ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846
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The Crowding-Out Effect of Foreign Capital

The inflow of foreign private capital to developing countries increased rapidly in the 1990s, but the result was growth of foreign currency reserves and not investment rates. This suggests that capital inflow actually crowded out domestic investment, thereby generating a surplus of domestic saving in recipient countries. This paper seeks to explain why such crowding-out might occur. A simple open-economy model is developed to show that crowding-out can be seen as an unavoidable consequence of substantial capital inflow, and that growth of foreign currency reserves is a corollary of crowding-out. The implication is that by allowing unrestricted inflow of foreign private capital, developing countries do not augment investment. They end up undermining their domestic investors, lending their own savings to developed countries and increasing their dependence on foreign investors for sustaining economic growth. Maintaining controls on capital flows is a good policy stance.

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