Financial openness and growth in developing countries: Why does the type of external financing matter?

Abstract

This study examines how external financing (EF) affects growth in developing countries by distinguishing between two forms of external financing: debt and foreign direct investment (FDI). We show that both types favor growth by boosting investment through the credit channel. However, excessive external debt increases vulnerability to financial crises. Contrariwise, FDI plays an amortizing role by reducing a crisis’ effects. The empirical evidence confirms these results and demonstrates that, despite the more secure nature of FDI, mixed financing (debt and FDI) remains more profitable for developing countries because of the inverted U-shaped growth effect of the FDI-to-debt ratio. Moreover, exchange rate stability decreases vulnerability to financial crises, whereas higher stability turns into exchange rate rigidity and thus increases crisis occurrence.