Capital Flows and Growth in Developing Countries: A Dynamic Panel Data Analysis

Abstract

This paper unravels the capital flow–growth nexus by employing a model that incorporates contemporaneous influences and contemporaneous expectations. Using an unbalanced panel data set, the paper considers and highlights the role of indirect effects, through the spillover or interaction channel, in influencing economic development. Rigorous tests—incorporating tertiary education, alternative capital flow types and an interaction term—confirm the hypothesis that private capital flows are growth promoting in general, and upper middle-income countries appear to gain more from such flows than low-income countries.

Notes

¹ Conducting the analysis in a panel context or using panel estimators increases the power of the tests (see, for instance, MacDonald & Nagayasu, 2000; Baltagi, 2001).

² Some, however, contend that foreign investors may display herd behaviour rather than rational thinking, so that sudden reversals in portfolio flows can destabilize the recipient countries' economies, and consequently can reduce growth.

³ There is empirical evidence, however, that advantageous effects of FDI are not necessarily positively related to the absorptive capacity of the host countries. Bende-Nabende et al. (2003) found a positive and significant impact for comparatively economically less-developed countries, but negative and significant impact in the more economically developed ones. The absorptive capacities of the former countries are lower than those of the latter.

⁴ In contrast to this finding, a survey study by De Mello (1997) suggests that the impact of FDI on growth seems to be higher in the less technologically advanced countries than in more technologically advanced ones.

⁵ The instrumental variable estimation method is designed to take care of the problems of possible correlation of the explanatory variables with the error term and the individual specific effects, and endogeneity.

⁶ A method of moments estimator derives the coefficients from the so-called moment restrictions, that is, restrictions on the covariance between regressors and the error term. The system GMM estimator combines the differenced equation with a levels equation to form a system GMM. In particular, the GMM estimators can be used to deal with the problem of simultaneous causation between growth and capital flows by allowing the lagged values of the explanatory variables as instruments.

⁷ LI, LMI and UMI economies are sometimes referred to as developing economies (World Bank, 2004).

⁸ A further detailed description of the data used in the study is provided in International Monetary Fund (1992, 2002).

⁹ Secondary education completes the foundations for lifelong learning and human development, by offering more subject- or skill-oriented instruction using more specialized teachers.

¹⁰ Life expectancy at birth indicates the number of years a newborn infant would live if prevailing patterns of mortality at the time of its birth were to stay the same throughout its life.

¹¹ Time dummies were included in these regressions (reported in Tables 1 and 2) but were found to be statistically insignificant. Also, as the time dummy tests (to save space these are not presented here but are available from the authors) suggest the insignificance of time effects, time dummies are excluded in the following regressions.

¹² In a balanced panel, the number of instruments used can be readily determined; however, this approach does not extend conveniently to our unbalanced panel. As the use of all lagged values of potential instruments may make the number of instruments used too large, and hence may reduce the power of the Sargan test, we have accounted for this by setting the maximum lag length to three to limit the number of instruments utilized.

¹³ The tertiary education variable has a few missing values; however, the availability of the tertiary education variable is as good as that of the secondary education variable overall. Indeed, there are more tertiary education data available in a number of countries, e.g. Thailand, Uganda and Madagascar, from 1997 onwards than there are for the secondary education variable.