 1990) or a higher relative cost of investment (Caselli and Feyrer, 2007). Another prediction of the standard theory, arguably less controversial, is that capital should flow into countries undergoing a sustained increase in total factor productivity (TFP). The experiences of developing countries during the last three decades contradict this prediction. Capital tends to flow out of countries with fast-growing productivity, and into those with poorer performance (Prasad et al., 2007; Gourinchas and Jeanne, 2008). From the time-series data of capital flows and TFP, we observe that many episodes of sustained TFP growths follow large-scale reforms and liberalizations. The periods of increasing net foreign asset positions (capital outflows) coincide with such episodes. A successful explanation of these phenomena requires both a theory of TFP dynamics and a model of international factor reallocation. In this paper, we present a quantitative framework where economy-wide growth-enhancing reforms and liberalizations lead to a sustained period of productivity growth and capital outflows. We study the transitional dynamics of open economies with heterogeneous production units and imperfect domestic financial markets. In our model, a reform initiates reallocation of resources from previously-subsidized producers to productive entrepreneurs who were not subsidized previously and were hence relatively poor. The reallocation is gradual because of the frictions in the domestic financial market. In the early stages of the post-reform transition, the problem for this economy is misallocation of capital, not under-accumulation. With demand for capital rental restricted by the poorly-functioning domestic financial markets, the surplus capital goes overseas in search of a higher return. Heterogeneous production units and imperfect financial markets are important elements of endogenous TFP dynamics (Buera and Shin, 2007). We model financial frictions in the form of collateral constraints founded on imperfect enforceability of contracts. We consider economies where, Department of Economics, University of California at Los Angeles; [email protected]. Department of Economics, Washington University in St. Louis and University of Wisconsin-Madison; [email protected].