The time path of productivity convergence and the international allocation of capital

Can cross-country heterogeneity in the time path of technological convergence account for observed allocation of international capital? The time path of technological convergence varies significantly across countries, whereas previous studies assume a common cross-country convergence path and one that is linear. We show that the time path of a country’s technological convergence has important implications for the predicted size of capital inflows from the rest of the world. Accounting for this observed heterogeneity accounts for around 20 percent of the puzzling allocation of capital across developing economies relative to neoclassical predictions, without the introduction of additional distortions common in the existing literature. Cross country differences in convergence paths are not powerful enough to account for capital outflows observed in particularly fast-growing Asian economies, but go a long way in explaining why the fastest developing and converging economies are not receiving capital inflows in the magnitude predicted by the standard neoclassical model.