82nd International Atlantic Economic Conference

October 13 - 16, 2016 | Washington, USA

Capital flows and rates of return: Is the “Lucas paradox” fading?

Sunday, October 16, 2016: 9:40 AM
Alexei Izyumov, Ph.D. , Economics, University of Louisville, Louisville, KY
The phenomenon of international investment not following profitability signals and going “uphill” - from poorer to richer countries, was a long-standing pattern in the global economy. In his seminal paper, Lucas (1990) called the problem of inadequate investment flows from capital-abundant to capital-poor countries the “central question for economic development”. 

The main research question of our paper is whether the “Lucas Paradox” applies to the recent period of globalization. We hypothesize that this period, characterized by financial liberalization, opening of post-communist countries, and radical improvement in communications brought about by the IT revolution may have changed the patterns of international investment. In a more open and transparent global economy, capital may find it easier to chase profitability and to flow across countries in a “normal” direction - downhill rather than up.

To answer this question we investigate how closely cross-country foreign direct investment (FDI) flows correlate with capital profitability as represented by macroeconomic rates of return. Using newly available data from the Penn World Table (PWT) 8.1 (2015) we provide estimates of pre-tax, after-tax and tax- and risk-adjusted returns on fixed capital for 1994-2011 for a sample of 110 developing, developed and post-communist transition economies, collectively comprising over 85% of global GDP. We then use the resulting rates of return (ROR) to analyze the cross-country flows of FDI to determine if net inflows of capital are sensitive to profitability in host countries. Based on our investigation of capital flows-profitability connection for 58 developing, 26 developed, and 26 transition economy countries, we found a statistically-significant link between pre-tax, after-tax and tax- and risk-adjusted profitability and FDI inflows. The positive relationship between capital flows and ROR during the recent period of globalization possibly indicates the dominance of downhill investment flows as the new norm. If this relationship holds in the long-run, it should contribute to the convergence of national ROR.

Key words: FDI, globalization, Lucas Paradox