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International Monetary Fund. Research Dept.
Do highly indebted countries suffer from a debt overhang? Can debt relief foster their growth rates? To answer these important questions, this article looks at how the debt-growth relation varies with indebtedness levels, as well as with the quality of policies and institutions, in a panel of developing countries. The main findings are that, in countries with good policies and institutions, there is evidence of debt overhang when the net present value of debt rises above 20–25 percent of GDP; however, debt becomes irrelevant above 70–80 percent. In countries with bad policies and institutions, thresholds appear to be lower, but the evidence of debt overhang is weaker and we cannot rule out that debt is always irrelevant. Indeed, in such countries, as well as in countries with high indebtedness levels, investment does not depend on debt levels. The analysis suggests that not all countries are likely to profit from debt relief, and thus that a one-size-fits-all debt relief approach might not be the most appropriate one.
Suparna Chakraborty and Mr. Robert Dekle

This paper builds a two-country model with differential productivity and financial frictions to quantitatively account for the recent increase in the U.S. current account deficit. An influential literature says that as U.S. productivity surged, capital was attracted to the United States to take advantage of the high returns to investment. We show, however, that when we include emerging Asia, the gap in productivity growth between the United States and the rest of the world cannot explain the U.S. current account deficits, especially since 2000. This is because on a gross domestic product-weighted basis, the rest of the world actually had higher productivity growth during this period; and standard macroeconomic models would predict an outflow of funds from the United States to the rest of the world, and a consequent narrowing of the U.S. current account deficit. This paper shows that greater financial integration abroad can explain this anomaly. However, we still cannot explain why U.S. per capita output growth has been so low, despite the large inflow of capital.

Goohoon Kwon, Lavern Mcfarlane, and Wayne Robinson

This paper provides comprehensive empirical evidence that supports the predictions of Sargent and Wallace’s “unpleasant monetarist arithmetic” that an increase in public debt is typically inflationary in countries with large public debt. Drawing on an extensive panel data set, we find that the relationship holds strongly in indebted developing countries, weakly in other developing countries, and generally does not hold in developed economies. These results are robust to the inclusion of other variables, corrections for endogeneity biases, relaxation of common-slope restrictions, and are invariant over subsample periods. We estimate a vector autoregression to trace out the transmission channel and find the impulse responses consistent with the predictions of a forward-looking model of inflation. Wealth effects of public debt could also affect inflation, as posited by the fiscal theory of the price level, but we do not find supportive evidence. The results suggest that the risk of a debt-inflation trap is significant in highly indebted countries and pure money-based stabilization is unlikely to be effective over the medium term. Our findings stress the importance of institutional and structural factors in the link between fiscal policy and inflation.

Mr. Andreas Billmeier and Tommaso Nannicini

Studies of the impact of trade openness on growth are based either on crosscountry analysis—which lacks transparency—or case studies—which lack statistical rigor. This paper applies a transparent econometric method drawn from the treatment evaluation literature (matching estimators) to make the comparison between treated (that is, open) and control (that is, closed) countries explicit while remaining within a statistical framework. Matching estimators highlight that common cross-country evidence is based on rather far-fetched country comparisons, which stem from the lack of common support of treated and control countries in the covariate space. The paper therefore advocates paying more attention to appropriate sample restriction in crosscountry macro research.

International Monetary Fund. Research Dept.
China’s growth performance since the start of economic reforms in 1978 has been impressive, but the gains have not been distributed equally across provinces. We use a nonparametric approach to analyze the variation in labor productivity growth across China’s provinces. This approach imposes less structure on the data than the standard growth accounting framework and allows for a breakdown of labor productivity into efficiency gains, technological progress, and capital deepening. We have the following results. First, we find that on average capital deepening accounts for about 75 percent of total labor productivity growth, while efficiency and technological improvements account for about 7 and 18 percent, respectively. Second, technical change is not neutral. Third, whereas improvement in efficiency contributes to convergence in labor productivity between provinces, technical change contributes to productivity disparity across provinces. Finally, we find that foreign direct investment has a positive and significant effect on efficiency growth and technical progress.
M. Ayhan Kose, Mr. Eswar S Prasad, Mr. Kenneth Rogoff, and Shang-Jin Wei

The literature on the benefits and costs of financial globalization for developing countries has exploded in recent years, but along many disparate channels with a variety of apparently conflicting results. There is still little robust evidence of the growth benefits of broad capital account liberalization, but a number of recent papers in the finance literature report that equity market liberalizations do significantly boost growth. Similarly, evidence based on microeconomic (firm- or industry-level) data shows some benefits of financial integration and the distortionary effects of capital controls, but the macroeconomic evidence remains inconclusive. At the same time, some studies argue that financial globalization enhances macroeconomic stability in developing countries, but others argue the opposite. This paper attempts to provide a unified conceptual framework for organizing this vast and growing literature, particularly emphasizing recent approaches to measuring the catalytic and indirect benefits to financial globalization. Indeed, it argues that the indirect effects of financial globalization on financial sector development, institutions, governance, and macroeconomic stability are likely to be far more important than any direct impact via capital accumulation or portfolio diversification. This perspective explains the failure of research based on cross-country growth regressions to find the expected positive effects of financial globalization and points to newer approaches that are potentially more useful and convincing.