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Ashoka Mody is in the International Monetary Fund’s Research Department and Antu Panini Murshid is with the Economics Department at the University of Wisconsin, Milwaukee. This paper was initiated as background to Chapter 3 of the World Bank, Global Development Finance, 2001and was completed while Murshid was visiting the International Monetary Fund. Special thanks go to Barry Bosworth, Peter Clark, Susan Collins, Simon Evenett, and Deepak Mishra. The authors are grateful also to Charles Blitzer, Menzie Chinn, William Easterly, Barry Eichengreen, Ross Levine, Homi Kharas, Alexander Lehmann, Frederick Mishkin, Sergio Schmukler, Luis Serven, and Antonio Spilimbergo for their valuable comments.
For instance, Blomstrom et. al. (1994), find that higher-income countries gain more from capital flows than poor countries, and similarly Edwards (2000) finds that measures of a country’s capital account liberalization are negligibly (or even negatively) related to growth in low-income countries but that the relationship turns positive as income levels increase. Borensztein et. al. (1998) conclude that FDI is positively associated with growth, but only where human capital is sufficiently high.
For instance, Mody and Negishi (2001), report sharp increases in cross-border M&A in East Asia between 1996 and 2000; a reflection of recent trends in foreign-entry into the service sector. As a consequence, mergers and acquisitions have accounted for an increasing share of foreign direct investment flows to East Asia, rising from 6 percent in 1995 to 30 percent by 1999.
Although the link between foreign capital and domestic investment may weaken as capital mobility increases, the nature of the investment (and hence implications for growth) is also likely to evolve. Obstfeld (1994) argues that greater capital mobility allows for greater risk sharing and hence permits a shift from low risk, low return, to higher risk, higher return activities. This shift, in turn, raises growth prospects. Thus, while a unit of foreign capital may do less for raising the level of investment, it may change the composition of investment with significant long-term benefits. Some, however, would argue that the higher risk investments might not be growth enhancing where the “risk” can be transferred to governments through implicit guarantees.
“Outflows” include errors and omissions.
Another recent study by Greene (2002) utilizes fixed-effects regressions to examine the effect of capital flows reversals on investment. The results of that study suggest a positive short-term relationship between private capital flows and investment. In addition, Greene finds private capital flows and investment to be co-integrated, suggesting the possibility of a long-term relationship as well.
Another very different approach has sidestepped the endogeneity issue altogether by focusing, not on the impact of capital flows on investment or growth, but on the impact of capital account liberalization instead (e.g., Grilli and Milesi-Ferretti 1995, Rodrik 1998, Edwards 2000, and Eichengreen and Arteta 2001). Although such analyses are less susceptible to endogeneity, they are silent as to the magnitude of the impact that capital flows have on various macroeconomic aggregates, such as investment.
Moreover, independently of issues arising through multicolinearity, the standard fixed effects estimator is biased when lagged dependent variables are included in the specification (see Nickell 1981, and Anderson and Hsiao, 1982), although the size of this bias decreases with the number of time periods.
This is the opposite of the convention sometimes used of treating a one as a restriction and a zero as the lack of restrictions.
A weighted two stage least squares estimator, which allowed for group- heteroscedasticity, yielded similar results to those reported in Table 5. A test of over- identifying restrictions was used to test the joint-exogeneity of our matrix of instruments. Using only the lagged values of capital flows as an instrument, we first estimated the errors in the capital flows-investment relationship; these errors were then regressed against our matrix of instruments and the uncentered R-squared from this regression was used to construct the appropriate chi-square test. These tests confirmed the validity of our instruments.
Due to the small number of cross-sections from the Middle East and North Africa (MENA) region, we combine the MENA countries, in our sample, with the Sub-Saharan African (SSA) nations.
Thus, for East Asia between 1990 and 1994, of the $73 billion of inflows, $19 billion went to augmenting reserves and $39.5 billion were outflows (including errors and omissions); thus, almost 5 out of 6 dollars of inflows augmented reserves or left the countries rather than increasing domestic consumption or investment. Between, 1995 and 1998, capital inflows jumped to over $120 billion but during that period, East Asia ran a current account surplus! For Latin America, just over half the inflows went into reserves or left as outflows.
It is worth noting that the problem of reverse causality is a positive function of the degree of financial openness, since shocks to investment are more likely to affect capital flows when capital is more mobile. However, this reverse causality from investment to capital flows would tend to bias our estimates upward. That we observe a weaker relationship in regions which are more financial integrated then only strengthens our conclusion that the role of capital flows in boosting domestic investment is negatively related to the degree of financial integration.
This would be the case for reasons suggested by Feldstein (1994), namely, that increasing integration could lead to more offsetting flows. In addition, as noted, the nature of FDI has also evolved over time to incorporate less of “greenfield” investment projects and more “mergers and acquisitions” that do not imply immediate new investment. Of course, this transition in the form of FDI could be seen as a broader process of financial market integration that goes beyond opening borders and includes a deeper integration of asset markets.