Foreign capital flows and economic growth in developing countries - Examining the role of institutional quality and financial development

Abstract

The ever growing literature has extensively documented both empirically as well as theoretically the important role of foreign capital flows along with its inherent risk on the economy. However, despite all the benefits they offer capital flows also bring in together some prominent challenges for policy makers around the world. The present study using an annual dataset for 62 developing countries from 1995 to 2019 bring forward three key findings. First, there is a significant positive effect of foreign capital flows on economic growth in developing countries. Second, the positive significant coefficient of the interaction terms of institutional quality and financial development with capital flows indicates that, institutional quality and financial development play a crucial role in enhancing the effects of foreign capital flows on economic growth. Lastly, the result from the dynamic panel threshold suggest that FDI and aid flows generate positive impact on growth beyond the minimum stipulated threshold of institutional quality and financial development. Interestingly, remittances are found to have a positive impact on economic growth in countries with lower level of institutional quality and higher levels of financial development.