Capital Flow Surges And Rising Income Inequality

from the San Francisco Fed

-- this post authored by Renuka Diwan, Zheng Liu, and Mark M. Spiegel

Surges of foreign investment into developing countries can amplify economic stress and potentially undermine their financial stability. New evidence suggests that excessive foreign capital inflows can also increase income inequality in emerging economies. Research shows that, as low global interest rates trigger more investment, those inflow surges benefit entrepreneurs by raising their returns, while lowering household earnings on bank deposits within the countries. The potential impact on income inequality provides another reason beyond financial stability for resisting abrupt surges in capital inflows.

Foreign capital inflows can benefit an emerging market economy (EME) by reducing the cost of financing domestic consumption and investment. However, surges and subsequent reversals of capital inflows can hurt financial and macroeconomic stability in EMEs. Recognizing the potential destabilizing impact of capital flow surges for EMEs, the International Monetary Fund (IMF) has become more amenable in recent years to using capital account restrictions as a “part of the policy toolkit to manage inflows" (Ostry et al. 2010).

This Economic Letter focuses on how capital surges into EMEs as a result of more open capital account policies can also distort the distribution of income in those countries. We present new evidence from 60 EMEs since the 1960s to show that increases in net inflows of private capital raise income inequality substantially. The potential impact on income inequality provides an additional motivation beyond financial stability to support policies that restrict surges in capital flows.

Relation between capital flows and income distribution

Income inequality within countries has been increasing around the world for a long time (Niño-Zarazúa et al. 2017). Recent evidence connects capital account policy with income distribution in emerging markets. For example, Furceri and Loungani (2018) found when capital account liberalization eased the flows of investment across country borders, these countries were associated with increased income inequality. In particular, using data from the 1960s through 2010, they found that the 1990s exhibited the greatest increases both in capital account openness and in income inequality. Moreover, easing restrictions on capital flows has a stronger impact on income inequality in countries with less-developed financial markets.

Little research has explored the formal link between capital flows and income inequality. In a recent paper, Liu, Spiegel, and Zhang (2020) present a theoretical framework to study how international investment could affect the earnings of different groups of the population in different ways. Their model considers two groups: entrepreneurs, who have access to capital markets - both domestic and foreign - and earn income from investment returns, and workers, who do not have access to investment opportunities and earn income from wages and interest on their savings. Domestic and foreign banks play an important role, providing savings options for households and loans for entrepreneurs to finance capital investments.

Under this framework, Liu et al. (2020) demonstrate that a surge in capital inflows to an EME triggered by a decline in the global interest rate can boost net local profits on capital and skew the income distribution in favor of entrepreneurs. In contrast, households suffer a reduction in interest earnings on their savings in domestic and foreign banks. The effect is symmetric: capital outflow surges are expected to skew the income distribution in favor of households.

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Disclaimer: Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the ...

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