Democracy Lab

Why Capital Flows Uphill

You wouldn't necessarily expect capital to move from poor countries to rich ones. But that's exactly what seems to be happening in some cases. Here's why.

Trillions of dollars in capital now cross borders each year in search of profit. And since more is flowing out of developing countries than coming in, the return must be higher in the rich industrialized economies.

Wait; that can't be right. The low-hanging fruit in the United States, Western Europe, and Japan was presumably picked long ago. Shouldn't capital now be sucked into places where labor's cheap and opportunities abound? Indeed, isn't that what global economic integration is about?

It's more complicated than that. (Bet that caught you by surprise.) But there's an important truth underlying this paradox: In a world in which financial market integration lags far behind the integration of trade and technology, flows of financial capital are playing a surprisingly limited role in driving growth in developing economies. In fact, there seems to be a negative correlation between growth and imports of financial capital: The fastest growing emerging-market economies typically save more than they invest at home, with the difference spilling into foreign securities.

To understand what's been happening, look closely at capital flows between the U.S. and China -- the iconic example of the aforementioned paradox. Each year, hundreds of billions of dollars more flow from China (where the productivity of capital is very high) to the United States (where the potential return is lower) than vice-versa. One reason is that Beijing is eager to support job-creating, politically wired exporters, and is thus willing to accept foreigners' IOUs in order to induce them to buy all those laptops and dining sets and designer jeans. To put it another way, if the China's central bank didn't buy humongous quantities of dollars (mostly in the form of U.S. Treasury securities) as a means for holding down the value of China's currency, Walmart and friends might well find it cheaper to buy goods in, say, Thailand or Mexico.

That's not the only reason, though, that Beijing pushes international capital "uphill." It fears currency exchange volatility if it lets private interests determine financial flows in and out of China. This fear, moreover, hardly springs from thin air. Back in 1997-98, surges of "hot" money (short-term liquid investments) from abroad shattered the stability of currencies from Thailand to Indonesia to Korea -- and then went on to wreak havoc in Russia and Brazil. Even Hong Kong, arguably the best-run economy on the planet, was badly shaken in the tumult.

China, by contrast, escaped relatively unscathed because capital controls kept its currency, the renminbi, out of global play. That is, for the most part, Beijing limited foreigners' holdings of renminbi to the amounts needed to do business in China.

Oh, you say: We've learned from the mistakes of the Asian currency crisis; now it's safe to go back in the water of global financial capitalism. Dream on. After all, it was the integration of international capital markets that meant that the American mortgage-backed securities collapse quickly spread to Europe and beyond. Why should China risk infection from global financial viruses?

Actually, China has yet another reason to brush aside the reality that it is investing hundreds of billions annually in U.S. Treasury bills while hundreds of millions of Chinese still lack the capital needed to earn a decent living. The Chinese, who save a higher proportion of their income than any other people in the world, already have more capital than they can make good use of. The real constraint on (even faster) economic development is that China lacks the efficient, well-developed banking and securities markets needed to allocate even more capital into investments that would eventually make the Chinese as productive as their North American or European counterparts.

Indeed, by this reckoning, opening the door to more financial capital would only lead to an asset bubble. The whole point of allowing capital to flow downhill would be to generate more investment in technical education, health care, more efficient transportation, and pollution control (not to mention more factories). But the result might just be more empty apartments and office buildings in the already overbuilt real estate markets of China's booming coastal cities.

Note an important distinction here. In contrast to purely financial investments --say, the purchase of bonds issued by Chinese companies -- the government welcomes foreign direct investment in businesses, especially those that come with new technology and highly skilled management. Foreigners have invested close to $800 billion in Chinese production facilities; the stock of foreign direct investment in China now far exceeds that in Australia, Switzerland or Canada. But it isn't the capital that China wants or thinks it needs, but the productivity spillovers from foreign technology and training.

It's pretty easy, then, to see why China is reluctant to conform to what is often called the "Washington Consensus," which includes the diktat that developing countries should open their economies to global market forces as fast as it is practical. China has done very well by doing things its own way. And (with reason), Chinese leaders suspect that the pressure to conform is in part motivated by ideology, along with rich countries' perceived interest in seeing Chinese exports become less competitive in world markets.

But before buying entirely into the Chinese view, consider this. The reality that China can't make good use of savings from rich countries -- that it chooses to invest in U.S. Treasury securities rather than education or infrastructure or whatever at home -- is not solely a consequence of the Chinese people's extraordinary thrift. It also is a symptom of institutional weakness, of China's well-founded fear that it lacks the management and regulation to operate stable, efficient private capital markets that could funnel more resources into building a modern economy.

It's not clear, moreover, that what is working now will work indefinitely. For one thing, the bigger the Chinese economy becomes, the more difficult it will be to sustain high growth without sophisticated domestic capital markets. And once that becomes painfully clear, China will have to play a dangerous game of catch-up.

For another, the success of China's strategy of export-led growth facilitated by recycling huge quantities of dollars ironically depends on Americans' inclination to save very little. Eventually, this delicate dance of co-dependence must end. More to the point, unless it ends in a coordinated fashion, with America becoming thriftier as the Chinese find satisfactory ways to invest and consume more, there will be hell to pay. And that smooth transition will be next to impossible if China does not speed the development of efficient private capital markets.

China isn't the only relatively poor country that is saving more than it invests at home -- that, in effect, is exporting capital to rich countries and adding to the stresses on an unbalanced global economy. While the particulars vary, these countries generally share the problem of being unable to absorb more capital because they lack efficient capital markets.

But as Eswar Prasad of Cornell (and, not coincidentally, the former head of the IMF's China Division) argues, change is slowed by an inherent tension. International financial integration will eventually serve developing countries' interests, helping to manage the complexity of associated with greater productivity. But the process of getting from here to there will be perilous, giving high-saving countries ample reason to think thrice before opening their doors to financial integration. Pretending otherwise won't make it any easier.



Friendship Under Fire

The Iranian nuclear threat will challenge Obama and Netanyahu's sometimes-rocky relationship like never before.

Next month, U.S. President Barack Obama and Israeli Prime Minister Benjamin Netanyahu will hold a key meeting over the Iranian nuclear challenge that will test their sometimes rocky relationship. After a weekend visit by National Security Advisor Tom Donilon to Israel, the White House announced this week that Obama will host Netanyahu in Washington on March 5. This will be an opportunity for the two leaders to synchronize their positions on Iran. Whether they can reach some common ground -- now or in the near future -- could be a decisive factor in Israel's decision-making on whether to strike Iran sometime this year.

International pressure on the Islamic Republic has never been higher. In addition to the new, crippling U.S. sanctions enacted on Dec. 31 and Feb. 6, the European Union recently pledged to halt the importation of Iranian oil by July 1. Iran's economy is reeling.

For their part, Iranian leaders have struck an increasingly aggressive note. They have threatened a preemptive strike against their foes, and warned that they could close the Strait of Hormuz, through which roughly 20 percent of the world's traded oil flows daily. In another recent act of defiance, Iranian President Mahmoud Ahmadinejad announced on Feb. 15 that a "new generation" of Iranian centrifuges had just been activated at the Natanz nuclear site. And this week, IAEA inspectors charged with monitoring Iran's nuclear program were denied access to a military facility, returning to Vienna after what they termed "disappointing" talks with their Iranian interlocutors.

Despite its saber-rattling, Iran is feeling the heat of international sanctions. Over the past month, the Iranian rial has been devalued by 50 percent. Iran has also indicated that it may even be willing to resume diplomacy, which it has scorned since the last round of negotiations in 2009 and 2010.

With the media rife with speculation about a possible Israeli military strike against Iran's nuclear facilities by this summer, tensions between the two countries have risen to an all-time high. Iran is blaming Israel for the recent assassinations of its nuclear scientists, and Israel is accusing Iran of masterminding the Feb. 13 terror attack against Israeli diplomats in New Delhi, as well as attempted attacks in Tbilisi and Bangkok.

It is no secret that Netanyahu and Obama have never been close, but now is the time for the two leaders to find common ground over the Iranian nuclear issue.

There has already been some progress in getting top U.S. and Israeli officials to speak about Iran in similar terms. Last week in the Knesset, Netanyahu said it is critical that the world -- not just Israel -- identify "red lines" when dealing with the Iranian nuclear program. In a CBS appearance last month, Defense Secretary Leon Panetta declared that Iran's development of a nuclear weapon, as well as closure of the Strait of Hormuz, are "red lines" for the United States.

However, the United States and Israel clearly differ in where their red lines lie. The United States has put the focus on Iran actually gaining a nuclear weapon, while Israel -- more vulnerable to Iranian missiles due to its geographic proximity -- views the threshold as the Iranian regime's acquisition of enough low-enriched uranium to build a bomb, pending a political decision to convert it to weapons-grade fuel.

The other set of differences between the United States and Israel has to do with how long they are willing to wait before judging the international sanctions of Iran to be a success or failure. On the one hand, this is the first time that the United States and the EU have imposed the type of "crippling" sanctions that Israel has long called for. But on the other, recent statements by Israeli Defense Minister Ehud Barak signal that Israel believes its window for military action is rapidly closing. As a result, Israeli officials fear they might not have the time to wait and see whether the sanctions halt Iran's nuclear program peacefully.

Israeli military capabilities to strike Iran's proliferating nuclear sites -- especially those bunkered deep within a mountain outside the city of Qom -- are more limited than those of the United States. The prospect of a new round of Iranian-U.S. diplomacy is another critical component of this equation, as it could further postpone U.S. military action in the event that sanctions fail. Taken together, these circumstances could force an Israeli decision on a preemptive strike under suboptimal conditions.

All this puts Israel on the horns of a dilemma. It can hope that sanctions will ultimately deter Iran's nuclear program, but this may mean foregoing decisive action against what it sees as an existential threat in the hope that the United States will act further down the road. Barak and Netanyahu are commonly identified as favoring a strike, but based on my recent trip to the region, it is clear that others within the Israeli cabinet and defense establishment still have doubts. As such, the prospect of a strike is not inevitable. If Israel believed that the United States were absolutely committed to handling this issue, it would certainly shift the Israeli debate about whether to strike.

But without absolute certainty, holding off on a strike is a tough decision for Israeli officials to make. Many Israeli military leaders are children of Holocaust survivors who joined the Israeli army to ensure Israeli self-reliance in fighting against enemies who regularly pledge to eradicate it. A poignant reminder is the iconic photo of Israeli jets flying over Auschwitz in 2003, which hangs on the walls of many of their offices.

Nonetheless, it is a fundamental misreading of Israel to view this as an ideological issue. Israeli considerations of a strike are rooted not in their ethos of self-reliance, but in the fear that the United States will ultimately fail to strike, even if sanctions fail. Israeli officials' fears are compounded by their knowledge that the American people are fatigued by conflict, and by the suspicions of some that the United States has not entirely ruled out a strategy of containment, U.S. protestations to the contrary.

The Obama administration's official policy opposes containment, holding that the Iranian nuclear program is too destabilizing for the Middle East. As the president told NBC on Feb. 5, "We are going to do everything we can to keep Iran from getting a nuclear weapon, and creating an arms race -- a nuclear arms race -- in a volatile region." Concerns about Iran handing dirty bomb technology to non-state actors, such as the Lebanese militia Hezbollah, along with fears that Iran would seek to dominate the Persian Gulf, are also all too real.

In light of these threats, some analysts could argue that Obama -- who is known for his preference for Predator drone strikes in Pakistan and such surgical operations as the one that killed Osama bin Laden -- would indeed resort to military action if sanctions failed. And despite tensions between Obama and Netanyahu over the Middle East peace process, sources close to Obama argued to me that these policy differences in no way infringe upon the president's commitment to Israel's security.

At the same time, U.S. officials have also raised fears of an Israeli strike in the short term -- as evidenced by Chairman of the Joint Chiefs of Staff Gen. Martin Dempsey's comments on Feb. 19 that an Israeli attack would be "destabilizing." Their fears center on the belief that an attack by Israel could unravel international sanctions, and that Iran would be able to reconstitute its program in fairly short order.

How can Obama and Netanyahu win each other's trust? The two sides should come to a more precise understanding of U.S. thresholds for the Iranian nuclear program and American responses should they be breached, as well as an agreement on a timetable for giving up on sanctions so their Iran clocks are synchronized. In other words, the two sides need to agree on red lines that might trigger action. Israel will probably seek some guarantees from the United States before agreeing to forgo a pre-emptive strike that might not succeed.

It may turn out that such guarantees are impossible, given the mistrust between the two parties and the ever-changing regional circumstances. Whatever the mechanism, there is no doubt that the U.S.-Israel relationship could benefit greatly from a common approach toward the Iran nuclear program at this tumultuous time. Their upcoming meeting and the months ahead promise to test the Obama-Netanyahu relationship like never before.