World Development, Vol. 17, No. 11, pp. 170?+1715,1989 Printed in Great Britain.

0305--750x/89 $3.00 + 0.00 0 1989 Pergamon Press pit

The Impact of Foreign Capital Inflows on Domestic Savings Reexamined:

The Case of Argentina

JACQUES MORISSET* University of Geneva

Summary. - Since the beginning of the 1970s. several economists have argued that there is a negative relationship between foreign capital inflows (F) and domestic savings (S). This paper attempts to demonstrate that the framework used by these authors is not appropriate to analyze the impact of F on S. The early empirical results may actually be a consequence of exogenous factors such as monetary and fiscal policies.

1. INTRODUCTION

In the economic literature of the past 20 years, the relationship between foreign capital inflows and domestic savings has received considerable attention. The main purpose of these efforts has been to determine whether in less developed countries (LDCs) foreign capital inflows and domestic savings are complements or substitutes. Most authors initially adopted the complemen- tary hypothesis, but more recently others have put forward the hypothesis that an increase in foreign capital inflows produces a decline in domestic savings. In the present state of re- search, the tendency is to admit the existence of a certain degree of substitutability between these two variables (see, e.g., Gersovitz, 1982; Wasow, 1979; and Griffin, 1978).

The previous studies, however, suffer from certain important limitations. The first and most severe limitation is that these studies do not make any serious attempts to specify the savings function which underlies the foreign capital inflows-domestic savings relationship. This pro- cedure may affect seriously the results, since the omission of explanatory variables in the regres- sion may bias the estimates of the parameters of the remaining variables. Second, the traditional approach assumes a causal relationship between foreign capital inflows and domestic savings. But this relationship may be more incidental than causal, and the estimated impact may capture the effects of variables not explicitly included in the model. The purpose of this paper is to confront

these two remarks with the Argentine data. More broadly, the paper can be viewed as an attempt to demonstrate that the framework used in the previous studies is not appropriate to analyze the impact of foreign capital inflows on domestic savings.

Section 2 presents a simple empirical test of the impact of foreign capital inflows on domestic savings, which is relevant for assessing the limits of the traditional approach. In Section 3, a number of potential explanatory variables of the savings function are selected in addition to foreign capital inflows, and are tested empiri- cally. These results are then compared with those obtained in the previous section. Section 4 is devoted to the demonstration that the early empirical results may actually be a consequence of exogenous factors, and therefore the econo- metric results should not be systematically inter- preted as the impact of foreign capital inflows on domestic savings.

In order to achieve a more precise specification of the savings function, the estimations presented in this paper only concern Argentina. Specifica- tion using cross-section data from LDCs, while providing many more observations, assumes a similarity of saving behaviors which is ques- tionable.

‘I am especially grateful to Ulrich Kohli and to an anonymous referee for helpful comments and suggestions.

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2. THE TRADITIONAL APPROACH

The substitution hypothesis between foreign capital inflows and domestic savings was origin- ally put forward by Haavelmo (1963). He pointed out that foreign investors could take the place of domestic investors and, in this way, they could reduce internal savings. Many theoretical and descriptive approaches have been developed from this starting point. The possible existence of a negative relationship between foreign capital inflows (fl and domestic savings (S) has mainly been justified with the argument that foreign capital could be used to increase consumption rather than investment.

Several attempts to apply statistical methods to this question support the view that S is inversely associated with F. The equation usually tested is:

S/Y = a + j3FfY (1)

where S is defined as domestic savings, F as external capital inflow (current account deficit), Y as gross domestic product and a as a constant. The parameter 0 represents the marginal impact of FIY on S/Y and must be nonpositive. The level of S remains unaffected and /3 equals zero when the full amount of F is used to increase invest- ment, but to the extent that a part of F is devoted to consumption, 0 becomes negative.

Some aspects of this simple regression have led to the following comments. First, as noted by Papanek (1973), F should not be considered as a homogeneous group since it can be financed in various ways. Second, the estimate of f3 is automatically biased negatively when the country has been subject to a foreign exchange con- straint; see, e.g., Landau (1971), Weisskopf (1972) and Gersovitz (1982). In spite of these two remarks, most of the studies estimating equation (1) by using the ordinary least squares (OLS)

method conclude that Facts as a substitute for S, the parameter /3 being negative and highly significant (see Table 1).

In order to confirm these results with a mote recent data set, we estimated this equation for some Latin American countries, including Argentina, over the 196&81 period. Our results are summarized in Table 2. They confirm the earlier results and indicate, furthermore, that the negative impact is even more pronounced during 1973-82 in Peru (6 = -0.8076) and in Argentina (fi = -0.9157) than during the earlier period. Chenery and Eckstein (1970) and Landau (1971) found that for Argentina the estimate of p was -0.50 during 1950-64 and -0.34 during 19.5566.

3. THE SPECIFICATION OF THE SAVINGS FUNCTION AND NEW ESTIMATES OF

THE IMPACT OF F ON S

The results obtained in the previous section are suggestive but not conclusive. While the econo- metric test suggests a negative causal relationship between F and S, the actual savings function has not been specified. This limitation may have important implications, not only on the residual variance of the regression, but also on the estimate of fl. Thus, the exclusion of relevant variables from the regression may be a very important source of error.

The specification of the savings function dis- tinguishes our approach from previous studies. Our Argentine savings function is derived from economic theory and the literature. The similari- ties in the estimated forms of the most popular consumption-savings functions enabled us to emphasize the partial adjustment hypothesis. We have included lagged consumption in the savings function because the adjustment process may be spread over several periods.

Table 1. Marginal impact of external capital inflow on domestic savings: A summary of results from previous studies

Authors Period of estimation Number of countries Marginal impact

Chenery and Eckstein

Landau

Griffin and Enos

Grinols and Bhagwati

195044 16 from -0.63 to -1.15

1955-66 18 from -0.2 to -0.9

1970 32 -0.73

19.52-70 1 -0.57

Sources: Chenery and Eckstein (1970). Landau (1971), Griffin and Enos (1970). Grinols and Bhagwati (1976).

CAPITAL INFLOWS AND DOMESTIC SAVINGS IN ARGENTINA 1711

Table 2. Marginal impact of external capital inflow on domestic savings in some Latin. American countries

(t-sratistics in parentheses)

Country @ (196b-81) fi (1973-81)

Argentina

Peru

Colombia

Bolivia

-0.6720 -0.9157 (-2.07) (-2.02)

-0.6075 -0.8076 (-3.82) (-4.35)

- -0.7677 (-2.44)

-0.7100 -0.6629 (-2.57) (-2.51)

Source: Data from IMF (1983) and (1985).

As a starting point, we consider the following long-run consumption function:

C*=aO+alY+a2F+asr+a4n (2)

where C* is the desired consumption, Y is the gross domestic product, r is a real interest rate (savings deposit), n is the inflation rate and F represents the foreign capital inflows. C, Y and F are expressed in real terms.

Assume now that the actual consumption (C) does not adjust immediately toward its desired level as a result of adjustment costs. Assume, moreover, that the adjustment process is linear:

c-c._,=~(c*-c_,),o<~~1 (3)

We then substitute equation (2) into equation (3), and using the identity S = Y - C, we finally get the following short-run savings function:

S = PO + plY + P2F + /3g + P4n + p&-l

(4)

where &, = -sop I33 = -a3l.r

PI = (1 - ad b4 = -a4p

02 = --a2P I.35 = --Cl -PO

The a priori expectations for the parameters pl, fi2 and p3 of equation (4) can be deter- mined on the basis of theoretical arguments. It is normally assumed that Y and r have positive effects on savings (fil > 0 and p3 > 0) and the coefficient p2 should be negative in accordance with the results of previous studies (p2 < 0). On the other side, the sign of fi4 remains very controversial in the literature (see Howard, 1978; and Thirwall, 1974).

The regression analysis was conducted using three alternative definitions of F. First, we defined F as the current account deficit (Fl). This

definition permitted us to compare our results with those of previous studies. Second, the annual net inflow of external resources (n), as measured by the Inter-American Development Bank (IADB), was used in order to confront our results with a data set closer to the definition of external debt. Finally, following Papanek (1973) and Begley (1978), we conducted a regression using private foreign investment (FPI) and offi- cial capital inflow (AID) as independent vari- ables. We defined S as the part of gross domestic product which is not spent on consumption (S = Y - C). As we attempt to provide the best esti- mate of the domestic savings effort in Argen- tina, gross domestic savings is more accurate than gross national savings since the large in- terest payments due on Argentina’s foreign debt must be financed from domestic savings. (Ex- cluding them would result in an underestimate of domestic resources mobilization.) In contrast, we did not include durable goods in the definition because the underlying purpose of buying dur- ables is the consumption of their services. As suggested by Begley’s study on savings-aid re- lationship, S could be fi;rther disaggregated into public and private savings. Unfortunately, data limitations precluded this approach for Argentina.’ In any case, “analysis of aggregate savings is valid to the extent that public and private savings are substitutes and/or respond to the same economic stimuli” (Leff and Sato, 1986,

P. 8). The data on S, FI and Y have been obtained

from the International Monetary fund’s Inter- national Financial Statistics. Series from IADB and World Bank debt tables have also been used for K!, AID, FPI, 2 and n. All variables have been deflated by the wholesale price index (WPI) and a dummy variable (Q) was introduced for the years when the external constraint was binding, to conform with Gersovitz.

In Table 3, we report OLS estimates for Argentina for the period 1960-81. On the whole, the results are quite satisfactory. The explanatory power (R2) and Durbin-Watson (D\V) statistics are both acceptable, suggesting a good specifica- tion of the model. The most interesting aspect of these results concerns the role of F. Indeed, the estimated coefficients for Fl, F2, AID. and FPI do not appear to be significant in our regressions. Hence, whereas simple correlation analysis showed a negative response of savings to varia- tions in F (see Table 2), the new results do not support (statistically) the substitution hypothesis which assumes that F crowds out S by allowing domestic residents to consume more. We can conclude that the mis-specification of the savings function in previous studies resulted in over-

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CAPITAL INFLOWS AND DOMESTIC SAVINGS IN ARGENTINA 1713

estimating the impact of F on S for Argentina for the period 196&81. Notice, however, that only the results of the first and second regressions are directly comparable with those presented in the first section, because F is defined in the same way.

The results pertaining to the other variables included in the Argentine savings function also deserve a brief explanation. The estimated co- efficient of Y is positive and highly significant, which is compatible with a priori theoretical expectations. The effect of r seems to be positive, but not significant in all our regressions; and the estimated coefficient of x is positive and signi- ficant. These results should be interpreted cautiously because we simplified the model using the actual inflation rate as a proxy of the expected inflation rate. The inclusion of exports in the savings function of LDCs has been advocated by various authors (see, e.g., Pap- anek, 1973); its estimated coefficient appears statistically positive in our study. Notice that we did not include this additional explanatory vari- able in the first regressions in order to avoid multicollinearity between ex orts

P and Fl.

Finally, as the lagged variable (C-t) and the dummy variable (I$) did not perform well in the first tests, they were excluded from our last regressions.

Using the theoretical hypothesis that F could influence S through an intermediate variable of the modeL4 we attempted to estimate the F-S relationship with a simultaneous model including n, r or Y as instrumental variables. But all tests done along these lines failed to prove the existence of significant indirect relationships between F and S. Therefore, only the tests concerning the reduced form of equation (4) were discussed in this paper.

4. A REINTERPRETATION: SIMUL- TANEOUS DETERMINATION OF

FANDS

There are a number of factors that might account for specification problems in equation (4). Particularly, as suggested by Papanek (1972), F may not be an exogenous determinant of S. It is indeed relevant to emphasize that the regressions presented in Sections 2 and 3 do not necessarily imply a causal relationship between F and S, but could actually be a consequence of exogenous factors which reduce S and increase F simultaneously. In fact, the F-S relationship may not even exist. The theoretical arguments assume that, other things equal, an increase in F lowers S. Usually, however, F being itself an

endogenous variable of the system, a change in F may imply that some other variable in the system has changed, and this could affect S as well.

To illustrate this point, let us consider an economy that is subject to variability of export revenue. Assuming a world of integrated capital markets, this economy could engage in external financial transactions (F) only to support dom- estic consumption when there is a shortfall in export revenue. Thus, the results of the empirical studies cannot be systematically intepreted in terms of the impact of F on S, considering that a rational policy response to economic shocks may also establish a negative relationship between F and S. Such an influence of exogenous factors on F has been recently pointed out in intertemporal models by various authors (see, e.g., Sachs, 1981; Svensson and Razin, 1983). As in other markets, the interpretation of variations in F must emphasize conditions not only in the supply of international capital, but also on the demand side.

Given that Argentina has been affected by many exogenous factors during the last 20 years, there is an actual risk that the implicit use of equation (4) may give rise to the illusion that there exists a causal relationship, whereas no such relationship actually exists. Considering that Argentina’s economy was continuously influ- enced by several exogenous factors during the 196&81 period, we estimated their impact on S and F by use of two reduced forms. It is noteworthy that equations (5) and (6) can be easily obtained from a simple macroeconomic model.

S = o0 + oiu + 02r* + u3t + a4B (5)

F = QO + !2,p + C&r* + R3t + S&B (6)

The most important factors were identified by considering the internal factors and external factors separately. Among the internal factors, it is well known that Argentina’s governments have followed a variety of policies resulting in a wide range of economic intervention during the last 20 years. This is illustrated by the inconsistency of fiscal and monetary policies (see Trapp, Fisher, and Hiemenz, 1985). Therefore, the rate of growth of money supply (u) and the public deficit (B) were selected as internal factors. Among the external factors, we chose the varia- tions in the terms of trade (t) and the changes in external interest rates (r*) cons.idering that these two factors seem to hit Argentina with the greatest force.

The OLS results are summarized in the appendix.’ The explanatory power of the regres- sions (B’) and the DW statistics are acceptable.

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With respect to particular parameters, the esti- mated coefficients on the internal factors are all significant. Monetary policy seems to have exerted a positive effect on S and F, and fiscal policy influenced S negatively and F positively. The estimated coefficient of r’ seems to be positive in equations (5) and (6). although the coefficient is only significant at the 10% level in both regressions. In contrast, the terms of trade do not seem to have had any effects (statistically) on Sand F. The last estimation corresponds to results from other studies which showed that t did not exert any significant influence on the Argentine economy.

As suggested in the first part of this section, the F-S relationship may be affected by various exogenous factors. The estimated coefficient (dS/dF) may be different from one period to another, even if there is no change in the nature of the relationship between these two variables. Following the above estimations, we could quantify the bias introduced by each of the exogenous factors on the measure of the impact of F on S. Thus:

dijdB, dS =-A -1.1079

dFjdB, dF, d=B (1.94)

dSjdm, dS, -3.994

dFjdm, =dF, d=M (6.17)

dS jdr*, dS, 1.33

dFjdr’, =dF, d:” (1.72)

On the whole, these results prove that some exogenous factors have influenced F and S simultaneously for the period 1960-81. Accord- ing to our estimations, the internal factors and r* satisfactorily explain the fluctuations of F and S

for Argentina and, consequently, they can create the illusion of a causal relationship between F and S when none really exists. Notice that we estimate the t-statistics using the variance formula for a nonlinear transformation. More- over, according to the nature of the factor, the variations of F and S may be positive or negative.

The use of a reduced form of equation (4) relies on the critical assumption that F is an exogenous variable. We demonstrated that this assumption is inappropriate, and that the para- meters of estimated reduced forms like equations (1) or (4) reflect in part the influence of several exogeneous factors of the model.

5. CONCLUSIONS

Since the beginning of the 197Os, several economists have argued that there is a negative relationship between F and S. In this paper, we have attempted to demonstrate that the frame- work used by these authors is not appropriate to analyze the impact of F on S. Our approach has been divided into two parts.

(1) We have estimated a plausible Argentine savings function. Our results indicate that F does not influence S significantly, at least not in the short term.

(2) We have demonstrated that the previous studies have misrepresented the causal relation- ship between these two variables. Indeed, as long as exogenous factors such as monetary and fiscal policies or changes in the external interest rate can affect F and S simultaneously, one is not able to interpret the traditional empirical results properly. Besides, we have found that, according to the nature of the shock, this estimate could be negatively or positively biased.

NOTES

1. Although the data on government investment rate minus the rate of change in wholesale price index. which are necessary in order to compute public and hence private savings appear not to be consistent 3. Assuming parameter u equals one. between the 1960-69 period and the 197C-81 period, we attempt to estimate equation (4) using private and 4. For example, variations in F can change the public savings alternatively. The results indicate that inflation level and thus affect 5. the impact of Fl is not significant in both cases, but the effect of R, AID and FPI seems to be positive on 5. Major publications of the IMF and the World public savings and negative on private savings. Bank furnished the data. The annual data for r* need to

be completed with the yield on long-term American 2. The variable r is defined as the nominal interest bonds (plus 1.5) for the 1961-66 period.

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CAPITAL INFLOWS AND DOMESTIC SAVINGS IN ARGENTINA 1715

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APPENDIX: THE IMPACT OF EXOGENOUS FACTORS ON S AND R

S =10.13 -0.034 t - 0.747 B +0.034 p +0.200 r’ F =-1.54 +0.0122 t +0.674 B +0.0085 p +0.150 r* (3.27) (1.37) (2.03) (6.15) (1.72) (0.74) (0.07) (2.72) (2.26) (1.90)

I?’ = 0.88, DW = 1.67 d’ = 0.42, DW = 1.66