The Rubik's Cube of economics

Like the Rubik's Cube, a three-dimensional combination puzzle where every twist also scrambles the face opposite of it, economics puzzles are similarly interlinked -- a change in policy may lead to repercussions elsewhere.

"My research is motivated by empirical puzzles in economic literature," he says. "As economists, we seek to augment or update existing economic theories to explain real world data. The challenge lies in the fact that markets and economies seldom function in a frictionless manner."

For example, Professor Zhang notes that capital has been flowing "uphill" from the poor to the rich, and from emerging economies to developed ones since the end of 1990s. This stands in stark contrast to neoclassical economic theory which states that capital should flow from the rich to the poor, as the rate of return on investments in poor countries should be higher than in rich countries. Financial friction and the resulting borrowing constraints in poor countries can explain such a puzzling fact, he explains.

Similar income levels, different patterns of capital flows

Patterns of international capital flows in emerging economies are another real world puzzle Professor Zhang has studied. Although income levels per person were comparable in emerging Asia (Indonesia, Malaysia, Philippines, Thailand and Vietnam) and emerging Europe (countries such as Hungary, Poland and Romania in Central and Eastern Europe), their patterns of international capital flows were not.

"We looked at the data from 1998 to 2011 and found that even though both regions received large amounts of foreign direct investment, emerging Asia witnessed financial capital outflows, while emerging Europe received financial capital inflows," he says.

"The 1997 Asian financial crisis severely damaged the financial and asset markets in emerging Asia," he says, referring to the catastrophic downturn during which currencies plunged, markets collapsed and millions of jobs were lost. "The region's recovery in the following years was slow. The financial markets were unable to efficiently mobilise domestic savings to finance domestic investment projects. As a result, domestic investors had to seek high returns elsewhere. This led to financial capital outflow."

In contrast, following the 2004 EU enlargement, the adoption of EU laws and directives significantly improved financial sector quality in emerging Europe by upgrading their legal, regulatory and supervisory frameworks to the same standard as in Western Europe, Professor Zhang explains. "The significant dominance of foreign banks in the Central and Eastern European financial markets also improved the quality of domestic banking sectors. Consequently, the domestic financial sector became relatively well-functioning and emerging Europe received financial capital inflows."

Thus, if a developing economy wants to benefit from international financial integration, Professor Zhang says it should first improve its financial sector considerably to benefit from capital inflows. "In the presence of an underdeveloped financial sector, simply opening up the doors to the country's markets may even be harmful."

Free trade and income divergence

According to neoclassical economics theory, free trade will lead to income convergence, says Professor Zhang, but "the empirical evidence on this relationship is mixed: it may lead to income convergence among rich countries, and divergence among poor countries."

In his research, Professor Zhang addresses this puzzle from the perspective of financial development. In the modern economy, some sectors such as the manufacturing sector have high Minimum Investment Requirements (MIR). This is because activities like industrial production and manufacturing (e.g., steel production or shipbuilding), require investments to reach a minimum level before the business can operate. Other sectors such as agriculture, however, have low MIR.

In a financially underdeveloped country, only a few investors can afford to invest in the high-MIR sector, due to the tight borrowing constraints. Goods from that sector will end up priced high in that country, because their output is relatively rare. At the same time, most investments will occur in sectors such as agriculture, because there is hardly any MIR there. The result is an oversupply of low-MIR goods (such as agricultural goods) in relation to high-MIR goods (such as manufacturing goods), making low-MIR goods relatively cheap in these less financially developed countries.

"Given its level of financial development, if a country is relatively rich initially, more investors can afford to invest in the high-MIR sector -- resulting in lower relative prices for high-MIR goods," Professor Zhang notes.

Hence, free trade among financially underdeveloped countries will make the initially rich countries specialise in the high-MIR sector, and the initially poor countries specialise in the low-MIR sector. Since the high-MIR sector has a higher rate of return than the low-MIR sector, free trade widens the cross-country income gap and leads to income divergence. However, free trade among financially developed economies will lead to income convergence among the member states, regardless if they are rich or poor, due to the loose borrowing constraints. This way, he says, the impact of free trade on income convergence depends critically on the level of financial development in the various countries.

"As such, countries need to examine the exact benefits and pitfalls that free trade could have on their respective economies, rather than subscribing to it wholesale. Countries should use free trade as an opportunity to improve their financial sectors. Blindly opening up the economy may cause problems," Professor Zhang warns.