The role of international capital flows in economic development raises important open questions. In particular, the question asked by Robert Lucasalmost twenty years ago—why so little capital flows from rich to poor countries—received renewed interest as capital has been flowing "upstream" from developing countries to the U.S. since 2000. This paper takes a fresh look at the pattern of capital flows to developing countries through the lenses of the neoclassical growth model.
Our contribution is twofold. First, we show that there is a significant discrepancy between the predictions of the text book neo-classical growth model for the distribution of capital flows across developing countries and the behavior of capital flows in the data. The basic framework predicts that countries that enjoy higher productivity growth should receive more net capital inflows.
We look at net capital inflows fora larges ample of non-OECD countries over the period 1980-2000 and find that this is not true. In fact the cross country correlation between productivity growth and net capital inflows is negative. The non-OECD countries that have grown at a higher rate over 1980-2000 have tended to export (not import) more capital. The international capital market, thus, does not allocate capital across developing countries in the way predicted by textbook theory a fact that we call here the "allocation puzzle".
Our second contribution is to delineate the respective roles of investment and saving in explaining this puzzle. We augment the neoclassical growth model with two "wedges": one wedge that distorts investment decisions, and one wedge that distorts saving decisions. It is then possible, for each country in our sample, to estimate the saving and investment wedges that are required to explain the observed levels of savings and investment (and so capital flows).
We find that the augmented model can explain the data with investment and saving wedges ofaplausible order of magnitude. Furthermore we find that the investment wedge cannot, by itself, explain the allocation puzzle. Solving the allocation puzzle requires a saving wedge that is strongly negatively correlated with productivity growth. That is, the allocation puzzle is a saving puzzle.
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Capital Flows to Developing Countries: The Allocation Puzzle
