Do Capital Flows Reflect Economic Fundamentals in Developing Countries?


WP/93/34-EA

Do Capital Flows Reflect Economic Fundamentals in
Developing Countries? by Atish R. Ghosh and Jonathan D. Ostry

This paper proposes a methodology for testing whether capital flows to
developing countries are determined by economic fundamentals or by purely
speculative forces. The methodology is based on the familiar notion that
capital flows should act as a buffer to smooth consumption in the face of
shocks to income, investment, and government expenditure. Under high
capital mobility, transitory income shocks, for example, will not elicit
corresponding changes in consumption, and the difference will be reflected
in changes in the level of capital flows.

The consumption-smoothing approach therefore provides a benchmark for
judging what capital flows ought to be, given the specific shocks affecting
the economy. Optimal capital flows, according to this approach, are those
that allow agents to smooth their consumption fully in the face of shocks
to national cash flow, defined as output less investment less government
expenditure. Once this benchmark for the optimal level of capital flows has
been obtained, it is possible to compare the benchmark series with actual
data.

Using data from a large cross-section of developing countries, the
paper finds considerable support for the consumption-smoothing view of
capital flows. Specifically, it uses a variety of formal statistical tests
as well as simple time-series plots of the predicted and actual data and
finds that the level and volatility of capital movements predicted on the
basis of the consumption-smoothing model are very close to the actual level
and volatility of such movements observed in the data. The results suggest
that capital flows in developing countries are indeed determined to a
significant degree by economic fundamentals and, in line with other recent
research, that effective capital mobility in developing countries may be
quite high.