Why Are Poor Countries Financing the Rich?

In an increasingly noticeable trend, poor countries seem to be financing the rich while the least productive countries receive the most foreign capital, according to Raghuram Rajan, chief economist of the International Monetary Fund and Eric J. Gleacher Distinguished Service Professor of Finance. As part of Chicago GSB’s Global Leadership Series, Rajan examined the phenomenon and the role foreign capital plays in the process of economic growth at an event hosted by the GSB in Singapore September 15.

Rajan said poor countries also have poorly developed financial systems, making it harder for citizens and outsiders to invest. Rich countries, however, have well-developed financial systems, and their citizens can take advantage of investment opportunities by investing their own money while the country itself draws in a lot of foreign capital, he said. Coupled with consumers’ ability to borrow against their potential to higher income, productivity growth translates into current account deficits, Rajan said.

One view of the evidence is that foreign capital has a fairly benign role to play in the process of economic growth. Rajan says, “It’s not saying foreign capital is a bad thing. It’s saying countries have varying abilities to use the foreign capital.”

Indeed, many poor countries use less foreign capital as they grow faster because the savings they generate are more than enough to undertake the limited investment opportunities the financial systems allow, he said. Rajan pointed out, “If you look at the current account, which is savings minus investment, that’s going up tremendously as these countries have a growth spurt.” It shows how the importance of savings far outweighs that of investments, he said.

There may also be benefits of relying more on domestic savings in the early stages of growth because that helps a country avoid over-valuation of its exchange rate, according to Rajan. Many African countries struggled economically by maintaining an overvalued exchange rate. While it allowed urban consumers to buy imported goods cheaply, it hurt industry. Asia fared far better, he says, by attempting to have a fairly valued exchange rate.

“As these poor countries improve their financial systems by improving retail finance and get their people to consume more, over time the deficits will come down in the rich countries, and the surpluses will come down in the poor countries. But right now,” Rajan says, “this is where we are.”

—Shobana Kesava