Foreign Capital Inflow in Developing Economies– An Overview

Foreign capital inflows refer to the transfer or movement of money or any form of capital or assets from one country to another country for the purpose of trade, investment or business activities. Foreign capital inflows also include the movement of corporate related fund flows as well as capital expenditure on operations, research and development and are considered as one of the key drivers of technological transfer and economic growth. The polices of liberalization, privatization and globalization during the period of 1990s have opened up new frontiers and possibilities for more directed and channelized capital inflows and subsequent investments in developing economies. Though at the outset, foreign capital inflow is believed to enhance the economic growth in developing and emerging economies, criticisms and counter arguments are quite dominant as well.

The traditional neoclassical school of thought holds an optimistic view towards the impact of FIC on economic growth, especially in the developing economies. FIC, through direct capital, is expected to increase economic growth through huge direct investment. On the other hand, economists like Rodrick, Stiglitz and Bhagwati are of the opinion that FIC through capital liberalization tends to create economic shocks in the financial market of developing countries. The market here is largely immature to benefit from a sudden push as well as inefficient in accommodating new changes. The idea of foreign capital inflow is thus strongly related to the idea of capital liberalization whereby the flow of capital and assets are liberalized and deregulated, ensuring huge financial inflows around the globe. The concept foreign capital inflow in the context of developing economies can be analysed from various dimensions like the relationship between economic growth and capital inflows, determinants of capital inflows, public and private capital inflows, arguments in favour and against capital inflows, etc.

Foreign capital inflow is an important component of capital pooling in any national economy, regardless of the development the country has acquired. Over the years, the relevance of FCI has increased to such an extent that it contributes largely to the development prospect of an economy. Capital inflows is an integral part of development for advanced economies in sustaining their financial system as well as to diversify their portfolios thereby reducing risks and expanding market. On the other hand, capital inflows are the major source of capital accumulation and investments for a developing economy. One of the challenges faced by a developing economy is the deficiency of capital accumulation as well as the inability to successfully establish and invest funds in productive activities. Thus, FCI provides an impetus for the development of the domestic financial system though certain negative effects are associated with the same depending on the level of sufficiency and effectiveness of institutional, economic and regulatory frameworks of an economy.

The major components of capital inflows are Foreign Direct Investment(FDI), Foreign Portfolio Investment(FPI), Depository Receipts(DR), Foreign Institutional Investments(FII) and External Commercial Borrowing(ECB). FDI refers to the investments made by investors in country other than their own country either through the purchase of shares and equities of companies or by establishing factory, branches or affiliates in the country. Thus, FDI accounts for all type of capital contributions like purchase of shares, stocks or bonds, reinvestment of earning by subsidiary company and even the lending of funds to a foreign subsidiary or branch. Foreign Portfolio Investment includes both Depository Receipts as well as FIIs. DRs are the equity receipts issued outside the country to non-resident investors. This is granted through authorized overseas sources. Among the developing or emerging economies, India tops the list for the value issued of DRs. ECBs are regarded as one of the important additional source of financing and funds in India so as to expand the financial base as well as to enhance the accessibility to the credit. Another important component of FIC is the non-resident deposits. Non-resident deposits refers to the deposit made by the non-resident citizens of a country in the domestic bank.

Foreign capital inflow and economic growth

The world economy has opened up in terms of trade and investments during the mid-1990s. the idea of capital liberalization stimulated the free flow of capital across the countries. This sharp increase in capital inflow and outflow continued till the global financial crisis of 2008. Meanwhile, countries benefited heavily from capital investments especially the developing economies, which also served as the best platform for a market economy for the developed economies. In contrast to the developed economies, the third world economies started to open up after the Asian Financial Crisis of 1997. The difference was not only visible in the case of the timeline but also in the type and share of inflows experienced by the developed and developing economies. While portfolio investment accounted for the big share of capital flows into the developed economies, the developing economies were characterised by direct investment accounts. The existence of a stable stock market system and infrastructural development were the reasons for the deeper penetration of capital inflows to the developed economies. The foreign capital inflow of the developed countries was twice larger than the latter economies.

The economic growth, however, didn’t register any remarkable growth after capital liberalization in both the type of economies. The economic growth remained somewhere at a rate of 2 percent for a little longer time after capital liberalization. At least, various empirical studies conducted over the course of time justify this statement. The study by Quinn in 1997 using data from 66 countries showed a positive relationship between economic growth and capital liberalization. On the other hand, the study conducted by Rodrick in 1998 using the average annual data of 99 countries stated a contrasting result.

Hence, it must be assumed that the relationship between economic growth and capital liberalization is more country specific as it depends largely on the policy, institutional and economic policies of the respective countries. Further, the recent study on capital liberalization and economic growth by Kose in 2009 revealed that 4 out of the 26 existing studies exhibited consistently positive relationship between economic growth and capital liberalization. But when changes where introduced into the study in terms of sample time period and estimation methods, the positive relations shown by nearly 18 papers turned out to be negative.

Picture Courtesy- BizWatchNigeria

**To read the second part, click here: Foreign Capital Inflow in Developing Economies– Further Analysis**


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