Applied Economics Letters, 2009, 16, 277–283 Growth effects of FDI and portfolio investment flows to developing countries: a disaggregated analysis by income levels Glauco de Vita* and Khine S. Kyaw Oxford Brookes University Business School, Wheatley Campus, Oxford OX33 1HX, UK What is the impact of foreign direct investment (FDI) and portfolio investment flows on the economic growth of low-, lower middle- and upper middle-income countries? In this article we address this question using a dynamic panel model and a large data set of 126 developing countries for the period 1985 to 2002. Employing the system-generalized methods of moments (GMM) estimation approach, our findings suggest that only developing countries that have reached a minimum level of economic development and absorptive capacity are capturing the growth-enhancing effects of both forms of investment inflows. I. Introduction There has been considerable debate in the literature as to whether different forms of inward investment stimulate economic growth in recipient developing countries. Portfolio investment flows can bolster economic growth by increasing the liquidity of domestic capital markets and by inducing greater market efficiency. As domestic markets become more liquid, deeper and broader, a wider range of projects can be financed, further stimulating growth and development. However, as noted by Nunnenkamp and Spatz (2003), international agencies have tradi- tionally advised the developing countries to rely primarily on foreign direct investment (FDI) as a source of external finance. FDI is generally consid- ered to be the most favourable form of capital inflows for boosting economic activity for several reasons. First, it produces externalities through the diffusion of new technology and of business know-how. Since these transfers have considerable spillover effects throughout the economy, over time, FDI is expected to enhance the productivity of all firms (Rappaport, 2000). Additionally, FDI may spur competition in factor and product markets and generate economies of scale for local producers and suppliers (Keller, 2001). Compared to portfolio flows, FDI is thought to be more costly to reverse and, because of this, less volatile (Lipsey, 1999) and less sensitive to global shocks (Durham, 2004). Despite the theoretical contention as to the relative virtues of these two forms of investment inflows, the evidence from extant empirical literature remains mixed and is yet to provide a conclusive answer to the *Corresponding author. E-mail: gde-vita@brookes.ac.uk Applied Economics Letters ISSN 1350–4851 print/ISSN 1466–4291 online ß 2009 Taylor & Francis 277 http://www.informaworld.com DOI: 10.1080/13504850601018437