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Two-Way Capital Flows and Global Imbalances

Financial capital and fixed capital tend to flow in opposite directions between poor and rich countries. This paper introduces frictions into a standard two-country neoclassical growth model to explain the pattern of two-way capital flows between emerging economies (such as China) and the developed world (such as the United States). We show how underdeveloped financial markets in China can lead to abnormally high rates of return to fixed capital but excessively low rates of return to financial capital relative to the U.S., hence driving out household savings (financial capital) on the one hand while simultaneously attracting foreign direct investment (FDI) on the other. When calibrated to match China’s high marginal product of capital and low real interest rate, our model is able to account for China’s rising financial capital outflows and FDI inflows as well as its massive trade imbalances in the past decades. Our model yields two additional implications that stand in sharp contrast to the existing literature: (i) Global trade imbalances between emerging economies and the developed world may be sustainable even in the long run; and (ii) the conventional wisdom that the "saving glut" of emerging economies is responsible for the global low world interest rate may be wrong.

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