Is free flow of capital justified in developing nations?

The resilience of foreign direct investment during financial crises may lead many developing countries to regard it as the private capital inflow of choice. Although there is substantial evidence that such investment benefits host countries, they should assess its potential impact carefully and realistically. This resilience could lead many developing countries to favor FDI over other forms of capital flows, furthering a trend that has been in evidence for many years.

Economists tend to favor the free flow of capital across national borders because it allows capital to seek out the highest rate of return. Unrestricted capital flows may also offer several other advantages. First, international flows of capital reduce the risk faced by owners of capital by allowing them to diversify their lending and investment. Second, the global integration of capital markets can contribute to the spread of best practices in corporate governance, accounting rules, and legal traditions. Third, the global mobility of capital limits the ability of governments to pursue bad policies. 

In addition to these advantages, which in principle apply to all kinds of private capital inflows, its worth noting that the gains to host countries from FDI can take several other forms such as transfer of technology—particularly in the form of new varieties of capital inputs—that cannot be achieved through financial investments or trade in goods and services. FDI can also promote competition in the domestic input market. Recipients of FDI often gain employee training in the course of operating the new businesses, which contributes to human capital development in the host country. Profits generated by FDI contribute to corporate tax revenues in the host country. In principle, therefore, free flow of capital should contribute to investment and growth in host countries through these various channels. 

Despite the strong theoretical case for the advantages of free capital flows, the conventional wisdom now seems to be that many private capital flows pose countervailing risks. Countries should view international debt flows, especially of the short-term variety, as "bad cholesterol". To what extent is there empirical support for such claims of the negative impact of free flow of capital? 

Author: Colletor Adoyo