Private Capital Flows, Financial Development, and Economic Growth in Developing Countries

An important issue in the debate over the desirability of freer capital mobility for developing countries is whether capital flows have significant effects on economic growth. Proponents of capital account liberalization cite the growth-promoting attributes of capital inflows as a key benefit of financial integration for developing countries. Unfortunately, there is little empirical evidence to confirm or refute this claim, except for several studies that establish a positive link between inflows of foreign direct investment (FDI) and economic growth. This paper helps to fill the gap in the literature by investigating the role of private capital flows in the determination of economic growth using panel data for 40 developing countries from 1975–95. Unlike existing empirical work, this paper focuses on the effects of a broad measure of capital flows on economic growth, rather than on a more specific category, such as FDI, and it emphasizes the role played by the domestic financial sector in the process linking capital flows and growth. A dynamic panel-data methodology is used that controls for country-specific effects and accounts for the potential endogeneity of the explanatory variables. This study finds evidence that capital inflows foster higher economic growth, above and beyond any effects on the investment rate, but only for economies where the banking sector has reached a certain level of development. The results thus suggest that the domestic financial sector plays a pivotal role in ensuring that international capital flows do indeed promote economic growth in developing countries.