Increased capital account openness is good for a nation''s poor – even though foreign investment may increase numbers in poverty

When governments ease restrictions on capital flows, it''s good news for the poorest citizens – although actual foreign direct investment has the opposite effect, according to research by Thuy Duong Vu, to be presented at the Royal Economic Society''s annual conference at the University of Bristol in April 2017.

The research looks at 32 developing countries between 2004 and 2011, and finds that when governments relax restrictions on capital flows, the result is that fewer people live on $2 or less a day. This may be because local banks are exposed to more international competition, which improves the way they allocate credit. On the other hand, FDI increases the poverty headcount, perhaps due to restructuring and the elimination of low-skilled jobs.

But the net result is positive for the poor unless there is a large influx of FDI when capital controls are loosened. ''The important policy-making implication is that the benefits associated with financial integration can potentially be greater than the costs'', the author concludes.


Fighting poverty: The importance of lifting controls on capital flows and the negative consequences of foreign direct investment

• Government''s restrictions on capital flows and actual cross-border capital movements have opposite effects on poverty.

• Lifting capital flows controls has a poverty-reducing effect thanks to its strong disciplining role in the economy.

• Higher foreign direct investment inflows and liabilities have a poverty-increasing impact due to negative effects of multinational enterprises'' presence.

• Positive effects of relaxing capital restrictions can be more pronounced than the negative effects of foreign direct investment.

Imposing stricter controls on capital flows, one of the popular tools used by governments in developing countries after the break out of the financial crisis of 2007-08, can be detrimental to the poor. Indeed, relaxing capital flows restrictions is proved to be an effective tool for poverty reduction. On the contrary, increased actual capital movements, such as FDI inflows and FDI liabilities, have poverty-increasing impact.

These are the key conclusions of this new study on the impact of de jure and de facto financial integration on poverty. De jure financial integration is defined as lifting restrictions on capital account. The de facto financial integration process occurs when there is an increase in actual cross-border capital movements.

Using data for 32 developing countries in the period 2004-2011, this study, for the first time, provides evidence that de jure and de facto financial integration have opposite effects on poverty headcount ratio. The latter measures the percentage of the population living on less than $2/day. To capture the effects of de jure financial integration, the author uses KAOPEN index, which measures a country''s degree of capital account openness on the scale from -1.89 to 2.39. De facto financial integration is proxied by FDI inflows and FDI liabilities.

The research reveals that relaxing capital flows restrictions has a poverty-reducing effect. It is estimated that an increase in KAOPEN index of 1 reduces poverty headcount ratio by 1.1 to 1.7 percentage points.

The positive impact of the jure financial integration is attributed to its strong disciplining role in economy. For example, domestic banks, being aware that loosening capital account restrictions might lead to an entry of foreign players, can be more motivated to adopt global best practices in loans application process to strengthen their market position. This can result in better capital distribution, which benefits start-ups, small firms and the poor directly.

On the contrary, higher FDI inflows and FDI liabilities hurt the poor. The study finds that an increase in FDI inflows of 1% of GDP raises poverty headcount ratio by 0.34 to 0.35 percentage points. A boost of FDI liabilities of 1% of GDP causes a surge in poverty headcount ratio by 0.05 to 0.09 percentage points. The negative effect of de facto financial integration can be explained by restructuring and low-skilled job destruction practices used by multinational enterprises.

The important policy-making implication is that the benefits associated with financial integration can potentially be greater than the costs. If relaxing capital controls is not accompanied by increased capital flows, it can still affect the poor through the positive disciplining effect. In the event of high FDI influx, lifting capital restrictions can minimise, or even outweigh, the negative effects of FDI on poverty.

''Fighting Poverty: The Role of Financial Integration in Developing Countries'' – Thuy Duong Vu at University College London