On the Relationship between Domestic Saving and the Current Account: Evidence and Theory for Developing Countries

Abstract

We examine the relationship between domestic saving and the current account in developing countries. Our three main findings are that: (i) domestic saving has a small effect on the current account; (ii) domestic saving has a significant positive effect on the trade balance—this effect is much larger than the effect that domestic saving has on the current account; and (iii) domestic saving has a significant negative effect on net‐current transfers. We use countries in the SSA region during the period 1980‐2009 as a laboratory for an instrumental variables (IV) approach. The IV approach enables to obtain estimates of causal effects. Underlying the IV approach is the significant positive first‐stage response of domestic saving to plausibly exogenous annual rainfall: an unanticipated, transitory supply‐side shock. We construct a small open‐economy DSGE model with debt adjustment costs and endogenous current transfers to match the empirical findings. The model enables to examine the relationship between domestic saving and the current account for different types of shocks. An important message of our paper is that, for developing countries, estimates of the relationship between domestic saving and domestic investment are not informative for answering the question how domestic saving affects a country's accumulation of net foreign assets.