Inequality and the Structure of Countries’ External Liabilities

2022 JUL Inequality and the Structure of Countries’ External Liabilities Philipp Harms, Mathias Hoffmann, Miriam Kohl and Tobias Krahnke WP/22/138 IMF Working PaperOffice of the Executive DirectorInequality and the Structure of Countries’ External Liabilities Prepared by Philipp Harms, Mathias Hoffmann, Miriam Kohl, and Tobias Krahnke Authorized for publication by Joerg Stephan IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.Abstract In this paper, we present empirical evidence that higher income inequality is associated with a greater equity share in countries' external liabilities, and we develop a theoretical model that can explain this observation: In a small open economy with traded and nontraded goods, entry barriers depress entrepreneurial activity in nontraded industries and raise income inequality. The small number of domestic nontraded-goods firms leaves room for foreign firms to operate on the domestic market, and it reduces external borrowing. The model suggests that barriers to entrepreneurial activity could be conducive to attract equity-type capital inows. Our empirical results lend some support to this conjecture. JEL Classification Numbers: D31, F21, F34, F36, F41 Keywords: Portfolio Equity; Foreign direct investment; External debt; External liabilities; Income Inequality Author’s E-Mail Address: philipp.harms@uni-mainz.de , mathias.hoffmann@bundesbank.de , miriam.kohl@uni-mainz.de , Tkrahnke@imf.org © 2022 International Monetary Fund WP/22/138 Inequality and the Structure of Countries’ ExternalLiabilities∗Philipp Harms†Johannes Gutenberg University MainzMathias Hoffmann‡Deutsche BundesbankMiriam Kohl§Johannes Gutenberg University MainzTobias Krahnke¶International Monetary FundAbstractIn this paper, we present empirical evidence that higher income inequality is asso-ciated with a greater equity share in countries’ external liabilities, and we developa theoretical model that can explain this observation: In a small open economywith traded and nontraded goods, entry barriers depress entrepreneurial activityin nontraded industries and raise income inequality. The small number of domes-tic nontraded-goods firms leaves room for foreign firms to operate on the domesticmarket, and it reduces external borrowing. The model suggests that barriers toentrepreneurial activity could be conducive to attract equity-type capital inflows.Our empirical results lend some support to this conjecture.Keywords:Foreign direct investment, Portfolio equity, External debt, Externalliabilities, Income inequalityJEL classification:D31, F21, F34, F36, F41.∗This paper has benefited from helpful comments by Cian Allen, Geert Bekaert, Eleonora Cavallaro,Bernardo Fanfani, Robert Kollmann, and the participants at the 11thPhD Workshop in Economicsof the Collegio Carlo Alberto, Torino, participants at the 2019 INFER Workshop on “New challengesof economic and financial integration”, Bordeaux, participants at the “5thMainz-Groningen workshopon FDI and Multinational Corporations”, Groningen, participants at the Brown Bag Seminar at theUniversity of Mainz, participants at the European Trade Study Group Annual Conference, Ghent, andparticipants at an internal IMF Webinar. This paper represents the authors’ personal opinions and donot necessarily reflect the views of the Deutsche Bundesbank and the International Monetary Fund or itsstaff.†Johannes Gutenberg University Mainz, Gutenberg School of Management and Economics, Jakob-Welder-Weg 4, 55128 Mainz, Germany; Email: philipp.harms@uni-mainz.de.‡Deutsche Bundesbank, Wilhelm-Epstein-Strasse 14, 60431 Frankfurt am Main, Germany; Email:mathias.hoffmann@bundesbank.de.§Johannes Gutenberg University Mainz, Gutenberg School of Management and Economics, Jakob-Welder-Weg 4, 55128 Mainz, Germany; Email: miriam.kohl@uni-mainz.de.¶International Monetary Fund, Washington, D.C., United States; Email: tkrahnke@imf.org. 1 IntroductionA broad consensus has emerged in the literature that the composition of foreign liabilities- that is, the relative shares of items such as foreign direct investment (FDI), portfolioequity, and external debt in a country’s external finance - is an important determinantof a country’s susceptibility to external crises. Given that liquidity crises are unlikely tobe generated by sudden stops in equity flows but have often been triggered by suddenstops in debt flows, large external debt liabilities are usually associated with an increasedcrisis risk (Cat ̃ao and Milesi-Ferretti (2014)). Moreover, the external capital structure ofcountries is seen as a determinant of economic performance, not least in l