Foreign Capital Inflows and Sources of Economic Growth in Emerging and Developing Economies: Role of Financial Development

Abstract

In the contemporary era of globalization, foreign capital inflows play a pivotal role in enhancing economic growth and investment potential, while also bridging the savings investment gap in developing countries. The study investigates the impact of foreign capital inflows on fundamental sources of economic growth, namely, physical capital, human capital, and total factor productivity, while examining the moderating role of financial development. Using panel data of emerging and developing economies from 1990-2023, the study analyzes the effects of four major types of inflows, which are foreign direct investment, foreign portfolio investment, foreign remittances, and foreign aid. Results indicate that foreign direct investment exerts a positive impact on sources of growth, whereas foreign aid negatively affects them. Remittances contribute positively to both human and physical capital, while foreign portfolio investment negatively impacts physical capital and TFP. Furthermore, findings reveal a mutually reinforcing relationship between financial development and foreign inflows. The study recommends that policies promoting foreign direct investment, reducing aid dependency, and strengthening financial sector development are crucial for enhancing the contribution of foreign capital inflows to key sources of economic growth.