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Foreign Capital and Economic Growth

  • Prasad, Eswar


    (Cornell University)

  • Rajan, Raghuram G.


    (University of Chicago)

  • Subramanian, Arvind


    (Peterson Institute for International Economics)

We document the recent phenomenon of “uphill” flows of capital from nonindustrial to industrial countries and analyze whether this pattern of capital flows has hurt growth in nonindustrial economies that export capital. Surprisingly, we find that there is a positive correlation between current account balances and growth among nonindustrial countries, implying that a reduced reliance on foreign capital is associated with higher growth. This result is weaker when we use panel data rather than cross-sectional averages over long periods of time, but in no case do we find any evidence that an increase in foreign capital inflows directly boosts growth. What explains these results, which are contrary to the predictions of conventional theoretical models? We provide some evidence that even successful developing countries have limited absorptive capacity for foreign resources, either because their financial markets are underdeveloped, or because their economies are prone to overvaluation caused by rapid capital inflows.

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Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 3186.

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Length: 65 pages
Date of creation: Nov 2007
Date of revision:
Publication status: published in: Brookings Papers on Economic Activity, 2007 (1), 153-230
Handle: RePEc:iza:izadps:dp3186
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  1. Reuven Glick & Xueyan Guo & Michael Hutchison, 2005. "Currency crises, capital account liberalization, and selection bias," Working Paper Series 2004-15, Federal Reserve Bank of San Francisco.
  2. Menzie D. Chinn & Eswar S. Prasad, 2000. "Medium-Term Determinants of Current Accounts in Industrial and Developing Countries: An Empirical Exploration," NBER Working Papers 7581, National Bureau of Economic Research, Inc.
  3. Ben S. Bernanke & Refet S. Gurkaynak, 2001. "Is Growth Exogenous? Taking Mankiw, Romer and Weil Seriously," NBER Working Papers 8365, National Bureau of Economic Research, Inc.
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  14. Richard Blundell & Steve Bond, 1995. "Initial conditions and moment restrictions in dynamic panel data models," IFS Working Papers W95/17, Institute for Fiscal Studies.
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  16. Arellano, Manuel & Bond, Stephen, 1991. "Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations," Review of Economic Studies, Wiley Blackwell, vol. 58(2), pages 277-97, April.
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  18. Peter Blair Henry & Prakash Kannan, 2008. "Growth and Returns in Emerging Markets," NBER Chapters, in: International Financial Issues in the Pacific Rim: Global Imbalances, Financial Liberalization, and Exchange Rate Policy (NBER-EASE Volume 17), pages 241-265 National Bureau of Economic Research, Inc.
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