Warren Alpert Professor of Business Administration
Laura Alfaro is the Warren Alpert Professor of Business Administration. She is also a Faculty Research Associate in the National Bureau of Economic Research's International Macroeconomics and Finance Program, Member of the Latin-American Financial Regulatory Committee (CLAAF), Faculty Associate at Harvard's Weatherhead Center for International Affairs, and member of the David Rockefeller Center for Latin American Studies’ (DRCLAS) policy committee. In 2008, she was honored as a Young Global Leader by the World Economic Forum. She served as Minister of National Planning and Economic Policy in Costa Rica from 2010-2012. She currently teaches Microeconomics of Competitiveness, a course listed at Harvard Business School and the Kennedy School of Government.
Laura Alfaro is the Warren Alpert Professor of Business Administration. She is also a Faculty Research Associate in the National Bureau of Economic Research's International Macroeconomics and Finance Program, Member of the Latin-American Financial Regulatory Committee (CLAAF), Faculty Associate at Harvard's Weatherhead Center for International Affairs, and member of the David Rockefeller Center for Latin American Studies’ (DRCLAS) policy committee. In 2008, she was honored as a Young Global Leader by the World Economic Forum. She served as Minister of National Planning and Economic Policy in Costa Rica from 2010-2012.
Professor Alfaro is the author of multiple articles published in leading academic journals such as the American Economic Review, Review of Economic Studies, and the Journal of International Economics, and of Harvard Business School cases related to the field of international economics and in particular international capital flows, foreign direct investment, and sovereign debt. At Harvard Business School since 1999, Professor Alfaro has taught in General Management Program, the Program for Leadership Development, and in other executive education offerings as well the first year and second year of the MBA program and the doctoral program. She earned her Ph.D. in Economics from the University of California, at Los Angeles (UCLA), where she was recipient of the Dissertation Fellowship award. She received a B.A in economics with honors from the Universidad de Costa Rica and a 'Licenciatura' from the Pontificia Universidad Catolica of Chile where she graduated with highest honors. She was awarded a Francisco Marroquin Foundation scholarship.
Do Prices Determine Vertical Integration?*
What is the relationship between product prices and vertical integration? While the literature has focused on how integration affects prices, this paper provides evidence that prices can affect integration. Many theories in organizational economics and industrial organization posit that integration, while costly, increases productivity. It follows from firms’ maximizing behavior that higher prices induce more integration. The reason is that at low prices, increases in revenue resulting from enhanced productivity are too small to justify the cost, whereas at high prices the revenue benefit exceeds the cost. Trade policy provides a source of exogenous price variation to assess the validity of this prediction: higher tariffs should lead to higher prices and therefore to more integration. We construct firmlevel indices of vertical integration for a large set of countries and industries and exploit cross-section and time-series variation in import tariffs to examine their impact on firm boundaries. Our empirical results provide strong support for the view that output prices are a key determinant of vertical integration.
The Real Effects of Capital Controls: Financial Constraints, Exporters, and Firm Investment
In aftermath of the global financial crisis of 2008–2009, emerging-market governments have increasingly restricted foreign capital inflows. The data show a statistically significant drop in cumulative abnormal returns for Brazilian firms following capital control announcements. Large firms and the largest exporting firms appear less negatively affected compared to externalfinance-dependent firms, and capital controls on equity have a more negative announcement effect than those on debt. Real investment falls following the controls. Overall, the results suggest that capital controls segment international financial markets, increase the cost of capital, reduce the availability of external finance, and lower firm-level investment.
Surviving the Global Financial Crisis: Foreign Ownership and Establishment Performance
We examine the differential response of establishments to the recent global financial crisis with particular emphasis on the role of foreign ownership. Using a worldwide establishment panel dataset, we investigate how multinational subsidiaries around the world responded to the crisis relative to local establishments. We find that, first, multinational subsidiaries fared on average better than local counterfactuals with similar economic characteristics. Second, among multinational subsidiaries, establishments sharing stronger vertical production and financial linkages with parents exhibited greater resilience. Finally, in contrast to the crisis period, the effect of foreign ownership and linkages on establishment performance was insignificant in non-crisis years.
Sovereigns, Upstream Capital Flows and Global Imbalances
We construct measures of net private and public capital flows for a large cross-section of developing countries considering both creditor and debtor side of the international debt transactions. Using these measures, we demonstrate that sovereign-to-sovereign transactions account for upstream capital flows and global imbalances. Specifically, we find that i) international net private capital flows (inflows minus outflows of private capital) are positively correlated with countries’ productivity growth, ii) net sovereign debt flows (government borrowing minus reserves) are negatively correlated with growth only if net public debt is financed by another sovereign, iii) net public debt financed by private creditors is positively correlated with growth, iv) public savings are strongly positively correlated with growth, whereas correlation between private savings and growth is flat and statistically insignificant. These empirical facts contradict the conventional wisdom and constitute a challenge for the existing theories on upstream capital flows and global imbalances.
Deregulation, Misallocation, and Size: Evidence from India
This paper examines the impact of the deregulation of compulsory industrial licensing in India on firm size dynamics and reallocation of resources within industries. Following deregulation, resource misallocation declines, and the left-hand tail of the firm size distribution thickens significantly, suggesting increased entry by small firms. However, the dominance and growth of large incumbents remains unchallenged. Quantile regressions reveal that the distributional effects of deregulation on firm size are significantly non-linear. The reallocation of market shares toward a small number of large firms and a large number of small firms is characterized as the "shrinking middle" in Indian manufacturing. Small- and medium-sized firms may continue to face constraints in their attempts to grow.
The Global Agglomeration of Multinational Firms
The explosion of multinational activities in recent decades is rapidly transforming the global landscape of industrial production. But are the emerging clusters of multinational production the rule or the exception? What drives the offshore agglomeration of multinational firms in comparison to the agglomeration of domestic firms? Using a unique worldwide plant-level dataset that reports detailed location, ownership, and operation information for plants in over 100 countries, we construct a spatially continuous index of agglomeration and analyze the different patterns underlying the global economic geography of multinational and nonmultinational firms. We present new stylized facts that suggest that the offshore clusters of multinationals are not a simple reflection of domestic industrial clusters. Agglomeration economies including technology diffusion and capital-good market externality play a more important role in the offshore agglomeration of multinationals than the agglomeration of domestic firms. These findings remain robust when we explore the process of agglomeration.
Intra-Industry Foreign Direct Investment (joint with Andrew Charlton)
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. These subsidiaries make up more than half of all vertical subsidiaries and are not readily explained by the comparative advantage considerations in traditional models of vertical FDI, where firms locate their low skill production stages abroad 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 650,000 multinational 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 significantly different 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 source raw materials and inputs in early stages of production from outside the firm, but tend to own the stages of production proximate to their final production giving rise to a class of high-skill intra-industry vertical FDI.
Intra-Industry Foreign Direct Investment
Sovereign Debt as a Contingent Claim: A Quantitative Approach (joint with Fabio Kanczuk)
We construct a dynamic equilibrium model with contingent service and adverse selection to quantitatively study sovereign debt. In the model, benefits of defaulting are tempered by higher future interest rates. For a wide parameter, the only equilibrium is one in which the sovereign defaults in all states; additional output losses, however, sustain equilibria that resemble the data. We show that due to the adverse selection problem, some countries choose to delay default in order to reduce loss of reputation. Moreover, although equilibria with no default imply in greater welfare levels, they are not sustainable in highly indebted and volatile countries.
Sovereign Debt as a Contingent Claim: A Quantitative Approach
Optimal Reserve Management and Sovereign Debt (with Fabio Kanczuk)
Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. Some of the implications of this analysis, however, may not be generalized once one considers the joint decision to hold debt and reserves by a sovereign. Given the sovereigns willingness to pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming debt levels constant does not allow addressing one of the puzzles behind the current accumulation of reserves. Sovereign countries have an alternative way of reducing the negative effects of external crisis: to reduce the level of sovereign debt. To study the joint decision of holding sovereign debt and reserves, we construct a small open economy stochastic dynamic equilibrium model, which is then calibrated to a sample of emerging markets. We study different scenarios associated with interest rate shocks, sudden stops, output costs and the use of contingent reserves. A robust quantitative result that emerges is that the optimal policy is not to accumulate reserves. In fact, in most of simulated economies, the optimal level of reserves holding is zero.
Optimal Reserve Management and Sovereign Debt
Capital Flows and Capital Goods (joint with Eliza Hammel)
We examine one of the channels through which financial integration can help promote growth. In particular, we study the effects of capital account liberalization on the imports of capital goods. We pay particular attention to the effects of equity market liberalization. We find that for the period 1980-1997, after controlling for trade liberalization and other macroeconomic reforms and policies, stock market liberalization leads to a substantial increase in the share of imports of capital goods. Our results suggest that with the increased access to international capital firms noticeably increase their spending on imports of machinery and equipment.
Capital Flows and Capital Goods
The Global Networks of Multinational Firms (with Maggie Chen)
In this paper we characterize the topology of global multinational networks and examine the macro and micro patterns of multinational activity. We construct indices of network density at both pairwise industry and establishment level and measure agglomeration in a global and continuous metric space. These indices exhibit distinct advantages compared to traditional measures of agglomeration including the independence on the level of geographic aggregation. Estimating the indices using a new worldwide establishment dataset, we investigate both the significance and causes of multinational firm co-agglomeration. In contrast to the conventional emphasis of the literature on the role of input-output linkages, we assess the effect of various agglomeration economies. We find that, relative to counterfactuals, multinationals with greater capital-market externalities, knowledge spillovers and vertical linkages exhibit significant co-agglomeration. The importance of these factors differs across headquarter, subsidiary and employment networks but knowledge spillovers and capital-market externalities, two traditionally under-emphasized forces, exert consistently strong effects. Within each macro network, there is a large heterogeneity across subsidiaries. Subsidiaries with a greater size and a higher productivity attract significantly more agglomeration than their counterfactuals and become the hubs of the network.
Selection, Reallocation, and Spillover: Identifying the Sources of Gains from Multinational Production (with Maggie Chen)
Quantifying the gains from multinational production has been a vital topic of economic research. Positive productivity gains are often attributed to knowledge spillover from multinational to domestic firms. An alternative, less stressed explanation is firm selection whereby competition from multinationals leads to market reallocation and survival of only the most productive domestic firms. We develop a model that incorporates both aspects and identify their relative importance in the gains from multinational production by exploring their distinct predictions on domestic productivity and revenue distributions. We show that knowledge spillover shifts both distributions rightward while selection and reallocation raise the left truncation of the distributions and shift revenue leftward. Using a rich firm-level panel dataset that spans 60 countries, our structural estimates suggest firm selection and market reallocation constitute an important source of productivity gains while its relative importance varies across nations. Ignoring the role of this source can lead to significant bias in understanding the nature of gains. We also perform counterfactual analysis and quantify both the aggregate and the decomposed welfare effects of multinational production.
Keywords: Gains from Multinational Production;
Why Doesn't Capital Flow from Rich to Poor Countries? An Empirical Investigation (joint with Sebnem Kalemli-Ozcan and Vadym Volosovych)
We examine the role of different explanations for the lack of
flows of capital from rich to poor countries -- the Lucas paradox
-- in an empirical framework. Broadly, the theoretical
explanations for this paradox include differences in fundamentals
affecting the production structure versus capital market
imperfections. Our empirical evidence, based on cross-country
regressions, shows that for the period 1971-1998, institutional
quality, which is a fundamental, is the most important causal variable explaining the Lucas
paradox. Human capital and asymmetric information do play a role
as determinants of capital flows but these variables cannot
account for the paradox.
Why Doesn't Capital Flow from Rich to Poor Countries? An Empirical Investigation
International Financial Integration and Entrepreneurship (joint with Andrew Charlton)
We explore the relation between international financial integration and the level of entrepreneurial activity in a country. Researchers have stressed the role of new firm activity and economic dynamism on growth. Yet, the empirical effects of international capital mobility on entrepreneurial activity have received little attention in the literature albeit the ambiguous theoretical predictions and the intense policy debate. Using a unique comprehensive data set of nearly 24 million firms in a close to 100 developed and developing countries, we find higher entrepreneurial activity in countries with fewer restrictions to international capital flows. Our results are robust to using various proxies for entrepreneurial activity such as entry, size, age, skewness of the firm-size and firm-age distribution and controlling for other variables that might affect the business environment such as the size of the market, regulation, enforcement of property rights and other institutional variables. We also use different empirical specifications in our analysis. We further explore various channels through which international financial integration can affect entrepreneurship and provide consistent evidence to support our results. In particular, we find that the presence of downstream foreign firms has a positive effect on firm activity (a foreign direct investment channel) and we find higher entrepreneurial activity in sectors more reliant on external finance (a capital/credit availability channel). Overall our study provides suggestive evidence that international financial integration has been associated with higher levels of entrepreneurial activity.
International Financial Integraton and Entrepreneurship
India Transformed? Insights from the Firm Level 1988-2005 (with Anusha Chari)
Using firm-level data this paper analyzes, the transformation of India’s economic structure following the implementation of economic reforms. The focus of the study is on publicly-listed and unlisted firms from across a wide spectrum of manufacturing and services industries and ownership structures such as state-owned firms, business groups, private and foreign firms. Detailed balance sheet and ownership information permit an investigation of a range of variables such as sales, profitability, and assets. Here we analyze firm characteristics shown by industry before and after liberalization and investigate how industrial concentration, the number, and size of firms of the ownership type evolved between 1988 and 2005. We find great dynamism displayed by foreign and private firms as reflected in the growth in their numbers, assets, sales and profits. Yet, closer scrutiny reveals no dramatic transformation in the wake of liberalization. The story rather is one of an economy still dominated by the incumbents (state-owned firms) and to a lesser extent, traditional private firms (firms incorporated before 1985). Sectors dominated by state-owned and traditional private firms before 1988-1990, with assets, sales and profits representing shares higher than 50%, generally remained so in 2005. The exception to this broad pattern is the growing importance of new and large private firms in the services sector. Rates of return also have remained stable over time and show low dispersion across sectors and across ownership groups within sectors.
How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages (with Areendam Chanda, Sebnem Kalemli-Ozcan and Selin Sayek)
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 novel
mechanism, which 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 combines the production
processes of foreign and domestic firms, which compete for skilled
labor, unskilled labor, and intermediate products. In order to
operate a firm in the intermediate goods sector, entrepreneurs must
first engage in R\&D to develop a new variety of intermediate good.
Innovation requires capital costs, which must be financed through
the domestic financial institutions. The more developed the local
financial markets are, the easier it is for credit constrained
entrepreneurs to start their own firms. Thus the number of varieties
of intermediate goods increases, causing positive spillovers to the
final goods sector. As a result the host country benefits from the
backward linkages between foreign and domestic firms since the local
financial markets allow these linkages to turn into FDI spillovers.
Our calibration exercise confirms our analytical results. For the
same proportion of foreign owned firms, countries with well
developed financial markets grow twice as fast compared to those
with poorly developed markets. Further the effect of an increase in
FDI on growth is higher for the countries with well developed
markets. The calibration exercise also shows the importance of the other local conditions such as market structure and human capital---the absorptive capacities---for the effect of FDI on economic growth.
How Does Foreign Direct Investment Promote Economic Growth?
Exploring the Effects of Financial Markets on Linkages
Nominal versus Indexed Debt: A Quantitative Horse Race (joint with Fabio Kanczuk)
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 these arguments and calibrate the model to assess the quantitative importance of each. 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 contingent inflation more than offset the benefits for any amount of nominal debt. We further discuss sustainability of nominal debt in volatile (developing) countries.
Nominal Versus Indexed Debt: A Quantitative Horse Race
Debt Maturity: Is Long-Term Debt Optimal? (with Fabio Kanczuk)
We model and calibrate the arguments in favor and against short-term and long-term debt. These arguments broadly include: maturity-term premium, tax smoothing, rolling over risk and the cost from defaulting. We use a dynamic equilibrium model with tax distortion, government outlays uncertainty, and model maturity as the fraction of debt that needs to be rolled over ever period. In the model, the benefits of defaulting are tempered by higher future interest rates. We obtain that the calibrated costs from defaulting long-term debt more than offset other costs associated with short-term debt. Therefore, short-term debt implies in higher welfare levels.
Debt Maturity: Is Long-Term Debt Optimal?
Multinationals and Linkages: an Empirical Investigation (joint with Andres Rodriguez-Clare)
Several recent papers have used plant-level data and panel econometric techniques to carefully explore the existence FDI externalities. One conclusion that emerges from this literature is that it is difficult to find evidence of positive externalities from multinationals to local firms in the same sector (horizontal externalities). In fact, many studies find evidence of negative horizontal externalities arising from multinational activity while confirming the existence of positive externalities from multinationals to local firms in upstream industries (vertical externalities). In this paper we explore the channels through which these positive and negative externalities may be materializing, focusing on the role of backward linkages. In particular, we criticize the common usage of the domestic sourcing coefficient as an indicator of a firms linkage potential and propose an alternative, theoretically derived indicator. We then use plant-level data from several Latin American countries to compare multinationals linkage potential to that of domestic firms. We find that multinationals linkage potential in Brazil, Chile and Venezuela is higher than for domestic firms. For Mexico, we cannot reject the hypothesis that foreign and local firms have similar linkage potential. Finally, we discuss the relationship between this finding and the conclusions that emerge from the recent empirical literature.
Multinationals and Linkages: An Empirical Investigation
FDI and Economic Growth: The Role of the Local Financial Markets (joint with Areendam Chanda, Sebnem Kalemli-Ozcan, Selin Sayek)
In this paper, we examine the various links among foreign direct investment (FDI), financial markets, and economic growth. We explore whether countries with better financial systems can exploit FDI more efficiently. Empirical analysis, using cross-country data between 1975-1995, shows that FDI alone plays an ambiguous role in contributing to economic growth. However, countries with well-developed financial markets gain significantly from FDI. The results are robust to different measures of financial market development, the inclusion of other determinants of economic growth, and consideration of endogeneity.
FDI and Economic Growth: The Role of the Local Financial Markets
Growth and the Quality of Foreign Direct Investment: Is All FDI Equal? (joint with Andrew Charlton)
In this paper we distinguish different qualities of FDI to re-examine the relationship between FDI and growth. Establishing the quality of FDI, however, is a difficult concept. Quality, that is the effect of a unit of FDI on economic growth, is a combination and interaction of many different country and project characteristics, those characteristics are hard to measure and the data quality is generally poor. Hence, we broadly 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, since no one characteristic of FDI can determine quality and because the quality of FDI is the interaction of investment and country characteristics. Finally, we use a two-stage least squares methodology to control for measurement error and endogeneity to establish the quality of FDI as determined by countries themselves. 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.
Growth and the Quality of Foreign Direct Investment
Inflation, Openness, and Exchange-Rate Regimes. The Quest for Short-Term Commitment
This paper further tests Romers (1993) extension of Kydland and Prescotts (1977) predictions on dynamic-inconsistency problems with regard to open economies. In a panel data set, I find that openness does not seem to play a role in the short run in restricting inflation, but a fixed exchange-rate regime plays a significant role. This result is robust to the use Reinhart and Rogoffs (2002) exchange rate regime classification. If the openness-inflation relationship arises from the dynamic inconsistency of discretionary monetary policy, the relationship is weaker in countries with fixed exchange-rate regimes.
Inflation, Openness, and Exchange-Rate Regimes
Capital Controls, Risk and Liberalization Cycles (joint with Fabio Kanczuk)
We construct an Overlapping-Generations model where agents vote on whether to open or close the economy to international capital flows. Political decisions are shaped by the risk over capital and labor returns. In an open economy, the capitalists (old) completely hedge their savings income. In contrast, in a closed economy, the workers (young) partially insulate wages from the productivity shocks. We find three possible equilibrium outcomes: economies that eventually remain open, those that eventually remain closed, and those that cycle between open and closed. In line with the stylized fact, cycles are more common in economies with moderate development levels.
Capital Controls, Risk and Liberalization Cycles
Capital flows in a Globalized Economy: The Role of Policies and Institutions (joint with Sebnem Kalemli-Ozcan and Vadym Volosovych)
We describe the patterns of international capital flows in the period 1970-2000. We then examine the determinants of capital flows and capital flow 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 and their volatility. Local financial structure measured as the share of bank credit in total is associated with high volatility of capital flows..
Capital Flows in a Globalized Economy
On the Political Economy of Stabilization Programs
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.
On the Political Economy of Stabilization Programs