In a well-known paper, Lucas (1990) pointed out that capital flows from rich to developing countries were much smaller than suggested by the return differential implied by per worker output ratios. As discussed in Prasad, Rajan and Subramanian (2007), the pattern of international capital flows has become even more surprising in the last decade with low income countries actually financing more advanced economies. It is remarkable, for example, that over the last few years the largest borrower and lender on the international markets have been respectively the US and China. A particularly puzzling feature is that China is a very fast growing country and, according to benchmark models based on the Permanent Income Hypothesis, should actually be borrowing heavily in order to finance investment and smooth consumption over time. It is tempting to think about the Chinese experience as very peculiar and possibly driven entirely by policy intervention to maintain an undervalued exchange rate. However, recent empirical evidence cautions against this interpretation by pointing out that growth and capital outflows tend to be positively correlated across all developing countries.
Gourinchas and Jeanne (2007) show that the capital flows predicted by the standard neoclassical growth model calibrated with country specific productivity over the 1980-2000 period are in fact negatively correlated with actual flows across a large sample of 69 developing countries. Similarly, Prasad, Rajan and Subramanian (2007) also detect a positive correlation between growth and net capital outflows across non-industrial countries. A simple way to get a quick grasp of the empirical evidence is to look at the time-series behavior of saving, investment, and the current account during growth acceleration periods. Using the criteria proposed by Hausmann, Pritchett and Rodrik (2005) and data from the World Development Indicators on developing countries between 1960 and 2008, we detect 41 growth acceleration episodes. Figure 1 shows the time series evolution of the cross country means of relevant variables from six years before to six years after the growth acceleration. We observe that as the country enters a period of higher per capita income growth, the saving rate, instead of decreasing to allow for consumption smoothing over time, rapidly rises. Furthermore, the increase is stronger than for investment so that the country witnesses an improvement in the current account.
In this paper we develop a small open economy model with uninsurable idiosyncratic investment risk which can account for these empirical findings. The crucial assumptions are that entrepreneurs are exposed to the idiosyncratic risk of failure and that financial markets are incomplete because they don’t allow for risk sharing. Under these circumstances entrepreneurs have to rely on self-financing to scale up their firms so that when new entrepreneurial opportunities open up they increase saving to finance the investment which triggers growth. The key feature of the model is that since investment is risky, saving has to increase more than investment to allow for the accumulation of precautionary savings. Therefore, while expanding their businesses, entrepreneurs generate a net saving increase which can sustain persistent current account surpluses.
The model’s calibration is based on standard values in the literature, with the exception of the production function curvature parameter and the risk of business failure which are structurally estimated using data from the Survey of Consumer Finances. We initialize the model to a setting in which all agents work as farmers in subsistence agriculture and study the dynamics generated by the opening up of entrepreneurial opportunities. The individuals with high entrepreneurial ability increase saving to finance investment in their new businesses, thus triggering a prolonged period of rapid growth. At the same time they also accumulate precautionary assets so that the economy generates large and persistent capital outflows consistent with the empirical evidence.
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Growth and Capital Flows with Risky Entrepreneurship
