2009 Decision Capital Account Convertibilityand Growth ADeveloping Country Perspective

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Capital Account Convertibility and Growth – A Developing Country

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page 55
Reserch Papers
Capital Account Convertibility and Growth: A Developing
Country Perspective
A.K. Seth
Sumati Varma
This paper investigates the link between capital account liberalization and growth for a cross – section of
seventeen developing countries, including India, both theoretically and empirically. It also explores the
different measures of capital account openness and the empirical evidence on the association between
financial openness and growth. Theoretically, capital account openness leads to growth through two main
channels: increase in aggregate investment and an improvement in productivity and efficiency. Existing
empirical evidence however suggests that the link between capital account openness and economic growth
is weak. The paper uses a de jure measure of capital account convertibility, calculated as the proportion of
capital flows to total flow of funds. The results find a positive association between financial openness and
growth. However growth is associated with an increase in the efficiency of inputs rather than due to an
increase in investment per se. JEL Classification Numbers: F21, F36, F43
Keywords: capital flows, capital account liberalization, growth
Introduction
The traditional debate of fixed versus flexible exchange rate systems continues to be as
relevant in the present context as it was at the time of the collapse of the Bretton Woods
System. The adoption of a flexible exchange rate system has given rise to a concurrent global
debate on the pace and sequencing of liberalization of the current versus capital account of
the balance of payments. Large parts of the industrial world adopted capital account
convertibility in the 1970s and 1980s, building on a process of international economic integration
that was already well advanced in the area of trade in goods and services. This trend was
facilitated by the Code for Liberalization of Capital Movements of the Organisation for
Economic Cooperation and Development (OECD),which was introduced in a limited way in
1961 and later extended in stages to include the full range of capital account transactions in
1989. The adoption in 1988 by the European Union (EU) of the Second Directive on
Liberalization of Capital Movements was also instrumental in further facilitating this trend.
With the emergence of the McKinnon (1973) and Shaw (1973) hypothesis, the last decade saw
large parts of the developing world with increasingly liberalized capital accounts as part of a
general move towards greater openness and integration. They asserted that financial repression
allocates capital to inefficient use and therefore it traps developing countries in a low saving
and low growth cycle. Outward-oriented trade, realistic exchange rates and financial
liberalization were likely to ensure more successful adjustments to external imbalances and
higher rates of economic growth in the developing world.
A.K. Seth is Professor, Department of Commerce, Delhi School of Economics, University of Delhi, New
Delhi, Email: akseth2020@yahoo.com.
Sumati Varma is Reader, Sri Aurobindo College, University of Delhi, New Delhi, Email:
varmasumati@yahoo.co.in.
Decision, Vol. 36, No.1, April, 2009
article 1 final proof

Capital Account Convertibility and Growth: A Developing Country Perspective 56
This theory became the basis of the IMF– World Bank sponsored Structural Adjustment
Programmes (SAP), which were adopted by large parts of the developing world. The focus of
any SAP was to remove inherent structural distortions in an economy through financial
liberalization so as to have higher rates of growth and development.
The last two decades have witnessed an unprecedented flow of private capital flows, and a
concurrent increase in the incidence of banking, currency and financial crises in the developing
world. Financial liberalization takes place through liberalization of both the domestic financial
markets and opening up the economy to external capital flows. Various studies have focused
on the association of economic growth with both domestic and external sector liberalization.
This paper examines the relationship between capital account convertibility and growth for
seventeen developing countries, including India.
Capital mobility and Growth: Theoretical underpinnings
The theoretical basis of capital account convertibility lies in the argument that free capital
mobility allows the global economy to reap the efficiency gains created by specialization in
the production of financial services. It is an extension of the logic of the benefits of free trade
which says that financial development can raise an economy’s growth rate in two ways: by
increasing the rate of capital accumulation and by spurring technological innovation
(McKinnon, 1973; Shaw, 1973).
According to the “two gap” structural development literature (Chenery and Bruno, 1962;
McKinnon, 1964), growth of an economy is limited not only by a country’s ability to save, but
also by foreign savings with which to buy necessary imported inputs. However such capital
flow must be supplementing in nature rather than crowding out domestic investment. Barro,
Mankiw and Sala-I-Martin (1995) have also emphasized that domestic residents can finance in
part or in full the physical capital by foreign savings which increases the rate of capital
accumulation.
In the neoclassical framework, the benefits of capital inflows into capital poor countries arise
from divergences in the marginal productivity of capital across countries. If labour in advanced
countries is equipped with better and more capital than labour in developing countries, capital
can be used more productively by being relocated to the latter. The simplest neoclassical
model is the two country Kemp-MacDougall model (MacDougall 1960) which illustrates the
benefits of capital inflows as well as their optimal size. The model assumes savings to be a
fixed proportion of per capita income. The marginal productivity of capital is higher in the
poor country than in the rich country in autarky and diminishes as the capital labour ratio
rises. With perfect capital mobility, the poor country benefits from capital inflows, until its
marginal product of capital is equated to that of the rich country, and in turn both are equal to
the world interest rate.
Endogenous growth models are characterized by the assumption of non-decreasing returns
to the set of reproducible factors of production. According to this approach long term growth
can be explained entirely by growth in capital, without any appeal to an exogenous Solow
technology residual. This implies external economies to capital accumulation: the elasticity of

output with respect to capital greatly exceeds its share of GDP at market prices. Such externalities
create a presumption that the benefits of capital inflows must be much higher than those
implied by the neoclassical approach. In contrast to the neoclassical growth framework where
technological change is exogenously given, the new growth literature highlights the
dependence of growth rates on the state of technology relative to the rest of the world.
The inter-temporal approach emphasized that the benefits of capital flows not only come from
directing world savings to the most productive investment opportunities but also from allowing
individuals to smooth consumption over different states of nature by borrowing or diversifying
portfolios abroad. Developing countries are likely to benefit greatly from the international
pooling of country-specific risk that would result in inter-temporal smoothing of consumption
levels. International capital mobility also gives the opportunity to trade off present levels of
absorption against future absorption. If saving falls short of desired investment, foreigners
have to finance the resulting current account deficit, leading to a rise in the country’s net
foreign liabilities.
Schumpeter (1911) argued that the services provided by financial intermediaries (eg. mobilizing
savings, evaluating projects, managing risk and facilitating transactions) are essential for
technological innovation and economic development. Authors such as Gurley and Shaw
(1960), Goldsmith (1969), Patrick (1966), and McKinnon (1973) have emphasized the role of
financial intermediation in the process of economic growth and argued that the increased
financialization of assets is instrumental in promoting economic development.
Global experience has shown that capital flows can be a mixed blessing. International borrowing
helps individual countries smooth consumption and finance productive investment. FDI can
facilitate the transfer of technological and managerial know-how. Portfolio investment and
foreign bank lending can also contribute to the deepening of the domestic financial market. It
has also been argued that, by rewarding good policies and penalizing bad ones, capital flows
promote more disciplined macroeconomic policies. However, the benefits of capital account
openness rest on the premise of an efficient capital market, ignoring the presence of distortions
such as information asymmetry, moral hazard and herding on the part of foreign investors.
The destabilizing effect of capital flows in the presence of these distortions has been highlighted
by the Asian crisis. This has led to a growing body of work that highlights the role of moral
hazard and explicit or implicit government guarantees in increasing the vulnerability of countries
to financial crisis (McKinnon and Pill, 1998). In a typical framework, firms borrow from non-
residents in foreign currency and lend domestically in local currency. Their investment
decisions incorporate the expectation that relatively stable exchange rates will be maintained
and, as governments are unable to credibly commit not to do so, that the government will bail
them out in the event of a run. As lenders share this expectation, they have little incentive to
monitor the quality of bank lending. This results in a level of investment that is higher than the
optimal level obtained in the absence of credible implicit or explicit guarantees. However,
foreign creditors stop lending when the government’s contingent liabilities exceed foreign
reserves. The resulting devaluation in turn causes widespread bankruptcies of institutions
with unhedged foreign currency exposures. Capital flows in this framework would not enhance

growth, and can in fact impede growth by making countries more vulnerable to financial
crises.
Review of literature
There is a large and growing literature that tests the potential benefits of capital account
liberalization through its influence on long run growth and development, by directly
investigating the empirical relationship between capital account liberalization and economic
growth. Almost all of these studies augment a basic growth model that includes variables
such as the level of schooling, investment, population growth and the level of GDP in the
initial year with a measure of capital account liberalization. The data are typically averaged
over five, ten, or twenty years so that the data set is converted into either a cross-sectional
data set or a panel data set. Distortions in the domestic economy such as information asymmetry
and moral hazard are proxied through the use of measures of institutional development and
policy environment such as the inflation rate and fiscal deficit.
The positive effects of capital account liberalization on growth
Wang (1990) develops a model in which international capital movements from the developed
North to the developing South transfers technology and shows that liberalization of the
capital account leads to greater foreign direct investment leading and a more efficient use of
domestic savings. It is shown that when the South shifts from autarky to free capital mobility,
its steady state growth rate of per capita income also increases. Obstfeld (1994) presents a
simple model of global portfolio diversification based on Romer (1990) and Grossman and
Helpman (1991) that links growth and financial openness. The model asserts that ongoing
growth depends upon investments that supply specialized and hence inherently risky
production inputs. The paper posits that a globally diversified portfolio made possible through
international asset trade, raises expected growth as well as national welfare.
Quinn (1997) uses a multivariate regression framework to determine the political and economic
variables with which a change in international financial regulation is robustly associated. The
study covers 58 countries over the period 1960 to 1989 but it is difficult to distinguish the
impact of current account and capital account liberalization on growth separately. Klein and
Olivei (1999) investigate the association between capital account liberalization and growth in
a cross-sectional regression specification of 82 countries over the period 1986 to 1995. Their
study first focuses on the role of capital account liberalization on financial development and
then considers the effect of financial development on growth. They conclude that the beneficial
effects of capital account liberalization can only be achieved in an environment in which there
is institutional support for the changes brought about by the free flow of capital. Edwards
(2001) examines whether the relationship between capital mobility and growth is different for
emerging and advanced economies and tests the impact of capital mobility on economic
growth, where growth is estimated in terms of GDP growth and total factor productivity (TFP)
growth.
Bekaert, Harvey and Lundblad (2001) examine the impact of stock market liberalization on
economic growth. Augmenting the standard set of growth model variables with their variables

indicating stock market liberalization, they maximize the time series content in their regression
using a moving average panel data method. These results along with those of Quinn, are the
strongest evidence supporting the hypothesis that capital account liberalization leads to
growth. O’ Donnell (2001) examines the impact of capital account liberalization using both
IMF rules-based measure and a quantitative based measure of financial openness. He found
rules based measures too coarse an indicator of capital account liberalization as it does not
take into account the nature of different types of controls. Using quantitative measures, he
finds that capital account liberalization does seem to speed up economic growth. He also
finds that benefits to all countries are not equal.
Chanda (2001) suggests that the impact of capital account liberalization may vary with the
level of ethnic and linguistic heterogeneity. He finds that capital controls lead to greater
inefficiencies and lower growth among countries with a high degree of ethnic and linguistic
heterogeneity. Chinn and Ito (2002) examine the empirical relationship between capital controls
and the financial development of credit and equity markets for 105 countries over the period
1977-1997. The authors investigate a broader set of proxy measures of financial development,
create and utilize a new index based on the IMF measures of exchange restrictions that
incorporates a measure of the intensity of capital controls and examine the implications of
institutional and legal factors. They conclude that the rate of financial development, as
measured by private credit creation and stock market activity, is linked to the existence of
capital controls. Klein (2003) offers robust empirical evidence that capital account openness
contributes in an important way to economic growth for middle-income countries if liberalization
is carefully managed and sequenced with appropriate controls, regulatory apparatus and
macroeconomic framework.
Studies not supporting the hypothesis that liberalization promotes growth
In a widely cited study Rodrik (1998) has cast doubts on the effects of capital account
liberalization on growth. In a sample that includes almost 100 countries, developing as well as
developed, he finds no significant effect of capital account liberalization, as measured by
Share. He also finds no relationship between capital account liberalization and investment-to-
income, or between capital account liberalization and inflation. These results are broadly
consistent with those of Kraay (1998), who undertakes a more comprehensive examination of
the effect of capital account liberalization on investment, growth and inflation. The study
includes data from 117 countries over the period 1985 –1997, and uses three different measures
of financial market development and policy environment.1 His regressions take the form of
cross sections, with one observation per country, where the dependent variable is the growth
in output between 1985 and 1997. He uses both OLS and the instrumental variable approach,
in which the capital account liberalization variables are instrumented by their own past values.
Methodology
The paper estimates the association between capital account openness and growth in a linear
regression framework for seventeen developing economies for the period 1970 –2000. The
data is a pooled data sample i.e. it is a combination of time series and cross sectional data and

forms a panel. The data is then averaged across time to give a cross- section of seventeen
observations per variable. The cross sectional technique is a standard practice to smooth out
short term fluctuations and focus on the long-run growth rate. Panel data analysis permits the
researcher to study the dynamics of change with short time series. The combination of time
series with cross sections can enhance the quality and quantity of data in ways that would be
impossible using only one of these two dimensions. Apart from this the results obtained are
more general and robust. In carrying out the empirical exercise both the fixed effects and
random effects estimation methods were explored. Since the data is a cross- section of the
variables averaged across time, we anticipate heteroskedasticity in the error term and correct
it by estimating robust standard errors.
In order to test the hypothesis of the influence of openness on growth, the following models
were estimated:
gj = α0 +α1Kj + α2Xj + εj (1)
τj = βo+β1kj + β2xj + µj (2)
where gj is average real GDP growth in country j during the period 1971 – 2000;
τj is the average rate of TFP growth during the period 1971-2000;
kj is a measure of capital account openness in country j, or an indicator of the extent of capital
account liberalization between 1971 and 2000.
Capital account openness is measured by the variable OPEN +, which is measured as the sum
of total capital flows to total flow of funds.
εj and µj are heteroskedastic errors with zero mean.
Xj are other variables that affect economic performance such as
a) INV + - The investment ratio during 1971–2000, proxied by the rate of gross fixed capital
formation to GDP;
b) HUM + - A measure of human capital, taken to be the total mean years of education;
c) LRG - - The log of real GDP per capita in 1971, which is taken to be a measure of initial
economic activity;
d) DEV + – A measure of the country’s level of development taken to be the product of LRG
and OPEN.
The superscript over the variable represents the expected obtainable sign.
The standard model of economic growth explains the long term trend in the potential output
of an economy by breaking it down into two parts:
• The first part which can be explained by the growth in inputs used in production. This is
called Real GDP Growth (RGDPG).

• That part of growth which can be explained by improvements in the efficiency with which
these inputs are used. The latter is called Total Factor Productivity (TFP) growth. TFP
growth is often described as the rate of “technological progress”.
Following this, we examine the impact of capital mobility on both measures of economic
performance – Real GDP Growth (RGDPG) and Total Factor Productivity growth (TFP). In
principle, a greater openness of the capital account has an impact on economic performance
through two alternative channels. The first one is the increase in foreign savings, and through
them, on aggregate investment. Following Edwards (2001), this is called the “Investment
Effect”. The second channel through which capital mobility may affect economic performance
refers to efficiency and productivity growth. This is termed the “Performance Effect”
The estimation of TFP is done using a fixed effects model, based on the standard Cobb-
Douglas specification of the production function. The fixed effects is a panel data model that
has constant slopes but intercepts that differ according to the cross sectional unit. Fixed
effects approach is a reasonable approach when we are confident that the difference between
cross section units can be viewed as parametric shifts of the regression function. That means,
it is based on the assumption that difference across cross sections can be captured through
the intercept.
The model is specified as:
Yit = αi +Xit′β+ εit
where i refers to the cross section and t refers to year. The component or intercept (αi) in this
model differs across cross section units but is time invariant. In contrast to the FE model, the
random effects model views individual specific constant terms as randomly distributed across
cross sectional units. This would be appropriate if we believed that sample cross sectional
units were drawn from a large population. The RE model could be represented as follows:
Yit= α+ Xit ′β+ µi + εit
The component µ is the random disturbance characterizing the ith observation and is constant
through time. The RE formulation assumes that the intercept term has a random element
whereas the FE formulation does not.
The two estimators – FE and RE – have different properties depending on the correlation
between group specific effects and the regressors.
• If the effects are uncorrelated with explanatory variables, the RE estimator is consistent
and efficient. The FE estimator is consistent but not efficient.
• If the effects are correlated with the explanatory variables, the FE estimator is consistent
and efficient but the RE estimator is now inconsistent.
This difference is utilized to construct the Hausman specification test, which is the classical
test of whether the fixed or random effects model should be used. The null hypothesis under
the Hausman test is
H0 = Effects and explanatory variables are uncorrelated.

The test statistic is defined as

H = (βRE - βFE)´ (∑FE - ∑RE)-1(βRE - βFE)
Where RE and FE refer to random effects and fixed effects estimates respectively and ∑
stands for the estimated variance – covariance matrix. Under the null hypothesis the test
statistic follows asymptotically a chi- square distribution with k degrees of freedom, where k
is the number of coefficients compared. If the test statistic is greater than the critical value of
the chi- square distribution at appropriate degrees of freedom we reject the null hypothesis.
The final estimation results are based on the use of the FE model for the estimation of TFP, on
the basis of the Hausman test reported in Tables 3 and 4. Four different models of TFP were
estimated in which capital and labour were proxied by gross fixed capital formation and
employment respectively.
Data sources
Data for the study has been taken from various issues of The International Financial Statistics
Yearbook, Nehru and Dhareshwar dataset (1994) and The Penn World Tables (2001).
Estimation and results
Since the data is in the form of a cross-sectional time series, the first step is to check stationarity
of variables, to see if the mean and variance of the series is time independent over the sample.
In all data which is in the form of a time series, the first step is to determine if the variables are
stationary in levels, or if a first or second order differencing is required to achieve stationarity.
For this purpose a unit root test is done. This is known as testing the order of integration of
variables. Various tests are available to test the order of integration of variables, including the
Dickey Fuller (Dickey and Fuller, 1979), Augmented Dickey Fuller (ADF), Phillips and Perron
(1988) and Durbin Watson (Sargan and Bhargava, 1983) test. This paper uses the Dickey
Fuller and Phillips Perron tests to test for the presence of unit roots and replaces non stationary
variables with the first difference of their values. Results of the test and their critical values
are reported in Tables 1 and 2.
The results show that two variables OPEN and HUM were found to be non-stationary for
some countries in the sample. These were replaced with the first difference of their values.
Tables 3 and 4 present the results of the Hausmann Specification test that validates the use of
the fixed effects model for the estimation of TFP.
Tables 5 to 7 present the main statistically significant findings of the estimation. The results
for the overall panel of seventeen countries shows that RGDPG, TFP and TFPH growth have
the expected statistically significant relationship with openness.
The coefficient of the explanatory variables HUM and LRG also have the expected signs but
are insignificant. The coefficient of DEV has a significant relationship with RGDPG but with
an adverse sign. The coefficient of INV however has a negative sign indicating that openness
and the resulting inflow of capital has been unable to translate itself into higher investment
for the countries in the sample. In order to test for the “Performance Effect” we regressed

different measures of TFP on openness, controlling for INV. The results tabulated in Table 7
indicate the existence of a robust and significant impact of TFP on growth.
Table 1: Testing for unit roots

DF Statistics
Rgdpg Open Inv Hum Lrg Dev

Argentina -4.344* -3.170** -6.802* -6.468* -4.344* -3.167**
(1st diff)
Bolivia -4.376* -3.555** -5.693* -3.877** -21.621* -3.528**

(0LT) (0LT)
Brazil -3.584** -.3731* -5.148* -2.687** -5.931* -3.701**
Chile -6.410* -3.955* -5.077* -8.729* -3.652** -3.691**
Colombia -3.539** -3.019** -4.253* -0.788 -3.312** -2.92***
Ecuador -5.530* -3.587** -6.099* -2.67*** -4.014* -3.556**
Mexico -20.052* -3.193** -6.020* -2.102 -4.059* -3.099**
Paraguay -4.179* -4.930* -3.793* -4.301* -2.88*** -4.851*
Peru -4.559* -3.032** -3.195** -0.093 -3.672** -3.077**
Uruguay -3.493** -3.978* -0.835 -0.661 -3.201** -4.010*
Venezuela -8.890* -4.040* -5.389* 0.617 -6.888* -4.054*
India -4.158* -7.137* -5.367* 0.542 -3.525** -7.209
(1st dif) (1stdif)
Indonesia -5.826* -6.227 -21.489* -0.383 -4.25* -6.236
(1st dif)
Korea -4.040* -11.976* -3.869** 0.060 -4.934* -5.190*
(1st dif) (1LT)
Malaysia -5.042* -7.5* -7.164* -1.830 -2.79*** -6.951
(1st dif) (1st dif)
Philippines -4.154* -7.166 -4.083* -3.971(3LT) -3.796* -5.773
(1st dif) (1st dif)
Thailand -3.169** -6.076 -10.351* -6.813* -3.360** -2.66***
(1st dif) (1L)
Critical values for zero lag: at 1% level of significance: 3.723 ‘dif’ stands for difference
5% level of significance: 2.989 ‘L’ indicates lag
10% level of significance: 2.625 ‘LT’ indicates lag trend
* indicates stationarity at 1% level of significance
** indicates stationarity at 5% level of significance
*** indicates stationarity at 10% level of significance

Table 2: Testing for unit roots

Phillips Perron Statistics
Rgdpg Open Inv Hum lrg Dev

Argentina -8.512 -15.60** -29.7*** -34.986* -23.862* -15.58**
Bolivia -24.105* -17.03** -31.652* -21.621 -21.630* -16.90**
(0LT) (1LT)
Brazil -18.733* -18.995* -28.110* -6.453 -22.863* -19.097*

Chile -18.776* -21.375* -28.331* -40.772* -19.072* -19.646*
Colombia -18.491* -14.73** -23.225* -1.010 -14.870* -14.02**
Ecuador -29.871* -18.542* -34.099* -2.279 -21.622* -18.419*
Mexico -30.234* -6.881 -22.882* -4.950 -21.536* -35.873
(1st dif)
Paraguay -20.082* -15.90** -20.209* -22.221* -15.063* -16.24**
Peru -25.232* -14.79** -17.523* -0.124 -19.352* -15.10**
Uruguay -14.05** -21.260* -5.115 -1.818 -15.7* -21.551*
Venezuela -33.135* -21.738* -30.058* 0.774 -23.528* -33.135*
India -22.614* -11.4*** -29.506* 0.834 -16.908* 37.9*
(1st dif)
Indonesia -29.166* -27.565* -15.47** -17.324* -23.235* -34.225
(1st dif) (1st dif)
Korea -21.780* -13.70** -10.085 0.087 -28.329* -14.53**
Malaysia -28.123* 29.234 -28.715* -7.630 -13.996* -10.3***
(1st dif)
Philippines -23.393* -30.397 -22.384* -3.569 -19.166* -32.027*
(1st dif) (1st dif)
Thailand -15.93** -11.5*** -46.335* -36.984* -17.186* -9.910
Critical values for zero lag: at 1% level of significance: -17.472 ‘dif’ stands for difference
at 5% level of significance: -12.628 L’ indicates lag
at 10% level of significance: -10.280 ‘LT’ indicates lag trend
* indicates stationarity at 1% level of significance

** indicates stationarity at 5% level of significance
*** indicates stationarity at 10% level of significance

Table 3: TFP : Alternative specifications

Cross-country econometric results, 1971-2000
Model 1 TFP Model 2 TFPH
FE RE FE RE
lnk 1.000459 .99967 .995499 .9949
(247.94) (304.7) (209.42) (259.33)
lnl 0.00433 -.049 -.024680 -.04634
(0.10) (-2.16) (-0.53) (-2.02)
lnh .215676 .2106701
(1.69) (2.45)
constant 1.534263 .1916 1.51954 1.72816
(4.42) (10.5) (4.39) (7.72)
R2 Within 0.994 0.994 0.994 0.994
R2 Between 0.9989 0.9993 0.999 0.999
R2 Overall 0.997 0.9972 0.997 0.997
No of Obs 510 510 510 510
Hausman# 6.24 4.31
Prob 0.04 0.23
Values in parentheses are t - statistics
Where lnk = logarithm of capital, lnl = logarithm of labour and lnh = logarithm of human.
Table 4: TFP: Alternative specifications

Model 3 TFP1 Model 4 TFPH1
dlnk .59479 0.6592 .594827 .659364

(18.78) (22.5) (18.76) (22.48)
dlnl -.09327 -.02659 -.08749 -.023546
(-0.36) (-0.11) (-0.33) (-0.10)
dlnh 1.40399 .0964151
(0.49) (0.05)

Model 3 TFP1 Model 4 TFPH1
constant .14448 .1191 0.112 .1167918

(5.9) (4.98) (1.58) (2.24)
R2 Within 0.418 0.419 0.419 0.418
2
R Between 0.9662 0.965 0.965 0.9668
R2 Overall 0.50 0.5 0.5 0.5
No of Obs 510 510 510 510
Hausman# 27.97 29.06
Prob 0.00 0.00

‘d’ stands for first difference
Table 5: Capital account openness and growth

Rgdpg Tfp Tfph

Open .126862 .0152305 .0152916
(3.65) (2.08) (1.97)
inv -.0365821 -.0108155 -.0068187
(-1.10) (-0.75) (-0.75)
Hum1 .7741864 0.8430228 1.035987
(0.25) (0.93) (1.41)
lrg .0021161 -.0005943 -.0004468
(1.64) (-1.12) (-0.97)
dev -.1162356 -.0031746 -.0090216
(-3.00) (-0.46) (-1.49)
cons -.0956922 -.1735054 -.1673195
(-0.18) (-1.28) (-1.04)
R2 0.5344 0.5234 0.4550
2
Adj R 0.3227 0.3081 0.2072
N 17 17 17
Values in parentheses are t – statistics


tfp tfph
Open .0125928 .0077958
(2.25) (1.38)
inv -.0108367 -.006879
(-0.79) (-0.77)
Hum1 .7782527 .8519241
(0.84) (1.04)
lrg -.0006505 -.0006067
(-1.50) (-1.53)
cons -.1605747 .1305732
(-1.26) (-0.87)
R2 0.5219 0.4213
2
Adj R 0.3619 0.2284
N 17 17
Tfp tfph
Open 0.13068 0.0080975
(2.34) (1.48)
inv
Hum1 0.7706285 .8470843
(0.88) (1.10)
lrg -0.000647 -.0006046
(-1.57) (-1.61)
dev
cons -0.178835 -.1421651
(-1.48) (-1.01)
R2 0.5008 0.4094
Adj R2 0.3856 0.27
N 17 17

Conclusion
This paper explores the link between capital account convertibility and growth for seventeen
developing countries during the period 1971 - 2000. Using a de jure measure of capital account
convertibility, calculated as the proportion of capital flows to total flow of funds the results
find a positive association between capital account openness and growth.
There is a positive association between capital account convertibility and both the measures
of growth used in the paper: real GDP growth (RGDP) and total factor productivity growth
(TFP). The paper also observes that the Performance Effect is a strong explanatory variable of
growth. This highlights the importance of improvements in efficiency and increased
productivity associated with foreign capital. It has been seen that foreign direct investment
has historically played a larger role in developing countries than have other forms of capital
flows. The results thus highlight the role that FDI plays through transfer of technology and
skills and its impact on growth.
The study also finds that investment has an insignificant relationship with growth. This
implies that the inflow of capital has been unable to translate itself into higher investment for
the countries in the sample. There could be different factors responsible for this. It has been
seen that in countries like Indonesia large inflows of capital went into unproductive real
estate activity that did not lead to increased investment. This points to the need for better
supervision of capital inflows. In countries like India there has been a smaller proportion of
FDI compared to portfolio flows in the total inflow of capital. Since it is FDI inflows that
manifest themselves into investment, this is possibly the reason for the “Investment Effect”
being less robust.
It is also understood that FDI as a form of capital inflow is preferred for its stability and the
technology and skills embodied in it. However economies that receive these inflows need to
be adequately equipped in terms of infrastructure to be able to use these skills and technology.
This is indicative of the need of domestic financial sector development to enhance the
absorptive capacity of capital inflows.
The overall conclusion of the study is that capital account convertibility has a positive
association with growth. However, for the economy to reap the benefits of an open capital
account, financial sector development is important. The study also points towards the need
for better supervision so that capital inflows may be productively channelised and lead to
growth of the economy.
References
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Appendix A: Data
Country List
Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, India, Indonesia, Korea, Malaysia, Mexico,
Paraguay, Peru, Philippines, Uruguay, Venezuela, Thailand.
Variable list and data sources
GROWTH: RGDPG – Average real GDP growth
TFPG - Average rate of TFP growth
Source: IMF’s International Financial Statistics
OPEN Total Capital flows to Total Flow of Funds
INV = Investment
Gross fixed capital formation to GDP


HUM = Human
Total mean years of education
Source: Nehru and Dhareshwar (1994) dataset.
LRG = LRGDPC
Log of real GDP per capita
Source: Penn World Tables, version 6 (2001)
DEV = Development
LRGDPC * OPEN
Appendix B: Estimation of TFP
The estimation of TFP is based on the Cobb- Douglas production function:
Y = A(0)eλtKαLβ (1)
where Y is value added, K and L are the capital stock and labour, α and β are output elasticities,
A(0) represents initial conditions and λ is the rate of technological progress. In this
specification of the production function, intermediate inputs can be explicitly incorporated by
relating gross output to labour, capital and intermediate inputs. We have chosen to exclude
intermediate inputs and relate value added to primary inputs only. Expressing equation (1) in
log linear form gives:
log Y = log A(0)+α log K+β log L (2)
equation (2) was estimated using a fixed effects model with the following specifications:
log Y =φ +Ó λi + α log K + β log L (3)
dlog Y =φ +Ó λi + α dlog K + β dlog L (4)
where φ is the TFP growth rate for the reference country, and the λs are the TFP growth rates
for the remaining countries.
I subsequently added a human component to the model, by adding another input into the
production function:
Log Y = φ + Σλi+ α logK + βdlog L + γlog H (5)
dlogY = φ + Σλi+ α dlogK + β dlogL + γ dlogH (6)
where H represents average rate of total education in each country.

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Decision, Vol. 36, No.1, April, 2009

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The test statistic is defined as

Decision, Vol. 36, No.1, April, 2009

Table 1: Testing for unit roots

Rgdpg Open Inv Hum Lrg Dev

Bolivia -4.376* -3.555** -5.693* -3.877** -21.621* -3.528**

Decision, Vol. 36, No.1, April, 2009

Table 2: Testing for unit roots

Rgdpg Open Inv Hum lrg Dev

Brazil -18.733* -18.995* -28.110* -6.453 -22.863* -19.097*

* indicates stationarity at 1% level of significance

Decision, Vol. 36, No.1, April, 2009

Table 3: TFP : Alternative specifications

Model 1 TFP Model 2 TFPH

Table 4: TFP: Alternative specifications

Model 3 TFP1 Model 4 TFPH1

dlnk .59479 0.6592 .594827 .659364

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Model 3 TFP1 Model 4 TFPH1

constant .14448 .1191 0.112 .1167918

Values in parentheses are t - statistics

Table 5: Capital account openness and growth

Rgdpg Tfp Tfph

Values in parentheses are t – statistics

Decision, Vol. 36, No.1, April, 2009

Table 6: Capital account openness and growth

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Source: IMF’s International Financial Statistics

Decision, Vol. 36, No.1, April, 2009

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