I. Introduction One common feature of the developing countries is the paucity of investible surplus due to lower income base. They can ‘overcome this problem if mobility of capital across political boundaries becomes unhindered. This state of affairs has one implication and that is that saving and investment in a particular country should not be correlated. This aspect has gained importance in the post World War II period because the world hasseen rapid integration of the capital markets of different countries and particularly countries in the European continent. The mobility of capital across the political boundaries has another implication. The microeconomic theories teach us that the capital formation of a country depends on her overall savings. In fact, steady-state growth of a closed economy is said to depend on the saving-income ratio and the incremental capital-output ratio. This induces the economists to prescribe for higher rate of savings which will guarantee a higher rate of capital formation. ‘The question which is important is that whether a country with low saving-income ratio can expect higher rate of growth depending on the borrowed funds, by encouraging direct foreign investments. To put the issue in a different perspective, it * "This paper is based on the research project “International Capital Mobility” submitted at NIBM in May 1995, Iwould like to express my gratitude and deep acknowledgement to NIBM for providing the financial support for this research. I am indebted to Mss Paramita Bhattacharya for rendering research assistance for this project and to Mrs Kumud Lagu for wordprocessing the manuscript in its present form, Journal of Foreign Exchange and International Finarce Vol. 1X, No. 2, pp. 115-131 Domestic Saving and Investment Correlation and International Capital Mobility Sukumar Nandi_ boils down to the question to what extent capital is mobile across the political boundaries. If the capital mobility is high, a country with a lower saving-income ratio can afford higher investment depending on foreign capital. This implies that saving-income ratio (S/y ratio) and investment-income ratio (I/y ratio) may be independent. Thus the degree of independence of these two ratios and the degree of capital mobility are treated on the same footing. This is the principal aspect of this study. In Section If we will analyse the principal models in the literature which explain different aspects of capital mobility, which again gives a brief survey of the literature. Section IMI will deal with the econometric estimation of one of the models. The implications of the results of the estimation will come in the form of a conclusion of the paper. II. Theories of International Capital Mobility ‘The study of the international capital mobility and the financial integration of the capital markets of different countries tries to trace the common elements affecting both. ‘The literature also defines weak and strong form of financial integration. A weak form of financial integration refers to a situation when domestic and foreign economicagents trade identical assets at the same price. This implies that law of one price prevails in the absence of artificial barriers. But foreign assets may be imperfect substitutes because of different political regimes. And financial integration is said to be strong when identically defined assets denominated in 15ao> woe | | | | Domestic Saving and Investment Correl batt’) Ste1/St= ELA + it’) Sea/Sd +e) Swhere e is the prediction error, a random "jg weakly efficient, the information set ghould contain the past prediction error, _ which is lagged value of et, which is serially “uncorrelated. If we consider the ex post differential di, given by de= (1+ it) — (1+ if) Se+1/St @) Now under the null hypothesis of UIP and rational expectation, dt is the negative prediction error. Thus the joint hypothesis can be tested by examining whether dr has a zero mean and is not serially correlated. One implication of the testing of the UIP "ig that the difference between the prices of identical assets in two countries shows the degree of financial integration. As the latter increases, the difference gets narrower. ‘Another aspect of financial integration is that as capital inflow is influenced by the differences in real returns, the changes in the savings levels of acountry should have little bearing on the investment. Ina more formal level, Feldstein and Horioka (1980) defined perfect capital mobility in the sense that exogenous changes in the national savings rate should have no effects on the investment rates. ‘The Feldstein-Horioka (F-H) condition requires that the real interest rate of the country should be tied with the world’s real interest rate by real interest parity condition. Further, it is also necessary that all determinants of a country’s rate of investment other than its real interest rate be uncorrelated with its rate of national saving. The estimated regression in the P-H approach is (/Y=a+b6/Yi+e where (I/Y) is the ratio of gross domestic investment to gross national product (GNP) and (8/Y) is the ratio of national savings to GNP. The argument is that under the hypothesis of perfect capital mobility, b should be zero for small countries. Again, for large countries, b should approximate lation and International Capital Mobility the country’s share of the world capital stock The original estimate of b in F-H study was close to 0.9 and they interpreted that value as consistent with a low degree of financial integration. This observation based on the high value of bis challenged by many economists, though the findings of F-H for large industrial countries have been confirmed in many studies. Further, in some estimates the estimated value of"b’ has been statistically different from the auturky value 1 indicating some degree of financial integration. We will get more scope for the discussion of F-H condition later. It is stated above that the F-H condition requires that real interest parity should hold, or ni-r=0 where ris the world interest rate and is exogenous. One criticism (Tobin, 1983; Murphy, 1984) is that if domestic country is large in the international market, r will not be exogenous and therefore, even if n-r =0 and in turn (I/Y) will be correlated with (S/Y). It means that a decrease in the domestic savings will drive up world interest rate and thus crowd out investment, both in the domestic economy and also abroad. Further, if saving-investment regression is a good test for financial integration, the coefficient ‘b’ is expected to fall over time. But evidence does not support this either in cross-section studies (Feldstein, 1983; Dooley ef al, 1987) or in time series study (Frankel, 1986; Obstfeld, 1986). Often endogeneity of the national savings is mentioned for this result, but opinion differs, as use of an instrumental variable does not change the result (Frankel, 1992). Sometimes it is assumed that the domestic market clearing interest rate (say i) can be expressed as a weighted average of the uncovered interest parity interest rate (i ) and the domestic market clearing interest zate that would be observed in the case of complete closed (say i). Edwards and Khan 47Journal of Foreign Exchange and International Finance different currencies under different political regimes are perfect substitutes to the economic agents. Economies that have experienced some kind of financial integration already and also the countries which are trying to integrate their capital market with the international capital market should be cautious of some implications of the financial integration (Montiel, 1994) Assuming that all domestic interest bearing assets are perfect substitutes, first it can be said that changes in excess supplies and demands of assets in a small economy have no influence on the world prices of the assets. When the latter rule in the domestic market, returns on assets become less sensitive to the changes in domestic saving schedule. As for example, even if real return on savings goes down, capital can be shifted abroad to realise the expected return. Second, one implication of the open economy macroeconomics literature is that the effects of domestic fiscal and monetary policies on aggregate demand depends on the degree of financial integration of the economy with the outside world. As for example, under the fixed exchange rate regime, strong financial integration implies that neither fiscal nor monetary policies can influence the conditions of domestic borrowing. Third, when the degree of integration of an economy increases, the effects of a given fiscal deficit on inflation increase for the following reasons. The latter depends on two things : the stock of base money and the elasticity of base money demand with respect to rate of inflation. As the degree of integration increases, the economic agents can increasingly dodge the inflation tax by a suitable change of their portfolios. Thus the scope of the inflation tax is reduced and increasing impact of the fiscal deficit is felt on the price level. This aspect is important for the developing economies which are increasingly seeking integration with the international capital market. Theoretically, the issue of financial integration on international capital mobility has been approached from a variety of angles. Many economists have tried to measure the extent of gross or net capital flows among the countries. Based mainly on the industrial countries various measures are obtained in Golub (1990), Feldstein (1986), Capino and Howard (1984), Obstfeld, (1986) and Penati and Dooky (1984). Also many major developing countries have experienced huge outflow of capital through their financial openness (Cuddington, 1986; Montiel, 1993). When a country is highly integrated with the rest of the world, it is expected that the country will experience a high level of capital flows. Generally, two reasons are cited in the literature (Montiel, 1994). First, ina strong integrated market borrowing and lending can often cross political boundaries. The present day Europe is an example. ‘Second, in case of financial integration, the term structure of interest rates at the domestic level is related to the level of the world and any change on either side in the rates of return will induce net: capital inflow. The latter helps in the equalisation of the returns which is generally measured by covered interest parity, uncovered interest parity and real interest parity. Again, for most developing countries covered interest parity is of little empirical relevance because, for the currencies of such countries, forward markets seldom exit. For the developing countries uncovered interest parity (UIP) is most relevant and it states that arbitrage equalizes expected returns on same type of foreign and domestic assets, or (+i) = ELA +i) Set /Sd | q where it is domestic and i foreign interest rate and St is the domestic currency price of one unit of foreign currency. Here both it and St+1 are stochastic variables because of the risk factor. Since RHS of equation (1) is not observable, we use rational expectation hypothesis (REH). Under the. assumption of REH, 116