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.
largely a nonindustrial, non-transition country phenomenon.31 The additional value of this result is
that it indicates we are not simply picking up some hitherto unnoticed mechanical or accounting
relationships in macroeconomic data that link current accounts positively to growth.
Finally, we check whether our results are robust to the inclusion of demographic
variables, a key determinant of saving. When we include the ratio of the working-age
population to total population in the baseline regression 1-2, the coefficient on the current
account is reduced by about 30 percent, while the coefficient on the working-age population ratio
is positive and highly statistically significant (regression 2-4). This suggests that something
associated with domestic saving is partly responsible for the results we find, a point that was also
There is, however, one key concern. The time horizon we have focused on is the long run,
spanning the thirty-five years between 1970 and 2004. Perhaps we are picking up not a cross-
sectional result but rather a time-series result: it may be that successful countries started poor and
ran large deficits, but eventually became rich enough to run surpluses. Averaged over a long
period, successful countries have had rapid growth and low average deficits, while the
unsuccessful have grown slowly and still appear to be running deficits. Thus the long-run
relationship might be obscuring a pattern over time that is analytically quite different.
One way to get at this is to look at growth over short periods. Figure 8 plots the current
account-GDP ratio over time for countries that experienced growth spurts,32 differentiating their
performance before and during the growth spurt. On average, current account balances increase
(or, put differently, current account deficits narrow) around the beginning of a growth spurt (top
panel). The bottom panel shows saving growing faster than investment in these same countries during
the same period. In other words, as they move from slow to sustained faster growth, countries also
reduce the foreign financing of domestic investment. It is noteworthy that the turnaround in the
current account balance is starker when we exclude, in figure 9, the three industrial countries
(Ireland, Portugal, and Spain) from the group of sustained rapid growers. This is also consistent
31 Abiad, Leigh, and Mody (2007) find that current account balances are negatively correlated with growth among
European countries, including a small group of transition countries. Their work is useful in pointing out that the
correlation for transition economies is different from that for other nonindustrial economies, a fact we verify above.
32 These are growth spurts that occurred after 1970 and were followed by sustained growth, as identified by
Hausmann, Pritchett, and Rodrik, (2005).
with our findings on the differences in the experiences of the industrial and developing countries.33
Another way to confirm that we are not picking up a phenomenon inherent in the life
cycle of countries is to turn to panel data and examine growth over shorter periods.34 This is
important for other reasons also. As a matter of robustness, it is always useful to check
whether the observed relationship between countries also holds within countries. If there were
a discrepancy between the panel and the cross-sectional evidence, it would call for caution in
interpretation. Another reason for doing panel estimations is that they help address, albeit
imperfectly, the problem of omitted variables and endogeneity that afflict pure cross sectional
estimations. The inclusion of country fixed effects in the panel controls for unobservable
heterogeneity between countries. We employ the generalized method of moments (GMM)
estimation technique in order to take a stab at dealing with the endogeneity issue, although in
a rather mechanistic fashion.35
Table 3 reports results of panel regressions estimated on five-year averages of the
underlying annual data. To maintain consistency with the cross-sectional results, we use the
same controls in each regression in table 3 that we use in the corresponding regression (by
33 This is not to say that all forms of foreign finance fall during growth spurts. Indeed, the average ratio of FDI to
GDP rises from an annual average of 0.2 percent in the five years before the initiation of a growth spurt to 0.7
percent in the five years after. Similarly, using the episodes of growth decelerations identified by Jones and Olken
(2005), we find that the average FDI-GDP ratio falls from 1.7 percent in the five years before the deceleration to 1
percent in the five years after. But even these increases and decreases are small compared with the changes in
domestic saving following a growth spurt or deceleration.
34 One version of the life cycle model applied to countries has implications for the evolution of current account
balances (see the discussion in Chinn and Prasad, 2003). According to this theory, poor countries that open up to
foreign capital early in the development process should run current account deficits as they import capital to finance
their investment opportunities. Eventually, these countries would become relatively capital rich and begin to run
trade surpluses, in part to pay off the obligations built up through their accumulated current account deficits.
35 GMM estimators come in two flavors. There is the difference-GMM estimator of Arellano and Bond (AB; 1991)
and the system-GMM estimator of Blundell and Bond (BB; 1998). In both, identification relies on first
differencing and using lagged values of the endogenous variables as instruments. In the AB estimator, lagged
levels are used to instrument for the differenced right-hand-side variables, whereas in the BB estimator, the
estimated system comprises the difference equation instrumented with lagged levels as in the AB estimator as well
as the level equation, which is estimated using lagged differences as instruments. Each estimator has its limitations.
The AB estimator often leads to a weak instruments problem because lagged levels are typically not highly
correlated with their differenced counterparts. So, in what follows, we present estimations based on the BB
estimator. All specifications include time effects to control for common shocks.
numbered column) in tables 1 and 2.36 In regression 3-1 the coefficient on the current account
balance is positive and similar in size to that in the cross-sectional regression, although the
coefficient is not estimated precisely. In regression 3-2 we drop the three countries that are
outliers in the cross section, and the coefficient on the current account increases slightly but
remains insignificant. In regression 3-3 we also drop the high-foreign-aid-receiving countries to
ensure that our results are not driven by official capital inflows. Now the coefficient
increases substantially and is significant at the 5 percent level. Regression 3-4 uses the same
sample as in regression 3-2 but nets out aid from the current account balance—the coefficients
are similar in the two regressions.
Next, in regression 3-5 we add the domestic investment-GDP ratio as a regressor. The
coefficient on this variable is significant, but it does not diminish the estimated coefficient on
the current account balance. Regression 3-6 substitutes domestic saving for the investment
variable. As in the cross section, this variable is significant and drives the coefficient on the
current account balance to zero. Regression 3-7 replaces domestic saving with the share of
the working-age population, and regression 3-8 estimates a separate current account
coefficient for industrial countries. Although the panel estimates are less precise, the similarity
of the coefficient estimates in both the cross-sectional and panel estimations, including when
investment and saving are included alternatively as variables, is reassuring for the robustness of
the core results. They tend to offer additional support for our finding that foreign capital inflows
(current account deficits) and growth are not positively correlated in nonindustrial countries, in
contrast to what the standard neoclassical growth model would predict.37
What Explains the Observed Relationship between Capital Flows and Growth?
The previous section identified a robust, nonnegative association between current account
36 One methodological point bears mentioning. GMM procedures allow a fair amount of freedom, especially in
specifying the lag structure for the instruments. There is a tradeoff: the greater the lags, the more the information that is
used. But greater lags can lead to overfitting and weak instrumentation. Two key diagnostics to use in checking for
these problems are the Hansen test for overidentifying restrictions and the Arellano-Bond test for serial correlation.
When we used the second lag, our results were stronger than reported in the text, but there were occasional problems
of overfitting, reflected in very large p-values for the Hansen test. We therefore report results using the third and
fourth lags, which are more reassuring in relation to these two diagnostics.
37 We cannot include data for the transition countries in the panel regressions, as our estimation procedure requires
data for at least four time periods for a country to be included in the sample.
balances and long-run growth in nonindustrial countries, which is significantly positive across a
number of subsamples and estimation procedures. At no point do we find a negative correlation in
this group of countries, as the standard theoretical models might suggest, although we do find such a
correlation for industrial and transition countries.
From a saving-investment perspective, the evidence seems to challenge the fundamental
premise that investment in nonindustrial countries is constrained by the lack of domestic
resources. If that were the case, the correlation between the current account and growth should
run through domestic investment. It does not. What explains all this? That is what this section
attempts to answer.
Consider the ingredients we already have for an explanation. First, the positive correlation
between current accounts and growth is found primarily in poor countries, suggesting that something
to do with the structure of poor economies may be responsible. Second, it appears that the
correlation runs through domestic saving and not through domestic investment. In other words,
investment does not seem to be highly correlated with net capital inflows, suggesting that it is not
constrained by lack of resources.
INSTITUTIONAL UNDERDEVELOPMENT. Let us now venture an explanation, which we will
put together with a number of ingredients. We know from figures 8 and 9 that income growth
spurts in poor countries lead to greater domestic saving.38 Theoretical models exist showing that
the saving rate could increase even in the face of a persistent increase in income—for example,
because of habit persistence in consumption.39 The link between income growth and saving in a
poor economy could be further strengthened if the relative underdevelopment of the financial
sector prevents consumers from borrowing against their anticipated future incomes.
Greater saving does not automatically mean a larger current account surplus or a smaller
deficit, because investment could increase more than commensurately. But suppose that poor
38 Bernanke and Gürkaynak (2002) report a positive correlation between productivity growth and saving in a broad
sample of countries—they do not break their sample out into different groups of countries based on income.
39 Carroll and Weil (1994), for instance, show that habit persistence may be one way to reconcile the strong positive
correlation between saving and growth, a correlation that runs counter to the predictions of the standard life cycle or
permanent income hypothesis. Jappelli and Pagano (1994) build a model showing how financial market
imperfections that limit the ability to borrow against future income could generate a correlation between saving and
growth in a fast-growing economy with a low level of financial development.
countries also suffer from capacity constraints in ramping up investment, even in the face of
positive productivity shocks, especially if resources have to be invested at arm’s length. This could
occur because the financial system does not intermediate saving well.40 Problems will be
particularly acute in the investment of foreign private capital, which by definition is invested at
arm’s length (apart from FDI). It could also result from weak protection of property rights in poor
countries, which militates against the long-gestation, investment-intensive, low-initial-profitability
projects that are the most dependent on financing. Again, to the extent that foreign capital does not
enjoy the domestic power relationships that substitute for institutional infrastructure such as
property rights protection, it may be at a particular disadvantage in financing such projects.41
There are some important differences between our explanation and that of Ricardo Caballero,
Emmanuel Farhi, and Gourinchas,42 who argue that weak financial development and the consequent
inadequate supply of reliable financial assets can explain the phenomenon of poorer countries
running larger current account surpluses. In these authors’ view, for example, developing country
households prefer holding foreign bonds to holding domestic financial assets, and this portfolio
decision drives local interest rates up and limits domestic investment. In our view domestic
households do accumulate domestic financial assets, especially those intermediated through
banks, and thus do finance domestic investment. Corporations can also do so through their own
saving. Instead it is difficulties in funneling foreign capital into domestic corporate investment that
limits the absorption of foreign capital.43
In other words, the real difficulty in these countries is not with domestic firms investing
internally generated funds or even raising funds from domestic sources such as domestic banks,
but with domestic firms raising funds at arm’s length, especially from foreigners. Indeed, in
growth episodes the firms with the best opportunities are likely to be new, typically private
sector, firms that usually are not connected through old ties to the banking system or the
government. Because these firms lack the contacts needed to borrow from banks, and because
they have difficulty raising money at arm’s length from domestic or foreign sources in an
40 Wurgler (2000) provides evidence that underdeveloped financial sectors are unable to reallocate resources to their
highest-productivity uses, leading to a mismatch between productivity increases and investment.
41 See Rajan and Zingales (1998).
42 Caballero, Farhi, and Gourinchas (2006).
43 In truth, many developing country households (for example, in China) have been accumulating domestic financial
assets in the form of bank deposits. The final holder of foreign assets is often the government, not households. One
could argue that households are willing to hold bank deposits only because banks hold central bank paper, which is
eventually a claim on foreign bonds, but this seems a tenuous line of reasoning.
underdeveloped financial system, investment is likely to be constrained.
This line of argument can also explain the negative correlation between current accounts
and growth for rich countries. Their greater financial and institutional development allows
investment to be more responsive to productivity increases.44 It also allows citizens to borrow
against anticipated future wealth in order to consume. So for industrial (and transition) countries,
investment may be significantly more responsive to productivity increases (the primary source of
growth in these countries), but saving may be less responsive, than in nonindustrial countries,
leading to larger current account deficits.
In this view, foreign capital inflows do not hurt growth in poor countries, but they do not
help either. These countries are typically constrained not by resources, but by the investment
opportunities that they can profitably exploit using arm’s-length finance. Foreign capital is not
directly harmful; it simply cannot be used well, especially in investment intensive, low-initial-cash-
flow, long-gestation projects.
This line of argument is plausible, but its empirical relevance remains open to question.
For instance, Gourinchas and Jeanne argue that although frictions in financial markets (for
example, underdeveloped financial systems) can result in the current account deficit being less
responsive to growth in countries with less developed financial systems, plausible model
parameterizations do not lead to the reversal in the sign on the correlation that we find.45 Indeed, Aart
Kraay and Jaume Ventura construct a plausibly parameterized model which implies that the impact
of productivity shocks on a country’s current account balance should be related to its initial net
liability position. In countries with a net foreign liability position, such as most of the nonindustrial
countries in our sample, productivity growth will typically lead to an increase in the current account
deficit, not a reduction as we find.46
A LESS BENIGN VIEW. The fact that conventional theoretical models, or even recent models
that depart from conventional theory (for instance, by positing habit formation in consumption),
cannot fully explain our findings suggests the need to explore alternative explanations. The way
44 Glick and Rogoff (1995) showed that country-specific productivity shocks tend to generate investment booms and
larger current account deficits (or smaller surpluses) in what were then the Group of Seven leading industrial
45 Gourinchas and Jeanne (2006a).
46 Kraay and Ventura (2000). Their argument is based on the intuition that the marginal portfolio allocation decision
(how to invest the extra saving generated by income shocks) will resemble the average decision (reflected in the
existing net liability stock) unless investment risk is low and domestic investment is highly subject to diminishing
forward may be to take a less benign view of the effects of foreign capital. Recall the textbook model
(figure 7) with which we started the last section. Suppose now that foreign financing can have
some deleterious effects, over and above its inability to be allocated properly in a country with a
weak financial system. In particular, large inflows could lead to an increase in real wages, an
appreciation of the currency in real terms, and a fall in the marginal product of investment.
Equivalently, the higher domestic consumption that necessitates a greater reliance on foreign
finance could fall substantially on nontraded goods, pushing up their price and leading to
currency overvaluation. The greater the capacity of a country to expand nontraded goods, the less
the overvaluation. Thus, where domestic saving is insufficient, the use of foreign capital to finance
investment may further depress the profitability of investment by causing an overvaluation of the
currency—a form of what is commonly known as Dutch disease. Countries that rely excessively
on foreign capital to fund their investment may find themselves becoming increasingly
uncompetitive on the trade front.
The textbook model will then have to be modified, and figure 10 suggests heuristically how
this can be done. Suppose foreign capital inflows strengthen the real exchange rate, making
potential exports less profitable. This will shift the investment schedule inward, reducing total
investment at any interest rate. The size of the shift will depend on the magnitude of the inflows, the
responsiveness of the exchange rate to those inflows, and the responsiveness of investment to the
change in the exchange rate. One way of depicting the shift in investment is to illustrate what capital
inflows would be at alternative levels of the elastic world supply of foreign capital (r*). Above rdom
there will be no foreign capital inflow, and so the investment schedule will be unaffected. Below
rdom one can trace a new investment schedule at each level of r*. This schedule will lie to the left of
segment I1 because of the negative relationship between inflows and investment that arises from the
exchange rate effect. And it will lie further to the left, the lower is r*, because inflows increase as
r* declines. If the exchange rate response to inflows and the investment response to exchange rate
changes are sufficiently strong, the new investment schedule will rotate leftward around point B and
be represented by the segment I2. In this case, when the country opens up, the new equilibrium at
point D is to the left of the old equilibrium B. There will be more capital inflows relative to B, but
lower investment, lower domestic saving, and slower growth, generating the correlation we find in
the data. Thus the introduction of distortions to the exchange rate and investment caused by capital
inflows can further help account for our findings.
Finally, an expansionary shift in domestic saving in such an economy (from S1 to S2 in
figure 11) can lead to an expansion of investment and growth. A shift in domestic saving, by
reducing foreign inflows at each level of the interest rate, will have a positive effect on investment
by reducing the extent of overvaluation. Not only will the saving curve shift right, but there will be
an associated rightward shift of the investment curve from I2 to I3 (because at each level of r* there
will be smaller inflows, and hence less overvaluation and greater investment). Note that, in this
case, an exogenous shift in domestic saving will increase investment and growth even in a country
with a fully open capital account, which would not have happened in a world in which inflows do
not distort the exchange rate.
Does Foreign Finance Matter? Evidence from Industry-Level Data
Let us now see if we can provide any evidence for the details of these explanations. One
explanation we have offered is that foreign capital is not a good method of financing investment in
countries with underdeveloped financial systems. One way to verify this is to see whether
industries that need a lot of finance are relatively better or worse off if the country where they are
located gets a lot of foreign capital, and to see how this varies with the country’s level of
financial development. In a sense this allows us to determine whether foreign capital has a
comparative advantage or disadvantage in financing.
The use of industry-level data has another big benefit: it allows us to get around the
endogeneity and reverse causality problems that are rampant (and difficult to control for) in
country-level data. For instance, even if rapid growth tends to pull in more capital inflows (rather
than inflows causing growth), or if growth and inflows are jointly determined by other factors,
there is no reason why the effect of inflows on industry-level growth through the financing
channel should be different across industries within the same country. Similarly, it is unlikely that
growth in a particular industry at this level of disaggregation can be a significant determinant of
aggregate capital flows, and so aggregate capital flows can be considered exogenous to an
industry’s growth. Thus, by exploiting cross-industry variation and controlling for country- and
industry-specific factors, we can make some progress toward tackling concerns about
endogeneity. (As noted earlier, the potential endogeneity used as an illustration here should lead to
a positive correlation between net foreign capital inflows and growth, whereas our cross-country
results show the opposite correlation.)
RELATIVE INDUSTRY GROWTH. Using the methodology of Rajan and Luigi Zingales,47 we
first ask whether, correcting for industry-specific and country-specific factors, manufacturing
industries that are dependent on outside finance (rather than internally generated cash flows) for
funding investment grow faster in countries that get more foreign capital (or are more open to foreign
capital). The estimation strategy is to run regressions of the form
(1) Gij = ψ + ζ1’Cj + ζ 2’Ii + ζ3 manij + α ( openj × depi ) + εij,
where Gij is the annual average rate of growth of value added in industry i in country j over ten-
year periods (1980-90, 1990-2000), obtained by normalizing the growth in nominal value added by
the GDP deflator; Cj is a vector of indicator variables for each country; Ii is a vector of indicator
variables for each industry; manij is the initial-period share of industry i in manufacturing in
country j (which controls for convergence-type effects); openj is “openness to capital flows of
country j,” which is some de facto or de jure measure of the capital account openness of country
j; depi is “dependence of industry i on finance,” which is the fraction of investment in that
industry that the typical firm could not fund from internally generated cash flows; and εij is the
error term.48 Dependence is typically high in industries where investment is large and positive
cash flows follow only after a lengthy gestation period.
The coefficient of interest for us is α. The textbook model would predict that countries
that are more open to capital should see financially dependent industries grow relatively faster,
and so we would expect the coefficient α to be positive (for tables 4 and 5 we use the current
account deficit rather than the current account balance, so that the predicted coefficient is the same
as for other measures of capital inflows).
The chief advantage of this strategy is that, by controlling for country and industry fixed
effects, the problem of omitted-variables bias or incorrect model specification, which afflicts
47 Rajan and Zingales (1998).
48 Rajan and Zingales (1998) describe how they calculate the number for the period 1980-89. We calculate a similar
number using U.S. corporate data between 1990 and 1998 (after 1998, normal financing behavior would be
contaminated by the equity bubble). In computing each industry’s dependence on finance for 1990-98, we first
compute the dependence on finance of each firm in the industry over the period, truncate outlier firms at the 10th
and 90th percentiles, and then average across all firms. We then take the average of the industry’s dependence for
the 1980s and the 1990s to get our final measure.
cross-country regressions, is diminished. Essentially, we are making predictions about within-
country differences between industries based on an interaction between a country and an industry
characteristic. Moreover, as discussed above, because we analyze differences between
manufacturing industries, we can rule out factors that would affect manufacturing in a country as a
whole as explanations of our results— these factors should not affect differences between
THE BASIC REGRESSION. Rajan and Zingales interact the country’s level of domestic financial
development with the industry’s finance dependence.49 Before we ask about the role of foreign
capital, an immediate question is whether their methodology “works” for this group of countries.
We estimate their basic regression including an interaction between the country’s domestic credit-
GDP ratio, our primary proxy for a country’s domestic financial development, and the industry’s
finance dependence. The coefficient on the interaction is positive and statistically significant for
both the 1980s and the 1990s, suggesting that it is a reasonable exercise to use this methodology to
investigate the role of foreign capital in finance.
We focus on six measures of capital account openness: five de facto measures and one
de jure measure. The de facto measures are the ratio of the stock of inward FDI to GDP, the ratio
of the stock of inward FDI and portfolio investment to GDP, the net flow counterparts of these two
ratios, and the average current account deficit over the period. The de jure measure is taken from
Menzie Chinn and Hiro Ito.50
We first ran these regressions without controlling for the level of domestic financial
development, to get a sense of the unconditional effect of foreign finance (estimates available from
the authors). The estimated interaction coefficients are neither uniformly significant nor of the
sign expected in the textbook model. Indeed, the results for the 1980s are more mixed, with the
coefficient on the current account deficit being negative and significant in the “wrong” direction.
The coefficients for the 1990s sample are of the expected sign (with a positive coefficient on the
current account deficit interaction) but are significant in only two of the six cases.51
THE IMPORTANCE OF DOMESTIC FINANCIAL DEVELOPMENT. It may well be that our
specification is not complete. Countries that are more open also have better developed financial
49 Rajan and Zingales (1998).
50 Chinn and Ito (2006).
51 To reduce the effect of data errors, all variables are “winsorized” at the 99 percent and the 1 percent level. Standard
errors are robust, and we report the estimates when we cluster by country. Results are qualitatively similar when we
cluster by industry. These results are available from the authors upon request.
markets.52 Financial integration may proxy for financial development. We should therefore
include an interaction between our proxies for the country’s domestic financial development and
an industry’s dependence on finance, to check whether the effects of foreign capital persist
even after we control for domestic financial development. Our primary proxy for financial
development is the ratio of domestic credit to GDP. A second proxy is the country index of the
quality of corporate governance (which is available for fewer countries and does not vary across
Also, we should check for threshold effects: the benefits of foreign capital may kick in
only after a country’s domestic financial development exceeds a certain level.54 So we include a
separate interaction between our measure of foreign capital penetration and an industry’s
dependence on finance if the country is below the median level of financial development (as
measured by the ratio of domestic credit to GDP) in our sample of countries. Since this is a triple
interaction, we also have to include all the relevant double interactions. So the final specification is
(2) Gij = ψ + ζ1’Cj + ζ 2’Ii + ζ3 manij + α1 ( openj × depi )
+ α2 ( openj × depi × bmedj ) + α3 ( credj × depi )
+ α4 ( credj × depi × bmedj ) + α5 ( govj × depi )
+ α6(depi × bmedj ) + εij ,
where credj is the ratio of domestic credit to GDP of country j; govj is the value of the corporate
governance index for country j ; and bmedj is an indicator variable equal to 1 if country j is below the
median ratio of domestic credit to GDP. The other variables are identical to those in equation 1.
If there are threshold effects, so that countries with under developed financial systems
cannot utilize foreign capital well to finance investment, we should find α1 to be positive and α2
negative. Table 4 reports the results from this augmented specification for the 1980s and 1990s
The results from this specification are much more stable and offer a consistent picture.
52 Kose and others (2006).
53 index was constructed by De Nicoló, Laeven, and Ueda (2006).
54 See Chinn and Ito (2006) and Alfaro and Hammel (2007).
Twenty-one of twenty-four coefficients have the expected sign (that is, expected in the model with
threshold effects where we postulate different effects of foreign capital in less financially
developed countries), and twelve are significant at conventional levels. The average effect we
obtained from estimating equation 1 seems to conceal very different implications for financially
developed and financially underdeveloped countries, effects that are visible only by estimating
equation 2. In particular, for countries that have above-median levels of financial development,
foreign capital aids the relative growth of those industries dependent on finance. In regression 4-7
the coefficient of the interaction term for countries that are above the median level of financial
development is about 50 percent higher than the “average” coefficient for the specification in
equation 1 (estimates available from the authors upon request).
But for countries below the median for financial development, the effect of foreign
capital inflows is diametrically opposite. The sum of the reported interaction coefficients in
each specification reflects the marginal effect of foreign capital on the relative growth of
dependent industries in countries that have below-median financial development. In eleven out of
twelve specifications, the sign on the sum of coefficients suggests that industries dependent
on finance grow relatively more slowly as a financially underdeveloped country draws in
more foreign capital. Foreign capital seems to hurt rather than help the relative growth of
industries dependent on finance in those countries.
Before we turn to interpretation, we present in table 5 our estimates from panel versions of
equation 2; the estimates include industry-country dummies in addition to separate country and
industry dummies. We use the within-country, within-industry, across-time variation to identify
effects.55 All the specifications clearly indicate that foreign capital detracts from the relative growth
rate of financially dependent industries in countries that are below the median with respect to financial
development. By contrast, all the specifications uniformly indicate that domestic financial
development is good for the relative growth rate of industries dependent on finance, and especially
55 Relative to the earlier specification, we drop the industry’s initial share of manufacturing and the interaction of
industry dependence on finance with the country’s corporate governance index. The initial share of
manufacturing should be absorbed in the industry × country indicator, and the interaction is not meaningful since
neither the corporate governance index nor dependence on finance varies across time. Note that in this panel
specification the openness to capital flows varies across time and countries, whereas dependence on external finance
varies across industries, which, in the presence of industry-country fixed effects, allows identification within
country, within industry, and across time.
so in countries that are below the median level of financial development.56
DISCUSSION. Foreign capital may need a developed domestic financial system to be effective,
because it may lack access to the informal sources of information and power that allow domestic
finance to operate even in an underdeveloped system. For instance, if property rights are not well
protected (an element of a sound financial system), foreign capital may shy away from industries
that require high long-term investment. Instead, incremental foreign capital may flow into industries
that typically do not require high up-front investment and that have high cash flows in the short
run, or into nonindustrial sectors that have clearly demarcated, collateralizable assets (such as real
estate). This could explain why finance-intensive industries do relatively poorly or,
equivalently, why industries that generate high and immediate cash flows with low up-front
investment do relatively well, as additional foreign capital flows into countries with
underdeveloped financial sectors. In other words, in such countries foreign capital does not come in
as a source of financing, but to exploit domestic opportunities that require little financing, or to
Of course, our findings are also consistent with the possibility that foreign capital may
actually hamper access to finance. Foreign capital may have to be channeled through domestic
intermediaries when the financial sector is underdeveloped, and it may facilitate rather than
hinder the formation of domestic financial monopolies, as the strongest domestic intermediaries
are further strengthened by access to foreign capital. Foreign capital may also choose (and be
able) to cherry-pick the few good opportunities in an underdeveloped country, leaving less
incentive for domestic financial institutions to enter or participate.57
Note that, in these financially underdeveloped countries, although an increase in foreign
capital does not help industries that are dependent on finance, an increase in domestic capital
(which is largely what the ratio of domestic credit to GDP represents) is indeed helpful. Perhaps
domestic credit institutions can better navigate the pitfalls of an underdeveloped system.
56 The coefficient on the interaction in the panel is negative also for countries with above-median levels of financial
development, unlike in the cross-sectional results. One interpretation of this is that the benefits of foreign capital
accrue even to financially well developed countries only in the medium run.
57 Detragiache, Tressel, and Gupta (2006) show that, in poor countries, a stronger foreign bank presence is robustly
associated with less credit to the private sector in both cross-sectional and panel tests. In addition, in countries with
more foreign bank penetration, credit growth is slower and there is less access to credit. By contrast, they find no
adverse effects of foreign bank presence in more advanced countries. Tressel and Verdier (2007) show that, in
countries with weak institutions, financial integration leads to greater investment by politically connected firms, with a
loss of efficiency. Our findings are not inconsistent with these results.
Perhaps also, more domestic credit reflects, and leads to, a better financial system that can
support more credit to financially dependent industries, and eventually from foreign sources.
Finally, one could ask whether domestic financial development is a proxy for
development more generally, or for the broader institutions that accompany development. We
reestimated the regressions in tables 4 and 5, replacing a country’s measure of financial
development with the logarithm of its GDP per capita (with additional interactions, where
necessary, based on whether a country is below the median on this measure). The coefficient
estimates of the triple interaction (available from the authors) were often insignificant and
sometimes the opposite of what one might expect. It is not primarily underdevelopment (or the
factors accompanying or causing it) that causes foreign capital to be ineffective in nonindustrial
countries; instead what matter seem to be factors related to a specific form of underdevelopment,
namely, financial underdevelopment.
In sum, the industry evidence can explain why foreign capital may not be an effective
source of finance for nonindustrial countries. Although the evidence thus far cannot rule out a
benign interpretation of the role of foreign capital, it strongly suggests that if poor countries are
seeking to improve financing for industry, instead of just hankering after additional financing in
the form of foreign capital, they can reap substantial benefits from focusing on domestic financial
Overvaluation, Trade, and Growth
Let us now turn to the less benign explanation: that capital inflows may lead to an
appreciation of the national currency in real terms, which in turn may reduce the profitability of
exports and thus reduce investment. The consequences of capital inflows for international
competitiveness may then be an important contributing factor to the patterns we observe.
OVERVALUATION AND CAPITAL FLOWS. Simon Johnson, Jonathan Ostry, and Subramanian
construct a measure of a country’s exchange rate competitiveness, accounting for the Balassa-
58 This argument does not, of course, detract from the possibility that foreign capital has large indirect benefits,
including on financial development itself. Some authors point to the beneficial effects of equity market liberalization
on growth (for example, Bekaert, Harvey, and Lundblad, 2005, and Henry, 2006). In addition to the problem of
timing that the literature notes—such liberalization is typically part of broader macroeconomic reforms that affect
outcomes—the countries that liberalize might be the same ones that are typically able to reap the benefits from
foreign finance, in part because they have stronger financial sectors. For this reason, our findings need not be
inconsistent with the more positive tone of the equity market liberalization literature.
Samuelson effect.59 Essentially, the idea is to measure the deviation of a country’s exchange rate
from purchasing power parity, after accounting for differences in incomes. This deviation we term
The immediate question is whether there is a relationship between overvaluation and
capital inflows. In table 6 the dependent variable is our measure of the extent of
overvaluation. We include as explanatory variables the ratio of the working-age population to the
total population (since a larger working-age population should increase the supply response of an
economy to any incipient overvaluation and help contain it) and, to capture financial openness,
different measures of capital inflows or the Chinn-Ito de jure measure of openness. Regardless of
the type of inflows included, the coefficient is always positive and nearly always significant: the
larger the inflows, the less competitive the recipient economy at the current real exchange rate.
For the Chinn-Ito de jure measure of openness, however, the coefficient is not significant
(regression 6-6), suggesting that only actual flows lead to pressures for real appreciation.60
Figure 12 plots the relationship, conditional on the share of the working-age population,
between overvaluation and one of the capital flow measures, total net private capital inflows.
The figure shows a strong positive relationship and that no outliers are driving the relationship,
If overvaluation in nonindustrial countries as a result of capital inflows is to account for
the observed positive relationship between current account balances and growth there, it must be
that capital inflows do not cause overvaluation in industrial countries. So in the last two
specifications of table 6 we include in the regression an interaction between the industrial
country dummy and the relevant flows variable. The results are striking. For example, when we
use net private inflows as the relevant capital flow variable, the coefficient on the interaction is
negative and significant (regression 6-8), whereas the direct effect is positive; so, for nonindustrial
countries, more inflows lead to more overvaluation. The total marginal effect of inflows on
overvaluation (−1,038 + 826 = −212) is statistically insignificantly different from zero for
59 Johnson, Ostry, and Subramanian (2007). On the Balassa-Samuelson effect, see Meese and Rogoff (1983). We
estimate the following cross-sectional equation for every year since 1960 for the full sample of countries: log pi = α
+ β log yi + εi, where p is the log of the price level for country i relative to that in the United States, and y is GDP at
purchasing power parity. Our measure of overvaluation is then overvali = log pi – (α-hat + β-hat log yi). We average
this measure for each country over the relevant period. This measure is also used by Rajan and Subramanian (2005).
60 We could run the same regression in a panel context, but there is more reason to expect the real exchange rate to
be decoupled from capital flows in the short run; countries can use sterilized intervention, fiscal policy, and other
measures to retain influence over the real exchange rate. Unless we can control for these short-run policies, it would be
difficult to identify the effect of flows on overvaluation.
industrial countries. The same result holds when we use net FDI inflows as the relevant measure of
capital flows (regression 6-7). What this suggests is that overvaluation, and thus the distortion of
investment returns caused by the use of foreign saving, may matter far less for industrial countries,
which may help explain the positive correlation between their use of foreign saving and growth.
Having established that there is a positive correlation in nonindustrial countries between
capital inflows and average overvaluation, let us now ask if such overvaluation has an effect on
competitiveness and growth.61 If it does, it could explain the negative correlation between capital
inflows and growth that we have already documented.
OVERVALUATION AND GROWTH. Table 7 introduces our measure of overvaluation into
the core specification of tables 1 and 3, in both the cross section and the panel. In the cross
section (regressions 7-1 and 7-2) the coefficient on overvaluation has the expected negative
sign and is significant at the 10 percent level.62 The coefficient is less negative when we
exclude countries receiving high levels of aid. The addition of the share of the working-age
population (regression 7-4) also reduces the impact of both the current account and
overvaluation. As argued earlier, this may reflect the possibility that exogenous shifts in saving
(due to demographic factors) lead to faster growth by way of reduced overvaluation.
In the panel version (in which the sample period is split into five-year subperiods), the
coefficient on overvaluation is negative and significant at the 5 percent level for the large sample,
both when the share of the working-age population is included (regression 7-8) and when it is not
(regression 7-5), but it falls just short of significance (p ≈ 0.12) when the sample is reduced and the
working-age population share is omitted (regressions 7-6 and 7-7).63 The magnitude of the coefficient
in regression 7-6 suggests that, in the short run, a 1-percentage-point increase in the degree of
61 One qualification to this result is that, when we use the current account-GDP ratio in place of private capital
inflows, we do not find a statistically significant relationship with our measure of overvaluation, either in the cross
section or in the panel. There is a huge endogeneity problem in such regressions, of course, which could explain this in
the context of non-industrial countries. Systematic undervaluation could stimulate speculative inflows through
unofficial channels when there are selective capital controls in place; similarly, overvaluation may lead to capital flight.
(Both these unofficial inflows and outflows would be reflected in the errors and omissions category of the balance of
payments.) This is why measures of private capital inflows may be more relevant for understanding the effects of net
flows on exchange rates. There is an endogeneity problem in this case as well, but it should drive the correlations that
we report in table 6 negative (more overvaluation reduces inflows of private inflows through official channels).
Hence the positive correlations that we find are still interesting.
62 Although this particular specification is sensitive to the inclusion of Mauritius, in others, where the Africa dummy
is dropped, the result is more robust.
63 Alternative lag structures yield a significant coefficient on the overvaluation term.
overvaluation decreases annual growth by about 0.4 percentage point.64
Figure 13 conveys some of the flavor of the panel relationship. The figure plots growth and
overvaluation over time for countries that experienced growth spurts,65 differentiating their
performance before and during the growth spurt. On average, overvaluation is substantially less
during the growth spurt than before. It is noteworthy that the turnaround in overvaluation is more
stark when we exclude, in the bottom panel, the three industrial countries (Ireland, Portugal, and
Spain) from the group of sustained growers. This is also consistent with our findings on the
differing experiences of industrial and developing countries.
It is also useful to ask whether countries can get as much of a competitive advantage from
undervaluation as they will suffer a competitive disadvantage from overvaluation. We estimate
separate slopes for countries with overvaluation and for countries with undervaluation (regression 7-
9). The negative effect is twice as large, and statistically significant, in the former. It is also negative
for the latter (suggesting that these countries secure a mild competitive advantage), but the
coefficient in this case is not significantly different from zero. The true test, though, of whether
exchange rate misalignment plays a symmetric role both when positive and when negative is
whether the coefficients are different from each other. Here we cannot reject the possibility that they
are the same. More work is clearly needed.
EXPORTS AND EXCHANGE RATES: WITHIN-COUNTRY, BETWEEN-INDUSTRY VARIATION. The
reduced-form relationship between overvaluation and growth should be mediated through exports
and, in particular, manufacturing exports. We now present evidence, based on industry-level data,
that suggests that this is indeed the case. As in the previous section, we exploit the within-country,
across-industry variation, which allows us to address issues of endogeneity and reverse causality
that cannot easily be dealt with even using panel macroeconomic data. The intuition on which
these regressions are based is that, in countries with more competitive exchange rates, industries that
are “exportable” (that is, whose products have greater inherent export potential) should see faster
growth than industries that are less exportable. This intuition is formalized in the following
64 Since the overvaluation term is instrumented in the panel, reverse causation should be less of a concern. See also
Razin and Collins (1999).
65 Again, as identified by Hausmann, Pritchett, and Rodrik (2005).
(3) Gij = ψ + ζ1’Cj + ζ 2’Ii + ζ3 manij + α ( overvalj × xporti ) + εij,
where Cj is a vector of country indicator variables; Ii is a vector of industry indicator variables;
manij is industry i’s initial-period share of manufacturing in country j; overvalj is real overvaluation
in country j; and xporti is the exportability of industry i.
The coefficient of interest for us is α. It captures an interaction between a country-specific
overvaluation variable and an industry’s exportability. We posit that countries with greater
overvaluation should see a more negative impact in industries that are more exportable, and so
we would expect α to be negative.
Before running this regression, we need to measure the inherent exportability of an
industry. Since this is clearly a function of a country’s endowment and level of income, we are on
safer ground in restricting our sample to developing countries, which are likely to be more
similar in their potential export trading patterns. However, even within our sample, countries are at
varying levels of development. We therefore define exportability in two ways. First, we divide
the sample of developing countries into two groups, based on whether their income lies above
or below the median. For each group we calculate the ratio of exports to value added for each
industry i, averaged across all countries in the group. Industries that have ratios above the median
within the group we call exportable. Finally, we create an exportable indicator that is equal to
1 for these above-the-median industries; for the other industries the indicator variable takes on
a value of zero.
Our second measure of exportability is simpler. We know from the postwar history of
world trade that developing countries typically have comparative advantage in the textiles and
clothing industry and the leather and footwear industry. So we code the four industries in the U.N.
Industrial Development Organization database that fall into these categories as exportable, and we
create an indicator variable that takes a value of 1 for these industries and zero otherwise. The
difference between this indicator variable and the first is that our textiles and leather indicator is
common to all developing countries in the sample, whereas our first indicator can vary across the
two groups of developing countries—richer and poorer—in our sample.
Table 8 presents results using the first indicator variable for the 1980s (regression 8-1), the
1990s (regression 8-4), and the pooled data (regression 8-7).66 The coefficient on the interaction
between the overvaluation variable and the exportability indicator is negative and significant for
both the 1980s and the 1990s. One way to interpret the coefficient is to say that, in a country whose
currency is overvalued in real terms by 1 standard deviation (about 24 percentage points) more
than that of another country, exportable industries grow 1.4 percentage points (0.0006 × 24) a
year more slowly than other industries in the first country relative to the second. This is
substantial when compared with the annual growth rate of the average sector in the sample of about
Regressions 8-2, 8-5, and 8-8 are for the same specification but with the textiles, clothing,
leather, and footwear industries as the exportable industries. Again the coefficient on the interaction
term is negative and significant. It is also greater for these industries than for those in the
previous sample, which is reassuring because it suggests that, even within exportable industries, the
most obviously exportable ones suffer more in the presence of overvaluation. Finally, we repeat the
exercise in regressions 8-3, 8-6, and 8-9, this time restricting the definition of exportable industries
to just textiles and clothing, and again we find that the coefficients are significant and increase in
magnitude for these clearly exportable sectors.
To summarize, we have presented evidence that capital inflows can result in
overvaluation in nonindustrial countries and that overvaluation can hamper overall growth. To
bolster this claim, we have shown that overvaluation particularly impinges on the growth of
exportable industries. Although the industry-level results go some way toward addressing
concerns about endogeneity, the issue remains whether they scale up to the economy as a whole.
Again, although these results are not conclusive, since they are, after all, based on reduced-form
estimations, the fact that the macroeconomic evidence and the industry-level evidence tell a
consistent story provides some comfort that our interpretation is reasonable. The results
presented in this section in some ways also generalize the point made by Rajan and Subramanian
about the deleterious effects of aid inflows on poor countries’ exchange rate competitiveness.67
66 It is less easy to run these regressions in a panel context because the exportability index exhibits virtually no time
variation, and the overvaluation variable is also quite persistent across the two decades. So there is very little time
variation to enable identification.
67 Rajan and Subramanian (2005).
Our analysis makes clear that nonindustrial countries that have relied on foreign capital have
not grown faster than those that have not. Indeed, taken at face value, there is a growth premium
associated with these countries not relying on foreign finance. Equally clearly, though, the reliance
of these countries on domestic rather than foreign saving to finance investment comes at a cost:
investment and consumption are less than they would be if these countries could draw in foreign
capital on the same terms as industrial countries’ or on the same terms as they can use their own
It does not seem to us that these nonindustrial countries are building up foreign assets just to
serve as collateral, which can then draw in beneficial forms of foreign financing such as FDI.68
Rather, it seems to us that even successful developing countries have limited absorptive capacity
for foreign resources, whether because their financial markets are underdeveloped, or because
their economies are prone to overvaluation caused by rapid capital inflows or overly rapid
consumption growth, or some combination of these factors.
As countries develop, absorptive capacity grows. The recent strong growth of the
emerging economies of Europe, accompanied by rising current account deficits, probably has a
lot to do with the strengthening of their financial sectors, in part through the entry of foreign
banks. Only time will tell what effects there are on the exchange rate and on competitiveness, as
well as whether this phenomenon is sustainable, and so all conclusions from this episode
have to be tentative.69
In sum, our results suggest that insofar as the need to avoid overvaluation is important
and the domestic financial sector is underdeveloped, greater caution toward certain forms of
foreign capital inflows might be warranted. At the same time, however, financial openness may be
needed to spur domestic financial development.70 This suggests that even though reformers in
developing countries might want to wait to achieve a certain level of financial development
before pushing for financial integration, the prospect of financial integration and ensuing
68 See, for example, Dooley, Folkerts-Landau, and Garber (2004a, 2004b). Why, for example, would Korea or
Taiwan be comforted, when making direct investments in China, by the fact that China holds enormous amounts of
U.S. government securities?
69 Of course, if development helps countries absorb foreign capital better, why is the correlation between current
account balances and growth for nonindustrial countries getting stronger over time, as figure 5 suggests? This is an
important question for future research.
70 See, for example, Rajan and Zingales (2003), Mishkin (2006), and Kose and others (2006).
competition may be needed to spur domestic financial development. One approach worth
considering might be a firm commitment to integrate financial markets at a definite future
date; this would allow time for the domestic financial system to develop without possible
adverse effects from capital inflows, even while giving participants the incentive to press for it by
suspending the sword of future foreign competition over their heads.71
A bleak read of the message in this paper is that because development itself may be the
antidote to the deleterious effects of foreign capital and may be necessary for countries to absorb
more capital, only some forms of foreign capital may play a direct role in the development
process. Certainly, the role of foreign capital in expanding a country’s resource constraints may be
limited. A more optimistic read would see a research and, eventually, policy agenda in
determining how to increase the capacity of poor countries to absorb foreign capital.
Over time, and especially in the aftermath of the East Asian crisis of the late 1990s,
certitudes about financial integration have gradually yielded to greater circumspection—a trend that
this paper suggests was perhaps warranted. But what does all this mean for policies
toward capital account openness? Certainly, the answer is not to go backward, but instead toward
more country and context specificity in assessing the merits of capital account openness, and
more flexibility and creativity in managing it.72 Even in his avatar that was skeptical of financial
integration, Keynes said, “Yet, at the same time, those who seek to disembarrass a country of its
entanglements should be very slow and wary. It should not be a matter of tearing up roots but of
slowly training a plant to grow in a different direction.”
71 The Chinese approach of trying to spur banking reform by committing to open up the country’s banking sector to
foreign competition in early 2007, as part of their World Trade Organization accession commitments, can be seen in
this light. Prasad and Rajan (2005) suggest an alternative strategy for dealing with the potential adverse effects of
inflows through controlled liberalization of outflows (essentially by securitizing inflows), which would allow
countries experiencing large capital inflows to develop their domestic financial markets and simultaneously mitigate
appreciation pressures associated with those inflows.
72 For instance, capital account openness means more than just opening up to inward flows; it also means allowing
outward flows. Outward flows could well relieve incipient appreciation pressures on the national currency, but they
could also be a source of fragility, especially if the financial sector is underdeveloped. The fragility associated with
the exit of capital could be attenuated if an economy is more open to trade (see Calvo, Izquierdo, and Mejia, 2004,
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Figure 1. World Aggregate Current Account Surplus, 1970-2006a
Percent of world GDP
Source: IMF World Economic Outlook (WEO) database and authors' calculations.
a. Each observation is the sum of current account surpluses of countries in the WEO database that had a surplus in that year, as a
percent of world GDP as calculated by the IMF.
Figure 2. Relative GDP per Capita of Capital Exporters and Capital Importers, 1970–2005a
Percent of highest GDP per capita in indicated year
197019751980 1985 19901995 2000 2005
Excluding China and United States
197019751980 1985 19901995 20002005
Source: Authors' calculations using data from the WEO database.
a. Each observation is the average GDP per capita (weighted by the country's share of the total current surplus or deficit) of
countries in the WEO database with current account surpluses or deficits in the indicated year, expressed as a percentage of GDP
per capita in the country with the highest GDP per capita that year. GDP per capita is adjusted for purchasing power parity.
Figure 3. Cumulative Current Account Deficits and FDI Inflows of Nonindustrial
Billions of 2004 dollarsb
Current account deficits
Source: Authors' calculations using data from Penn World Tables (Version 6.2) and Lane and Milesi-Ferretti (2006).
a. Our sample of fifty-nine nonindustrial countries, excluding China and India, is divided into three groups of roughly equal total
populations based on income per capita. Bar heights indicate the sum of each group's cumulative current account deficit or FDI
inflows in the indicated period. Negative numbers in the top panel indicate current account surpluses.
b. Deflated using the U.S. consumer price index.
c. Percentages above each bar indicate the period-average median growth rate of real GDP per capita for that group.
Net FDI inflows
Figure 4. Growth in GDP per Capita and Level of Current Account Balances, 1970–2004a
Growth in GDP per capita
(percent a year)
-12-10 -8-6-4-2 024
Source: Authors' calculations using data from the Penn World Tables and the World Bank, World Development Indicators.
a. Data are for the fifty-six nonindustrial countries in the core sample (the nonindustrial countries listed in appendix table A-1,
excluding outlier Mozambique, Nicaragua, and Singapore).
Current account balance (percent of GDP)
Figure 5. GDP Growth and the Current Account Balance over Time: Nonparametric
(percent a year)
Source: Authors' regressions using data from the Penn World Tables and the World Bank, World Development Indicators.
a. Graph plots predicted growth in GDP per capita growth against the current account balance using estimates from locally
weighted regressions for each sub-period. Data are for the entire sample of fifty-nine nonindustrial countries plus Bangladesh.
Average current account balance (percent of GDP)
Growth in GDP per capita
Figure 6. Growth in GDP per Capita and Levels of Investment and the Current
Growth in GDP per capita
(percent a year)
Source: Authors’ calculations using data from the World Bank, World Development Indicators.
a. Data are for the fifty-nine nonindustrial countries in the entire sample plus Bangladesh. All data are period averages.
Figure 7. Saving, Investment, and Economic Growth in an Undistorted Economy
Source: Authors' model described in the text.
Figure 8. Current Account Balance, Saving, and Investment before and after Growth
Spurts in Eleven Countriesa
Current account balance
Saving and investment
Sources: World Bank, World Development Indicators; the Penn World Tables; Hausmann, Rodrik, and Pritchett (2005); and
a. Simple averages of current account balance, saving, and investment. Countries and initial year (year 0) of their growth spurts
are Chile (1986), China (1978), Egypt (1976), India (1982), Ireland (1985), Korea (1984), Mauritius (1983), Pakistan (1985),
Spain (1984), and Sri Lanka (1979).
Percent of GDP
Figure 9. Current Account Balance, Saving, and Investment before and after Growth
Spurts in Eight Nonindustrial Countriesa
Current account balance
Saving and investment
Sources: World Bank, World Development Indicators; the Penn World Tables; Hausmann, Rodrik, and Pritchett (2005); and
a. Simple averages of current account balance, saving, and investment. Country sample is the same as in figure 8 except that
Ireland, Portugal, and Spain are excluded.
Percent of GDP
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Figure 10. Saving and Investment in an Economy Distorted by Foreign Capital Inflows
Source: Authors’ model described in the text.