Foreign Capital and Economic Growth
ABSTRACT Nonindustrial countries that have relied more on foreign finance have not grown faster in the long run as standard theoretical models predict. The reason may lie in these countries’ limited ability to absorb foreign capital, especially because their financial systems have difficulty allocating it to productive uses, and because their currencies are prone to appreciation (and often overvaluation) when such inflows occur. The current anomaly of poor countries financing rich countries may not really hurt the former’s growth, at least conditional on their existing institutional and financial structures. Our results do not imply that foreign finance has no role in development or that all types of capital naturally flow “uphill.” Indeed, the patterns associated with foreign direct investment flows have generally been more consistent with theoretical predictions. However, we find no evidence that providing financing in excess of domestic saving is the channel through which financial integration delivers its benefits.
- SourceAvailable from: Jean-Pierre Allegret[Show abstract] [Hide abstract]
ABSTRACT: Oil-exporting countries usually experience large current account improvements following a sharp increase in oil prices. In this paper, we investigate this oil price-current account relationship on a sample of 27 oil-exporting economies. Relying upon the estimation of panel smooth transition regression models over the 1980-2010 period, we provide evidence that refines the traditional interpretation of oil price effects on current accounts. While current accounts are positively affected by oil price variations, this effect is nonlinear and depends critically on the degree of financial development of oil-exporting economies. More specifically, oil price variations exert a stronger impact on the current account position for less financially developed countries, this influence diminishing with financial deepness.Journal of International Money and Finance 10/2014; · 1.02 Impact Factor
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ABSTRACT: Finance is generally regarded as important for economic growth, but the role of finance in economic growth is a controversial issue in the economic literature. The concept of “finance for growth” refocuses the relationship between finance and economic growth by redirecting the role of government policies in finance, and recognizes how finance without frontiers is changing what government policies can do and achieve. The focus of this paper is not to join the debate, nor to analyse the impact of financial development on economic growth, but to discuss the concept of “finance for growth” within the context of emerging and developing economies. The increasing development needs of Emerging Market Economies (EMEs) to raise per capita income, reduce unemployment rate, construct and maintain basic infrastructure, and invest more in human capital, make the role of finance for growth in these economies indispensable. The paper reviews the financial policies in selected EMEs including: China, South Africa and Nigeria and attempts to situate the Nigerian economy among the EMEs within the context of Finance for Growth. The paper notes that financial policies designed in various EMEs had the similar goal of making the financial system to provide key financial functions. However, large differences exist in the efficiency of the financial system in each country. The paper found that what matters to economic growth is access to financial services or financial inclusion and not which sector supplies the funds. The paper suggests appropriate policy options to build confidence in the Nigerian financial system.Asian Development Policy Review. 08/2014; 2(2):20-38.
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ABSTRACT: Purpose ‐ The purpose of this paper is to examine the impact of foreign direct investment (FDI) on GDP growth in Sub-Saharan Africa (SSA) with particular emphasis on Chinese FDI. Design/methodology/approach ‐ Based on the growth accounting model, a dynamic GMM estimation is used. To compare the results with previous findings, the paper also uses OLS and fixed effect estimates. Findings ‐ The paper finds that neither FDI net inflows in SSA nor Chinese FDI has a significant effect on economic growth in SSA. By testing other economic growth determinants in SSA countries based on growth accounting theory, the paper finds the change in capital stock per labor has a persistent and significant positive impact on growth in SSA. Originality/value ‐ This study provides new evidence on the influence of Chinese FDI on the growth of the SSA economies. There are very few empirical studies that analyze the growth of the SSA economies from a macroeconomic perspective using a partial equilibrium model. This paper tests the determinants of GDP growth using key macroeconomic variables and provides new insights into the determinants of GDP growth in the SSA countries.International Journal of Emerging Markets 01/2014; 9(2).
IZA DP No. 3186
Foreign Capital and Economic Growth
Eswar S. Prasad
Raghuram G. Rajan
D I S C U S S I O N P A P E R S E R I E S
zur Zukunft der Arbeit
Institute for the Study
Foreign Capital and Economic Growth
Eswar S. Prasad
Cornell University and IZA
Raghuram G. Rajan
University of Chicago
Peterson Institute for International Economics
Discussion Paper No. 3186
P.O. Box 7240
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IZA Discussion Paper No. 3186
Foreign Capital and Economic Growth*
We document the recent phenomenon of “uphill” flows of capital from nonindustrial to
industrial countries and analyze whether this pattern of capital flows has hurt growth in
nonindustrial economies that export capital. Surprisingly, we find that there is a positive
correlation between current account balances and growth among nonindustrial countries,
implying that a reduced reliance on foreign capital is associated with higher growth. This
result is weaker when we use panel data rather than cross-sectional averages over long
periods of time, but in no case do we find any evidence that an increase in foreign capital
inflows directly boosts growth. What explains these results, which are contrary to the
predictions of conventional theoretical models? We provide some evidence that even
successful developing countries have limited absorptive capacity for foreign resources, either
because their financial markets are underdeveloped, or because their economies are prone
to overvaluation caused by rapid capital inflows.
JEL Classification: F3, F4, E2, O4
Keywords: North-South capital flows, financial globalization
Eswar S. Prasad
Department of Applied Economics and Management
440 Warren Hall
Ithaca, NY 14853
* We are grateful to Menzie Chinn, Josh Felman, Olivier Jeanne, Gian Maria Milesi-Ferretti, Dani
Rodrik, Thierry Tressel, and participants at the Federal Reserve Bank of Kansas City meetings at
Jackson Hole and the Brookings Panel, especially our discussants Susan Collins and Peter Henry, for
helpful comments and discussions. We are also grateful to the editors of the Brookings Papers on
Economic Activity, William Brainard and George Perry, for constructive comments. We thank Manzoor
Gill, Ioannis Tokatlidis, and Junko Sekine for excellent research assistance.
In one of his most memorable and widely quoted passages, John Maynard Keynes extolled
the virtues not only of trade integration but also of financial integration when he wrote, in 1920, of the
fabled Englishman who could “adventure his wealth in. . . new enterprises of any quarter of the
world, and share, without exertion or even trouble, in their prospective fruits and advantages.”1
Consistency was, of course, not a Keynesian virtue, and in 1933, in one of his less quoted passages,
Keynes’s musings on globalization turned more melancholy, even skeptical: “I sympathize with
those who would minimize, rather than with those who would maximize, economic entanglement
among nations. Ideas, knowledge, science, hospitality, travel—these are the things which should
of their nature be international. But let goods be homespun whenever it is reasonably and
conveniently possible. . .” He reserved his deepest skepticism for financial globalization,
warning, “and, above all, let finance be primarily national.”2
Which Keynes was right? the Keynes of 1920 or the Keynes of 1933? And why? Or, to put
it more mundanely, does foreign capital play a helpful, benign, or malign role in economic growth?
The question has fueled passionate debates among economists, policymakers, and members of
civil society. It has gained importance in recent years because of the curious, even seemingly
perverse, phenomenon of global capital flowing “uphill” from poorer to richer countries. But it
has economic relevance beyond the current conjuncture because it goes to the heart of the process
of development and the role of foreign capital in it. It also has enduring policy relevance as
developing countries try to decide whether to open themselves up more to financial globalization,
and if so, in what form and to what degree.
We undertake an empirical exploration of this question, beginning with some stylized facts
that motivate our analysis. The current account balance, which is equivalent to a country’s saving
less its investment, provides a summary measure of the net amount of capital, including private
and official capital, flowing in or out of a country.3 Figure 1 shows that net global cross-border
financial flows, measured as the sum, relative to world GDP, of national current account
1 Keynes (1920, p. 11).
2 Keynes (1933).
3 A current account surplus has to equal the sum of the following: net private and official outflows of financial capital
(this includes debt and nongrant aid, but not remittances, which should properly be reflected in the current account
itself); net errors and omissions (a positive number could, for instance, represent capital flight through unofficial
channels); and net accumulation of international reserves by the government (typically the central bank). Thus the
current account surplus summarizes the net amount of capital flowing out of the country in a given period or,
equivalently, the excess of domestic saving over domestic investment in that period; correspondingly, a current account
deficit summarizes net capital flowing in or, equivalently, the excess of domestic investment over domestic saving.
surpluses of countries that have surpluses, has been more or less steadily increasing over the last
three and a half decades. Although financial globalization was also well advanced in the era
leading up to World War I,4 there appear to be some important differences in the current episode:
today’s globalization involves a greater number of countries; not only are net flows sizable, but
there are large flows in each direction as well; and these flows encompass a wider range of more
sophisticated financial instruments. But it is the apparent perversity in the direction of flows that is
most characteristic, and most puzzling, about the globalization of today.5
In the benchmark neoclassical model, capital should flow from rich countries with
relatively high capital-labor ratios to poor countries with relatively low ratios. Yet, as the top
panel of figure 2 suggests, the average income per capita of countries running current account
surpluses (with income measured relative to that of the richest country in that year, and with
countries weighted by their surpluses in calculating the average) has been trending downward.
Correspondingly, the average relative income per capita of deficit countries, weighted in the
analogous way, has trended upward. Indeed, in this century the relative income per capita of the
surplus countries has fallen below that of the deficit countries. Not only is capital not flowing from
rich to poor countries in the quantities the neoclassical model would predict—the famous
paradox pointed out by Robert Lucas6—but in the last few years it has been flowing from poor to
rich countries. However, this is not a new phenomenon. In the late 1980s as well, the weighted
average relative income per capita of surplus countries was below that of deficit countries.
Nor is the pattern entirely driven by the large U.S. current account deficit and the large
Chinese surplus. The bottom panel of figure 2, which excludes these two countries, still shows a
narrowing of the difference in weighted-average income between surplus and deficit countries by
2005, not the widening that would be predicted in an increasingly financially integrated world
under a strict interpretation of the benchmark neoclassical model.7
The Lucas paradox has many potential explanations. The risk-adjusted returns to capital
investment may not be as high in poor countries as their low capital-labor ratios suggest, either
4 See Obstfeld and Taylor (2004) for example.
5 See, for example, Bernanke (2006).
6 Lucas (1990).
7 Excluding the oil-exporting countries does not alter the basic patterns in figure 2 (not shown). We also constructed
similar graphs using initial (1970) relative income, rather than relative income in each period, in order to take out the
effects of income convergence. This, too, makes little difference to the shapes of the plots.
because they have weak institutions,8 or because physical capital is costly in poor countries,9 or
because poor country governments have repeatedly defaulted on their debt finance.10 But there is a
deeper paradox in the data: it seems that foreign capital does not flow even to those poor countries
with more rapidly growing economies, where, by extension, the revealed marginal productivity
of capital (and probably creditworthiness) is high.11 Pierre-Olivier Gourinchas and Olivier Jeanne
argue that, among developing countries, capital should flow in greater amounts to those that
have grown the fastest, that is, those likely to have the best investment opportunities.12 But does
it? Figure 3 divides nonindustrial countries into three equally sized (by aggregate population)
groups, plus China and India each handled separately, and computes cumulative current account
deficits for each group, in dollars deflated by the U.S. consumer price index. The top panel of
figure 3 indicates that, over 1970-2004, as well as over subperiods within that range, net foreign
capital flows to relatively rapidly growing developing countries have been smaller than those to
the two slower-growing groups. In fact, China, the fastest-growing developing country, runs a
surplus in every period. During 2000-04 the pattern is truly perverse: China, India, and the high-
growth and medium-growth groups all exported significant amounts of capital, while the low-
growth group received a significant amount. Gourinchas and Jeanne have dubbed this failure of
capital to follow growth the “allocation puzzle,” but it is actually a deeper version of the Lucas
From a pure financing perspective, a composite measure of net flows of all forms of
financial capital is the relevant one for examining the role of foreign capital in growth. But of
course not all types of capital are the same, in terms of either their allocation or their effects
on growth. Indeed, the allocation of capital presents a more nuanced picture when net foreign
direct investment (FDI) flows are examined (bottom panel of figure 3). During the most recent
8 Alfaro, Kalemli-Ozcan, and Volosovych (2005).
9 Hsieh and Klenow (2003); Caselli and Feyrer (2007).
10 Gertler and Rogoff (1990); Reinhart and Rogoff (2004).
11 Of course, more-rapid growth could imply greater factor employment and even a lower marginal productivity of
capital. However, there is a positive cross-sectional correlation between GDP growth and the Bosworth-Collins (2003)
measure of total factor productivity growth (based on the updated version of their dataset that goes through 2003) for
the nonindustrial countries in our dataset. Caselli and Feyrer (2007) have constructed a measure of the marginal
product of physical capital that corrects for the share of natural capital (land) in the total capital stock of each country
and for differences in the relative price of capital across countries. For the countries that are common to our dataset
and theirs, average GDP growth is strongly positively correlated with the Caselli-Feyrer measure. This suggests that
high-growth countries do have more attractive investment opportunities.
12 Gourinchas and Jeanne (2006a); the same authors also provide evidence of a negative correlation between capital
inflows and investment rates.
period (2000-04), net FDI flows do not follow growth, but in the other periods they do (except
in the case of India), with the fastest-growing group of nonindustrial countries receiving the
most FDI over the period 1970-2004, and China receiving almost as much. This suggests that
fast-growing countries do have better investment opportunities, which is why they attract more
FDI. Yet they do not utilize more foreign capital overall, and, again, China is a net exporter of
The above figures show that capital does not flow to poor countries, at least not in the
quantities suggested by theory. But does a paucity of foreign capital hurt a country’s economic
growth? Do those poor countries that can fund investment with the greatest quantity of foreign
capital grow the most? Of course, growth in steady-state equilibrium will come primarily from
increases in total factor productivity, which could stem from the use of foreign capital. But for
poor, capital-starved countries that are far from the steady state, and where investment in physical
capital is constrained by the low level of domestic saving, growth can also come simply from
additions to domestic resources that enable these countries to reach the steady state faster. So does
foreign capital help poor countries grow, either by advancing the stock of knowledge and
productivity of the economy or by augmenting scarce domestic resources? This question is at
the heart of the debate over whether financial integration has direct growth benefits for
A small step toward the answers can be taken by looking at the correlation between growth
and the current account balance over the period 1970-2004 for roughly the same sample of
nonindustrial countries recently analyzed by Barry Bosworth and Susan Collins (figure 4).14 The
correlation is positive, not negative as one might have expected: nonindustrial countries that rely
less on foreign capital seem to grow faster.15
But this might be taking too long run a view. What has happened over specific subperiods in
the last three and a half decades? Figure 5 plots the results of nonparametric, Lowess regressions of
13 Henry (2006) argues correctly that the financing provided by foreign capital can have permanent effects on the
level of income but only temporary effects on its rate of change. But for the not-so-long horizons examined in this
paper, and given how far developing countries are from their steady states, transitional and permanent effects are
probably indistinguishable in the data, making the growth effects from additional investment a reasonable focus of
14 The sample differs from that of Bosworth and Collins in that it omits Bangladesh, Guyana, and Taiwan; the
countries are listed in appendix table A-1.
15 A more negative current account balance indicates larger net inflows of foreign capital. A positive current account
balance indicates a net outflow of capital.
economic growth on the current account for the entire sample of nonindustrial countries (plus
Bangladesh) for four subperiods: the 1970s, the 1990s, 1985-97, and 1999-2004.16 The 1985-97
period is probably the golden era of financial integration in recent times, and the period 1999-
2004 is considered distinctive because of the reserves buildup in some Asian countries in the
aftermath of the crises there. The figure shows that the puzzling positive correlation between the
current account and growth is absent in the 1970s: the line for that decade slopes downward
over most of its range. In every period since then, the slopes are positive over most of their range
and almost uniformly positive in the range of current account deficits. There is less uniformity in
the range of current account surpluses. It does not appear that our core results are simply an
artifact of the long time period that we consider.
Figure 6 offers a clue to the direction this paper will be heading in. The figure splits the
sample of nonindustrial countries into four groups depending on whether their ratios of investment
to GDP and of the current account balance to GDP are above or below the median. Countries
with higher investment are seen to fare better (have faster growth of GDP per capita) than those
with lower, which is not surprising. What is noteworthy is that countries that had high investment
ratios and lower reliance on foreign capital (smaller current account deficits, or larger surpluses)
grew faster— on average, by about 1 percent a year—than countries that had high investment but
also relied more on foreign capital.
The remainder of the paper starts by placing figure 4 on a firmer footing: we show that,
among nonindustrial countries, there is a significantly positive correlation between current account
balances (surpluses, not deficits) and growth, even after correcting for standard determinants of
growth. The correlation is quite robust: it is evident in cross-sectional as well as in panel data, it
is not very sensitive to the choice of period or countries sampled, it cannot be attributed just to aid
flows, and it survives a number of other robustness tests. Even the most conservative
interpretation of our finding—that there is no negative correlation for nonindustrial countries
between current account balances and growth, or equivalently, that developing countries that have
relied more on foreign finance have not grown faster in the long run, and have typically grown
more slowly—runs counter to the predictions of standard theoretical models.
In an interesting contrast, we find that, among industrial countries, those that rely more on
16 The Lowess procedure estimates a locally weighted regression relationship between the dependent variable and the
explanatory variable. It thus allows us to estimate a smoothed, nonparametric relationship between the two.
foreign finance do appear to grow faster. This difference will need to be taken into account in
sifting through possible mechanisms that could explain the correlation for nonindustrial countries.
We explore two, not mutually exclusive, explanations for our main finding. First, it is
possible that, when facing improved domestic investment opportunities and associated higher
incomes, poor countries do not have corporations or financial systems that can easily use arm’s
length foreign capital to ramp investment up substantially. Indeed, we show that countries with
underdeveloped financial systems are especially unlikely to be able to use foreign capital to
At the same time, poor countries that are growing rapidly are likely to generate substantial
domestic saving, because the persistence of household consumption habits is likely to mean that
consumption does not respond quickly to higher incomes—a possibility accentuated by the
inability of households in these countries to use the financial system to borrow and consume
against expected future income. Thus, with both investment and consumption constrained by
weaknesses in the domestic financial system, fast-growing poor countries may not be able to
utilize foreign capital to finance growth.
A more pessimistic view sees foreign capital as not just ineffective but actually damaging:
when it flows in, it leads to real overvaluation of the currency, further reducing the profitability of
investment beyond any constraints imposed by an inadequate financial system. Indeed, by stifling
the growth of manufacturing exports, which have proved so crucial to facilitating the escape of
many countries from underdevelopment, the real overvaluation induced by foreign inflows can
be particularly pernicious. We show that foreign capital can indeed cause overvaluation, which in
turn has a detrimental effect on manufacturing exports and overall growth.
These two views of foreign capital—that poor countries have little ability to absorb it,
especially when provided at arm’s length, and that when it does flow in, it could lead to
overvaluation, which hurts competitiveness— are not mutually exclusive. Indeed, an
underdeveloped financial system is more likely to channel foreign capital not to potentially highly
productive but hard-to-finance investment in the tradable manufacturing sector, but rather to easily
collateralized nontradeable investments such as real estate. Thus financial underdevelopment, and
underdevelopment more generally, could exacerbate foreign capital’s contribution to a rise in
costs in the nontraded sector, and to overvaluation.
Moreover, consistent with the relationship we have posited between financial
development and overvaluation, we do not find evidence of a similar effect of capital inflows
on overvaluation in industrial countries. We do find that the ability to avoid overvaluation is
helped by favorable demographics, namely, a rapidly growing labor force relative to the
population, which provides a relatively elastic supply of labor. Favorable demographics thus plays
a key role in generating saving, but also in providing the microeconomic basis for sustaining
competitive exchange rates.
The critics of capital account openness point to yet another reason countries may (or ought
to) actively avoid foreign capital, namely, the broader risks, including that of inducing greater
economic volatility, and especially that of financial or balance of payments crisis. There is little
systematic evidence, however, that capital mobility by itself can precipitate crises.17 Moreover,
even though financial openness does seem to induce additional macroeconomic volatility, which
in general is not conducive to promoting investment and growth, there is some evidence that
volatility resulting from greater financial (or trade) openness by itself is not destructive to long-
run growth, compared with volatility induced by other factors.18 Hence volatility is by itself
unlikely to be a major explanation for our results, although this deserves more scrutiny in
future work. We do not pursue this further here.
Our paper builds upon the vast and growing literature on financial integration and
growth,19 although this literature has largely focused on measures of financial integration or
narrow measures of capital inflows rather than on current account balances. A sizable literature
looks separately at the relationship between saving and investment, on the one hand, and
growth on the other. Hendrik Houthakker, Franco Modigliani, and Christopher Carroll and
David Weil have shown a large positive correlation between saving and growth in a cross section
of countries.20 But this does not necessarily mean a positive correlation between growth and the
current account, because investment in high-saving countries could also be higher. Indeed,
Philippe Aghion, Diego Comin, and Peter Howitt see high domestic saving as a prerequisite for
attracting foreign saving (and hence for a current account deficit).21 Gourinchas and Jeanne
conclude that poorer countries are poor because they have lower productivity or more
distortions than richer countries, not because capital is scarce in them—the implication being
17 See Edwards (2005) and Glick, Guo, and Hutchison (2006).
18 Kose, Prasad, and Terrones (2006).
19 (2006) and Kose and others (2006) provide surveys.
20 Houthakker (1961), Modigliani (1970), and Carroll and Weil (1994).
21 Aghion, Comin, and Howitt (2006).
that access to foreign capital by itself would not generate much additional growth in these
In addition to Gourinchas and Jeanne, our paper is related to that of Joshua Aizenman,
Brian Pinto, and Artur Radziwill,23 who construct a “self-financing” ratio for countries in the
1990s and find that countries with higher ratios grew faster than countries with lower ratios.
However, the connection of capital flows to growth seems to be more than just the connection
through financing. If financing were all that mattered, because it expands the resource envelope,
then net foreign liability positions would be positively correlated with growth. As we will later
show, the opposite is true: positive net foreign asset positions are positively associated with
growth. Moreover, although fast-growing countries do absorb some forms of capital inflows such
as FDI, on net they rely little on foreign capital. This suggests that the full explanation for the
relationship between growth and foreign capital inflows has to go beyond financing.
Finally, a broad methodological point. Throughout this paper we will employ a variety of
data sources, disaggregated in different dimensions, for our empirical analysis. Although our core
correlation will be established at the cross-sectional level, we will also exploit time-series
variation to confirm the main finding as well as to substantiate the channels through which some of
the effects of foreign capital work. The panel data allow us to try and deal with endogeneity
issues, albeit in a rather mechanistic fashion. It is still difficult, even using the panel, to
disentangle some of these effects — especially the relationship between financial development
and capital inflows—in macroeconomic data, and so we complement our analysis by using
industry-level data. We do not of course regard the latter as conclusive, since by construction
they cannot account for general equilibrium effects. But the industry-level evidence does allow
us to make progress in addressing the endogeneity that plagues some of the cross-country
regressions, since we can directly control for countrywide shocks and exploit the cross-industry
variation within each country. These results suggest a relationship between foreign capital and
growth that is far more nuanced and complex than is suggested by traditional theory.
Ultimately, what we offer are a set of strikingly robust correlations that run counter to the
immediate predictions of conventional theoretical models, and a set of plausible explanations for
these correlations that are buttressed by various types of evidence. Although this evidence may
22 Gourinchas and Jeanne (2006b).
23 Aizenman, Pinto, and Radziwill (2004).
not be conclusive, we hope it will set the stage for progress on the theoretical front that will
help get a better handle on these correlations, as well as explanations for the patterns we have
detected in the data.
The Relationship between Foreign Capital and Growth
We begin by reviewing the textbook model of how foreign capital inflows should affect
economic growth in a country that is open to them. We then proceed to test the model’s
implications in cross-sectional regressions, check the robustness of the findings, and further
confirm the results in regressions using panel data for the same sample of countries.
The Textbook Theory
The textbook model plots domestic saving and investment against the real interest rate
(figure 7).24 When the economy is closed to foreign capital, equilibrium is at point B with the interest
rate given by rdom. When the economy is opened and the capital account is liberalized (or
frictions impeding the flow of foreign capital are reduced), investment increases to point C, with
the increase in investment financed more than fully by foreign saving (the current account
deficit). In this world, increases in capital inflows, as impediments come down, result in a steady
movement of domestic interest rates toward world interest rates (r*), and thus in higher
investment and faster growth.
Also, given investment, the extent of utilization of foreign saving should have no effect on
growth—it really does not matter whether investment is financed by domestic or foreign capital.
The question we now turn to is whether these predictions are borne out in the data.
Financial Integration and Growth
We begin by testing the relationship between financial integration and growth. Since the
traditional textbook model focuses on foreign capital as an aggregate source of financing, we
will examine aggregate capital inflows, that is, the current account balance, in what follows.
24 This discussion draws upon Rodrik (2006).
Of course, different types of flows could well have different consequences. The literature
has noted that FDI could be an important source of technology transfer as well as of finance. Also,
debt and equity flows could have different implications for a country’s macroeconomic volatility.
The literature has therefore used a variety of measures of financial integration, including policy or
de jure measures but also de facto measures based on actual capital movements in terms of stocks
and flows.25 We will present some robustness checks based on these alternatives, but our core
measure will be the current account balance, which has the advantage of being related to
macroeconomic variables such as saving, investment, and the exchange rate.
Let us start by placing the correlation between the current account balance and growth
depicted in figure 4 on firmer ground. Table 1 presents our core regression results, which build on
the work of Bosworth and Collins.26 The dependent variable is the annual average growth rate of
purchasing power parity-adjusted GDP per capita over 1970-2004, taken from the Penn World
Tables (version 6.2). We include the following controls in the standard specification: log of initial
(1970) GDP per capita, initial-period life expectancy, initial-period trade openness (the Sachs-
Warner measure),27 the fiscal balance, a measure of institutional quality, and dummy variables
for sub-Saharan African countries and oil exporters.
When we estimate the above equation using data for the full nonindustrial country sample
from Bosworth and Collins (regression 1-1), the coefficient on the current account balance
is positive and tightly estimated, suggesting that countries tha t rely less on foreign financing
(that is, run smaller current account deficits) grow faster. The coefficient estimate suggests that
a 1-percentage-point increase in the current account balance (a smaller deficit or a larger
surplus) is associated with approximately a 0.1-percentage-point improvement in the growth
Regression 1-2 drops three outliers from the Bosworth-Collins sample of countries, and
regression 1-3 drops, in addition, all countries receiving aid flows that, on average, exceed 10
percent of their GDP. In regression 1-4 the sample is the same as in regression 1-2, but the
current account is measured net of aid. In all cases the coefficient is positive and significant.
Regressions 1-3 and 1-4 provide reassurance that the results are not driven by poor countries
25 Kose and others (2006) review these measures and argue that, since de jure ones cannot capture the enforcement
and effectiveness of capital controls, they may not be indicative of the true extent of financial integration. Actual
capital flows may be more relevant for examining the role of foreign capital in the growth process.
26 Bosworth and Collins(2003). Ourr (Bosworth and Collins, 1999).
27 Sachs and Warner (1995).
receiving large official aid flows. Since we control for net government saving in all our
regressions, our current account coefficient can be interpreted as the marginal effect of private
saving on growth, conditional on the level of government saving. In sum, the coefficient estimate
is the opposite of that predicted by the standard textbook model postulated earlier.
In what follows we focus on the intermediate sample that excludes the three outliers (we
will call this our “core sample”), referring to the other samples only when the results are
qualitatively different. Given that current account balances, averaged over a long period, should
be directly related to the stock of foreign assets, we check the relationship between growth and
the stock position.28 In regression 1-5 we replace the current account with the net foreign asset
position and find, consistent with the core result, that it is positively correlated (although not
statistically significantly) with growth: countries that have accumulated assets over time have grown
faster. Regression 1-6 splits the net asset position into gross assets and gross liabilities positions,
and we find that the former is positively and significantly related to growth, whereas the latter is
negatively but not significantly related to growth.
If, in fact, the binding constraint for countries in our sample is domestic resources, as in the
textbook model, larger current account deficits should foster growth by augmenting investment.
But the separate inclusion of domestic investment in the regression equation should greatly
diminish the coefficient on the current account: conditional on investment, the split between
domestic and foreign saving should not matter. Interestingly, however, as regression 1-7 indicates,
the inclusion of the investment-GDP ratio barely changes the coefficient on the current account
from that in regression 1-2, even though the coefficient on the investment-GDP ratio has the
expected positive sign and is almost statistically significant at conventional levels (thus suggesting
that mismeasurement of investment is unlikely to be the explanation).29 More domestic saving
financing a given quantum of investment seems to be positively correlated with growth, a
formalization of the result depicted in figure 6. By contrast, when we replace the investment-
GDP ratio with the saving-GDP ratio (regression 1-8), the coefficient on the current account loses
statistical significance and indeed turns negative. The saving-GDP ratio has the expected
significantly positive coefficient. Thus the evidence suggests that the correlation between the
current account and growth is positive and stems largely from a relationship between domestic
28 These stock measures have been constructed by Lane and Milesi-Ferretti (2006).
29 See Bosworth and Collins (2003), who argue that growth in the capital stock is a better measure than the
investment-GDP ratio for the purposes of growth accounting and regressions.
saving and growth, and not negative as in the more traditional view that foreign capital permits
capital-constrained poor countries to expand domestic investment and thereby increase growth.30
Before turning to explanations, we report in table 2 some important robustness checks.
First, we estimated the core specification over a different time period, 1985-97, considered a
golden age for financial globalization because it was marked by a surge in flows without any
significant increase in crises (the exception being the Mexican crisis of December 1994, which
was limited in its fallout). The current account coefficient (regression 2-1) remains positive
and significant, and, interestingly, the magnitude is over twice that for the period 1970-2004
Although we have established a general pattern for nonindustrial countries, it is worth
asking whether the pattern also is present for more economically advanced countries. We revert to
the 1970-2004 time period and add industrial countries to the sample. We allow the coefficients on
the current account to differ for industrial countries. It turns out (regression 2-2) that the
coefficient on the current account balance for industrial countries is significantly different from that
for nonindustrial countries and negative overall (−0.20 + 0.11 = −0.09), suggesting that industrial
countries that run larger current account deficits experience more growth.
If we restrict ourselves to the period 1990-2004, we can also include economies in
transition from socialism and estimate separate coefficients for them. Although the pattern of
coefficients for industrial countries is as before (regression 2-3), the transition countries resemble
industrial countries in that current account surpluses are negatively correlated with growth; that is,
larger inflows of foreign capital boost growth. The phenomenon we have identified thus seems to be
30 We test in appendix table A-2 whether there is a relationship between financial integration and growth, using the
measures of integration that have conventionally been used in the literature. We find, consistent with Kose and others
(2006), no relationship, in our sample of countries, either between GDP growth and the level of financial openness,
whether measured by stocks or by flows, or between GDP growth and changes in these measures. There is weak
evidence that FDI, which is qualitatively different from other flows in bringing in technology, is positively
correlated with growth (see Borensztein, De Gregorio, and Lee, 1998). We also tested whether the trade balance (as
opposed to the current account balance) is the prime driver (results are available from the authors). It turns out that
the trade balance, defined as net exports of goods and nonfactor services, is positively correlated with growth, but not
statistically significantly so, and the magnitude of the correlation is smaller than that between the current account
balance and growth. Clearly, there are elements in the current account balance (including factor incomes and
transfers) that add to its explanatory power. For nonindustrial countries, these items can be quite large.