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 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; (iii) domestic saving has a significant negative effect on net-current
transfers. We use countries in the sub-Saharan African region as a laboratory for an
instrumental variables approach. The IV approach enables to obtain estimates of casual
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
effects a country’s accumulation of net foreign assets.