The effects of capital inflows on the economic growth in the Med Area

Journal of Policy Modeling 27 (2005) 839–851

The effects of capital inflows on the economicgrowth in the Med Area

Lucio Lauretia,∗, Paolo Postiglionea Universita LUM “Jean Monnet”Bari Jean Monnet Permanent Course,

European Commission, Italyb Dipartimento delle Scienze Aziendali, Statistiche, Tecnologiche ed Ambientali,

Universita “G. d’Annunzio” di Chieti-Pescara, Italy

Received 20 September 2004; received in revised form 10 March 2005; accepted 23 May 2005Available online 28 June 2005

Abstract

There is a wide number of empirical studies that seek to identify the most relevant determinants ofa country’s economic growth. In this paper, in particular, we analyze the effects of capital inflows andtest these effects with reference to the eleven Mediterranean Countries that took part to the BarcelonaEuro-Mediterranean Conference in 1995. We estimate a dynamic panel model exploiting a GMMestimation method and using yearly data in the period ranging from 1990 to 2000. The differentregressions performed are based on a data set provided by The World Bank.© 2005 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.

Keywords: Financial integration; Dynamic panel model; GMM estimation

1. Introduction

In the last decade, the European Union (EU) and the North Africans countries, that tookpart to the Euro-Mediterranean Conference held in Barcelona on 27–28 November 1995(henceforth referred to as MED countries), are making an effort that will bring them toa greater integration and to the constitution within the year 2010 of a free-exchange area,coherently with the process of regionalization that is characterizing them. The entry of Malta

∗ Corresponding author. Tel.: +39 085 34126; fax: +39 085 4519134.

0161-8938/$ – see front matter© 2005 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.doi:10.1016/j.jpolmod.2005.05.003

840 L. Laureti, P. Postiglione / Journal of Policy Modeling 27 (2005) 839–851

and Cyprus in the European Union and the future possible entry of Turkey and Moroccoshows that the process goes on. This integration will lead to the creation of an area of over700 million consumers.

Moreover, globalisation (or better the macro-regionalization1) is also producing itseffects in terms of a wider international commerce, a larger variety of products, increasedtourist flows, joint ventures between enterprises and greater integration. In the meantime,financial globalisation has brought to an exponential increase of the capital movements interms of flows for the new financial products and for the investments directed towards thedeveloping countries. In fact, in the last 10 years, there has been a strong increase of inter-national flows of private capitals to the developing countries. The net flows have shiftedfrom an annual average of 36 billions dollars in the period 1985–1987 to an annual averageof 230 billions in the period 1995–1997, representing the 5% of the gross domestic product(GDP) of the developing countries (Salvatore, 2004).

Up to the mid 1990s, the MED countries have not gathered this extraordinary waveof international private investments: in fact, they represented the 3.3% of the GDP of alldeveloping countries, but received only 1.4% of private capitals flows. The reasons of thiscan be found in the political situation (still in tension, especially in the Middle East), in theeconomic politics, that do not facilitate the freedom of international movements of capital,and in the delays of the privatisations.

However, from mid nineties, the markets woke up: the Israeli market has become themost developed of the region and it now attracts significant shares from the internationalinvestors, furthermore, the capitalization in Egypt, Morocco and Tunisia has increased fourtimes and a good market is developing in Lebanon2. The foreign investors, attracted by thehigh growth rates, started to insert the actions of the MED countries in their wallets. Suchactions shifted from an average of 35 millions dollars in 1980 to 3.487 millions of dollarsin 2000, privileging, above all, the markets of Egypt and Turkey.

Furthermore, it is interesting to ask ourselves if the constant and increasing developmentof the financial markets in the MED area, and therefore the financial globalization, has alsoproduced effects in the real economy in terms of growth. In other terms, we ask ourselvesif the privatizations, the most higher level of investments, the development of the StockExchanges and the introduction of new financial tools, have contributed, in this last decade,to the development and to the growth of the MED countries.

In the past, many papers dealt with this problem.Borensztein, De Gregorio, and Lee(1998)andDe Mello (1999)show that capital inflows promote growth in the developingcountries.Bailliu (2000)illustrates that debt flows over long periods, bank and commercialcredits and portfolio bond flows, are negatively linked with the growth.

Soto (2000)shows that, in a financial system poorly developed, these flows can have anegative impact on the growth; it is possible that, in the presence of a weak financial system,these capitals do not find opportunity of productive investments. Finally,Rodriguez andRodrik (1999)andLaureti (2001)estimate the effects of the international commerce on the

1 The globalization has, in reality, provoked above all a subdivision in macro-regions (Europe, America andEast Asia) of the markets as it regards the small and the medium firms.

2 In 1996, Egypt privatized companies for around a milliard of dollars and other privatizations were effected inMorocco, Turkey, Tunisia, Israel attracting around 700 milliard of dollars.

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growth: countries characterized by an insufficient opening to the international commerceare limited in the economic growth.

In this paper, we analyze the effects that the different typologies of capital inflows, from1990 to 2000, had on the economic growth of the Mediterranean countries. The layout ofthe paper is the following. Section2 is devoted to a description of the econometric modelapplied in our analysis. In particular, we describe an approach based on panel data analysis,by following the path traced bySoto (2000). A description of data is given in Section3.Section4 is devoted to a descriptive analysis of the relationship between foreign directinvestments and economic growth of the MED countries. Section5 presents the empiricalanalysis of the effects of capital flows on economic growth of eleven countries belongingto MED area. Finally, in Section6 we discuss some concluding remarks and we outline thefuture research agenda.

2. The model framework

To estimate the link between capital inflows and economic growth, we use an econometricmodel. Let us start from the neoclassical Solow–Swan’s model (Solow, 1956; Swan, 1956).According this model we can write that:

Y (t) = F (K(t); L(t)) (1)

∂k

∂t= sf (k) − pk

whereY(t) is the total production at timet, F(.) is a production function, homogenous ofdegree one,K is the stock of physical capital,L is the labor force,k is the per-capita capital,∂k/∂t is the derivative ofk with respect to time,s is a constant saving rate,f(k) is theper-capita production andp is the population’s growth rate.

This approach leads to the following per-capita production growth rate�t:

γt = −Φ(k)y(t) + Φ(k)y∗ (2)

whereγt = (∂y/∂t)/y(t); y(t) andy* represent, respectively, the natural logarithm of per-capita production at timet and at the steady-state. The steady-statey* depends upon anumber of variables, including the constant saving rates and the population’s growth ratep. The specification of the functionΦ(.) depends on the production functionF(.) and on theparameters of the equation system(1).

In the past, a time-discrete approach to Eq.(2) was estimated. For example,Mankiw,Romer, and Weil (1992)showed that an augmented Solow model with accumulation ofhuman and physical capital gives an excellent description of cross-country data. They esti-mated the model using annual data, covering the period from 1960 to 1985.

However, the framework of cross-section studies for the analysis of economicconvergence was soon criticized.Islam (1995) was the first to propose the use ofpanel data framework in economic convergence analysis. Following this approach, itis possible to check for individual-specific and time characteristics of the analysedcountries.


In this paper, we follow the path indicated bySoto (2000)and use a panel data approachto estimate an economic growth equation for the Mediterranean countries. Therefore, ourapproach to analyze economic growth is described by the following equation:

yi,t − yi,t−1 = αyi,t + X′i,t−1� + νi + τt + εi,t (3)

whereyi,t is the logarithm of the per-capita GDP in the countryi at timet, α is a negativeparameter linked to the “speed of convergence” (Soto, 2000), X′

i,t-1 is a row vector ofexogenous covariates of the steady-state level at timet − 1 with associated parameters�,νi is the country-specific effect,τt the time-effect andεi,t the residual term.

The variables used to explain the steady-state level are: the investment rate, the degreeof openness to international trade and political stability.

As Caselli, Esquivel, and Lefort (1996)have pointed out, several empirical studies havenot considered the consistency problems that arise when model(3) is estimated by fixed orrandom-effect models.

So, in a standard way, to transform Eq.(3), we drop the time effect, as in the case ofthe simpler fixed effect model, by subtracting from each variable of(3) the average in theperiodt (Baltagi, 2001). As a consequence, Eq.(3) can be rewritten as:

yi,t − yi,t−1 = αyi,t−1 + X′i,t−1� + νi + εi,t (4)

whereyi,t , X′i,t−1, νi andεi,t represent, respectively, the variables centered on their spatial

average in periodt and the resulting new error term.Furthermore, by taking the first difference of model(4), we eliminate the country specific

effect (individual effect). Therefore, we reparametrize model(4), obtaining the followingdynamic panel model:

γi,t = (α + 1)′γi,t−1 + (X′i,t−1 − X′

i,t−2)� + µi,t (5)

whereγ i,t represents the GDP growth rate in countryi at timet, measured as ˜yi,t − yi,t−1,andµi,t = εi,t − εi,t−1. These dynamic relationship is characterized by the presence of alagged dependent variable among the regressors.

Dynamic models are of great interest in a wide range of economic applications: forinstance in the analysis of household consumption and of economic growth empirical mod-els. For an excellent discussion of dynamic panel models see very interesting books likeBaltagi (2001)andArellano (2003).

The dynamic model described in Eq.(5) is characterized by the presence of temporalautocorrelation due to the introduction of a lagged dependent variable among the regressors.This fact introduces some problems in the model estimation. In particular, the lagged variableγ i,t − 1 is correlated with the new error termµi,t and, as a consequence, the OLS estimator arebiased and inconsistent (seeTrognon, 1978for details). Moreover, the within transformationoperated for the fixed effects estimation, drops out the time effect, but the transformedvariables ˜yi,t is still correlated with the error term. For this reason, the fixed effect estimatoris biased and inconsistent and the inconsistency depends upon the time dimension (Nickell,1981). The random effect GLS estimator is also biased in a dynamic equation (Anderson& Hsiao, 1981).


In order to solve the problems connected with the presence of a lagged variable amongthe regressors, the Generalised Method of Moments estimation extended to the presence ofadditional regressors is performed in the present paper. This method, developed byHoltz-Eakin, Newey, and Rosen (1988)and Arellano and Bond (1991)provides a convenientframework for obtaining asymptotically efficient parameters estimators in dynamic paneldata models.

3. Data issues

The economic autonomy of the MED countries, after the de-colonization, is a recentevent; so, in these countries the capital inflows have started to cover a certain importanceonly at the end of the eighties. For this reason, it is difficult to obtain suitable informationon private capital inflows.

In this paper, the period under investigation is ranging from the year 1990 to the year2000. Since the sample to be analyzed is of 11 years, we use a 1-year sample rather than the5 years average as it is frequently suggested in the literature (e.g. byBarro & Lee, 1994;Caselli et al., 1996).

The sample considered includes the totality of the countries participants to the Euro-Mediterranean Conference held in Barcelona in 1995 with the only exclusion of PalestinianAuthority. The countries under investigation are therefore: Algeria, Cyprus, Egypt, Jordan,Israel, Lebanon, Malta, Morocco, Syria, Tunisia, Turkey. In the following table, the selectedcountries are divided in classes of income, according to the World Bank classification.

Most of the countries, as it is well shown byTable 1, are classified in the lower middleincome class and only Cyprus, Israel and Malta are in the high income.

The data set employed is built from the 2002World Development Indicators (WDI), andGlobal Development Finance (GDF), provided bythe World Bank (2002b, 2002a).

The aim of this paper is to evaluate the effects of different typologies of capital inflowson the economic growth of the MED countries. Therefore, in this analysis we consider thefollowing variables: foreign direct investments (FDI), portfolio equity flows (PEF), portfoliobond flows (PBF), bank credits (BCRED), debts values with maturity of less than 1 year(DEB). The debt values PBF and BCRED exclusively refer to long run debts that is debtswith a maturity of more than 1 year. The other covariates considered are: the degree ofopenness to the international commerce (EI), government consumption (GOV), nationalsaving (S), in accordance with important empirical studies on growth (Barro & Sala-i-Martin, 1995; Barro & Lee, 1994; Caselli et al., 1996; Frankel & Romer, 1999; Rodriguez& Rodrik, 1999). In our analysis, the dependent variable is represented by economic growth,

Table 1Classification of selected countries in income level (The World Bank, 2002b)

Income level Country

High income Cyprus, Israel, MaltaUpper middle income Lebanon, TurkeyLower middle income Syrian, Morocco, Tunisia, Egypt, Algeria, Jordan


Table 2Implicit deflator of United States

US 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000Deflator 88.20 91.41 93.64 95.88 97.87 100.00 101.95 103.95 105.26 106.84 109.20

computed in terms of per-capita GDP logarithm, measured in purchasing power parity (PPP)expressed in 1995 dollars.

The data published by the World Bank are not available in this form and so we performedsome initial transformations to homogenize them. First of all, we converted the data intocurrent values in accordance to PPP. We can define the conversion rates of the PPP as thenumber of units of a country’s currency required to buy the same amount of goods andservices in the domestic market as one US dollar would buy in the United States. Accordingto this definition we can define the conversion rate as:

conversion ratePPP = P

P∗ (6)

whereP indicates the local currency units necessary to buy one determined quantity ofgoods or services andP* the correspondent US dollar units necessary to buy the samequantity of goods or services in the United States market. For an analysis of the problem ofdata transformation according to PPP criterion in the MED area seeLaureti (2001).

The adjusted GDP series thus obtained is now expressed in terms of current dollars, sowe have to transform the data in constant values using the US GDP deflator with base in1995. The implicit GDP deflator is given by the relationship among the nominal GDP of 1year and the corresponding real GDP and it measures the variation of the prices during theperiod under study. In the followingTable 2, we report the GDP implicit deflator of UnitedStates with reference to years considered (The World Bank, 2002a).

The transformed data, measured in PPP terms expressed in 1995 US dollars, are sum-marised in the followingTable 3.

In the sample considered, the range of per-capita GDP is rather large, going from 1870to 20824 1995 US dollars. However, the level of per-capita GDP is not included amongthe regressors. These different values are rough indicators of the great heterogeneity of theobservations included in the sample estimated. The variability, measured in terms of coef-ficient of variation (seeTable 3), of capital inflows variables is relatively large if compared,

Table 3Data Statistics

Variables Mean Standard deviation Coefficient of variation

GDP per capita 7130.93 5377.02 0.75S 18699 26037.16 1.39FDI 841.83 1092.12 1.30PEF 367.52 934.99 2.54PBF 580.82 2002.65 3.45BCRED 131.64 1822.02 13.84DEB 533.99 3247.73 6.08EI 49052.08 47363.66 0.97GOV 13272.78 13825.58 1.04


for example, to Government consumption (GOV) and to degree of openness to the interna-tional commerce (EI). This large variability shows that MED countries are very dissimilarin terms of capability of capital inflows attractiveness.

Finally, we underline that all the variables used in the empirical analysis, with the onlyexclusion of per-capita GDP, are normalized by ratioing them to the GDP.

4. Foreign direct investments and economic growth: a descriptive analysis

The MED countries are very different in terms of households income, economic structureand international policy. The empirical economic theory underlines the effect of push thatforeign direct investments have on economic growth.Borensztein et al. (1998)and DeMello (1999) show that these capital inflows, associated to a certain level of stock ofhuman capital, support the growth in developing countries. In other words, the FDI are afundamental component in the growth process.

Fig. 1. (a and b) Relationship between economic growth and foreign direct investments.


Fig. 1. (Continued ).

For these reasons, in this section we want to analyze in descriptive way the relationshipbetween FDI and economic growth. Here, we present some time series graphs (seeFig. 1aand b) in order to describe the relationship between FDI and economic growth in elevenMED countries.

The region of the Mediterranean, as it can be deduced from this brief intuitive analy-sis, is characterized by different economic realities. On one side there are countries likeEgypt, Turkey, Malta, Cyprus, Israel, Tunisia and Syria, where structures and economicpolicy are more reactive, on the other side there are economies that are not prone to struc-tural changes and to specific political reforms addressed to an economic and financialdevelopment.

One of the economies that seems to mostly enjoyed some expansion of the financialmarkets is Egypt that in the last 10 years, has attracted the interest of foreign investors. Weobserve that this region has been able to enjoy an enormous quantity of foreign capitals witha consequent push of the growth rate. Also Malta and Cyprus are active economies duringthis period; from 1990 to 2000: they grew at a rate of about 5%, even if the FDI flows arenot remarkably high.


Turkey is a country that in MED area attracted great quantity of capitals, not only derivingfrom foreign direct investments, but also from stock wallets. Comparing the trend of thestock flows, we can notice that Turkey was the first economy to be able to receive stockwallets flows starting from 1995.

Within the first group of countries we can also include Tunisia, Syria and Israel thatfavoured in the years from 1990 to 2000, foreign capitals flows. This significant capital inflows is accompanied by economic growth in all countries.

Conversely, Jordan, Lebanon and Morocco seem to have economies that are less able tointegrate themselves in a global financial structure. For instance, Jordan only in the last yearshas supported the foreign capitals inflows. During the period analyzed the growth rate isnegligible. Only in the last 5 years, Lebanon has attracted foreign capitals, but these capitalflows did not have yet any significant effects on the growth rate of the country. Finally,Morocco, attracted foreign investors interest at the beginning of nineties, but it does notseem to have satisfied their expectations and in more recent years lost most of the foreigndirect investments.

5. The empirical analysis

The purpose of our empirical analysis is to estimate the effects of the different typologiesof private capital inflows on the growth of the Mediterranean countries. The regressions wererun on panel data of the MED countries in the period 1990–2000. The main results of theestimation are summarized inTable 4.

In Table 4, we present the various results obtained by considering the different typologiesof private capitals inflows.

The Arellano–Bond methodology assumes that there is no second order autocorrelationin the first differenced errors. For these reason, we have verified such hypothesis through atest proposed byArellano and Bond (1991, p. 281–282). The results obtained (seeTable 4)in the different regressions provide no evidence to suggest that the assumption of seriallyuncorrelated errors is inappropriate in this empirical analysis.

It is interesting to notice that the different forms of capital inflows have a differentimpact on growth. In some alternative regressions, that are not reported here for the seek ofsuccinctness, we aggregated these variables in one single representative voice of the foreignsavings and noticed that the effect on growth were poorly significant.

Regression (1) has been performed using all the available variables considered inTable 4as regressors. The other regressions are obtained by dropping from the estimation processthe variables that were not significant. The level of confidence at which the coefficients aresignificant are reported at the end ofTable 4.

In commentingTable 4, let us notice the effect of the national savings on growth. Infact, countries characterized by low levels of income (as in general those belonging toMediterranean area) are also characterized by a low marginal propensity to saving. Thisjustifies the small influence that this variable has on economic growth and, so, the coefficientobtained in the regressions are very small in absolute term.

The regressions obtained also show that foreign direct investments (FDI) is a variablepoorly significant in explaining growth. The heterogeneity and the low level of these

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Table 4Dependent variable ln(GDPt)–ln(GDPt-1)

Variables Regression (standard errors in parenthesis)

(1) (2) (3) (4) (5) (6)

ln (GDP) 0.405* (0.122) 0.403* (0.129) 0.418* (0.118) 0.431* (0.117) 0.427* (0.119) 0.409* (0.115)S −0.211* (0.055) −0.213* (0.560) −0.206* (0.494) −0.203* (0.051) −0.227* (0.069) −0.217* (0.067)FDI 0.022 (0.209)PEF −1.331** (0.662) −1.313** (0.658) −1.324** (0.644) −1.400*** (0.837) −1.400*** (0.885)PBF 0.227 (0.232) 0.228 (0.236) 0.245 (0.228) 0.548* (0.252) 0.542** (0.224) 0.474** (0.221)BCRED −0.176 (0.275) −0.177 (0.276)DEB 0.526 (0.504) 0.513 (0.557) 0.512 (0.554)EI 0.048 (0.408) 0.052** (0.023) 0.049** (0.019) 0.052** (0.021) 0.074** (0.283) 0.068* (0.028)GOV 0.073 (0.120) 0.065 (0.072) 0.069 (0.067) 0.053 (0.073)

Arellano–Bond testp-value 0.268 0.281 0.247 0.293 0.779 0.813

All variables are taken in differences and the regressors are lagged one period. (* , ** , *** ) The coefficient are significant at a 1, 5, 10%, respectively.


investments in MED area (see Section4) produce coefficients that are not significant inthe estimated models.

The coefficient associated to PEF variable exhibits a negative relation with growth. It islikely that the sign of this coefficient is linked to the scarce abilities of the industrial sector ofthe MED area and to the marginal role played by these capital inflows cover in the countriesconsidered. The portfolio equity flows, in fact, don’t assume significant value before the sec-ond half of the nineties, while in some MED economy these flows are currently equal to zero.

The coefficient associated to PBF variable is positive and so, it shows a direct link witheconomic growth.Bailliu (2000)showed that these debts flows can have a positive impacton the economy supporting domestic investments.

The bank credits (BCRED) are not positively correlated with economic growth. Never-theless, it is necessary to consider that, as it is stated bySoto (2000), in a poorly developedfinancial system, these inflows can have a negative influence on the growth. In fact, it ispossible that in developing countries (as the greater part of the MED area) where financialsystem doesn’t offer sufficient warrants, these capital inflows are parked in the banks andresult unprofitable. In practice, financial resources, that should be introduced in the eco-nomic circuit in order to multiply the investments and the production, are scattered in thesystem without productivity.

The regressions show that the debts values with maturity of less than 1 year are positivelycorrelated with economic growth. This result can be explained by the presence in MED areaof a great number of small and medium firms. These firms, unlike the big ones, investigatethe market in the short run and only in a second moment take the investment decision. So,in this situation, we have a large quantity of short run investment and a relevant effect oneconomic growth.

The coefficient associated with the degree of openness to the international commerce (EI)shows a positive effect on economic growth of the countries considered, but less than weexpected on theoretical basis. This result is consistent withRodriguez and Rodrik (1999).In fact, they found little evidence that a limited opening to the international commerce, forexample, introducing tariff barriers to the trade, influenced negatively economic growth.However, the weak result obtained confirms the main reasons that provoked the gatheringof Barcelona Conference: the creation of the free exchange area and the need for an increaseof international commerce.

Finally, the coefficient relative to GOV variable shows a positive relation to economicgrowth. The result obtained is coherent with the Keynesian theories (that are recently expe-riencing a renewed popularity in many countries) that consider fiscal policies more effectivethan monetary towards the aim of achieving the growth objectives. This is especially trueif the expenditure are oriented to infrastructure development and so to the modernizationof the country.

6. Concluding remarks

In this paper, we have examined the relationship between economic growth and capitalinflows of the eleven Mediterranean countries that participated at Barcelona Conference in1995 in the period 1990–2000,


The empirical analysis reveals that the MED countries have exploited less than theother developing countries the extraordinary wave of capital inflows that has character-ized the economies at the end of the last century. During the period under investigation,these countries have not developed significant political initiatives to support the pri-vate capitals inflows as those, for example, directed to the liberalization of the marketand to the creation of an economic system that is able to exploit domestic and foreigninvestments.

The major aim of this paper is represented by the estimation of the economic growthusing some financial variables as covariates, through a dynamic panel data. The resultsobtained show that capital flows, with particular reference to foreign direct investments, arenot yet developed in the MED countries.

In a previous paper (Laureti, 2001), the MED countries were divided in two groups.These countries are different in terms of commercial flows and of economic convergence.The same result can be found inFerragina, Giovanetti and Pastore (2004), In this paper, wealso identified two groups in the MED countries (see Section4). The first is constituted bythose countries that have made some important steps towards the liberalization of the marketsand towards the opening to international commerce. These countries adopt macroeconomicpolicies of opening market and of endogenous (through the domestic investments) andexogenous development. These countries also receive a large quantity of financial flowsand, consequently, produce positive growth rates.

Conversely, the second group is constituted by those countries that are still late inthe openness process and that, for cultural, religious and political reasons, have not fullyembraced the theories on international commerce and on markets opening.

A further consideration refers to the fact that the MED countries have UE as principalpartner, in the commercial and financial opening; and they only partially show a certainform of horizontal integration. In 2003, the commerce with the UE represented the 45%of the total of the MED economies, while, in the same period, the commerce among MEDcountries was only of 3%.

In conclusion, we can observe that the MED countries show a large quantity of unex-pressed potentialities in the field of financial development. The debate started with theBarcelona Conference is therefore still in progress, since many European Countries haveseen great opportunities of economic development in the cooperation and in the integrationof this area.

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The effects of capital inflows on the economic growth in the Med Area