Capital inflows and government debt: evidence of moderation and bidirectional causality

Purpose The alarming rise in government debt across countries is a motivation for this study, and it aims to provide thorough insights into how stable capital inflows, primarily foreign direct investment, reduce government debt levels. Design/methodology/approach The author applies two-step System Generalized Panel Methods of Moments (PGMM) regressions with the instrumental variable (IV) technique in investigating a strongly balanced panel data set of 46 countries. In support of the main results, the author also uses robustness and alternative specifications. This study covers the financial liberalization periods and capital flow shifts and excludes pandemic shocks and new policy shocks. Further, this study establishes the causal direction and magnitude of the relationship using the Panel Granger Causality (PGC) test proposed by Dumitrescu and Hurlin (2012); Breitung and Candelon (2006)’s frequency domain Granger causality (FDGC) test. Findings This study shows that there exists a dynamic interrelationship between capital inflows and government debt and reveal the pronounced persistence effect in government debt. The author shows that higher capital inflows influence reduction in government debt levels, suggesting the role of fiscal substitution and growth enhancing mechanisms. Consistent with the hypothesis, the panel Granger causality test and FDGC tests reveal the presence of bidirectional causality between capital inflows and debt. Originality/value To the best of the author’s knowledge, this study is first of its kind in providing unified empirical evidence for the mitigating effect of capital inflows on government debt using two-step System GMM estimator, and 2SLS GMM estimator supported by five robustness and alternative specifications tests. The author also establishes causal effects between the capital ivnflows and government debt using panel Granger causality (DH) test and FDGC test.