Macroeconomic impacts of capital flows in emerging market and developing economies

Abstract

Cross-border capital flows are one pillar of the evolving economic globalisation that governs today’s world economy. Because of several waves of capital account liberalisation across developed and developing countries starting in the mid-1970s, cross-border capital flows have become a new norm. According to data from the IMF Balance of Payments database, gross capital inflows into emerging market and developing economies (EMDEs) rose steadily from an average of 4.9% of GDP in the 1990s to around 9.6% of GDP in the last decade. Dramatic surges in and variations of cross-border financial flows have extensive ramifications for the capital-receiving countries and their policy responses. This leads to debates on how the benefits of capital flows can be maximised and the costs minimised for EMDEs. This study examines the impacts of capital flows on economic growth, domestic credit growth and real exchange rate in EMDEs. The study uses gross capital inflows and their different components (i.e., foreign direct investment (FDI), portfolio equity, portfolio debt and other investment) to assess their impacts on three macro-financial variables. The study sample of 130 EMDEs comprises 31 emerging market economies and 99 low-income developing economies between 1991 and 2015, incorporating all the world’s regions; thus making it a most comprehensive study. The study employs a dynamic panel data approach to model the impacts of capital inflows on economic growth, domestic credit growth, and the real exchange rate. The models are estimated by the two-step system generalised method of moments. This study documents multiple important findings. First, capital inflows are significantly strongly associated with economic growth. This strongly supports the economic view that foreign capital plays a vital direct role in driving economic growth in the capital-recipient economy. Second, there is substantial evidence that capital inflows are a driver of domestic credit growth. Third, capital inflows have a positive relationship with the real exchange rate. Fourth, capital inflow composition matters. Among the different forms of capital inflow, only FDI exerts an effect on the three macro-financial variables. FDI inflows promote economic growth, increase domestic credit growth and appreciate the real exchange rate. Fifth, financial development helps dampen the real appreciation effects of capital inflows but it does not have any mediating effect on the capital inflow-economic growth and capital inflow-domestic credit growth nexuses. However, the empirical evidence shows that financial development is conducive to economic growth and helps lessen the pace of domestic credit growth. Finally, institutional quality plays a vital role in enlarging the growth-enhancing effects and reducing the domestic credit growth-inducing effects driven by capital inflows.