Foreign capital and economic growth in emerging markets: Are foreign aid and foreign direct investment substitutes?

This paper studies the short-run and long-run effects of foreign aid and foreign direct investment on economic growth in emerging markets. Upon applying the so-called Pooled MEan Group estimator to an unbalanced panel for 94 countries over the period 1960-2012, we find a positive and significant long-run relationship between these two types of foreign capital and growth. We then enquire which type of foreign flow is more effective to stimulate economic growth, and find that both effects are not statistically different in various dynamic specifications and robustness checks. This finding may account for a possible substitutability relationship between foreign aid and foreign direct investment in the long-run. An implication is that what matters for growth in emerging markets is the aggregate amount of foreign capital, rather than its composition.