Appendix 1 for a discussion of the country groups. The dummy variable assumes a value of one if the economy belongs to a group and zero otherwise.<sup>5</sup>

# **Table 1. Explanatory** **<u>Variables and Expected Signs</u>**

|Symbol|Description of the explanatoryvariables|Expected sign|
|---|---|---|
|_lngdppci,t_|Logarithm of the initial level of real GDP per capita in 1985 US $ (measured in<br>purchasing power parity terms)|‒|
|_edui,t_||+|
||Educational attainment of the adult population over age 25 (average years of schooling)||
|_popgri,t_|Annual growth rate of country’s population|+ / ‒|
|_relpii,t_|<br>Relative price of investment|+|
|_toi,t_|<br>Trade openness (sum of exports and imports, in percent of GDP)|+ / ‒|
|_fci,t_|<br>Different measures of country’s reliance on foreign capital||
||_cabi,t_<br>Current account balance (in percent of GDP)|+ / ‒|
||<br>_nfai,t_<br>Net foreign assets (in percent of GDP)|+ / ‒|
|_agedepi,t_|<br>Age dependency ratio [ (0-14 and 65+) / 15-64 ]|‒|
|_gnsi,t_|<br>Gross national saving (in percent of GDP)|+|
|_invi,t_|Gross capital formation (in percent of GDP)|+|

Note: ―+‖ indicates a positive relationship, ―‒‖ a negative relationship, and zero denotes a theoretically ambiguous relationship with the dependent variable.

In order to investigate the consistency of the empirical results, the baseline regression is amended with two control variables: gross capital formation and gross national saving, both expressed as a percentage of a country’s GDP. This enables us to understand the channels through which foreign capital affects growth. Due to the simultaneity problem, the investment and saving rates and the current account balances are treated as endogenous variables in the system GMM model. In addition, we explore the role of financial depth and financial frictions by adding threshold effects. Finally, recognizing that the crisis had a severe negative impact on emerging Europe’s growth, we revise the sample by excluding countries that are deemed to have had unusually large external imbalances that ended in sharp reversals in GDP and conclude that foreign savings and growth link is indeed robust in a subset of emerging European countries.

# **4. Economic Growth and Foreign Capital Inflows**

# _<u>A Flow Perspective</u>_

The estimation results from the baseline growth regression are presented in Table 2. The estimated coefficients on income per capita are statistically significant at the 1 percent level and reveal strong and consistent impact on growth.<sup>6</sup> In line with the beta-convergence hypothesis, the initial per capita income is negatively and strongly correlated with the rate of economic growth. More precisely, a lower initial GDP per capita by 10 percent will, on average, lead to 0.23 percentage points higher rate of GDP per capita growth (other things being equal). Given the

> 5 In specifications not reported we also include dummy variables for other regional groups; these are not statistically significant and are excluded from the more parsimonious specification described in this paper.

> 6 The diagnostic tests for residual autocorrelation indicate that in all empirical specifications, the null hypothesis of _m1_ statistic (no first-order autocorrelation in the differenced error terms) is decisively rejected, whereas the _m2_ statistic provides insufficient evidence to reject the hypothesis of no second-order autocorrelation in the differenced error terms. As presented in Table 2, the Hansen test of over identifying restrictions conducted on the second-step estimators, which considers whether the instruments are uncorrelated with the error term, provides no evidence to reject the null hypothesis that the instruments used are valid.

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