metadata: authors: 0: author: Fry, Maxwell J.
1: author: Claessens,Constantijn A.
2: author: Burridg
count: World
docna: 0: docna: Foreign direct investment, other capital
            flows, and current account deficits : what causes what?
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Investment and Investment Climate,Industrial Economics,Economic Growth,Macroeconomic Management
teratopic: Finance and Financial Sector Development
abstracts: cdata!: This paper is part of a larger effort to
            study the determinants and impact of foreign direct
            investment.  The authors examine flows of foreign direct
            investment to 46 developing countries to test whether such
            flows are autonomous or accommodating vis-a-vis the current
            account and other capital flows.  Using Granger-casualty
            tests, they find that: 1) requirements to surrender exports
            proceeds to the monetary authorities and the existence of
            special exchange rates for some capital account transactions
            reduce the probability that foreign direct investment is
            independent; 2) the more liberal a country's foreign
            exchange system, the more foreign direct investment is
            likely to be independent or exogenous; and 3) foreign direct
            investment is associated with a larger increase in capital
            formation when it is independent than when it is
            Granger-caused by other capital flows.
repnme: repnme: Foreign direct investment, other capital
            flows, and current account deficits : what causes what?
display_title: Foreign direct investment, other
            capital flows, and current account deficits : what causes what
listing_relative_url: /research/1995/10/696997/foreign-direct-investment-other-capital-flows-current-account-deficits-causes
topicv3: Economic Growth m1326241 471,Capital Account m1326277 1134,Current Account m1326278 1135,Balance of Payments m1326965 441,Investment Entry m1504647 2544
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Development Data Group (DECDG)
no_of_pages: 56
model_extractions: **Poi** F A **RESEARCH** W(ORKING PAI'I **K** 15 27

# **Summary findings**

FrvC Claessens, Burridge, and Blanchet examine flows of foreign direct investilicim t to 46 developing countries to test whethler **SucIh** flows are aLutollonOtLIs or accomimillodating _uis-di-vis_ the current account and othetr capital flows, sinig Granger-causality tests, they find that: Requiremlients to surrender export proceeds to the monetarv authlorities and the existence of special exchanige rates for some capital accouLnt transactions reducc the probability that foreign direct investmient is indepenidenr.

_*_ The more liberal a countrv's forteigo exchange ssten, the more foreigni direct investmiienit is likely to bh independenit or exogenious.

Foreign direct investimient is associated witrh a larger increase in capital formation wvhen it is independenit than when it is Granger-caused bv other capital flows.

This paper -a product of the Debt and International Finance Division, Internationial Economics Departiielt - is part of a larger effort **in** the department to study thEt determinanitsand impact of foreign direct investnment. The studyv wvas funded by the Bank's Researchi Support Budget under the researclh project "Foreign Direct Investment in a Mlacroeconomici Framework" (RPO 678-15). Copies of this paper are available free fromi the World Bank, 1818 H StreetrNWV Washington, DC 20433. Please contact Rose _Vo,_ room N3-046, telephone 202-473-3722, fax 202-522-3277, Internet addreFx hvo l **(t** aworldbank.org. October 1995. (21 pages) _1hc 'olicv Research_ **_Wo(_** _Vrking Paper Series disseminates the_ **_firndings_** _)f fwork in progress to_ **_encourage_** _the exchange of/ ideas_ **_aib,aiii_** _|devLelo pmi')t issules. Anohsibectiu'e of the series is to get the findings out quiclGkly, even/ if the presentaltion(s are less thano hfully p,d5ishe._ 1 _/'t papers earn' the names of the authors and should be_ **_tIsed and_** _cited accordingly. The findings, interpretations, and coniclusitits_ **_ale'_** _thoe authors_ **_own antd_** _should_ **_niot bIe_** _attributed to the World_ **_Bank,_** _its Executive Board of Dir ctors, or anPly of its_ **_iember_** _be_ **_,,tunct_** _tes._

Jiroduicedj by the Policy kRsearclh Disseminiation Center
# Foreign Direct Investment, Other Capital Flows and Current Account Deficits: What Causes What?

MAXWELL J. FRY, STIJN A. CLAESSENS, PETER BURRIDGE, AND MARIE-CHRISTINE BLANCHET* _University of Birmingham, World Bank, University of Birmingham, University of Birmingham_ _JEL_ Classifications: F21, F32, 05. Key words: foreign direct investment, current account deficits.

'This paper was written for the International Economics Department of the World Bank under the World Bank's Research Support Budget RPO-678-15. The views expressed in this paper do not necessarily reflect those of the World Bank, its Board of Directors, its management, or any of its member countries. _EViews,_ version 1.0, and _MicroTSP,_ version 7.0, were used for all the regressions presented in this paper.
I
1

# 1 Introduction

Foreign capital inflows to developing countries constitute part of the world's saving. Over the past two decades, world saving as a proportion of world income has fallen. As world saving has shrunk, so the real interest rate measured in terms of U.S. dollar interest and inflation rates has risen from 0.8 per cent during the period 1971-1978 to 4.8 per cent in the period 1981-1991 _(International Financial Statistics,_ CD-ROM, September 1994).' It is against this background that foreign direct investment **(FDI)** has appeared increasingly attractive to developing countries facing declining domestic investment and higher costs of foreign borrowing. Foreign direct investment seems an attractive form of capital inflow because it involves a risk-sharing relationship with the suppliers of this type of foreign capital. This kind of risk sharing does not exist in the formal contractual arrangements for foreign loans. Furthermore, as the World Bank (1993, 3) claims, there may be dynamic benefits: "Foreign direct investment is a large and growing source of finance that may help developing countries close the technology gap with high-income countries, upgrade managerial skills, and develop their export markets." Globally, FDI has increased dramatically over.the past decade. However, most of this increase has occurred in the industrial countries. In the developing countries, **FDI** has been heavily concentrated among a small number of countries; over 90 per cent of **FDI** inflows to developing countries in 1990 was received by only 18 countries. Half of this total flowed to eight Pacific Basin developing market economies (Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand). Given that neither Korea nor Taiwan has shown strong interest in attracting **FDI,** it may seem surprising that these economies feature in this group of developing countries. Their appearance in this list may support the view that explicit incentive packages are not the key determinants of **FDI** flows.

In undertaking any analysis of FDI, one must recognize that **FDI** data record financial flows which may or may not correspond to changes in capital formation. Whether or not they do depends on (a) the extent of substitutability of this type of financial flow for other types of financial flows and (b) the extent to which **FDI** crowds out domestically financed 'The **real interest rate is proxied here by the London interbank offered rate on U.S. dollar deposits adjusted for the percentage change in the** U.S. **GDP deflator. During the period 1992-1995, this real interest rate averaged only** 1.5 **percent,** but **has** been **rising rapidly since** 1993 **_(World_ Economic** **_Outlook,_ May** 1994, **177):**
2 investment. In some of the literature, the view prevails that FDI can serve two purposes, namely, raise investment and relieve foreign exchange shortages.<sup>2</sup> Unless FDI. affects national saving, however, it can raise domestic investment or provide additional financing for a preexisting current account deficit or achieve some combination of the two, but these two effects must always sum to one. In other words, if $100 FDI increases capital formation by only $75, it would provide $25 for additional current-account financing. If it simply substitutes for an alternative type of capital inflow, however, FDI neither raises capital formation nor does it provide additional current-account financing.

This study examines the question of whether FDI to a sample of developing countries substitutes for other capital flows, increases capital formation, or provides additional foreign exchange for balance-of-payments support. Using James Meade's (1951) distinction between autonomous and accommodating capital flows, Philip Turner (1991, 91-95) addresses the question of whether or not net FDI flows are accommodating and hence constitute additional balance-of-payments financing by regressing components of the capital account on the current account financing requirement (both in first differences) for some OECD countries.

Turner's estimated equation takes the form: _AKFi = ao + a, AKFR,_ where AKFi is the year-on-year change in the net capital flow item expressed as a percentage of _GNP_ and _AKFR_ is the year-on-year change in the current account minus changes in official reserves also expressed as a percentage of GNP (both in current prices). Turner (1991, 92) finds that short-term bank flows are significantly correlated with the current account financing requirement with coefficients ranging from 0.27 (United Kingdom) to 0.88 (Canada) for seven of the 10 OECD countries. In the case of FDI, however, Turner concludes that this flow is much closer to being autonomous than accommodating; the coefficient is significant only in the case of France with a value of only 0.13.

Using Turner's. methodology with annual data on net capital flows from _International Financial Statistics_ CD-ROM for a sample of 16 developing countries<sup>3</sup> for the period 1975-

> 2For example, Laurence Cockcroft and Roger Riddell (1991, 3) note: "Two of the principal factors inhibiting higher levels of economic growth in Sub-Saharan Africa in the 1990s are low levels of investment and foreign exchange shortages. The first attraction of foreign investment lies in its potential to address both these constraints."

3 Argentina, Brazil, Chile, Egypt, India, Indonesia, Korea, Malaysia, Mexico, Nigeria, Pakistan, the Philip-
3 1990, Fry (1993, 13). finds a rather different response pattern in developing countries. In contrast to the OECD countries, other long-term capital flows appear to be just as sensitive to current account financing requirements as short-term flows in this sample of developing countries. For these countries, therefore, one might rank portfolio investment as the most autonomous, FDI or capital inflows to the public sector next, and both long- and short-term bank loans as the most accommodative type of capital flow.

All but one of the estimated coefficients for FDI are less than 0.1. Even in the case where FDI is most accommodative (Malaysia), the coefficient is still only 0.14. On the basis of these estimates, therefore, **FDI** appears to be autonomous on Turner's criterion. The negative coefficients of FDI in India and Korea (Fry 1993, 13), and in the United Kingdom (Turner 1991, 92) may reflect the deterrent effect of increasing current account deficits on FDI inflows, since large current account deficits can worsen a country's investment climate. This would also support the view that FDI inflows are largely unrelated to balance-of-payments financing requirements. However, it does suggest that FDI should be treated as endogenous to a country's saving-investment process.

Unfortunately, Turner's technique is seriously flawed. First, with enough substitutability between alternative types of capital inflows, there may be no bivariate correlation between' any of the components and the overall current account financing requirement. Indeed, Fry's (1993, 13) results indicate that this is the case for Egypt, Nigeria, and. the Philippines. Out of 80 regressions, only 12 yield significant coefficients at the 95 per cent confidence level. Fry's findings support Michael Dooley's (1990, 75) assertion that financial flow variables such as FDI have far too high degrees of substitutability to provide any useful analytical information. Second, the bivariate regressions fail to establish causality. To explore these issues, this paper presents Granger-causality tests to examine not only the direction of causation between current and capital account imbalances but also between current account and three components of the capital account, **FDI,** portfolio investment **(Pi),** and other capital flows (OKF). Whether or not substitutability and fungibility are so high that **FDI** flows provide no relevant economic information at all is an empirical question.

**pines,** Sri Lanka, **Thailand, Turkey, and Venezuela.**
4

# 2 Granger-Causality

# in the Balance of Payments

Our first question is whether current account-imbalances Granger-cause capital account imbalances or _vice versa._ To answer this question, we use an error-correction model (ECM) with one lag. For the long-run analysis conducted here, we ignore errors and omissions in the balance-of-payments accounts and assume that the desired level of international reserves is zero. Hence, the balance of payments on current account is equal and opposite to the balance of payments on capital account. Since changes in international reserves are a disequilibrium phenomenon, we use them as an error-correction term.

So that all countries can be treated in a uniform manner, we assume that international reserves are stationary with a constant long-run equilibrium ratio to GNP. Hence, the previous period's reserve balance can be treated as the disequilibrium term in an ECM of the form: where _CA_ is the current account and _KA_ is the capital account. The term CAt.. + KAt-1, the lagged change in official reserves, is the error-correction mechanism. The rationale is that, if there are co-movements in _CA_ and _KA,_ they should be equilibrating in the long run.<sup>4</sup> This leads to a causality test based on the significance of either the coefficient _b_ or the coefficients _dj._ When _KA_ is substituted for _CA_ as the dependent variable, the relevant coefficients are _b_ and ci.

We faced a choice between examining quarterly data for a small sample or annual data for a larger sample of developing countries. From a total of 115 developing countries for which some balance-of-payments data were available, we selected an initial sample of 75 developing countries that had experienced FDI inflows of at least half a percent of GNP for at least five years over the period 1970-1992. Data deficiencies reduced this sample to 46 countries with annual data and only 14 countries with quarterly data. We chose the larger country sample, 4 Peter Montiel (1994, 329) makes a similar point about the relationship between national saving, domestic investment, and the current account: "The current account provides the resources with which a country repays its external creditors. Solvency thus imposes a constraint that prevents deviations between national saving and investment from becoming permanent. Because gaps between saving and investment must eventually be reversed for the country to remain solvent, sufficient observations should show these two series to be cointegrated." **In** this case, the lagged current account is the error-correction mechanism that equilibrates saving and investment in the long run.
5 Table 1: Granger-Causality Tests for Current (CA) and Capital (KA) Accounts, 1970-1992.

|_KA_Causes_CA_<br>_CAUSKC_|_CA_Causes_KA_<br>_CAUSCK_|Neither<br>_CAUSN_|
|---|---|---|
|Algeria|Algeria|Bolivia|
|Argentina|Honduras|Barbados|
|Brazil|Indonesia|Chile|
|Costa Rica|Korea|C6te d'Ivoire|
|Greece|Malta|Colombia|
|Kenya|Mexico|Ecuador|
|Malta|Panama|Egypt|
|Mauritius|Portugal|El Salvador|
|Paraguay|Rwanda|Guatemala|
|Peru|Singapore|Jamaica|
|Philippines|Turkey|Malawi|
|Rwanda|Uruguay|Malaysia|
|Singapore||Niger|
|Swaziland||Nigeria|
|Thailand||Saudi Arabia|
|Tunisia||Sierra Leone|
|Venezuela||South Africa|
|||Suriname|
|||Togo.|
|||Trinidad and Tobago<br>Zambia|

which meant that a wider search for possible **ECM** forms was not feasible. For the same reason, we use only one lag for _n ciACAt-._ and Ej1_1 _diAKAt-j._ In other words, we set both i and j equal to one.

Table 1 shows the results of the initial Granger-causality tests between the current and capital account over the period 1970-1992. Both variables are expressed as proportions of GNP. The capital account Granger-causes current account imbalances in 13 countries and
6 we detect the opposite direction of causation in eight countries. In four countries Grangercausation goes both ways, while no causality is detected in the remaining 21 countries.

The second question we address here is whether disaggregated capital flows are interdependent or independent. Interdependence means that one or more other capital flows Granger-cause this particular capital flow. Independence means that neither of the other capital flows exerts any causal influence. If the capital account Granger-causes the current account, all three capital flows may be independent and hence could Granger-cause the current account imbalance. However, it is also possible that high substitutability ensures that all three capital flows are interdependent and that no individual capital flow Granger-causes the current account imbalance. There are six additional possibilities: any one of the three capital flows may be independent or two capital flows in any of the three combinations may be independent. Hence, eight different Granger-causality results can occur among the components if the capital account Granger-causes the current account. If the current account Granger-causes the capital account, the same eight results are possible. The current account imbalance may influence all. three flows, two flows, one flow, or no individual flow at all because of high substitutability. In other words, all capital flows or no capital flow can be independent.

In testing for causality within and between components of _CA_ and _KA,_ there is no natural measure of disequilibrium. Hence, we adopt a forrm of the procedure advocated by Cheng Hsiao (1979), and elaborated by Mitsuhiro Odaki (1986) and Edward Chartey (1993). Using the finding by Jean-Pierre Urbairi (1989) that the Schwartz information criterion performs relatively. well in small samples, we use it to determine lag length in the Hsiao procedure described below.

First, we test all component series for unit roots. If either y or x were found to be nonstationary, we employ the Hsiao procedure using the appropriate level of differencing. The Hsiao procedure starts by assuming a maximum possible order **_Pmax_** for the unrestricted VAR linking the variables under investigation; we chose **P,,,a,** = 4. Univariate _AR(p)_ models, _p= 1, ... ,_ **_Pmax_** are then fitted to y; the lag length pY that minimizes the chosen information criterion is selected. This minimized value is denoted _SBCy(py,O)._ Now lags _p2_ of the variable x that could be causal are added in sequence up to lag py. If the minimum of the corresponding _SBCyr(pI,px)_ lies below **_SBCy(py,0),_** we conclude that x causes y since the optimum model for predicting y contains **pY** lags of y and pX _>_ 0 lags of x.
7 This procedure can be generalized to more than two variables to control for covariates as advocated by Ghartey (1993). However, constraints on degrees of freedom prevent us from testing a multivariate model. Hence, the results reported below in Table 2 and Appendix A-1 and A-2 are based on bivariate equations only.

Table 2 shows the key part of the second-stage estimation results concerning FDI; the full results are presented in Appendix A-1. Even where the capital account Granger-causes the current account, all three capital flows are interdependent in four countries (Argentina, Brazil, Peru, and Venezuela). Conversely, all three capital flows are independent in Indonesia, where the current account Granger-causes the capital account. Of central relevance to this study is the finding that FDI iS independent of other capital flows in 20 of the 46 countries.

The third question is whether or not there is any Granger-causality between one of the disaggregated capital flows-FDI, Pi, and OKF-and the current account or _vice versa._ Countries with no Granger-causation between current and capital accounts are excluded. For countries with Granger-causation running from the capital account to the current account, we test Granger-causality from each capital flow to the current account. For countries with Granger-causation running from the current account to the capital account, we test Grangercausality from the current account to each capital flow. Finally, for countries with bidirectional Granger-causality, we run combined tests of Granger-causality from and to each capital flow to and from the current account. The full results are presented in Appendix A-2. They show that FDI Granger-causes the current account in seven countries (Algeria, Brazil, Costa Rica, Peru, Rwanda, Singapore, and Venezuela) and is Granger-caused by the current account in four countries (Algeria, Malta, Panama,. and Rwanda).

# 3 Explaining Causality Results

The results reported in Tables 1 and 2 display no evident patterns or country groupings. A cursory inspection indicates that these classifications bear no relation to either location or per capita income. However, there may be some feature or features of a country's economy, specifically of its balance-of-payments regime, that are associated with particular causal patterns. To investigate such possibilities, we ran logit and probit regressions to explain the causal variables. The four dependent variables we examine are _CA USKC_ for the capital account Granger-causing the current account, _CAUSCK_ for the current account Grangercausing the capital account, _CA USN_ for no Granger-causation between the capital and current
8 Table 2: Independent and Interdependent Foreign Direct Investment.

|FDI Independent|FDI Interdependent|
|---|---|
|Colombia|Algeria|
|C6te d'Ivoire|Argentina|
|Greece|Barbados|
|Guatemala|Bolivia|
|Honduras|Brazil|
|Indonesia|Chile|
|Kenya|Costa Rica|
|Malta<br>'|Ecuador|
|Mexico|Egypt|
|Nigeria|El Salvador|
|Panama|Jamaica|
|Paraguay|Korea|
|Philippines|Malawi|
|Saudi Arabia|Malaysia|
|Suriname|Mauritius|
|Swaziland<br>.|Niger|
|Thailand|Peru'|
|Tunisia|Portugal|
|Uruguay|.Rwanda|
|Zambia,|Sierra Leone|
||Singapore|
||South Africa|
||Togo|
||Trinidad and Tobago|
||Turkey<br>Venezuela|
9 Table 3: Potential Explanatory Variables for Direction of Balance-of-Payments Causation.

|_RESC_|_-_|Article XIV status|
|---|---|---|
|_RESD_|-|Special rates for some or all capital transactions and/or some or all invisibles|
|_RESE_|-|More than one exchange rate for imports|
|_RESF_|-|More than one exchange rate for exports|
|_RESG_|-|Restrictions on current account payments|
|_RESH_|-|Restrictions on capital account payments|
|_RESI_|-|Import surcharges|
|_RESJ_|-|Advance import deposits|
|_RESK_|-|Surrender of export proceeds required|
|_PCY_|-|Natural logarithm of per capita income in U.S. dollars|
|_YG_|-|Rate of growth in realGNP|
|_INF_|-|Inflation (continuously compounded rate of change inGNPdeflator)|
|_OPEN_|-|Exports plus imports as a proportion ofGNP|
|_FLY_|-|Cumulated current account deficit as proportion ofGNP|
|_DETY_|-|Foreign debt as a proportion ofGNP|
|_GBLY_|-|Government deficit (-) as a proportion of_GNP_|
|_DCGR_|-|Net domestic credit to the government as a proportion of total domestic<br>credit|
|_DCGY_|-|Net domestic credit to the government as a proportion ofGNP|
|_BLA_|-|Black market exchange rate premium|
|_RR_|-|Square of real interest rate|
|_DCPY_|-|Domestic credit to the private sector as a proportion ofGNP|

account, and _FDIX_ for FDI being independent or **exogenous. These** variables take a value of 1 when a country exhibits the particular **Granger-causation specified** and 0 when it does not. Since there were only four countries with bidirectional Granger-causation, these were treated as positive for both _CAUSKC_ and _CAUSCK._ The potential explanatory variables **are listed** in **Table** 3. The **first** set of explanatory variables consist of balance-of-payments restriction variables reported annually at the back of the International Monetary Fund's Balance of **_Payments_** _Yearbook._ The variables _RESC_
10 to _RESK_ take a value of 1 if the practice exists and 0 otherwise.

An informal principal components-type aggregation suggests that these variables might be meaningfully summed in various combinations. Specifically: _RESU RESC + RFSD + RESE + RES + RSG + RESH + RESI + REV + RFK; (3)_

|_RESV =RED_<br>_+ RESE + RESF;_|_(4)_|
|---|---|
|_RESW=RESG+RFSH;_|(5)|
|_RESX= RESI + RES + RESK;_|_(6)_|
|_RFSY=RESI+RESJ;_|(7)|
|_RFSZ=RESG+RE5I._|(8)|

The remaining explanatory variables include per capita income, real **GNP** growth, inflation, the openness of the economy, two foreign debt variables, three measures of the government's domestic borrowing requirements, and three indicators of distortions in the domestic economy. The three indicators of domestic distortions are the black market exchange rate premium BLA, used as a proxy for the degree of foreign exchange liberalization, the square of the real rate of interest _RR,_ an indicator of the extent of financial repression or financial distortion, and the ratio of private sector domestic credit to **GNP** _DCPY,_ another indicator of financial repression.

The functional form for the real interest rate follows a claim by Jose De Gregorio and Pablo Guidotti (1992) that real interest rates are not a good indicator of financial repression or distortion. Appealing to work by Guillermo Calvo and Fabrizio Coricelli (1991), they suggest that the relationship between real interest rates and economic growth might resemble an inverted U-curve: "Very low (and negative) real interest rates tend to cause financial disintermediation and hence tend to reduce growth, as implied by the McKinnon-Shaw hypothesis.... On the other hand, very high real interest rates that do not reflect improved efficiency of investment, but rather a lack of credibility of economic policy or,various forms of country risk, are likely to results in a lower level of investment as well as a concentration in excessively risky projects" (De Gregorio and Guidotti 1992, 9). For this reason, De Gregorio and Guidotti abandon real interest rates in favor of domestic credit to the private sector divided by **GNP** _DCPY._
11 Since there are 46 observations for each Granger-causation variable in Tables I and 2, we chose for each country two alternative values for each variable listed in Table 3. The first is the value in 1970 at the start of the observation period, the second is the average value throughout the period 1970-1992. As no variable measured at its 1970 value provided any predictive power, we report only estimates using average:values.

The significant bivariate associations using these measures are shown in Table 4.5 On the one hand, higher levels of both foreign and domestic indebtedness reduce the probability of causation running from capital to current accounts and increase the probability that there is no causation. On the other hand, a high rate of economic growth increases the probability of causation running from current to capital account, while reducing the probability that there is no causation. A higher ratio of private sector credit to GNP also increases the probability of causation running from current to capital account.

The existence of restrictions on capital account payments reduces the probability of causation running from current to capital accounts. The existence of special exchange rates for some capital account transactions reduces the probability that **FDI** is independent. Finally, the probabilities of causation running from current to capital accounts and of FDI being independent of the current account are reduced in countries where export proceeds must be surrendered to the monetary authorities. Table 4 suggests that the more liberal is a country's foreign exchange system, the more likely is FDI to be exogenous or independent.

# 4 Foreign Direct Investment and Capital Formation

Where FDI is not independent but Granger-caused by other capital inflows, one might reasonably assume that FDI inflows would be less likely to increase capital formation than in the case where FDI is independent. Hence we now estimate the impact of FDI on domestic investment for countries in which FDI is independent and for countries in which FDI is interdependent.

The investment function specified here in terms of the ratio of investment to GNP is based on the flexible accelerator model. Mario Blejer and Mohsin Khan (1984, pp. 382-383) describe some of the difficulties of estimating neoclassical investment functions for developing 5Multivariate estimates produced similar results, but multicoUinearity considerably reduced coefficient precision.
12 Table 4: Determinants of Causality.

|||Logit Model|||Probit Model||
|---|---|---|---|---|---|---|
|Dependent||Explanatory|Count||Explanatory|Count|
|Variable|Constant|Variable|R<sup>2</sup>|Constant|Variable|_R_<sup>_2_</sup>|
|_CAUSKC_|1.139<br>(1.338)|-3.569(DETY)<br>(-2.001)|0.683|0.700<br>(1.356)|-2.184(DETY)<br>(-2.090)|0.683|
|_CAUSKC_|0.316<br>(0.594)|_17.524(GBLY)_<br>(1.785)|0.644|0.195<br>(0.591)|_10.728(GBLY)_<br>(1.844)|0.644|
|_CAUSCK_|-2.902<br>(-3.173)|_6.171(DCPY)_<br>(2.322)|0.804|-1.669<br>(-3.441)|3.511(DCPY)<br>(2.362)|0.804|
|_CA USCK_|-2.397<br>(-2.843)|33.793(YG)<br>(1.899)|0.783|-1.438<br>(-3.037)|20.203(YG)<br>(1.936)|0.783|
|_CA USCK_|0.180<br>(0.234)|_-1.620(RESH)_<br>(-1.704)|0.761|0.107<br>(0.224)|-0.982(RESH)<br>(-1.707)|0.761|
|_CA USCK_|1.391|_-2.809(RESK)_|0.783|0.799|_-1.661(RESK)_|0.783|
||(1.110)|(-2.021)||(1.136)|(-2.140)||
|_CA USN_|1.213|-38.535(YG)|0.696|0.747|-23.518(YG)|0.696|
||(1.811)|(-2.301)||(1.840)|(-2.390)||
|_CA USN_|-1.137|_2.348(FLY)_|0.622|-0.706|_1.462(FLY)_|0.622|
||(-1.988)|(1.880)||(-2.036)|(1.932)||
|_CA USN_|-1.910|_3.255(DETY)_|0.732|-1.170|_2.004(DETY)_|0.732|
||(-2.336)|(2.186)||(-2.435)|(2.273)||
|_CAUSN_|-1.073|_-16.881(GBLY)_|0.622|-0.670|_-10.609(GBLY)_|0.622|
||(-1.944)|(-1.870)||(-1.998)|(-1.918)||
|_FDIX_|0.265|_-1.985(RESD)_|0.587|0.164|_-1.220(RESD)_|0.587|
||(0.670)|(-1.915)||(0.667)|(-1.993)||
|_FDIX_|1.947|_-2.467(RESK)_|0.630|1.216|_-1.542(RESK)_|0.630|
||(1.394)|(-1.654)||(1.465)|(-1.732)||
13 countries. Without data on the capital stock and the return to capital, there is little choice in practice but to use some version of the accelerator model.

The accelerator model has the desired capital stock Kg proportional to real output y: This can be expressed in terms of a desired ratio of net investment to output (I/Y)*: where -y is the rate of growth in output denoted YG in the regression equation.

The partial adjustment mechanism specified for the investment ratio is somewhat more complicated than the equivalent mechanism for the _level_ of investment. Specifically, there could be a lag in achieving the same investment ratio this year as last year if output rose rapidly last year; this year's desired investment level will be higher than last year's, despite a constant desired _ratio_ of investment to output. To incorporate this adjustment lag, last year's growth rate yt-I can be included as an explanatory variable. In this case, however, the coefficient of a-l was insignificant; hence, At-i is omitted from the estimate.

The remaining adjustment mechanism allows the actual investment ratio to adjust partially in any one period to the difference between the desired investment ratio and the investment ratio in the previous period: or where A is the coefficient of adjustment.

The flexible accelerator model allows economic conditions to influence the adjustment coefficient A. Specifically, where zi are the variables that affect A. Since one of these variables can be an intercept term for the depreciation rate, the flexible accelerator model can be estimated for the gross rather than the net investment ratio.

A simple specification search suggests that, for the 46 developing countries analyzed here, the speed of adjustment is determined by the ratio of FDI inflows to GNP _FDIY,_ the lagged
14 real exchange rate index expressed in natural logarithms _REXL,i1,6_ the lagged cumulated net foreign liabilities converted into domestic currency and divided by lagged GNP _FLYt..,_ and credit availability as measured by the change in domestic credit divided by GNP _DDCY._ The price of intermediate imports may affect the profitability of investment projects in these developing countries. Hence, the real exchange rate expressed in natural logarithms _REXL_ is included as a proxy for the price of nontradable goods in relation to import prices. We measure the real exchange rate _REX_ as (domestic GNP deflator/U.S. wholesale price index)/domestic currency per U.S. dollar. Therefore, a higher value of _REXL_ implies a lower relative price of imports. By appreciating the real exchange rate, capital inflows may stimulate investment. On the other hand, an appreciation in the real exchange rate prices exports out of world markets and may worsen the investment climate. Hence, its effect on investment is ambiguous.

Effective domestic costs of borrowing are extraordinarily difficult to measure in almost all developing countries because of selective credit policies and disequilibrium institutional interest rates; hence the quantity rather than the price of credit is used here. The availability of institutional credit can be an important determinant of the investment ratio, for the reasons discussed by Alan Blinder and Joseph Stiglitz (1983), Fry (1980) and Peter Keller (1980). Banks specialize in acquiring information on default risk. Such information is highly specific to each client and difficult to sell. Hence, the market for bank loans is a customer market, in which borrowers and lenders are very imperfect substitutes. A credit squeeze rations out *some bank borrowers who may be unable to find loans elsewhere and so be unable to finance their investment projects (Blinder and Stiglitz 1983, p. 300). Here, therefore, the investment ratio is influenced by the change in total domestic credit scaled by GNP _DDCY._ The variable _FLYt_._ .is included as a proxy for the effective domestic real interest rate. If a buildup of foreign indebtedness makes foreign lenders more reluctant to lend, the effective domestic real interest rate rises and so deters investment (Fry 1993).

The regression method used here is iterative three-stage least squares which is, asymptotically, full-information maximum likelihood (Johnston 1984, pp. 486-492). We estimate the 46 individual country investment equations as two systems of equations with cross-equation equality restrictions on all coefficients except the intercept. Hence, the estimates apply to a representative member of these samples of developing countries. The estimation technique

***The** variable _REXL_ is divided by 10 for scaling purposes in the regression estimates.
15 corrects for heteroscedasticity across country equations and exploits contemporaneously correlated disturbances. The instruments are the exogenous explanatory variables plus the lagged FDI ratio, lagged domestic credit expansion divided by GNP, the lagged terms-of-trade index in natural logarithms, lagged growth, the public sector borrowing requirement divided by GNP, the world real interest rate, oil price inflation, and the rate of growth (continuously compounded) in OECD output. The estimation period is 1970-1991 and the dependent variable _IY_ is gross domestic investment divided by GNP at current prices.

The first estimate is for the 20 countries in which **FDI** is independent (354 observations):<sup>7</sup> The corresponding estimate for the 26 countries with interdependent **FDI** is (513 observations): The coefficient of _FDIY,_ the ratio of FDI to GNP, is not only substantially but also significantly higher for the country group in which FDI is independent of other balance-of-payments flows than it is for the country group in which FDI is Granger-caused by some other balance-ofpayments flow. Hence, these estimates support our assumption that Granger-caused **FDI** inflows are less likely to affect capital formation than independent **FDI** inflows.

**7Saudi Arabia and Suriname were dropped because of data deficiencies, so reducing the number of countries in this estimate to** 18.
16

# 5 Conclusion

In this paper, we have examined the question of whether capital flows, particularly inflows of foreign direct investment, Granger-cause current account deficits or _vice versa._ The initial results produce considerable diversity. While Granger-causality runs from capital to current accounts in some countries, it runs from current to capital accounts in others. We detect bidirectional Granger-causality in some countries and no causality at all in others. Within the capital account, three types of capital flows are Granger-caused by other flows in some countries, while all three are independent of movements in other capital and current-account flows in others. The six other possible combinations of Granger-causality among the three types of capital flows are all detected. There are no signs of any predominant tendencies among this sample of 46 developing countries.

Nevertheless, we are able to find variables that can predict the direction of Grangercausality. High levels of both foreign and domestic indebtedness reduce the likelihood that the capital account Granger-causes the current account and increase the likelihood of no causality. Conversely, a high rate of economic growth raises the likelihood that the current account Granger-causes the capital account and reduces the likelihood of no causality. A higher ratio of private sector credit to GNP also increases the probability of causation running from current to capital account.

The existence of restrictions on capital account payments reduces the probability of causation running from current to capital accounts. The existence of special exchange rates for some capital account transactions reduces the probability that **FDI** is independent. Finally, the probabilities of causation running from current to capital accounts and of FDI being independent of the current account are reduced in countries where export proceeds must be surrendered to the monetary authorities. The empirical results suggest that the more liberal is a country's foreign exchange system the more likely is FDI to be exogenous or independent.

Finally, we find that when FDI is independent of other balance-of-payments flows it increases capital formation in the host country by considerably more than it does when FDI is Granger-caused by some other balance-of-payments flow. This finding is consistent with our interpretation of the Granger-causality tests. Although FDl could still crowd out domestically financed investment even if it were independent, we find that the majority of independent FDI increases capital formation; for each $100 in FDI capital formation is increased by $64. On the other hand, endogenous or interdependent FDI raises capital formation by only $13
17 for every $100 FDI inflow.
18

# References

- Blejer, Mario I. and Mohsin S. Khan (1984), "Government Policy and Private Investment in Developing Countries," _International Monetary Fund Staff Papers,_ 31(2), June 1984, 379-403.

- Blinder, Alan S. and Joseph E. Stiglitz (1983), "Money, Credit Constraints, and Economic Activity," _American Economic Review,_ 73(2), May 1983, 297-302.

- Calvo, Guillermo A. and Fabrizio Coricelli (1992), "Stagflationary Effects of Stabilization Programs in Reforming Socialist Countries: Enterprise-Side vs. Household-Side Factors," _World Bank Economic Review,_ 6(1), January 1992, 71-90.

- Cockcroft, Laurence and Roger C. Riddell (1991), "Foreign Direct Investment in Sub-Saharan Africa" (Washington, D.C., International Economics Department, WPS 619: World Bank, March 1991).

- De Gregorio, Jose, and Pablo E. Guidotti (1993), "Financial Development and Economic Growth" (Washington D.C.: International Monetary Fund, July 1993).

- Dooley, Michael P. (1990), "Comment" in _Taxation in the Global Economy_ edited by Assaf Razin and Joel Slemrod (Chicago: University of Chicago Press for the National Bureau of Economic Research, 1990), 74-78.

- Fry, Maxwell J. (1980), "Money, Interest, Inflation and Growth in Ibrkey," _Journal of Monetary Economics,_ 6(4), October 1980, 535-545.

- Fry, Maxwell J. (1993), _Foreign Direct Investment in Southeast Asia: Differential Impacts_ (Singapore: Institute of Southeast Asian Studies, 1993).

- Ghartey, Edward E. (1993), "Causal Relationship between Exports and Economic Growth: Some Empirical Evidence in Taiwan, Japan and the U.S.," _Applied Economics,_ 25(9), September 1993, 1145-1152.

- Hsiao, Cheng (1979), "Autoregressive Modeling of Canadian Money and Income Data," _Journal of American Statistical Association,_ 74(367), September 1979, 553-560.

- Johnston, John (1984), _Econometric Methods,_ third edition (New York: McGraw-Hill, 1984).

- Keller, Peter M. (1980), "Implications of Credit Policies for Output and the Balance of Payments," _International Monetary Fund Staff Papers,_ 27(3), September 1980, 451-477.
19 Meade, James E. (1951), _The Theory of International Economic Policy. Volume 1: The Balance of Payments_ (Oxford: Oxford University Press, 1951).

Montiel, Peter J. (1994), "Capital Mobility in Developing Countries: Some Measurement Issues and Empirical Estimates," _World Bank Economic Review,_ 8(3), September 1994, 311-350.

- Odaki, Mitsuhiro (1986), "Tests of Granger Causality by the Selection of the Orders of a Bivariate Autoregressive Model," _Economics Letters,_ 22(2-3), 1986, 223-227.

- Turner, Philip (1991), _Capital Flows in the 1980s: A Survey of Major Trends_ (Basel: Bank for International Settlements, Monetary and Economic Department, BIS Economic Papers No. 30, 1991).

- Urbain, Jean-Pierre (1989), "Model Selection Criteria and Granger Tests: An Empirical Note," _Economics Letters,_ 29(4), 1989, 317-320.

World Bank (1993), "Global Economic Prospects and the Developing Countries" (Washington, D.C.: World Bank, 1993).
20 Appendix A-1: Independent and Interdependent Capital Flows.

|_KA_Causes_CA_|_CA_Causes_KA_<br>Both|Neither|
|---|---|---|
|_CA USKC_|_CA USCK_<br>_CA USE_|_CA USN_|
||_All Capital Flows Independent_||
|Greece|Indonesia|C6te d'Ivoire|
|Kenya<br>Paraguay||Guatemala|
||FDI_and_**Pi**_Independent_||
|Swaziland|Honduras<br>Malta<br>Mexico<br>Panama|Suriname|
||FDI_and_OKF_Independent_||
|Thailand|Uruguay|Colombia<br>Nigeria<br>Saudi Arabia|
||Pi_and_OKF_Independent_||
||Algeria|Bolivia<br>Egypt|
||FDI_Independent_||
|Philippines<br>Tlunisia||Zambia|
||Pi_Independent_||
|Costa Rica|Turkey|Barbados<br>Chile<br>El Salvador<br>Malawi<br>Malaysia|
||**OKF**_Independent_||
|Mauritius|Portugal|Ecuador<br>Jamaica<br>Sierra Leone<br>Trinidad and Tobago|
||_No Capital Flows Independent_||
|Argentina|Korea<br>Rwanda|Niger|
|Brazil|Singapore|South Africa|
|Peru<br>Venezuela||Togo|
21 Appendix A-2: Causality Tests for Current and Capital Accounts Components.

|KA Causes_CA_|_CA_Causes_K_|_A_|Bidirection|al Causation|
|---|---|---|---|---|
||||Capital Flow<br>Causes CA|CA Causes<br>Capital Flow|
|||FDI|||
|Brazil|Panama||Algeria|Algeria|
|Costa Rica|||Rwanda|Malta|
|Peru|||Singapore|Rwanda|
|Venezuela|||||
|||**Pi**|||
|Brazil|Uruguay||Malta|Rwanda|
|Costa Rica|||Rwanda|Singapore|
|Mauritius|||Singapore||
|Tunisia|||||
|||OKF|||
|Argentina|Korea||Malta|Algeria|
|Costa Rica|Portugal||Singapore|Malta|
|Philippines|Turkey|||Rwanda|
|Thailand|Uruguay||||
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**_____ps__S_ t7**

POLICY RESEARCH WORKING PAPER Foreign Direct Investment, Other Capital Flows, **and Current Account** Deficits 1527 The more liberal acountry foreign exchange system, the more foreign direct investment is likely to be independent of current account and other capital flows.

What Causes What?

_Alaxwell J. Fry_ _Stijn Claessens Peter Burridge Marie-Christine Blanchet_ The World Bank International Economics Department Debt and International Finance Division October 1995
P(>LItYa Rti` S:A((H W\ORKIN( PAI"iH 1 527

# Summary findings

Fry, Claessens, B3urricige, and Blanichet exanmine flows of ftoreign direct investinenit to 46 developing countries to test w hether such flows are autoioniomous or accommlilodatinig i's-d-Vis the current accounit and other capital flows.

Using Granger-caU.salits tests, thev find that: Requirenients ro surrender export proceeds to the monietary authorities and rhe existetnce of special exchange rates for somile capital accoulit transactions reduce the probability that foreign direct investment is independent.

The niore liberal a country's fore ign exchange systeim, the more foreign direct investment is likely to be independent or exogenous.

Foreign direct inlvestmenit is associated with a larger increase in capital formation wheni it is independetit thin when it is Granger-caused by othter capital flows.

T-his paper - a product of the Debt and International Finance Division, Internationial Economics Department - **is** palt of a larger efforr in the department ro study the determninants and impact of foreign direct investment. The study was fu ide d by the Banik's Research Support Budget under the researcil project "Foreign Direct Investmenit in a Mactoeconomnic Frameworkl" (RPO 678-15). Copies of this paper are availab le free from the World Bank, 18 18 H Str-et NW, Washiilngton, _1)C_ 204.33. Please contact Rose Vo, room N3-(J46, telephone 202-473-3722, fax p02-522-3277. InrnerICt addit-s hvo 1 **_@It_** worldbank.org. October 1 995. (21 pages) _[The 'olicy Research W`orkrin Paper Series dissemninates the findings ot work in progress tO encourage the exchange of iJl,as_ **_ib ulS_** _dei.celopnicnt issues._ **_Ani_** _obiet tive oft_ **_tfe_** _series is to get the findings_ **_out_** _quiick/v. even if the presentations are less than fzillv polished._ **_Ibi_** _papers carry the tiamnes of the authobrs_ **_and_** _sh?ould be used and Lited according/y. The findings, interpretations,_ **_and contclusiojn5sar i(_** _tb_ **_authors' ouw_** _and should not be attributed to t't World Bank. its Exec utive B,oard of Direc tors, or any of its mroember c ountries._ P'roduced bv thc Policv Researclh Disseiminationi Ceniter
Foreign Direct Investment, Other Capital Flows and Current Account Deficits: What Causes What?

MAXWELL J. FRY, STIJN A. CLAESSENS, PETER BURRIDGE, AND MARIE-CHRISTINE BLANCHET* _University of Birmingham, World Bank, University of Birmingham, University of Birmingham_ JEL Classifications: F21, F32, 05. Key words: foreign direct investment, current account deficits.

'This paper was written for the International Economics Department of the World Bank under the World Bank's Research Support Budget RPO-678-15. The views expressed in this paper do not necessarily reflect those of the World Bank, its Board of Directors, its management, or any of its member countries. EViews, version 1.0, and _MicroTSP,_ version 7.0, were used for all the regressions presented in this paper.
I
1

# 1 Introduction

Foreign capital inflows to developing countries constitute part of the world's saving. Over the past two decades, world saving as a proportion of world income has fallen. As world saving has shrunk, so the real interest rate measured in terms of U.S. dollar interest and inflation rates has risen from 0.8 per cent during the period 1971-1978 to 4.8 per cent in the period 1981-1991 _(International Financial Statistics,_ CD-ROM, September 1994).1 It is against this background that foreign direct investment (FDI) has appeared increasingly attractive to developing countries facing declining domestic investment and higher costs of foreign borrowing. Foreign direct investment seems an attractive form of capital inflow because it involves a risk-sharing relationship with the suppliers of this type of foreign capital. This kind of risk sharing does not exist in the formal contractual arrangements for foreign loans. Furthermore, as the World Bank (1993, 3) claims, there may be dynamic benefits: "Foreign direct investment is a large and growing source of finance that may help developing countries close the technology gap with high-income countries, upgrade managerial skills, and develop their export markets." Globally, FDI has increased dramatically over.the past decade. However, most of this increase has occurred in the industrial countries. In the developing countries, **FDI** has been heavily concentrated among a small number of countries; over 90 per cent of **FDI** inflows to developing countries in 1990 was received by only 18 countries. Half of this total flowed to eight Pacific Basin developing market economies (Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand). Given that neither Korea nor Taiwan has shown strong interest in attracting **FDI,** it may seem surprising that these economies feature in this group of developing countries. Their appearance in this list may support the view that explicit incentive packages are not the key determinants of **FDI** flows.

In undertaking any analysis of **FDI,** one must recognize that **FDI** data record financial flows which may or may not correspond to changes in capital formation. Whether or not they do depends on (a) the extent of substitutability of this type of financial flow for other types of financial flows and (b) the extent to which **FDI** crowds out domestically financed 'The **real interest rate is proxied here by the London interbank offered rate on U.S. dollar deposits adjusted for the percentage change in the** U.S. **GDP deflator. During the period 1992-1995, this real interest rate averaged only** 1.5 **percent, but has been rising rapidly since** 1993 _(World_ **_Economic Outlook,_ May** 1994, **177).**
2 investment. In some of the literature, the view prevails that FDI can serve two purposes, namely, raise investment and relieve foreign exchange shortages.<sup>2</sup> Unless FDI affects national saving, however, it can raise domestic investment or provide additional financing for a preexisting current account deficit or achieve some combination of the two, but these two effects must always sum to one. In other words, if $100 FDI increases capital formation by only $75, it would provide $25 for additional current-account financing. If it simply substitutes for an alternative type of capital inflow, however, FDI neither raises capital formation nor does it provide additional current-account financing.

This study examines the question of whether FDI to a sample of developing countries substitutes for other capital flows, increases capital formation, or provides additional foreign exchange for balance-of-payments support. Using James Meade's (1951) distinction between autonomous and accommodating capital flows, Philip Turner (1991, 91-95) addresses the question of whether or not net **FDI** flows are accommodating and hence constitute additional balance-of-payments financing by regressing components of the capital account on the current account financing requirement (both in first differences) for some OECD countries.

Iurner's estimated equation takes the form: where _AKFi_ is the year-on-year change in the net capital flow item expressed as a percentage of GNP and _AKFR_ is the year-on-year change in the current account minus changes in official reserves also expressed as a percentage of **GNP** (both in current prices). Turner (1991, 92) finds that short-term bank flows are significantly correlated with the current account financing requirement with coefficients ranging from 0.27 (United Kingdom) to 0.88 (Canada) for seven of the 10 OECD countries. In the case of **FDI,** however, Turner concludes that this flow is much closer to being autonomous than accommodating; the coefficient is significant only in the case of France with a value of only 0.13.

Using Turner's. methodology with annual data on net capital flows from _International Financial Statistics_ **CD-ROM** for a sample of 16 developing countries<sup>3</sup> for the period 1975-

**2For example, Laurence Cockcroft and Roger Riddell (1991, 3) note: "Two of the principal factors inhibiting higher levels of economic growth in Sub-Saharan Africa in the 1990s are low levels of investment and foreign exchange shortages. The first attraction of foreign investment lies in its potential to address both these constraints."**

> **3Argentina, Brazil,** Chile, **Egypt, India, Indonesia, Korea, Malaysia, Mexico, Nigeria, Pakistan, the** Philip-
3 1990, Fry (1993, 13). finds a rather different response pattern in developing countries. In contrast to the OECD countries, other long-term capital flows appear to be just as sensitive to current account financing requirements as short-term flows in this sample of developing countries. For these countries, therefore, one might rank portfolio investment as the most autonomous, FDI or capital inflows to the public sector next, and both long- and short-term bank loans as the most accommodative type of capital flow.

All but one of the estimated coefficients for **FDI** are less than 0.1. Even in the case where FDI is most accommodative (Malaysia), the coefficient is still only 0.14. On the basis of these estimates, therefore, **FDI** appears to be autonomous on Turner's criterion. The negative coefficients of FDI in India and Korea (Fry 1993, 13), and in the United Kingdom (Turner 1991, 92) may reflect the deterrent effect of increasing current account deficits on **FDI** inflows, since large current account deficits can worsen a country's investment climate. This would also support the view that **FDI** inflows are largely unrelated to balance-of-payments financing requirements. However, it does 'suggest that **FDI** should be treated as endogenous to a country's saving-investment process.

Unfortunately, Turner's technique is seriously flawed. First, with enough substitutability between alternative types of capital inflows, there may be no bivariate correlation between' any of the components and the overall current account financing requirement. Indeed, Fry's (1993, 13) results indicate that this is the case for Egypt, Nigeria, and. the Philippines. Out of 80 regressions, only 12 yield significant coefficients at the 95 per cent confidence level. Fry's findings support Michael Dooley's (1990, 75) assertion that financial flow variables such as FDI have far too high degrees of substitutability to provide any useful analytical information. Second, the bivariate regressions fail to establish causality. To explore these issues, this paper presents Granger-causality tests to examine not only the direction of causation between current and capital account imbalances but also between current account and three components of the capital account, **FDI,** portfolio investment **(pi),** and other capital flows (OKF). Whether or not substitutability and fungibility are so high that **FDI** flows provide no relevant economic information at all is an empirical question.

**pines,** Sri **Lanka, Thailand, Turkey, and Venezuela.**
4

# 2 Granger-Causality in the Balance of Payments

Our first question is whether current account imbalances Granger-cause capital account imbalances or _vice versa._ To answer this question, we use an error-correction model (ECM) with one lag. For the long-run analysis conducted here, we ignore errors and omissions in the balance-of-payments accounts and assume that the desired level of international reserves is zero. Hence, the balance of payments on current account is equal and opposite to the balance of payments on capital account. Since changes in international reserves are a disequilibrium phenomenon, we use them as an error-correction term.

So that all countries can be treated in a uniform manner, we assume that international reserves are stationary with a constant long-run equilibrium ratio to GNP. Hence, the previous period's reserve balance can be treated as the disequilibrium term in an ECM of the form: where _CA_ is the current account and KA is the capital account. The term CAt- _+ KAt-1,_ the lagged change in official reserves, is the error-correction mechanism. The rationale is that, if there are co-movements in _CA_ and _KA,_ they should be equilibrating in the long run.<sup>4</sup> This leads to a causality test based on the significance of either the coefficient b or the coefficients dj. When _KA_ is substituted for CA as the dependent variable, the relevant coefficients are b and **ci.** We faced a choice between examining quarterly data for a small sample or annual data for a larger sample of developing countries. From a total of 115 developing countries for which some balance-of-payments data were available, we selected an initial sample of 75 developing countries that had experienced FDI inflows of at least half a percent of GNP for at least five years over the period 1970-1992. Data deficiencies reduced this sample to 46 countries with annual data and only 14 countries with quarterly data. We chose the larger country sample,

**'Peter Montiel (1994, 329) makes a similar point about the relationship between national saving, domestic investment, and the current account: "The current account provides the resources with which a country repays its external creditors. Solvency thus imposes a constraint that prevents deviations between national saving and investment from becoming permanent. Because gaps between saving and investment must eventually be reversed for the country to remain solvent, sufficient observations should show these two series to be cointegrated." In this case, the lagged current account is the error-correction mechanism that equilibrates saving and investment in the long run.**
5 Table 1: Granger-Causality Tests for Current _(CA)_ and Capital _(KA)_ Accounts, 1970-1992.

|_KA_Causes_CA_<br>_CA USKC_|_CA_Causes_KA_<br>_CA USCK_|Neither<br>_CA USN_|
|---|---|---|
|Algeria|Algeria|Bolivia|
|Argentina|Honduras|Barbados|
|Brazil|Indonesia|Chile|
|Costa Rica|Korea|C6te d'Ivoire|
|Greece|Malta|Colombia|
|Kenya|Mexico|Ecuador|
|Malta|Panama|Egypt|
|Mauritius|Portugal|El Salvador|
|Paraguay|Rwanda|Guatemala|
|Peru|Singapore|Jamaica|
|Philippines|Turkey|Malawi|
|Rwanda|Uruguay|Malaysia|
|Singapore||Niger|
|Swaziland||Nigeria|
|Thailand||Saudi Arabia|
|Tunisia||Sierra Leone|
|Venezuela||South Africa|
|||Suriname|
|||Togo.|
|||Trinidad and Tobago|
|||Zambia|

which meant that a wider search for possible **ECM** forms was not feasible. For the same reason, we use only one lag for l ciACAt-. and _Ej'=l djAKAt-j._ In other words, we set both i and j equal to one.

Table 1 shows the results of the initial Granger-causality tests between the current and capital account over the period 1970-1992. Both variables are expressed as proportions of GNP. The capital account Granger-causes current account imbalances in 13 countries and
6 we detect the opposite direction of causation in eight countries. In four countries Grangercausation goes both ways, while no causality is detected in the remaining 21 countries.

The second question we address here is whether disaggregated capital flows are interdependent or independent. Interdependence means that one or more other capital flows Granger-cause this particular capital flow. Independence means that neither of the other capital flows exerts any causal influence. If the capital account Granger-causes the current account, all three capital flows may be independent and hence could Granger-cause the current account imbalance. However, it is also possible that high substitutability ensures that all three capital flows are interdependent and that no individual capital flow Granger-causes the current account imbalance. There are six additional possibilities: any one of the three capital flows may be independent or two capital flows in any of the three combinations may be independent. Hence, eight different Granger-causality results can occur among the components if the capital account Granger-causes the current account. If the current account Granger-causes the capital account, the same eight results are possible. The current account imbalance may influence all. three flows, two flows, one flow, or no individual flow at all because of high substitutability. In other words, all capital flows or no capital flow can be independent.

In testing for causality within and between components of _CA_ and _KA,_ there is no natural measure of disequilibrium. Hence, we adopt a forrm of the procedure advocated by Cheng Hsiao (1979), and elaborated by Mitsuhiro Odaki (1986) and Edward Ghartey (1993). Using the finding by Jean-Pierre Urbain (1989) that the Schwartz information criterion performs relatively, well in small samples, we use it to determine lag length in the Hsiao procedure described below.

First, we test all component series for unit roots. If either y or x were found to be nonstationary, we employ the Hsiao procedure using the appropriate level of differencing. The Hsiao procedure starts by assuming a maximum possible order _Pmax_ for the unrestricted VAR linking the variables under investigation; we chose **_Pmax_** _=_ 4. Univariate AR(p) models, _p 1_ **_Pmax_ J p** are then fitted to y; the lag length py that minimizes the chosen information criterion is selected. This minimized value is denoted _SBCy(pY,O)._ Now lags pZ of the variable x that could be causal are added in sequence up to lag py. If the minimum of the corresponding _SBCy.(p1I,p)_ lies below _SBCy(p,O),_ we conclude that x causes y since the optimum model for predicting y contains pY lags of y and pX _>_ 0 lags of x.
7 This procedure can be generalized to more than two variables to control for covariates as advocated by Ghartey (1993). However, constraints on degrees of freedom prevent us from testing a multivariate model. Hence, the results reported below in Table 2 and Appendix A-1 and A-2 are based on bivariate equations only.

Table 2 shows the key part of the second-stage estimation results concerning FDI; the full results are presented in Appendix A-1. Even where the capital account Granger-causes the current account, all three capital flows are interdependent in four countries (Argentina, Brazil, Peru, and Venezuela). Conversely, all three capital flows are independent in Indonesia, where the current account Granger-causes the capital account. Of central relevance to this study is the finding that FDI is independent of other capital flows in 20 of the 46 countries.

The third question is whether or not there is any Granger-causality between one of the disaggregated capital flows-FDI, **Pi,** and OKF-and the current account or _vice versa._ Countries with no Granger-causation between current and capital accounts are excluded. For countries with Granger-causation running from the capital account to the current account, we test Granger-causality from each capital flow to the current account. For countries with Granger-causation running from the current account to the capital account, we test Grangercausality from the current account to each capital flow. Finally, for countries with bidirectional Granger-causality, we run combined tests of Granger-causality from and to each capital flow to and from the current account. The full results are presented in Appendix A-2. They show that FDI Granger-causes the current account in seven countries (Algeria, Brazil, Costa Rica, Peru, Rwanda, Singapore, and Venezuela) and is Granger-caused by the current account in four countries (Algeria, Malta, Panama,. and Rwanda).

# 3 Explaining Causality Results

The results reported in Tables 1 and 2 display no evident patterns or country groupings. A cursory inspection indicates that these classifications bear no relation to either location or per capita income. However, there may be some feature or features of a country's economy, specifically of its balance-of-payments regime, that are associated with particular causal patterns. To investigate such possibilities, we ran logit and probit regressions to explain the causal variables. The four dependent variables we examine are _CA USKC_ for the capital account Granger-causing the current account, _CAUSCK_ for the current account Grangercausing the capital account, _CA USN_ for no Granger-causation between the capital and current
8 Table 2: Independent and Interdependent Foreign Direct Investment.

|FDI Independent<br>FDI Interdependent|
|---|
|Colombia<br>Algeria|
|C6te d'Ivoire<br>Argentina|
|Greece<br>Barbados|
|Guatemala<br>Bolivia-|
|Honduras<br>Brazil|
|Indonesia<br>Chile|
|Kenya<br>Costa Rica|
|Malta<br>Ecuador|
|Mexico<br>Egypt|
|Nigeria<br>El Salvador|
|Panama<br>Jamaica|
|Paraguay<br>Korea|
|Philippines<br>Malawi|
|Saudi Arabia<br>Malaysia|
|Suriname<br>Mauritius|
|Swaziland<br>Niger|
|Thailand<br>Peru|
|Tunisia<br>Portugal|
|Uruguay<br>.Rwanda|
|Zambia<br>Sierra Leone|
|Singapore|
|South Africa|
|Togo|
|Trinidad and Tobago|
|Turkey<br>Venezuela|
9 Table 3: Potential Explanatory Variables for Direction of Balance-of-Payments Causation.

|_RESC_|_-_|Article XIV status|
|---|---|---|
|_RESD_|-|Special rates for some or all capital transactions and/or some or all invisibles|
|_RESE_|-|More than one exchange rate for imports|
|_RESF_|-|More than one exchange rate for exports|
|_RESG_|-|Restrictions on current account payments|
|_RESH_|-|Restrictions on capital account payments|
|_RESI_|-|Import surcharges|
|_RESJ_|-|Advance import deposits|
|_RESK_|-|Surrender of export proceeds required|
|_PCY_|-|Natural logarithm of per capita income in U.S. dollars|
|_YG_|-|Rate of growth in realGNP|
|_INF_|-|Inflation (continuously compounded rate of change inGNPdeflator)|
|_OPEN_|-|Exports plus imports as a proportion ofGNP|
|_FLY_|-|Cumulated current account deficit as proportion ofGNP|
|_DETY_|-|Foreign debt as a proportion ofGNP|
|_GBLY_|-|Government deficit (-) as a proportion ofGNP|
|_DCGR_|-|Net domestic credit to the government as a proportion of total domestic<br>credit|
|_DCGY_|-|Net domestic credit to the government as a proportion ofGNP|
|_BLA_|-|Black market exchange rate premium|
|_RR_|-|Square of real interest rate|
|_DCPY_|-|Domestic credit to the private sector as a proportion ofGNP|

account, and _FDIX_ for FDI being independent or exogenous. These variables take a value of 1 when a country exhibits the particular Granger-causation specified and 0 when it does not. Since there were only four countries with bidirectional Granger-causation, these were treated as positive for both _CAUSKC_ and _CAUSCK._ The potential explanatory variables are listed in Table 3. The first set of explanatory variables consist of balance-of-payments restriction variables reported annually at the back of the International Monetary Fund's _Balance of Payments Yearbook._ The variables _RESC_
10 to _RESK_ take a value of 1 if the practice exists and 0 otherwise.

An informal principal components-type aggregation suggests that these variables might be meaningfully summed in various combinations. Specifically:

|_RESU=RESC_<br>_+ RF_|_SD + RFSE + RES + RES + RESH + RESI + RES + REK;_<br>_RESV = RESD + RESE +RESF;_|(3)<br>_(4)_|
|---|---|---|
||_RESW = RESG + RES;_|(5)|
||_RESX = RSI + RESJ + RESK;_|_(6)_|
||_RESY= RESI + RESJ;_|_(7)_|
||_RESZ =RESG + RESI._|(8)|

The remaining explanatory variables include per capita income, real **GNP** growth, inflation, the openness of the economy, two foreign debt variables, three measures of the government's domestic borrowing requirements, and three indicators of distortions iin the domestic economy. The three indicators of domestic distortions are the black market exchange rate premium _BLA,_ used as a proxy for the degree of foreign exchange liberalization, the square of the real rate of interest _RR,_ an indicator of the extent of financial repression or financial distortion, and the ratio of private sector domestic credit to **GNP** _DCPY,_ another indicator of financial repression.

The functional form for the real interest rate follows a claim by Jos6 De Gregorio and Pablo Guidotti (1992) that real interest rates are not a good indicator of financial repression or distortion. Appealing to work by Guillermo Calvo and Fabrizio Coricelli (1991), they suggest that the relationship between real interest rates and economic growth might resemble an inverted U-curve: "Very low (and negative) real interest rates tend to cause financial disintermediation and hence tend to reduce growth, as implied by the McKinnon-Shaw hypothesis.... On the other hand, very high real interest rates that do not reflect improved efficiency of investment, but rather a lack of credibility of economic policy or,various forms of country risk, are likely to results in a lower level of investment as well as a concentration in excessively risky projects" (De Gregorio and Guidotti 1992, 9). For this reason, De Gregorio and Guidotti abandon real interest rates in favor of domestic credit to the private sector divided by **GNP** _DCPY._
11 Since there are 46 observations for each Granger-causation variable in Tables 1 and 2, we chose for each country two alternative values for each variable listed in Table 3. The first is the value in 1970 at the start of the observation period, the second is the average value throughout the period 1970-1992. As no variable measured at its 1970 value provided any predictive power, we report only estimates using average-:values.

The significant bivariate associations using these measures are shown in Table 4.5 On the one hand, higher levels of both foreign and domestic indebtedness reduce the probability of causation running from capital to current accounts and increase the probability that there is no causation. On the other hand, a high rate of economic growth increases the probability of causation running from current to capital account, while reducing the probability that there is no causation. A higher ratio of private sector credit to GNP also increases the probability of causation running from current to capital account.

The existence of restrictions on capital account payments reduces the probability of causation running from current to capital accounts. The existence of special exchange rates for some capital account transactions reduces the probability that **FDI** is independent. Finally, the probabilities of causation running from current to capital accounts and of FDI being independent of the current account are reduced in countries where export proceeds must be surrendered to the monetary authorities. Table 4 suggests that the more liberal is a country's foreign exchange system, the more likely is FDI to be exogenous or independent.

# .4 Foreign Direct Investment and Capital Formation

Where FDI is not independent but Granger-caused by other capital inflows, one might reasonably assume that FDI inflows would be less likely to increase capital formation than in the case where FDI is independent. Hence we now estimate the impact of FDI on domestic investment for countries in which FDI is independent and for countries in which FDI is interdependent.

The investment function specified here in terms of the ratio of investment to GNP is based on the flexible accelerator model. Mario Blejer and Mohsin Khan (1984, pp. 382-383) describe some of the difficulties of estimating neoclassical investment functions for developing

> 5Multivariate estimates produced **similar** results, but multicollinearity considerably reduced coefficient precision.
12 Table 4: Determinants of Causality.

|||Logit Model|||Probit Model||
|---|---|---|---|---|---|---|
|Dependent||Explanatory|Count||Explanatory|Count|
|Variable|Constant|Variable|_R_<sup>_2_</sup>|Constant|Variable|_R2_|
|_CAUSKC_|1.139|_-3.569(DETY)_|0.683|0.700|_-2.184(DETY)_|0.683|
||(1.338)|(-2.001)||(1.356)|(-2.090)||
|_CAUSKC_|0.316|17.524(GBLY)|0.644|0.195|_10.728(GBLY)_|0.644|
||(0.594)|(1.785)||(0.591)|(1.844)||
|_CAUSCK_|-2.902|_6.171(DCPY)_|0.804|-1.669|_3.511(DCPY)_|0.804|
||(-3.173)|(2.322)||(-3.441)|(2.362)||
|_CA USCK_|-2.397|33.793(YG)|0.783|-1.438|20.203(YG)|0.783|
||(-2.843)|(1.899)||(-3.037)|(1.936)||
|_CA USCK_|0.180|_-1.620(RESH)_|0.761|0.107|_-0.982(RESH)_|0.761|
||(0.234)|(-1.704)||(0.224)|(-1.707)||
|_CA USCK_|1.391|_-2.809(RESK)_|0.783|0.799|_-1.661(RESK)_|0.783|
||(1.110)|(-2.021)||(1.136)|(-2.140)||
|_CA USN_|1.213|-38.535(YG)|0.696|0.747|-23.518(YG)|0.696|
||(1.811)|(-2.301)||(1.840)|(-2.390)||
|_CA USN_|-1.137<br>(-1.988)|2.348(FLY)<br>(1.880)|0.622|-0.706<br>(-2.036)|1.462(FLY)<br>(1.932)|0.622|
|_CAUSN_|-1.910|3.255(DETY)|0.732|-1.170|_2.004(DETY)_|0.732|
||(-2.336)|(2.186)||(-2.435)|(2.273)||
|_CAUSN_|-1.073|_-16.881(GBLY)_|0.622|-0.670|_-10.609(GBLY)_|0.622|
||(-1.944)|(-1.870)||(-1.998)|(-1.918)||
|_FDIX_|0.265<br>(0.670)|_-1.985(RESD)_<br>(-1.915)|0.587|0.164<br>(0.667)|_-1.220(RESD)_<br>(-1.993)|0.587|
|_FDIX_|1.947|_-2.467(RESK)_|0.630|1.216|_-1.542(RESK)_|0.630|
||(1.394)|(-1.654)||(1.465)|(-1.732)||
13 countries. Without data on the capital stock and the return to capital, there is little choice in practice but to use some version of the accelerator model.

The accelerator model has the desired capital stock _K'_ proportional to real output y: This can be expressed in terms of a desired ratio of net investment to output _(I/Y)':_ where y is the rate of growth in output denoted _YG_ in the regression equation.

The partial adjustment mechanism specified for the investment ratio is somewhat more complicated than the equivalent mechanism for the _level_ of investment. Specifically, there could be a lag in achieving the same investment ratio this year as last year if output rose rapidly last year; this year's desired investment _level_ will be higher than last year's, despite a constant desired ratio of investment to output. To incorporate this adjustment lag, last year's growth rate yt-1 can be included as an explanatory variable. In this case, however, the coefficient of t-, was insignificant; hence, yt1 is omitted from the estimate.

The remaining adjustmeat mechanism allows the actual investment ratio to adjust partially in any one period to the difference between the desired investment ratio and the investment ratio in the previous period: or where A is the coefficient of adjustment.

The flexible accelerator model allows economic conditions to influence the adjustment coefficient A. Specifically, where zi are the variables that affect A. Since one of these variables can be an intercept term for the depreciation rate, the flexible accelerator model can be estimated for the gross rather than the net investment ratio.

A simple specification search suggests that, for the 46 developing countries analyzed here, the speed of adjustment is determined by the ratio of FDI inflows to GNP _FDIY,_ the lagged
14 real exchange -rate index expressed in natural logarithms REXLt.1,6 the lagged cumulated net foreign liabilities converted into domestic currency and divided by lagged GNP _FLYt-1,_ and credit availability as measured by the change in domestic credit divided by GNP _DDCY._ The price of intermediate imports may affect the profitability of investment projects in these developing countries. Hence, the real exchange rate expressed in natural logarithms _REXL_ is included as a proxy for the price of nontradable goods in relation to import prices. We measure the real exchange rate _REX_ as (domestic GNP deflator/U.S. wholesale price index)/domestic currency per U.S. dollar. Therefore, a higher value of _REXL_ implies a lower relative price of imports. By appreciating the real exchange rate, capital inflows may stimulate investment. On the other hand, an appreciation in the real exchange rate prices exports out of world markets and may worsen the investment climate. Hence, its effect on investment is ambiguous.

Effective domestic costs of borrowing are extraordinarily difficult to measure in almost all developing countries because of selective credit policies and disequilibrium institutional interest rates; hence the quantity rather than the price of credit is used here. The availability of institutional credit can be an important determinant of the investment ratio, for the reasons discussed by Alan Blinder and Joseph Stiglitz (1983), Fry (1980) and Peter Keller (1980). Banks specialize in acquiring information on default risk. Such information is highly specific to each client and difficult to sell. Hence, the market for bank loans is a customer market, in which borrowers and lenders are very imperfect substitutes. A credit squeeze rations out *some bank borrowers who may be unable to find loans elsewhere and so be unable to finance their investment projects (Blinder and Stiglitz 1983, p. 300). Here, therefore, the investment ratio is influenced by the change in total domestic credit scaled by GNP _DDCY._ The variable _FLYi-I_ .is included as a proxy for the effective domestic real interest rate. If a buildup of foreign indebtedness makes foreign lenders more reluctant to lend, the effective domestic real interest rate rises and so deters investment (Fry 1993).

The regression method used here is iterative three-stage least squares which is, asymptotically, full-information maximum likelihood (Johnston 1984, pp. 486-492). We estimate the 46 individual country investment equations as two systems of equations with cross-equation equality restrictions on all coefficients except the intercept. Hence, the estimates apply to a representative member of these samples of developing countries. The estimation technique

> 6 The variable _REXL_ is divided by 10 for scaling purposes in the regression estimates.
15 corrects for heteroscedasticity across country equations and exploits contemporaneously correlated disturbances. The instruments are the exogenous explanatory variables plus the lagged **FDI** ratio, lagged domestic credit expansion divided by **GNP,** the lagged terms-of-trade index in natural logarithms, lagged growth, the public sector borrowing requirement divided by GNP, the world real interest rate, oil price inflation, and the rate of growth (continuously compounded) in OECD output. The estimation period is 1970-1991 and the dependent variable IY is gross domestic investment divided by GNP at current prices.

The first estimate is for the 20 countries in which FDI is independent (354 observations):<sup>7</sup> _1Y_ = _0.635FD1Y_ - _0.010FLY,_1 +_ 0.525DDCY (10.548) (-2.933) (34.128) (14) _+ 0.037REXL_ **t-1** + 0.386YG + 0.6401Yi_l. (10.575) (27.781) (44.593) R2 = 0.613 _DW =_ 1.92 The corresponding estimate for the 26 countries with interdependent FDI is (513 observations): ~~~~~~~~~~~~~~(15) The coefficient of _FDIY,_ the ratio of FDI to GNP, is not only substantially but also significantly higher for the country group in which **FDI** is independent of other balance-of-payments flows than it is for the country group in which **FDI** is Granger-caused by some other balance-ofpayments flow. Hence, these estimates support our assumption that Granger-caused **FDI** inflows are less likely to affect capital formation than independent **FDI** inflows.

**7Saudi Arabia and Suriname were dropped because of data deficiencies, so reducing the number of countries** in **this estimate to** 18.
16

# 5 Conclusion

In this paper, we have examined the question of whether capital flows, particularly inflows of foreign direct investment, Granger-cause current account deficits or _vice versa._ The initial results produce considerable diversity. While Granger-causality runs from capital to current accounts in some countries, it runs from current to capital accounts in others. We detect bidirectional Granger-causality in some countries and no causality at all in others. Within the capital account, three types of capital flows are Granger-caused by other flows in some countries, while all three are independent of movements in other capital and current-account flows in others. The six other possible combinations of Granger-causality among the three types of capital flows are all detected. There are no signs of any predominant tendencies among this sample of 46 developing countries.

Nevertheless, we are able to find variables that can predict the direction of Grangercausality. High levels of both foreign and domestic indebtedness reduce the likelihood that the capital account Granger-causes the current account and increase the likelihood of no causality. Conversely, a high rate of economic growth raises the likelihood that the current account Granger-causes the capital account and reduces the likelihood of no causality. A higher ratio of private sector credit to GNP also increases the probability of causation running from current to capital account.

The existence of restrictions on capital account payments reduces the probability of causation running from current to capital accounts. The existence of special exchange- rates for some capital account transactions reduces the probability that FDI is independent. Finally, the probabilities of causation running from current to capital accounts and of FDI being independent of the current account are reduced in countries where export proceeds must be surrendered to the monetary authorities. The empirical results suggest that the more liberal is a country's foreign exchange system the more likely is FDI to be exogenous or independent.

Finally, we find that when FDI is independent of other balance-of-payments flows it increases capital formation in the host country by considerably more than it does when FDI is Granger-caused by some other balance-of-payments flow. This finding is consistent with our interpretation of the Granger-causality tests. Although FDI could still crowd out domestically financed investment even if it were independent, we find that the majority of independent FDI increases capital formation; for each $100 in FDI capital formation is increased by $64. On the other hand, endogenous or interdependent FDI raises capital formation by only $13
17 for every $100 FDI inflow.