International Capital Allocation, Sovereign Borrowing, and Growth

The key in the investigation of "where" and "why" capital flows, relative to the neoclassical benchmark, is how we measure these flows. The macro literature has been using three main yardsticks: the current account balance, returns to capital, and the volume of net capital flows. We argue that all of these measures will partly reflect non-private non-market activities, while the neoclassical predictions are about private-market behavior. After a careful separation of public and private components of capital flows three main findings emerge: 1) international capital flows net of aid flows are positively correlated with different proxies of growth and productivity consistent with the predictions of the neoclassical model; 2) international capital flows net of government debt are also allocated according to the neoclassical predictions; 3) government debt is negatively correlated with growth only if government debt is financed by another sovereign and not by private lenders. Our results are robust to different country and time samples including the recent period characterized by global imbalances. Overall these findings suggest that recent "puzzles" in the literature about the lack of correlation (or negative correlation) between capital flows and growth are due to the role of sovereign to sovereign borrowing (debt or aid) while private capital flows are indeed allocated according to the predictions of the neoclassical model.