Capital Inflows and Economic Growth: Does the Role of Institutions Matter?

Abstract

Recent evidence shows that institutions figure prominently in explaining the 'Lucas paradox'. Using a threshold regression model, we extend this evidence to a situation where institutions index the relationship between foreign capital inflows and economic growth. We find strong and robust evidence that portfolio equity (including foreign direct investment) and debt inflows have positive effects on growth only in countries with high-quality institutions. Countries that fall below the threshold level of institutional quality record either insignificant or negative effects. This paper provides a possible explanation on the so-called Lucas paradox.

The role of external debt in the foreign direct investment–growth relationship

“…As noted above, several studies (e.g., Alfaro et al, 2004;Borensztein et al, 1998;Okada & Samreth, 2014) have used interaction terms in regression models to determine the existence of threshold effects and thus the role for spillover effects in the FDI-growth link. However, as emphasized by Girma (2005), Azman-Saini, Law, and Ahmad (2010), and Slesman et al (2015), this modelling strategy has the drawback of imposing the a priori restriction that spillovers are monotonically increasing (or decreasing) with absorptive capacity. A more flexible estimation method is proposed by Hansen (1996Hansen ( , 2000, which entails determining threshold effects through a sample decomposition based on dividing the data sample according to the categories (debt regimes) chosen.…”

“…Finally, following Slesman et al (2015), we include a set of three institutional quality controls to represent the effects of democracy, rule of law, and control of corruption, using data from the ICRG. Not only do institutions influence growth (Acemoglu, Johnson, & Robinson, 2005), but they may also have an influence through financial development (Fergusson, 2006).…”

“…Balasubramanyam, Salisu, and Sapsford (1996) find that the degree of trade openness provides a critical threshold for FDI to induce higher growth. More recently, Slesman, Baharumshah, and Wohar (2015) present robust evidence that portfolio equity (including FDI) and debt inflows have a positive impact on economic growth only in countries with high-quality institutions. More recently, Slesman, Baharumshah, and Wohar (2015) present robust evidence that portfolio equity (including FDI) and debt inflows have a positive impact on economic growth only in countries with high-quality institutions.…”

“…Borensztein, De Gregorio, and Lee (1998) emphasize that only countries meeting a minimum level of human capital can benefit from FDI-led growth gains. More recently, Slesman, Baharumshah, and Wohar (2015) present robust evidence that portfolio equity (including FDI) and debt inflows have a positive impact on economic growth only in countries with high-quality institutions. Countries that fall below the identified threshold level of institutional quality record either negative or insignificant effects.…”

Do foreign portfolio capital flows affect domestic investment? Evidence from Brazil

“…Also, portfolio investment may harm the economy for its procyclicality, as it increases when economies are booming but rapidly retreats when economies are slowing, for overheating exchange rates and for inducing bubbles in real estate and financial asset prices (Aizenman & Pasricha, 2013). Moreover, empirical evidence strongly suggests that institutional quality plays an important role too, working as a catalyst channelling all the aforementioned benefits from capital flows to real variables, such as economic growth, investment, and productivity (Ayhan Kose, Prasad, & Taylor, 2011;Bekaert, Harvey, & Lundblad, 2011;Slesman, Baharumshah, & Wohar, 2015).…”