Capital account flows, consumption ratios and the middle‐income trap

• Author: Daping Zhao,W. Robert J. Alexander,Sajid Anwar
• DOI: http://doi.org/10.1111/rode.12597
• Published date: 01 August 2019
• Date: 01 August 2019

Rev Dev Econ. 2019;23:1459–1476. wileyonlinelibrary.com/journal/rode

|

1459

© 2019 John Wiley & Sons Ltd

1

|

INTRODUCTION

Having attained middle- income status, a developing country faces the problem of transition to high-

income. It may become trapped at the middle- income stage, squeezed between low- income, low- wage

and high- income, high- wage economies, finding it difficult to compete with the former in manufac-

tured exports and the latter in innovative products and services.

The middle- income trap may be exacerbated by both internal and external factors. On the domestic

side of the economy, it is necessary to move from a relatively low consumption share of income to a

DOI: 10.1111/rode.12597

REGULAR ARTICLE

Capital account flows, consumption ratios and the

middle-income trap

DapingZhao1

|

SajidAnwar1,2

|

W. Robert J.Alexander2

1Shanghai Lixin University of Accounting

and Finance, Shanghai, China

2University of the Sunshine Coast,

Maroochydore DC, Australia

Correspondence

Sajid Anwar, University of the Sunshine

Coast, Maroochydore DC, QLD 4558,

Australia.

Email: sanwar@usc.edu.au

Funding information

This study is supported by the China

National Social Science Fund Research on

the Risks and Experiment of RMB Capital

Account Liberalization in Shanghai FTA

(No.14BJY178).

Abstract

The existing literature suggests that it is important to under-

stand the factors that may slow the transition of an economy

from middle to high income. Many factors have been sug-

gested as promoting or retarding economic growth, but little

attention has been paid to the roles of the capital account and

consumption ratio. Using panel regressions involving 48

countries over the 1950–2013 period as well as employing

extreme bounds analysis, we find that foreign investment

outflows are associated with a mature economy and that there

is an optimal consumption ratio that must be surpassed to

break out of middle- income status. These findings are robust

to an extreme bounds analysis incorporating a wide range of

variables potentially related to growth performance.

JEL CLASSIFICATION

O47, E21, F21

KEYWORDS

capital account flows, consumption ratio, growth slow-down, middle-

income trap

1460

|

ZHAO etAl.

relatively high consumption ratio. If the consumption ratio that is optimal for economic growth cannot

be attained, then growth will inevitably slow. The main challenge faced with respect to the foreign

sector is the role of foreign investment, particularly in the context of liberalization of the capital ac-

count. Relaxation of controls on foreign investment, both inward and outward, raises the prospect of

a foreign exchange or more general financial crisis. It is unclear whether foreign investment inflows

and/or outflows are positively or negatively associated with economic growth.

We undertake an analysis of growth slowdowns in a sample of 48 countries over the period 1950–

2013. We first define and identify periods of slowdown, as well as classifying countries as high-

income, middle- income, and middle- income trapped. Then we estimate a panel model of economic

growth, focusing on the roles of consumption and the foreign sector, in the full sample and in the

sub- samples of high- income, middle- income and middle- income- trapped economies. The main find-

ings are that middle- income- trapped economies have consumption ratios that are quite low compared

to what would be optimal for economic growth and that inward foreign investment is associated with

lower growth while outward foreign investment is associated with higher economic growth. These

two factors pose potentially serious obstacles to escaping the middle- income trap. To examine the

robustness of the findings, we conduct an extreme- bounds analysis (EBA), adding to the variables of

interest a number of other variables that have been proposed in the literature. The findings are robust

to the inclusion of these other factors.

The outline of the paper is as follows. Section 2 presents a selective review of the literature on the

middle- income trap, focusing on the role of domestic consumption and the capital account. Section 3

discusses the data and sets out precise definitions of growth slowdowns and classifications of middle-

income and middle- income- trapped economies. Section 4 outlines the model and the EBA method.

Section 5 presents the results of the estimations. Section 6 concludes.

2

|

LITERATURE REVIEW

In the neoclassical model of economic growth (Solow, 1956) the sole long- run determinant of growth

is technological progress. In the short run, that is, in the process of convergence to long- run equilib-

rium, the accumulation of capital per worker is the driving force. If k is capital per effective worker,

f(k) the production function in intensive form, s the savings ratio, n the growth rate of the labor force,

g the rate of technological progress, and δ the rate of depreciation, then the basic differential equation

of the Solow model is

Clearly, when actual savings, sf(k), exceeds desired savings, (n+g+δ)k, k will increase (i.e. capital

will accumulate). The further a country is from the long- run value of capital per worker, the faster it

will grow, so that low- income countries are expected to grow more quickly than middle- income coun-

tries. The importance of the accumulation of capital during the process of convergence suggests that,

in empirical work, we need to consider capital flows, both internationally and via domestic savings, s.

In the Solow model, if s increases, then the long- run equilibrium value of k also increases, enlarging

the actual versus desired savings gap. An increase in savings is equivalent to a decrease in consump-

tion, so that we might expect to observe a fast- growing developing economy to have a relatively low

consumption ratio. It can be shown, in the Solow model, that equilibrium consumption is related to

savings by

(1)

̇

k=sf (k)−(n+g+

𝛿

)k.

(2)

𝜕c∗

𝜕s

=[f�(k)−(n+g+𝛿)]

𝜕k∗

dc .