Journal Article

Capital Flows to Developing Countries: Trends, Volatility and Policy Implications

Published on 1 January 2004

Capital inflows are a fundamental element in economic performance. Such inflows are essential to finance investment and economic policy is sensitive to the mobility of capital given the globalisation of capital markets. Economic policy and performance influences inflows and these inflows in turn have implications for macroeconomic management. The economic implications will depend on the type of inflow, whether official (aid) or private capital. Developing countries, including the poorest (predominantly, but not exclusively, in sub-Saharan Africa), are trying to attract increased levels of private inflows, especially foreign direct investment (FDI) but also other (short-term) private capital. This article reports results, with a central focus on sub-SaharanAfrica (SSA), on capital inflows to identify trends and volatility (the extent of yearon-year changes) of different types of inflows and evaluate the influences for economic policy. Since the 1970s, what have been the trends in the level and composition of capital flows to developing countries, and what are the economic implications?

The analysis shows that although private capital flows to developing countries remain low (relative to gross domestic product, GDP), especially for the poorest countries, the 1990s have witnessed an increase. Although aid remains the most important capital inflow (relative to GDP) for developing countries, again especially the poorest, the composition is changing towards private inflows. While many would consider this increase in private inflows to be desirable, there are associated problems. Short-term(non-FDI) private capital is shown to be themost volatile type of inflow, i.e. there can be large year-on-year variations in the level of the flow (and large outflows are possible). If the composition of capital inflows is changing such that a greater share of inflows is inherently short term and mobile (i.e. volatile), there are implications for macroeconomic management. Governments want to reduce aid inflows and increase private inflows, so they aimfor macroeconomic stability and growth. However, large inflows of private capital can undermine macroeconomic stability. Indeed, the volatility of private capital (the threat of an outflow) can precipitate an economic crisis even in countries with sound macroeconomic policies. This danger is explored in later parts of this article.

The article is organised as follows: Section 2 reports on the trends in different types of capital inflow, official and private, for developing countries (classified according to relative income) since the 1970s. The poorest countries are found to have become increasingly dependent on official (aid) inflows, although private inflows have begun to increase recently. Section 3 then considers the differences in the volatility of such inflows. Private inflows are found to be more volatile than official inflows. Although only relatively richer developing countries attract sufficient private inflows for this to be a matter of real concern, private inflows are increasing to poor countries. Section 4 presents a brief discussion of the determinants of capital inflows, to indicate the economic policies that attract private inflows. The conclusion in Section 5 considers the policy implications. The objective is to contribute to our understanding of how poor countries can influence and manage the composition of capital inflows.

Related Content

This article comes from theĀ IDS Bulletin 35.1 (2004) Capital Flows to Developing Countries: Trends, Volatility and Policy Implications

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Morrissey, O. and Osei, R. (2004) Capital Flows to Developing Countries: Trends, Volatility and Policy Implications. IDS Bulletin 35(1): 40-49

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Oliver Morrissey
Robert Osei

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IDS Bulletin, volume 35, issue 1