Foreign Direct Investment, Other Capital Flows, and Current Account Deficits: What Causes What?

October 1995 The more liberal a country's foreign exchange system, the more foreign direct investment is likely to be independent of current account and other capital flows. Fry, Claessens, Burridge, and Blanchet examine flows of foreign direct investment to 46 developing countriesto test whether such flows are autonomous or accommodating vis-á-vis the current account and other capital flows. Using Granger-causality tests, they find that: ° Requirements to surrender export proceeds to the monetary authorities and the existence of special exchange rates for some capital account transactions reduce the probability that foreign direct investment is independent. ° The more liberal a country's foreign exchange system, the more foreign direct investment is likely to be independent or exogenous. ° Foreign direct investment is associated with a larger increase in capital formation when it is independent than when it is Granger-caused by other capital flows. This paper --- a product of the Debt and International Finance Division, International Economics Department --- is part of a larger effort in the department to study the determinants and impact of foreign direct investment. The study was funded by the Bank's Research Support Budget under the research project Foreign Direct Investment in a Macroeconomic Framework (RPO 678-15).