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Can countries rely on foreign saving for investment and economic development?

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Abstract

Contrary to widespread presumption, a surprisingly large number of countries have been able to finance a significant fraction of their investment for extended periods using foreign finance. While many of these episodes are in countries where official finance is important, we also identify episodes where a substantial fraction of domestic investment is financed by private capital inflows. Although there is evidence of a positive growth effect of such inflows in the short run, that positive impact dissipates after 5 years and turns negative over longer horizons. Many such episodes end abruptly, with compression of the current account and sharp slowdowns in investment and growth. Summing over the inflow (current account deficit) episode and its aftermath, we find that growth is slower than when countries rely on domestic savings. The implication is that financing growth and investment out of foreign savings, while not impossible, is risky and too often counterproductive.

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Notes

  1. See for example, Fischer (1988, 1994, 2003) for warnings on the risks associated with large current account deficits.

  2. Although the difference in long-run growth between episodes and non-episodes is not always statistically significant.

  3. Reinhart and Trebesch (2015) suggest that Greece’s long history of debt crisis is a classic example of the pitfalls of relying on external financing.

  4. Adalet and Eichengreen (2007) document that current account reversals were relatively few before 1914, compared to the last quarter of the 20th century. This speaks to the third related literature considered in the next paragraph.

  5. See also Reisen (1997) and Bussière and Fratzscher (2008) on the complex interrelationships between foreign savings, financial openness, stability and growth.

  6. Table 8 in the “Appendix” provides the full list.

  7. We use total net official flows and divide them by the current account balance. We set this variable equal to zero for country-years with negative official flows or a current account surplus.

  8. These values are 1.2% of GDP when we look at 4% current account deficits, 1.6% of GDP for 6% current account deficits, 2.4% of GDP for 8% current account deficits, and 3% of GDP for 10% current account deficits.

  9. Table O1 in the online appendix considers 6, 8 and 10% episodes.

  10. In contrast, large and persistent current account deficits are associated with above-average FDI inflows. While portfolio inflows are also higher than in than control group cases, the difference is not large, and it is never statistically significant for developing countries. Whether large current account deficits financed mainly by FDI “turn out better”—whether or not followed by equally sharp changes in GDP growth—is a separate question, to which we turn in Sects. 4 and 5 below.

  11. This is in line with the results of Table 2 showing that episodes are more frequent in developing countries.

  12. It goes up to 3 percentage points in the 8% episodes, though the difference is not always statistically significant.

  13. While there is much analysis of why some countries earn excess returns on their net foreign assets and whether these returns are sustainable (see inter alia Gourinchas and Rey 2007; Curcuru et al. 2007; Hausmann and Sturzenegger 2007; Eichengreen 2004), we simply note that countries may be able to run larger current account deficits when the return on their gross foreign assets is higher than that on their gross foreign liabilities.

  14. There are instead no clear patterns for GDP growth. The real exchange rate tends to depreciate at the end of the episode but the effect is not statistically significant.

  15. Balance of payments accounting distinguishes three main sources of external financing: (i) capital transfers (for example, grants and debt forgiveness by creditors) which are recorded in the capital account of the balance of payment; (ii) liabilities creating capital inflows (direct investment, portfolio investment, other investment, and changes in reserve assets) which are recorded in the financial account of the balance of payments; and (iii) net errors and omissions which is a residual category to insure that the balance of payments sums to zero.

  16. The results of columns 7 and 8 and difficult to interpret because, when we consider 10% episodes, the dependent variable becomes collinear with the advanced economies and Asian dummies.

  17. Tables O2 and O3 in the online appendix report results for 6, 8, and 10% episodes.

  18. Results are essentially identical if we estimate this model without controlling for the saving rate.

  19. We define as high FDI inflows periods where FDI inflows relative to GDP are above the sample median.

  20. Since we have four models and four thresholds, we estimate a total of 320 regressions. Full regression results are in Tables O7–O22 in the online Appendix.

  21. For instance, the top left panel of Fig. 3 plots the coefficients of the regressions reported in Table O7: when h = 1, EPI has a positive and statistically significant coefficient (the point estimate is 0.0205), the coefficient remains positive and statistically significant until h = 4, at h = 5 is positive but not significant, and at h = 6 it becomes negative but still insignificant. For h > 6, the coefficient remains negative but it is never statistically significant. The top-left panel of Fig. 7, instead, plots the coefficient reported in Table A12. In this case, the coefficient is always positive but not statistically significant when h > 6.

  22. A possible solution to this problem would be estimating a full-fledged simultaneous equation model, but the estimation of such a model is well beyond the objective of this paper.

  23. For 8 and 10% episodes, there seem to be no difference between episodes with large and small FDI flows.

  24. We would like to thank an anonymous referee for suggesting to drop low income countries and intermediate cases.

  25. The first stages of the IH regressions pass the standard weak instrument and specification tests. The Cragg Donald Wald F test is 14.87 for the regressions that focus on 4% episodes, 19.69 for 6% episodes, 20.39 for 8% episodes, and 13.95 for 10% episodes. The p value of the Sargan tests are 0.36, 0.71, 0.74, and 0.92, respectively.

  26. That difference is statistically significant at year 11.

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Acknowledgements

We would like to thank Luis Servén, and two anonymous referees for very useful comments and Kailin Chen, Matías Marzani and Juan Espinosa for research assistance. The opinions expressed are those of the authors and do not necessarily reflect the views of the Inter-American Development Bank, its Board of Directors, or the countries they represent.

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Authors and Affiliations

  1. Inter-American Development Bank, Washington, DC, USA

    Eduardo Cavallo

  2. NBER, and CEPR, University of California, Berkeley, Berkeley, CA, USA

    Barry Eichengreen

  3. The Graduate Institute, Geneva and CEPR, Geneva, Switzerland

    Ugo Panizza

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  1. Eduardo Cavallo
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  2. Barry Eichengreen
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  3. Ugo Panizza
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Correspondence to Ugo Panizza.

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Appendix

Appendix

See Tables 8 and 9.

Table 8 Full list of episodes at various current account deficit thresholds
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Table 9 Description of the variables and data sources
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Cavallo, E., Eichengreen, B. & Panizza, U. Can countries rely on foreign saving for investment and economic development?. Rev World Econ 154, 277–306 (2018). https://doi.org/10.1007/s10290-017-0301-5

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