On the relationship between domestic saving and the current account: evidence and theory for developing countries

We examine the relationship between domestic saving and the current ac-count in developing countries. Our three main findings are that: (i) domesticsaving has a small effect on the current account; (ii) domestic saving has asignificant positive effect on the trade balance—this effect is much largerthan the effect that domestic saving has on the current account; and (iii) do-mestic saving has a significant negative effect on net-current transfers. Weuse countries in the SSA region during the period 1980-2009 as a laboratoryfor an instrumental variables (IV) approach. The IV approach enables toobtain estimates of causal effects. Underlying the IV approach is the signifi-cant positive first-stage response of domestic saving to plausibly exogenousannual rainfall: an unanticipated, transitory supply-side shock. We constructa small open-economy DSGE model with debt adjustment costs and endoge-nous current transfers to match the empirical findings. The model enables toexamine the relationship between domestic saving and the current accountfor different types of shocks. An important message of our paper is that, fordeveloping countries, estimates of the relationship between domestic savingand domestic investment are not informative for answering the question howdomestic saving affects a country’s accumulation of net foreign asset