Banking crises and economic growth in developing countries: Why privileging foreign direct investment over external debt?

The impact of external financing on the economies of developing countries is still a subject of debate among economists and policy makers. The objective of this paper is to contribute to this debate by shedding light on the interaction between foreign direct investment (FDI) and external debt. To this end, we begin by formulating an overlapping generation growth model that integrates a banking sector and find two complementary results. First, we show that external financing boosts investment projects and accelerates the dynamic of capital accumulation and economic growth. The second one mitigates this channel by showing two opposite indirect effects of external debt and FDI. Indeed, while external debt financing increases the vulnerability to a bank run that generates a recessionary impact on economic growth, FDI attenuates this recessionary impact and plays the role of a shock absorber. We empirically confirm these results for 67 developing countries over the period 1972-2015 using the GMM estimation of growth models and panel-logit models to predict the determinants of banking crises. Hence, this study provides a comprehensive assessment of developing countries' involvement in financial globalization and offers recommendations for their future international economic policies.