Publications by Author: Alfaro, Laura

Global Capital and National Institutions: Crisis and Choice in the International Financial Architecture

All managers face a business environment in which international and macroeconomic phenomena matter. International capital flows can significantly affect countries' development efforts and provide clear investment opportunities for businesses. During the 1990s and early 2000s, the world witnessed an explosion in capital flows at the global level. Gross foreign assets and liabilities stood at two or three times GDP for many countries, as compared to just two decades ago. This explosive growth, especially in emerging markets, has been fueled both by changes in world politics (e.g., the end of the Cold War, collapse of the Soviet Union, shifting political climate in China, and political changes in Latin America and Asia) and advances in technology. Private capital flows—debt finance, equity capital, and foreign direct investment (FDI)—became larger than current and past official capital flows. This new era of foreign capital mobility has also been characterized by low interest rates in industrial countries, growing external imbalances in the US economy, and the rise of China, all of which posed new challenges to policy management. In 2009, the global economy remained mired in a deep crisis following the subprime meltdown in the US. The situation was also a true testimony of how intertwined individual economies had become over the years. The effect of policies to deal with the ongoing global crisis and new policy choices remain to be seen. Understanding these phenomena—the determinants of capital flows, the effects of foreign capital on host countries, the impact of exchange-rate movements, and the genesis of financial and currency crises—is a crucial aspect to making informed managerial decisions.

The cases in this book have been designed to give students an appreciation of the critical role of institutions and policies in affecting patterns of international capital flows and the abilities of government to manage them effectively. The case studies are tied together by two broad themes: (1) the determinants and effects of international capital, and (2) policy-makers' management of these flows. The cases approach these themes by exploring institutional detail in deep local context. The cases expose students to recent key events that have shaped the way economists think about these subjects. The events covered have a clear global perspective as the cases are set in Africa, Asia, Europe and Latin America, as well as the United States. The cases also cover events that occurred during the last three decades as not only do they affect the business environment that managers face today but they also hold important lessons. An important feature the cases reveal is the cyclical nature of international capital flows.

Global Capital and National Institutions: Crisis and Choice in the International Financial Architecture is composed of three intellectual segments: (1) Determinants and Effects of International Capital Flows, (2) Policies and Strategies for Harnessing the Benefits of Financial Globalization, (3) Challenges and Policies of Large Economies. Chapter I presents a detailed overview of the cases and readings in the module and relates the cases included to the main patterns of international capital flows in the last thirty years. Finally, the chapter also presents the key insights from the field of international economics covered in the cases as well as the current state of debate among policy-makers.

Alfaro, Laura, Andrew Charlton, and Fabio Kanczuk. 2007. “Firm-Size Distribution and Cross-Country Income Differences”. Abstract

We investigate, using a unique firm level dataset of nearly 20 million firms in 80 countries, whether differences in the allocation of resources across heterogeneous plants are a significant determinant of cross-country differences in income per worker. Using a monopolistic competitive firm framework to derive our benchmark calibration, we find that the model over-explains income variance. We further explore whether the results are driven by sample biases, calibration assumptions, or modeling choice. We find the same results prevail even in sub-samples in which the data are more reliable, and when we vary the calibration assumptions. This suggests the need for more complex modeling structures. Despite these acknowledged shortcomings, our results suggest that misallocation of resources is a crucial determinant of income dispersion.


Harvard Business School Working Paper 07-086, April 2007

In this paper we distinguish different “qualities” of FDI to re-examine the relationship between FDI and growth. We use ‘quality’ to mean the effect of a unit of FDI on economic growth. However, this is difficult to establish because it is a function of many different country and project characteristics which are often hard to measure. Hence, we differentiate “quality FDI” in several different ways. First, we look at the possibility that the effects of FDI differ by sector. Second, we differentiate FDI based on objective qualitative industry characteristics including the average skill intensity and reliance on external capital. Third, we use a new dataset on industry-level targeting to analyze quality FDI based on the subjective preferences expressed by the receiving countries themselves. Finally, we use a two-stage least squares methodology to control for measurement error and endogeneity. Exploiting a new comprehensive industry level data set of 29 countries between 1985 and 2000, we find that the growth effects of FDI increase when we account for the quality of FDI.


Harvard Business School Working Paper 07-072, May 2007

The empirical literature finds mixed evidence on the existence of positive productivity externalities in the host country generated by foreign multinational companies. We propose a mechanism that emphasizes the role of local financial markets in enabling foreign direct investment (FDI) to promote growth through backward linkages, shedding light on this empirical ambiguity. In a small open economy, final goods production is carried out by foreign and domestic firms, which compete for skilled labor, unskilled labor, and intermediate products. To operate a firm in the intermediate goods sector, entrepreneurs must develop a new variety of intermediate good, a task that requires upfront capital investments. The more developed the local financial markets, the easier it is for credit constrained entrepreneurs to start their own firms. The increase in the number of varieties of intermediate goods leads to positive spillovers to the final goods sector. As a result financial markets allow the backward linkages between foreign and domestic firms to turn into FDI spillovers. Our calibration exercises indicate that a) holding the extent of foreign presence constant, financially well-developed economies experience growth rates that are almost twice those of economies with poor financial markets, b) increases in the share of FDI or the relative productivity of the foreign firm leads to higher additional growth in financially developed economies compared to those observed in financially under-developed ones, and c) other local conditions such as market structure and human capital are also important to generate a positive effect of FDI on economic growth.


Harvard Business School Working Paper 07-013; NBER Working Paper No. w12522, September 2006.

We explore the relation between international financial integration and the level of entrepreneurial activity in a country. We use a unique firm level data set of approximately 24 million firms in nearly 100 countries in 2004 and 1999, which enables us to present both cross-country and industry level evidence. We establish robust cross-country correlations between increased international financial integration and the activity of entrepreneurs using various proxies for entrepreneurial activity such as entry, size, and skewness of the firm-size distribution and de jure and de facto measures of international capital integration. We then explore causal channels through which foreign capital may encourage entrepreneurship. We find evidence that entrepreneurial activity in industries which are more reliant on external finance is disproportionately affected by international financial integration, suggesting that foreign capital may improve access to capital either directly or through improved domestic financial intermediation. Second we find that entrepreneurial activity is higher in industries which have a large share of foreign firms or in vertically linked industries.


Harvard Business School Working Paper 07-012; NBER Working Paper No. 13118, February 2007.

Alfaro, Laura, and Andrew Charlton. 2007. “Intra-Industry Foreign Direct Investment”. Abstract

We identify a new type of vertical foreign direct investment (FDI) made up of multinational subsidiaries producing intermediate inputs, which are of similar skill intensity to the final goods produced by their parents, and which are overwhelmingly located in high skill countries. Making up more than half of all vertical FDI, these subsidiaries are not readily explained by the comparative advantage considerations in traditional models, where firms locate their low skill production stagesabroad in low skill countries to take advantage of factor cost differences. In this paper we exploit a remarkable new firm level data set which establishes the location, ownership, and activity of 650,000multinational subsidiaries—close to a comprehensive picture of global multinational activity. A number of patterns emerge from the data. Most foreign direct investment (FDI) occurs between rich countries. The share of vertical FDI (subsidiaries which provide inputs to their parent firms) is larger than commonly thought, even within developed countries. More than half of all vertical subsidiaries are only observable at the four-digit level because the inputs they are supplying are so proximate to their parent firm’s final good that they appear identical at the two-digit level. We call these proximate subsidiaries ‘intra-industry’ vertical FDI and find that their location and activity are significantlydifferent to the inter-industry vertical FDI visible at the two-digit level. We explain this pattern of intra-industry north-north vertical FDI in terms of the decision to outsource versus own the production of intermediate inputs. Overwhelmingly, multinationals tend to own the stages of production proximate to their final production giving rise to a class of high-skill intra-industry vertical FDI.


NBER Working Paper w13447, February 2007.

Alfaro, Laura, and Faisal Z Ahmed. 2007. “The Price of Capital: Evidence from Trade Data”. Abstract

In this paper we use highly disaggregated data on trade in capital goods to study differences in the price of capital across countries. Our strategy is motivated by the fact that most countries import the bulk of machinery equipment (from a small number of industrialized countries). We find the price of imported capital goods to be negatively and significantly correlated with the income of the importing country. Because most low-income countries import the bulk of capital goods, our results provide suggestive evidence that capital goods are more expensive in poor countries, consistent with the conventional explanation regarding the low real investment rates in poor countries.


Harvard Business School Working Paper 07-073, March 2007

Alfaro, Laura. 2006. “Capital Flows and Capital Goods”. Abstract

We examine one of the channels through which financial integration can help promote growth. We study the effects of capital account liberalization on the imports of capital goods paying particular attention to equity market liberalization. We find that for the period 1980–1997, after controlling for trade liberalization and other macroeconomic policies and reforms, stock market liberalization leads to a significant increase in the share of imports of machinery and equipment and the varieties of capital goods imports. Hence, this paper provides evidence that increased access to international capital allows countries to enjoy the benefits embodied in international capital goods.

Alfaro, Laura, and Eliza Hammel. 2006. “Capital Flows and Capital Goods”. Abstract

We examine one of the channels through which international financial integration can help promote growth. We study the relation between equity market liberalization and imports of capital goods. For the period 1980–1997, we find that, after controlling for other macroeconomic policies and fundamentals, stock market liberalization is associated with a significant increase in the share and variety of imports of machinery and equipment. We hypothesize this can be attributed to the consequences of financial integration, which allows access to foreign capital, and provide evidence consistent with this channel. Hence, we find that increased access to international capital allows countries to enjoy the benefits embodied in international capital goods.


WCFIA Working Paper 06–03, March 2006

Alfaro, Laura, and Fabio Kanczuk. 2006. “Debt Maturity: Is Long-Term Debt Optimal?”. Abstract

We model and calibrate the arguments in favor and against short-term and long-term debt. These arguments broadly include: maturity premium, sustainability, and service smoothing. We use a dynamic equilibrium model with tax distortions and government outlays uncertainty, and model maturity as the fraction of debt that needs to be rolled over every period. In the model, the benefits of defaulting are tempered by higher future interest rates. We then calibrate our artificial economy and solve for the optimal debt maturity for Brazil as an example of a developing country and the U.S. as an example of a mature economy. We obtain that the calibrated costs from defaulting on long-term debt more than offset costs associated with short-term debt. Therefore, short-term debt implies higher welfare levels.


Harvard Business School Working Paper 06-005; NBER Working Paper 13119, August 2006

Alfaro, Laura, and Fabio Kanczuk. 2006. “Optimal Reserve Management and Sovereign Debt”. Abstract

Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. However, given the sovereign’s willingness-to-pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming constant debt levels does not allow addressing one of the puzzles behind using reserves as a means to avoid the negative effects of crisis: why do not sovereign countries reduce their sovereign debt instead? To study the joint decision of holding sovereign debt and reserves, we construct a stochastic dynamic equilibrium model calibrated to a sample of emerging markets. We obtain that the optimal policy is not to hold reserves at all. This finding is robust to considering interest rate shocks, sudden stops, contingent reserves and reserve dependent output costs.


Harvard Business School Working Paper 07-010; NBER Working Paper No. 13216, July 2006

Alfaro, Laura, and Fabio Kanczuk. 2006. “Sovereign Debt: Indexation and Maturity”. Abstract

In this paper we review the literature on sovereign debt with particular emphasis on indexation and maturity and the main policy proposals related to these topics. We also advance some implications derived from our work. In Alfaro and Kanczuk (2005a, b, c), we modeled sovereign debt as a contingent claim following the framework developed by Grossman and Van Huyck (1988). Our framework, however, recognizes that contingent debt might be associated with incentive problems. Applying this framework to the study of the sustainability of sovereign debt, the tradeoff between nominal and indexed debt, and the optimal debt maturity, we find some of the proposals advanced in the literature regarding lengthening debt maturity and issuing nominal debt to be unsustainable in emerging (volatile) economies.


Inter-American Development Bank Working Paper Series WP-560, April 2006

We examine the empirical role of different explanations for the lack of flows of capital from rich to poor countries–the "Lucas Paradox." The theoretical explanations include differences in fundamentals across countries and capital market imperfections. We show that during 1970–2000 low institutional quality is the leading explanation for the lack of capital flows. For example, improving Peru?s institutional quality to Australia?s level, implies a quadrupling of foreign investment. Recent studies emphasize the role of institutions for achieving higher levels of income but remain silent on the specific mechanisms. Our results indicate that foreign investment might be a channel through which institutions affect long–run development.


WCFIA Working Paper 06–04, April 2006


We describe the patterns of international capital flows in the period 1970–2000. We then examine the determinants of capital flows and capital flows volatility during this period. We find that institutional quality is an important determinant of capital flows. Historical determinants of institutional quality have a direct effect on today's foreign investment. Policy plays a significant role in explaining the increase in the level of capital flows over time and their volatility.

Working Paper 11696, National Bureau of Economic Research, October 2005.

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There are different arguments in favor and against nominal and indexed debt which broadly include the incentive to default through inflation versus hedging against unforeseen shocks. We model and calibrate these arguments to assess their quantitative importance. We use a dynamic equilibrium model with tax distortion, government outlays uncertainty, and contingent–debt service, which we take to mean nominal debt. In the model, the benefits of defaulting through inflation are tempered by higher future interest rates. We obtain that calibrated costs from inflation more than offset the benefits from hedging. We further discuss sustainability of nominal debt in developing (volatile) countries.

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This paper provides a political economy explanation for temporary exchange–rate–based stabilization programs by focusing on the distributional effects of real exchange–rate appreciation. I propose an economy in which agents are endowed with either tradable or nontradable goods. Under a cash–in–advance assumption, a temporary reduction in the devaluation rate induces a consumption boom accompanied by real appreciation, which hurts the owners of tradable goods. The owners of nontradables have to weigh two opposing effects: an increase in the present value of nontradable goods wealth and a negative intertemporal substitution effect. For reasonable parameter values, owners of nontradables are better off.