Does External Financing drive Growth?

Evidence for the growth impact of capital inflows remains open to question. Capital inflows can directly support economic growth by relaxing constraints on domestic resources, but can also indirectly weaken growth by hampering competitiveness through a real appreciation of the exchange rate. This policy brief revisits the issue, focusing on a large sample of low- and middle-income countries. Drawing on a recent analytical paper, this brief discusses how the volume, composition, and volatility of capital inflows can have different impacts on real exchange rate and economic growth. Higher capital inflows tend to support economic growth overall, more than offsetting the concomitant appreciation of the real exchange rate. The real exchange rate appreciation associated with remittances is larger than that due to aid and FDI. While an important issue, volatility of capital inflows does not seem to have had a big influence on growth in low- and middle-income countries, where the most volatile flows such as portfolio investments have been very limited.