International capital flows : to what extent do these impact on growth in developing countries

Abstract

The last three decades have been characterised by a marked increase in international capital mobility as financial globalisation gathered momentum in both developed and developing nations. In theory, capital is deemed to move to countries where the marginal product of capital is highest implying that it flows to developing countries and in the process aids economic performance. When capital inflows are in the form of direct investment, they may provide financing for high-return investments which would not have been otherwise possible. They also often bring with them improved technology, management techniques as well as wider access to international networks. Against this scenario, this paper aims to analyse trends in cross border flows as well as to determine whether capital mobility enhances long term economic performance both within a theoretical context and empirically. The study entails the impact of three categories of flows, namely, foreign direct investment, portfolio equity and debt, on economic growth in developing countries. In addition, the effect of volatility of these flows is also analysed. Following the literature review and to a lesser extent empirical analyses, some conclusions were derived and based on these, a number of recommendations were highlighted. ln the first place, it has been shown that foreign direct investment flows should be encouraged as these are only mildly reversible and thus aid a nation's economic growth rate. At the same time, such growth enhancing flows will only be attracted to countries which have a certain absorptive capacity, in terms of the quality of human capital and infrastructure, governance and rule of law as well as political, macroeconomic and financial stability. Secondly, although portfolio equity flows can also positively impact on economic performance, these have been shown to exhibit volatility which has been shown to adversely affect growth. Finally, debt flows are highly volatility and are the least preferred source of capital inflows for a developing nation. This is so despite the fact that, at times, they may be viewed as helping in consumption smoothing.