Open Capital Account: Concrete Wealth or Paper Wealth

Empirical evidence shows that capital inflows are often used by developing countries to finance excessive consumption. The existing literature explains these phenomena as resulting from institutional imperfections. In contrast, we argue that they can be fundamental outcomes of open capital account, under which ineffectiveness in using foreign savings for investments tends to result in capital inflows being channeled to consumption through wealth effect. Our analysis shows that, while risk aversion causes low investment elasticity and hence reduces the total benefit of capital account liberalization for society over time, it nevertheless tends to increase the benefit enjoyed by current generations and hence drive consumption booms. We show that the proportion of capital inflows used for financing consumption is negatively correlated with investment elasticity. We show that a positive yet uncertain future productivity shock is likely to cause consumption booms because of sluggish investment reactions. Our analysis shows that, the greater the expected future productivity is; or the greater the uncertainty is; the stronger the consumption booms will be. (JEL F21 F32 F41 F43)