Susan M. Collins

English

Research Papers in Economics

Commentary: 
Patterns of International Capital
Flows and Their Implications for
Economic Development
In their wide-ranging paper, Prasad, Rajan, and Subramanian
(PRS) update and explore a new dimension of the well-established,
though seemingly perverse, Lucas puzzle—that capital tends to flow
from poor to rich countries. Building on the recent finding by
Gourinchas and Jeanne (2006) that capital flows to nonindustrial
countries have been relatively concentrated among the slow, not the
rapid growers, PRS document that current account balances for
these countries are also positively correlated with long-run growth.
Thus, countries that grew more quickly have been less reliant on
foreign finance. In contrast, they find the opposite (but expected)
negative correlation for industrial countries. After presenting a
variety of relevant empirical relationships, the authors consider
possible explanations for this new “stylized fact.” Their preferred
hypotheses focus on the role of underdeveloped domestic financial
markets that limit countries’ ability to absorb foreign capital and on
countries’ desire to avoid capital inflows that would cause overvalu-
ation. They also discuss a variety of possible implications, including
for interpreting recent global imbalances and informing policy
toward capital account openness.
159
Susan M. Collins
 160 Susan M. Collins
A strength of the paper is its wealth of interesting and provocative
empirics. In particular, I found the documentation of the correlations
between current accounts and growth to be novel as well as convinc-
ing. The paper also updates and extends indicators of both the
well-known Lucas paradox and the more recent Gourinchas-Jeanne
“allocation puzzle.”
However, as the authors recognize in places, correlations do not
imply causality. While I found their preferred explanations plausible,
the empirical evidence they present is suggestive at best. It is difficult
to draw conclusions from regressions that relate clearly endogenous
variables, such as the current account, saving, and investment, to
output growth. The analysis would benefit from additional structure
and a more explicit attempt to identify underlying exogenous factors.
Indeed, a simple framework suggests that finding faster growth tends
to be associated with current account surpluses may not be so
puzzling after all. There are also significant difficulties with available
measures of key variables such as financial development and integra-
tion. Thus, I am particularly uncomfortable when, in the final
sections of the paper, PRS push their analyses in an attempt to draw
policy conclusions.
In the remainder of my remarks, I first elaborate on the possible
interpretations of the new stylized fact that current accounts and
growth are positively correlated in nonindustrial economies. I then
address three additional issues: (1) linkages between saving, invest-
ment, and growth; (2) difficulties in measuring financial integration;
and (3) the apparent differences between foreign direct investment
(FDI) capital flows.
Most of my discussion relates to the linkages between current
account balances and growth, and relatively little to the parts of the
paper that focus on the Lucas paradox. PRS devote considerable
attention to the latter, including carefully and creatively documenting
that capital flowed even more intensively from poor to rich countries
during the recent period of greater international financial integration
than previously. However, as emphasized by Gourinchas and Jeanne
 Commentary 161
among others, the small amount of capital flowing to developing
countries could be explained by low relative returns to investment in
these countries, perhaps arising from domestic distortions and weak
institutions. Much more puzzling and seemingly perverse is why
capital flowing to developing countries should be relatively concen-
trated among those that have grown slowly, where returns were
relatively low. While PRS acknowledge this point, the role of returns
more generally warrants greater attention than it receives here and
must clearly be a central piece in solving the puzzles regarding
patterns of global capital flow.
Current accounts and growth
The standard accounting identities provide a useful starting point
and a simple organizing structure for examining the current account.
The balance of the payments account implies that the current
account is identically equal to the change in a country’s net foreign
assets, as well as to exports less imports of goods and services (ignor-
ing unilateral transfers). The national income and product account
implies that the current account is identically equal to the difference
between national saving and investment.
(1) CA  =∆NFA = S – I  = X – M
While all of these relationships must, of course, hold simultaneously,
each one provides a potentially valuable alternative “window” into
understanding (and modeling) economic performance. 
For example, consider an economy with constrained access to
foreign capital—perhaps arising from distortions in the global finan-
cial system. In many such models, additional inflows of capital would
raise domestic investment and accumulation of physical capital,
spurring output growth. The higher investment would be associated
with deterioration in the current account—generating a negative
correlation with growth. If this is the expected scenario, finding a
positive correlation between current account balances and growth is
indeed quite puzzling. But a variety of alternative scenarios are also
plausible. Suppose the underlying shock is a demographic shift that162 Susan M. Collins
both reduces dependency rates and increases the share of the popula-
tion of labor force age. As noted in an earlier version of the paper, this
might raise both saving and output growth, resulting in a positive
correlation between growth and the current account. To the extent
that this channel has been important, we should not be surprised to
observe a positive correlation. Indeed, as discussed further below,
PRS’s regression results do show that most of the positive correlation
stems from a relationship between saving (not investment) and
growth. Furthermore, as they note, a number of studies have docu-
mented that faster GDP growth tends to raise saving. Ideally, a
structural estimation would more clearly specify the relevant linkages
and address the fundamental issues of simultaneity. 
In the current version of the paper, PRS highlight another possible
saving-related explanation for the positive correlation. In financially
underdeveloped economies, they suggest that productivity shocks
might raise output but cause consumers to save much of the increased
income, as financial impediments limit both profitable investment
opportunities and desired private consumption. While plausible, the
channel is highly speculative, and no direct evidence is provided to
show that the link between productivity shocks and saving depends
on financial development. PRS provocatively revisit this interpreta-
tion in the section on external imbalances.
A third possible explanation for the positive correlation comes from
the exports minus imports perspective. Suppose the shock is a policy
shift toward export promotion (possibly including avoidance of overval-
uation to maintain competitiveness). If successful, exports, and the
current account, should increase and stimulate faster output growth.
PRS find that overvaluation is associated with slower growth among
nonindustrialized countries, and that those nonindustrialized economies
actually receiving more capital inflows tended to have relatively overval-
ued exchange rates. Taken together, these findings do suggest this may
be a fruitful avenue for further examination. However, the link to (finan-
cial account and export promotion) policy choices of countries has yet
to be developed. PRS are unable to find significant evidence that policy
 Commentary 163
toward financial integration matters for either overvaluation or growth.
Indeed, available indicators of financial integration are not strongly
correlated with measures of actual flows among developing countries.
These are only some of the many channels that may have been
operating during the 1970-2000 period PRS examined. There are a
great many jointly determined variables, but, unfortunately, few
clearly exogenous variables to use as instruments, making it very diffi-
cult to tease out the relative importance of any particular hypothesis. 
The long time period studied in most of the analysis also may exac-
erbate the difficulties of uncovering the underlying relationships
between key variables. In particular, shorter periods (such as five-year
panels) would provide additional variation in country experiences that
may enable the authors to estimate the two-way linkages between
saving and growth that are buried in 30-year averages. The same is true
for studying overvaluation and growth, as countries may experience
both considerable overvaluation and undervaluation during different
decades. A short period of extreme overvaluation may have different
implications for growth than a long period of mild overvaluation, but
the two are observationally equivalent in the current formulation.
Saving, investment, and growth
Saving seems to be the driving force behind the positive relation-
ship between current accounts and growth that PRS uncover. The
regressions reported in Table 2 of the PRS paper show that including
saving (in a growth regression that already includes the current
account balance) adds more explanatory power than including invest-
ment. This finding is worth highlighting for at least two reasons.
First, it emphasizes the need for additional research to understand
saving in developing economies. Researchers continue to debate
reasons for the strong positive cross-country correlation between
growth and saving found in the data. As also noted by Gourinchas
and Jeanne, the finding that saving and growth are more highly corre-
lated than investment and growth makes it even more challenging to
develop a theory consistent with all relevant empirical facts.
 164 Susan M. Collins
Second, some may interpret the relatively small coefficient on
investment as suggesting that capital accumulation is unimportant
for growth. However, as discussed in more detail in Bosworth and
Collins (2003), a country’s average investment rate is only a good
proxy for the change in its capital stock in steady state. But a constant
capital-output ratio is clearly a weak assumption for developing coun-
tries, which are initially relatively capital poor. For a similar sample of
countries and time period to that used by PRS, we show that average
annual growth in the capital stock and average investment has a
surprisingly low correlation. This is primarily because a given invest-
ment rate will imply a much smaller capital stock change in a country
with zero (or negative) output growth than in one with growth that
is rapid and sustained. To illustrate the point, the adjusted R2 goes
from just 0.25 when we include the investment rate in a simple
growth regression to 0.67 when we substitute the change in the
capital stock. While saving and investment are clearly an appropriate
way to disaggregate the current account, investment should not be
taken as an indicator of the role of capital accumulation for growth.
Measuring financial integration 
As PRS appropriately highlight, the large number of available indi-
cators of financial integration raises a potentially confusing plethora
of alternative results. Their empirical strategy is to explore the range
of options, present representative results, and indicate cases in which
the results appear sensitive to choice of indicator. While this seems a
sensible approach for documenting patterns in the data, next stages in
the analyses would benefit from a closer look at what particular indi-
cators are intended to measure and how well they are able to do so.
Available indicators are typically divided into two broad groupings.
1
The first includes indicators of policy. In particular, the indices of
capital account restrictiveness constructed from International Mone-
tary Fund reports are widely used as providing annual data for a large
sample of countries over a long time period. However, these are rela-
tively simplistic, classifying policy as “open” or “closed” along a small
number of dimensions. This indicator is considered de jure, as itCommentary 165
makes no attempt to adjust for the extent of enforcement. The few
studies that construct more nuanced indicators of policy are typically
available for much smaller samples and time periods. Thus, it remains
unclear whether empirical analyses, such as the one undertaken here,
do not find indicators of financial openness to be robustly related to
economic growth because such policy restrictions really do not
matter—or because available indicators are simply not informative. 
The second group of indicators measures actual capital flows or
cumulated capital stocks. In addition to aggregate measures, one can
distinguish by type (FDI, equity, other portfolio, etc.) and look sepa-
rately at assets and liabilities. Many of these measures behave quite
differently across countries and over time, and perform quite differ-
ently in empirical analyses. Furthermore, unlike for the industrial
countries, de jure and actual financial integration measures are not
highly correlated for developing countries. 
Both of PRS’ preferred explanations for the positive current
accounts-growth correlation relate directly to international financial
integration. The hypothesis about avoiding overvaluation focuses on
the role of policy choice. And a growing literature argues that domestic
financial sector development is positively linked to financial integra-
tion—arguably including both actual flows and policy restrictions.
2
The apparent differences between FDI and other capital flows 
Unlike some other studies, PRS do not find a strong positive corre-
lation between FDI flows and economic growth. However, they do
note throughout their analysis that FDI behaves quite differently than
the current account balance and other indicators of financial integra-
tion. It is worth highlighting these differences in one place. First, net
importers of FDI (recipients) do tend to have lower per capita incomes
on average than net exporters. Second, during the period 1970-2004,
FDI flows to nonindustrial countries were concentrated among those
that grew most quickly. (However, this was not true during the rela-
tively short period 2000-2004.) And third, the ratio of FDI to GDP
does tend to rise during growth spurts. 
 166 Susan M. Collins
On the one hand, these findings suggest that rapidly growing coun-
tries do indeed have higher returns to capital, hence, their ability to
attract FDI. At the same time, they arguably shine a spotlight on the
puzzle as to why aggregate capital flows do not behave in a similar
fashion. Is domestic financial sector development less important for
FDI? Does domestic policy aimed at avoiding overvaluation tend to
encourage FDI relative to other inflows? Perhaps focusing on differ-
ences between FDI and other types of flows can help suggest fruitful
directions for further analysis. It also would be helpful to distinguish
between public versus private sector.
New economic geography?
This paper appears to provide an interesting contrast to the other
papers prepared for this conference. A unifying theme throughout that
work was the extremely rapid pace at which various global processes
appear to be changing. The authors of this paper highlight a puzzling
relationship among nonindustrial economies that is most pronounced
among the poorest countries. The evidence suggests that this positive
current accounts-growth correlation is nothing new and, indeed, may
have weakened somewhat among those countries that have developed
most. Instead of a “new geography,” is this a slowly dissipating vestige
of an old pattern that became more pronounced as the volume of inter-
national capital flows exploded? I look forward to the next phases of the
research to help us better understand this phenomenon.
In sum, the PRS paper presents a wealth of interesting and provoca-
tive facts and figures about the patterns of international capital flows.
However, the jury is still out regarding what we should conclude
about their implications for economic development. Commentary 167
References
Bosworth, Barry P., and Susan M. Collins. 2003. “The Empirics of Growth: An
Update,” Brookings Papers on Economic Activity, no. 2, 113-206.
Edison, Hali J., Michael W. Klein, Luca Antonio Ricci, and Torsten Slok. 2004.
“Capital Account Liberalization and Economic Performance: Survey and Synthe-
sis,” IMF Staff Papers, vol. 51, no. 2, 220-56.
Gourinchas, Pierre-Olivier, and Olivier Jeanne. 2006. “Capital Flows to Develop-
ing Countries: The Allocation Puzzle,” IMF draft, June 30, 2006.
Kose, M. Ayhan, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei. 2006. “Finan-
cial Globalization: A Reappraisal,” IMF Working Paper, June 2006.
Endnotes
1For example, see Edison and others (2004) and Kose and others (2006) for more
detailed discussions of alternative indicators of financial integration.
2Kose and others (2006) discusses this literature and provides references.
 

Capital Flows to Developing Countries: The Allocation Puzzle,” IMF draft,

Financial Globalization: A Reappraisal,”

Patterns of international capital flows and their implications for economic development : commentary

http://www.kansascityfed.org/Publicat/sympos/2006/PDF/12CollinsComment.pdf

Patterns of international capital flows and their implications for economic development : commentary

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