Does It Pour When it Rains? Capital Flows and Economic Growth in Developing Countries
Jean-Louis Combes, Tidiane Kinda, Rasmané Ouedraogo, and Patrick Plane
FERDI Working Paper No. 157, February 2017
This paper assesses the impact of capital inflows and their composition on the real exchange rate and economic growth in developing countries. Using the Generalized Method of Moments (GMM) technique for dynamic panel data, the authors hypothesize that not only do net capital inflows matter to growth, but also that their composition and possibly their fluctuations matter too. They also try to account for indirect effects of capital inflows channeled through the real exchange rate. In addition, the different sources of heterogeneity across the sample of 77 low- and middle-income economies investigated over the period 1980-2012 are also explored, including a country’s level of development and the exchange rate regime.
Capital Inflows and Growth
After seven decades of studies related to development economics, evidence on the growth impact of capital inflows remains mixed (Kose et al. 2006). When developing countries manage to attract capital inflows, it is not always a blessing as instability and potential “crowding out” effects can arise. Rather than stimulating growth by filling the investment-savings gap, external resources can substitute domestic financing for the most profitable projects, leaving unfunded projects of lower quality. The objective of this paper is to revisit the relationship between capital inflows and economic growth by considering a large sample of low- and middle-income countries.
Based on a large sample of 77 low- and middle-income economies over the period 1980-2012, the key results are as follows:
- A 10 percent increase in total net capital inflows appreciates the real exchange rate by 5 percent.
The appreciation effect of remittances is twice the effect of aid and ten times greater than the effect of FDI.
Capital inflows are associated with higher economic growth; doubling capital inflows per capita would increase growth by about 50 percent.
The direct effect alone represents a doubling of the annual growth rate (7.4 percent compared to 3.7 percent) observed over the period 1980-2012.
The empirical study finds that, for low- to middle-income countries, the capital inflows affect economic growth through two channels. While they have a direct and positive impact on growth, they indirectly lower growth prospects by appreciating the real exchange rate and weakening the recipient country’s competitiveness. Further, the contribution of net capital inflows to the variation of the real effective exchange rate (REER) was significant and the impact was found to be more pronounced for low-income countries. As such, developing countries, notably low-income economies should fully internalize the fact that capital inflows, while critical to finance development needs and to spurring economic growth, can also lead to significant REER appreciation and loss of competitiveness, thereby complicating macroeconomic management.