Foreign Capital and Economic Growth

Eswar S. Prasad (Cornell University), Raghuram Rajan (University of Chicago) and Arvind Subramanian (PIIE)

Paper presented at the Federal Reserve Bank Conference at Jackson Hole
Published in Brookings Papers on Economic Activity, March 2007

March 1, 2007

Contrary to the predictions of standard theoretical models, non-industrial countries that have relied more on foreign finance have not grown faster in the long run. By contrast, growth and the extent of foreign financing are positively correlated in industrial countries. We argue that the reason for this difference may lie in the limited ability of non-industrial countries to absorb foreign capital – especially because of the difficulty their financial systems have to allocate it to productive uses, and because of the proneness of these countries to exchange rate appreciation (and, often, overvaluation) when faced with such inflows. Our paper suggests that the current anomaly of poor countries financing rich countries may not really hurt the former’s growth, at least conditional on their existing institutional and financial structures. Our results do not imply that there is no role for foreign finance in the process of economic development or that it is natural for all types of capital to flow “uphill”. Indeed, the patterns of foreign direct investment flows have generally been more in line with the predictions of theory. However, there is no evidence that providing additional financing in excess of domestic savings is the channel through which financial integration delivers its benefits.