Financial flows and economic growth in developing countries

• Published in: Economic modelling 2019-12, Vol.83, p.195-209
• Main Authors: Combes, Jean-Louis, Kinda, Tidiane, Ouedraogo, Rasmané, Plane, Patrick
• Format: Article
• Language: English
• Subjects: Economic growth; Financial flows; Quantitative Finance; Real exchange rate dynamics
• ISSN: 0264-9993; 1873-6122
• DOI: 10.1016/j.econmod.2019.02.010

This paper assesses the impact of financial flows and their composition on the real exchange rate and on economic growth for a sample of low- and middle-income countries over the period of 1980–2012. Financial flows can directly support economic growth by relaxing constraints on domestic resources, but can also indirectly weaken growth through appreciation of the real exchange rate. We use the generalized method of moments (GMM) for dynamic panel. Results show that net financial flows affect economic growth both directly and indirectly: (i) a one percent increase in total financial flows appreciates the real exchange rate by 0.5 percent; (ii) the real exchange rate appreciation effect of remittances is twice the effect of aid and ten times greater than the effect of Foreign Direct Investments; (iii) financial flows stimulate economic growth regardless of the development level. An increase of $10 per capita financial flows leads to a gain of 0.08 points of annual growth. This gain amounts to 0.15 when we control for the negative impact of the real exchange rate. Instability of market-oriented flows, such as FDI and portfolio investments, exacerbates instability of the economic growth rate. •Financial flows stimulate economic growth.•The real exchange rate appreciation partly compensates the benefits of financial flows.•Impact on the GDP growth and the exchange rate varies with the composition of financial flows.•The impact of financial flows differs with the level of development and the exchange rate regime.•Instability of financial flows exacerbates the instability of economic growth.