Private capital flows and economic growth in Africa: The role of domestic financial markets

• We examine the relation between private capital flows and economic growth in Africa.
• Private capital flows and its components namely foreign direct investment, foreign equity portfolio investments and private debt flows all exhibit a negative relation with economic growth.
• However, countries with vibrant financial markets benefit more by being able to transform this negative impact into a positive one.

This study examines the relation between private capital flows and economic growth in Africa during the period 1990–2007. We estimate the empirical relation with a panel Instrumental Variable Generalized Method of Moments (IV-GMM) estimator which allows for arbitrary heteroskedasticity and endogeneity. Decomposing private capital flows into its component parts, we find that foreign direct investment, foreign equity portfolio investment and private debt flows all have a negative impact on economic growth. Countries with strong domestic financial markets, however, benefit more by being able to transform the negative impact of private capital flows into a positive one. Private capital flows, thus, promote economic growth in the presence of strong domestic financial markets. These results suggest that strong financial markets are needed for private capital flows to impact economic growth positively. Our results are robust to the control of population size, savings, financial openness and institutional quality.