Private Capital Movements and Exchange Rates in Developing Countries Rudolf R. Rhomberg* This is a revised text of a paper presented to the International Economic Association, Round Table Conference on Capital Movements and Economic Development, Washington, D.C., July 28, 1965. It will also appear in the proceedings of the Conference published by The Macmillan Company, London, and St. Martin's Press, New York.1 HE ECONOMIC AND FINANCIAL literature of recent years has Tcontained a considerable amount of discussion of the relationship between exchange rates and international differences in interest rates, on the one hand, and capital movements between the major industrial coun- tries, on the other. Much less attention has been paid to the question of the effect of variations in exchange rates, or of the choice among alterna- tive exchange rate systems, on private capital flows from industrial to developing countries. The present paper deals primarily with this rela- tively neglected topic. The principal question that will be considered is the following: how are private capital movements in any one country likely to respond to changes, or expected changes, in foreign exchange rates and in the country's prices and costs, given the other factors which influence the incentive to invest in that country? Although the paper is chiefly concerned with flows of private capital to developing countries, the general analysis of the influence of changes in prices, costs, and exchange rates on movements of various types of capital applies also to international investment in industrial countries. The concluding section elaborates some implications of the analysis with regard to the broader question of the effect of alternative exchange rate systems (fixed or fluc- tuating exchange rates, unitary or multiple exchange rates) on capital flows. These questions must be approached mainly through a priori reasoning. Countries that differ insofar as their exchange rate systems are concerned ordinarily differ also with respect to a number of other factors influencing * Mr. Rhomberg, Chief of the Special Studies Division of the International Monetary Fund, is a graduate of the University of Vienna and of Yale University and has been a member of the faculty of the University of Connecticut. He has contributed chapters to several books on economic subjects and articles to eco- nomic journals. 1 The author has benefited greatly from comments made at the Round Table Conference by Professor Wolfgang F. Stolper and other participants. 1 ©International Monetary Fund. Not for Redistribution 2 INTERNATIONAL MONETARY FUND STAFF PAPERS the attractiveness of their economies to foreign investors. Many of these factors cannot easily be quantified. Moreover, investment responds not to the actual changes in the determinants of returns on capital assets but rather to the changes which potential investors expect; the historical record reveals the former but not the latter. For these reasons, the scope for statistical testing of theoretical propositions concerning the deter- mination of the extent, timing, direction, and composition of foreign investment is very limited. The empirical material presented in this paper is intended only for illustrative purposes. Exchange Rates, Inflation, and Capital Movements If a country in which investment is contemplated is plagued by rapid domestic inflation, the exchange rate must be expected to depreciate sooner or later. It is generally agreed that the expectation of the deprecia- tion of a currency tends to discourage foreign investment in assets with given prices and yields denominated in that currency. This is so because of the exchange loss which a potential investor has to expect whenever the proceeds of some of the earnings and of the ultimate liquidation of an asset have to be converted into the investor's currency at a less favorable exchange rate than that at which the asset was originally purchased. These considerations, which concern a particular type of foreign invest- ment, are sometimes applied to foreign investment in general. This leads to the view that inflation and exchange instability (i.e., repeated devalua- tions or a continuously depreciating exchange rate) in the investee country reduce earnings on foreign investments and thus discourage capital inflows and encourage capital outflows.2 It is, however, difficult to reconcile the presumed deterrent effect of inflation and exchange depreciation with the continued large inflows of private capital into some of the countries whose currencies show very rapid rates of loss of internal and external purchasing power. Net inflows of private capital into four less developed countries—Argentina, Brazil, Chile, and Colombia—during the period 1951-63 are shown in Table 1. These countries experienced rapid inflation (measured by the cost of 2 This view finds expression, e.g., in the following statement: "Balance-of- payments problems, inflation, and consequent currency depreciation have for many years been a way of life in most Latin American nations, with a resulting adverse effect on earnings in terms of U.S. dollars, as well as an erosion of U.S. dollar investments in Latin American enterprises, particularly manufacturing" ("Proposals to Improve the Flow of U.S. Private Investment to Latin America: Report of the Commerce Committee for the Alliance for Progress," Private Investment in Latin America, Hearings Before the Subcommittee on Inter-American Economic Rela- tionships of the Joint Economic Committee, 88th Cong., 2nd Sess., p. 79). ©International Monetary Fund. Not for Redistribution TABLE 1. SELECTED DEVELOPING COUNTRIES WITH HIGH RATES OF INFLATION: NET PRIVATE CAPITAL INFLOW AND CHANGES IN COST OF LIVING AND EXCHANGE RATES, 1951-63 Net Private Capital Inflow Proportion of Increase in Increase in Price of Amount exports Cost of Foreign Exchange Total1 Long-term 2 Total ! Long-term 2 Living Index3 Capital4 Commercial 5 PRIVAT Million US. dollars Per cent Argentina 1951-63 882 1,583 7 12 1,848 846 1,665 E CAPITA 1951-57 398 253 6 4 214 164 140 1958-63 484 1,330 7 20 520 258 636 Brazil L 1951-63 1,901 2,146 10 12 3,518 3,052 3,265 MOVEMENT 1951-57 1,118 1,057 11 10 246 360 264 1958-63 783 1,089 10 14 945 585 825 Chile 1951-63 535 540 8 9 4,166 4,075 3,502 S AN 1951-57 101 178 3 5 1,033 961 1,058 1958-63 434 362 15 12 276 293 211 D EXCHANG Colombia 1951-63 11 351 5 194 225 299 1951-57 -181 103 3 54 102 112 1958-63 192 248 7 9 90 61 88 E RATE Sources: Capital movements, from International Monetary Fund, Balance of Payments Yearbooks; cost of living index, exchange rates, exports, from International Monetary Fund, International Financial Statistics, monthly issues and Supple- ment 1964/65. S 1 Including net errors and omissions. A minus sign indicates a net capital outflow. 2 Direct and other long-term investment. 3 Annual averages; computed changes are from the average of 1950-51 to that of 1963-64, from the average of 1950-51 to that of 1957-58, and from the average of 1957-58 to that of 1963-64. U> 4 Exchange rates applicable to capital movements at the end of the year; computed changes are from year-end 1950 to year-end 1963, from year-end 1950 to year-end 1957, and from year-end 1957 to year-end 1963. 5 Exchange rates applicable to most commercial transactions (excluding principal export commodities) at the end of the year; see also footnote 4 above. ©International Monetary Fund. Not for Redistribution 4 INTERNATIONAL MONETARY FUND STAFF PAPERS living index) and exchange depreciation (measured both by the exchange rates mainly applicable to capital transactions and by those mainly appli- cable to general commercial transactions). They were, in fact, selected because, among the countries for which the relevant data could be com- piled, they had the highest rate of inflation. During the 13-year period 1951-63, the net inflow of private long-term capital to the four countries totaled $4.6 billion. This inflow contributed to the foreign exchange earnings of these countries an amount equal to 10 per cent of their earnings from merchandise exports. They experienced a net outflow of short-term capital (including errors and omissions)3 of about $1.3 billion; however, the net inflow of private capital of all types was quite large ($3.3 billion), amounting to 7 per cent of their combined exports. A comparison between two subperiods shows no consistent evidence— country by country—that long-term capital inflows were smaller in more inflationary periods than in less inflationary ones. In three of the four countries, prices rose much more rapidly from 1958 to 1963 than from 1951 to 1957. Yet during the 6-year period 1958-63, the net private long- term capital inflow into the four countries amounted to the equivalent of $3 billion (15 per cent of export earnings), almost one fifth of the net private long-term capital flow (including long-term private export credits) from the member countries of the Organization for Economic Cooperation and Development (OECD) to all less developed countries.4 This more inflationary period was also characterized by a substantial outflow of short-term capital from these four countries; it amounted to $1.1 billion, compared with only $150 million for the 7-year period 1951-57. This short-term capital outflow constitutes a loss of foreign exchange resources which these countries can ill afford. Nevertheless, what is surprising—in view of the financial instability of the four selected 3 Net short-term capital flows can be obtained in Table 1 by subtracting long- term from total capital inflows. It is here assumed that errors and omissions reflect mainly unrecorded capital flows of a short-term character.