More on Capital Flows and growth

I had posted earlier on this topic here and here. The last one was a summary of an excellent survey (which is a summary of the empirical work done so far) which showed capital flows do not help in growth as theory suggests. It also showed that equity flows are better than debt flows.

I came across this another State of the art paper by Eswar Prasad, Raghuram Rajan and Arvind Subramanian titled Foreign Capital and Economic Growth. It has looked at some very interesting arguments:

“Developing countries that have relied more on foreign finance have not grown faster in the long run, and have typically grown more slowly. By contrast, we find that among industrial countries, those that rely more on foreign finance do appear to grow faster.”

Reasons:

First, the positive correlation between current account balances and growth is stronger among less financially developed countries

. In these countries, the range of profitable investment opportunities, as well as private consumption, for those that experience growth episodes, may be constrained by financial sector impediments, so investment can be financed largely through domestically generated savings.

Second,a developing country may actively choose not to absorb too much foreign capital in order to avoid exchange rate overvaluation. In turn, this ensures that the country’s manufacturing/tradable goods sector is competitive, thus allowing it to play its customary important role in fostering growth.

The paper is different as it mentions the role of financial system in absorbing capital flows which has been missing in previous papers (as finance has never been really thought as important in most previous work on economics). This paper attempts at correcting that biased viewpoint.

Further the paper adds:

The apparent perversity of overall foreign financing is even more dramatic when one examines the allocation of capital across developing countries……within this group capital should flow in greater amounts to countries that have grown the fastest, that is, countries that are likely to have the best investment opportunities. Does it?

Their research shows that it doesn’t infact capital flows mostly to medium and low growth developing countries!! Another puzzle is that when we look at FDI it does flow to top performing developing countries.

It is an excellent analysis once again from the team. However, the paper is a bit confusing as somehow the flow is not as clear-cut as it is in most Rajan papers. Perhaps it is missing Zingales (Rajan’s co-author in most papers) factor.

Summary of all papers I have read so far including this one: There is no relationship between openness of an economy to economic growth.  

4 Responses to “More on Capital Flows and growth”

  1. Praveer Says:

    I think in developing countries the demand is for very basic goods and services. Since the per capita income is low, the consumption pattern of people will be skewed towards the very basic.
    Now assuming that development is equal at each level of properity the demnad for luxuries will start rising and the technology (both material and in terms of know-how) needed to build up these luxurious products will have to be imported. Thus capital flow will come into effect.
    But what if development is unequal. Will copious consumption of the upper strata create an artificial demand for imports of technology for luxuries? Is this what is happening in India? What are your views?
    Further is there a a +ve correlation between current account and growth but not between capital account and growth or BoP and Growth? Perhaps these are a few things we need to look at. Take India as a proxy for developing and Singapore as a proxy for developed as the consumption patterns and demand patterns may be similar….Shall we try this out….

  2. Amol Agrawal Says:

    Why should India’s and S’pore’s consumption patterns be similar? We are at a different level of growth.

    I think the question which need to be checked for India are:

    1. Whether capital flows have contributed to eco growth or not?
    2. Post 1991 what has mattered more, capital flows or our own domestic savings….
    3. Then segment the capital flows and find out what has helped- ECB, FII, FDi or what?

    Just to correct…. Capital account and current account are mirrors….so there is no relationship between growth and either of the two…however, if u look at different capital flows.. u do find equity flows are better suited….

  3. Assorted Links « Mostly Economics Says:

    […] its impact on India; the topic which is of recent interest to me and I have blogged and summarised here. Eswar Prasad is also one of the co-authors for the paper on financial globalization I critiqued […]

  4. Institutions and their impact on India’s growth « Mostly Economics Says:

    […] paper by Arvind Subramaniam (AS from now on, I had done a review of his papers earlier as well, here and here) which talks about evolution of India’s institutions and their impact on Indian […]

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