or less effective. One relates to the existence of ―thresholds in financial development‖ that improve the flow and quality of information and enhance a country’s absorptive capacity (Blanchard and Giavazzi, 2002). Another relates to the existence of ―financial friction‖ and how this impacts intermediation. These frictions might be linked to institutional developments.

# **Table 5. How is Foreign Savings Supporting Growth? Investment Opportunities versus** **<u>Savings Substitutions</u>**

|_Growth regressions_<br>||Dependent var<br>growth of rea<br>|iable i<br>l GD|s four-ye<br>Pper capi<br>|ar average<br>ta(PPP)<br>|
|---|---|---|---|---|---|
|_Explanatory variable_|[1]|[2]||[3]|[4]|
|Log of initial GDP per capita<sup>[A]</sup>|-2.303|-2.291||-2.121|-2.199|
||[0.425]|*** [0.428]|***|[0.407]|*** [0.527] ***|
|Educational attainment of population above|0.479|0.492||0.455|0.424|
|25 years of age|[0.114]|*** [0.113]|***|[0.140]|*** [0.154] ***|
|Population growth|-0.339|-0.327||-0.427|-0.379|
||[0.141]|** [0.140]|**|[0.177]|**<br>[0.152] **|
|Relative price of investment|0.001|-0.035||-0.514|-0.742|
||[0.561]|[0.573]||[0.773]|[0.883]|
|Trade openness (in percent of GDP)|0.011|0.011||0.000|0.002|
||[0.003]|*** [0.003]|***|[0.004]|[0.004]|
|Current account balance; in percent of GDP,|0.044|0.047||0.079|-0.107|
|four-year averages (CAB)|[0.053]|[0.053]||[0.061]|[0.071]|
|EU-10 country dummy x CAB|-0.245|||||
||[0.101]|**||||
|EU candidates country dummy x CAB|-0.124|||||
||[0.062]|**||||
|EU 10 and EU candidate dummy x CAB||-0.165||-0.085|-0.141|
|||[0.077]|**|[0.059]|[0.062] **|
|EU neighborhood country dummy x CAB|0.485|0.471||0.495|0.445|
||[0.135]|*** [0.130]|***|[0.178]|*** [0.129] ***|
|Gross capital formation (in percent of GDP, four-year averages)||||0.318<br>[0.068]|***|
|Gross national saving (in percent of GDP, four-year averages)|||||0.228<br>[0.066] ***|
|Number of observations|584|584||584|584|
|Number of countries|88|88||88|88|
|Number of instruments|45|40||49|49|
|Hansen test for over-identifying restrictions|0.204|0.204||0.188|0.062[B]|
|Arellano-Bond AR(1) test (p-value)|0.000|0.000<br>||0.000|0.000|
|Arellano-Bond AR(2)test(p-value)|0.769|0.725||0.680|0.937|

Notes:<sup>[A]</sup> GDP data are adjusted for international differences in purchasing power of the dollar.<sup>[B]</sup> When the p-value of the Hansen test is a borderline case, the instruments are further validated by the supplementary evidence from the Sargan test of the over-identifying restrictions. Robust standard errors in parentheses; asterisks indicate statistical significance at the ***1, **5, and *10 percent level. Data for the transition economies refer only from 1997 onwards. All equations include time period and group-specific dummies.

The next step, therefore, is to assess the role of financial development and financial frictions. Financial development is examined by adding indicators of financial depth into a growth equation and exploring their impact on the underlying foreign savings-growth link among the EU-specific country groups we have highlighted throughout this paper. The assumption is that only after a certain threshold of financial depth is reached are foreign savings good for growth. More precisely, once such a threshold has been exceeded, EU-specific foreign savings for the EU10 and EU candidate countries should no longer be important. If such thresholds do not exist, however, it might then be the case that financial frictions are more important. In other words, it may be institutional development what makes the effective use of foreign savings possible. Again, if thresholds in indicators of financial frictions are included, then this should 18