Abstract
This study examines the cost and benefits of capital inflow in emerging economies and delineates equity and debt to examine the nature and trends of capital inflows in Brazil, Russia, India, China, South Africa (BRICS), East Asia and Sub-Saharan Africa since their economic reforms. We adopt a two-step process to address endogeneity and to tease out the causal effect of capital flow on economic growth and vice versa. First, we run the panel Granger causality test to examine the precedence of causality between per capita GDP growth, Foreign Direct Investment (FDI) inflows, portfolio inflows and the real effective exchange rate. We follow this test with a fixed-effect panel regression model to test for the magnitude of causality between the variables. The study finds the presence of a strong causality between FDI equity flows and a weak and lagged causality between short term capital flows and economic growth. In the short-run, there is bi-directional causality in growth and equity flows. In the longer run, the effects of equity fade away, but the effect of sustained debt kicks in. Among other results, an average currency appreciation for one-year causes equity inflow and causes GDP growth for two years.
Highlights
Post-World War II, the idea of a big push (Roland 1943) in maintaining a positive investment climate has rocketed as a key policy tool for economic growth, development and poverty reduction
There has been no consistent trend among the BRICS economies in attracting Foreign Direct Investment (FDI) and portfolio flows, highlighting the changing positions in terms of being favorable destinations of capital inflows
The reason we created a structural break in the summary data was to understand how foreign and domestic capital evolved between World War II and recent economic reforms of these emerging economies
Summary
Post-World War II, the idea of a big push (Roland 1943) in maintaining a positive investment climate has rocketed as a key policy tool for economic growth, development and poverty reduction. It would be interesting to see if there is bi-directional ‘causality’ between economic growth and capital inflow in emerging economies It has enduring policy relevance as developing countries try to decide whether to open themselves up more to financial globalization, and if so, in what form and to what degree. Far, there has been no study on the causal impact of foreign capital on economic growth and vice versa This question has gained importance in recent years because of the curious, even seemingly perverse, phenomenon of global capital flowing “uphill” from poorer to richer countries (Prasad et al 2007).
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