- Comments and Discussion
Susan M. Collins:
In this paper Eswar Prasad, Raghuram Rajan, and Arvind Subramanian update and extend their previous work on net foreign capital flows and economic growth. Their starting point is the well-known Lucas puzzle, that capital tends to flow uphill from relatively poor to relatively rich countries. Recent analyses have also highlighted the so-called allocation puzzle, that even among poor countries capital does not go primarily to those countries that are growing most rapidly, as some theories would predict. The story here focuses on a related observation: that among nonindustrial countries net capital outflows (as measured by the current account) are positively correlated with growth. The opposite appears to be true for industrial countries, for which faster growth is associated with net capital inflows (current account deficits). The authors first convincingly document this finding in a variety of ways. They then offer some very plausible explanations, together with some empirical evidence, and pull together some lessons for successful development strategies. Along the way they touch on a wide range of interesting issues, only a few of which I will attempt to discuss here.
In my view a strength of the paper is the extensive evidence the authors amass in support of their main finding. They consider time-series as well as cross-sectional and panel data. They present simple charts as well as results of regressions, some estimated by ordinary least squares and others by the generalized method of moments. They explore omitting outliers and altering the sample time period. Their finding does indeed seem to be quite robust and convincing. Thus they have added to the list of stylized facts that, among developing countries, faster growth tends to be associated with current account surpluses (net aggregate capital outflows), not current account deficits (net capital inflows). An important caveat, however, is that [End Page 210] this finding does not hold across all types of capital. In particular, faster growth tends to be associated with net inflows of foreign direct investment (FDI).
It was less obvious to me that the authors' main finding should be characterized as a puzzle. Certainly some textbook models associate borrowing with faster growth for poor, finance-constrained economies. But even simple models can also generate a variety of realistic scenarios in which faster growth goes hand in hand with current account improvement (that is, a rising balance), not deterioration. And although I find the authors' two main explanations of their finding quite plausible, I can think of other plausible explanations as well. As discussed below, the additional empirics they provide do not really help in teasing out whether or not their conjectures are correct. Thus I would caution the authors against attempting to jump from their interesting correlations among jointly determined variables to drawing broad-brush conclusions about effective development strategy.
The first of the authors' two suggested explanations is an institutional underdevelopment story, which conjectures that faster income growth (for example, due to productivity shocks) results in increased saving but a limited increase in investment (possibly because of a weak financial system, or inadequate protection of private property, or both). In this scenario growth would be associated with current account improvement in developing but not in industrial economies. I certainly agree that weak financial systems and other differences in institutional development likely play a role in explaining the positive correlation between growth and the current account in poor but not in rich countries.
To support this conjecture, the authors present some interesting results using industry-level panel data. I think there is often much to learn from combining micro with macro evidence and that this is a potentially interesting direction for research. As expected, they find that, in countries with developed financial markets, increased capital inflows tend to spur growth in industries that rely on outside financing. Interestingly, the opposite is true for countries with less developed financial markets. One concern is that the dummy variable they use in their regressions to identify countries below the median in financial development is picking up a variety of other country characteristics as well, since various measures of development tend to be highly correlated. The insignificant results obtained by replacing that variable...