Rates of return and FDI flows: How close a connection?

In the “textbook perfect” world economy international investment seeking higher returns always flows down-hill: from capital abundant (rich) countries to capital-scarce poor ones. However in the real world much of capital travels among rich countries and substantial amounts go uphill – from poor to rich countries. In one of his famous papers, Lucas (1990) hypothesized that seemingly inadequate international investment going from rich to poor countries could result from the low effective marginal productivity of capital (MPK) in the latter resulting from the lower quality of complementary factors such as labor. Other authors explained the same phenomenon focusing on capital frictions related to higher risk of investing in LDCs. With no reliable estimates of cross-country MPKs many questions remain. The paper tries to fill this gap by investigating the empirical connection between various measures of macroeconomic profitability and cross-country FDI flows. Our findings establish a strong link between profitability and FDI and a trend towards convergence of rates of return towards the global average. The study is based on the original estimates of levels and trends in profitability for a broad sample of developed, developing, and transition economies comprising over 90% of the global output. The underlying distributional and efficiency-related determinants of profitability are analyzed. For the period of 1994-2011 our estimates indicate an overall upward trend in profit rates driven by an increase in capital productivity and profit shares in the GDP. Throughout the study period, macroeconomic rates of return on capital in developing and transition economies demonstrated a certain trend toward convergence, reflected in a substantial reduction of their variation around group averages. While rates of return in developed economies did not show similar patterns, the overall dispersion of national rates of return around the global average decreased. The principal driver of profitability convergence was the convergence in output-capital ratios resulting from increased volume of cross-country international capital flows in the period of globalization. Our results generally support the predictions of theory: different pace of capital accumulation and increasing openness to foreign investment facilitate the convergence of national rates of return on capital. The study contributes to the discussion of the Lucas paradox concerning the prevalence of “uphill” capital flows.