FOREIGN DIRECT INVESTMENT AND ECONOMIC GROWTH IN DEVELOPING COUNTRIES

Theory suggests that foreign direct investment (FDI) contributes to capital accumulation and technological progress and is an important catalyst for industrial development. In the context of an endogenous model, we investigate the impact of FDI on economic growth, and test the hypothesis that the beneficial effect of FDI inflows is stronger in those countries with higher level of economic development. Our results show a strong direct impact of FDI on economic growth in developing countries, as well as an indirect impact through the interaction of FDI with human capital. Additionally, our results suggest that the impact of FDI on economic growth is greater among technological leaders. We conclude that absorptive capacity in the host country is important in allowing FDI to positively and fully impact economic growth. JEL Classifications: F21, F23, O47 INTRODUCTION The contribution of foreign direct investment (FDI) to economic growth in host countries has long been the subject of intense debate. The literature points to its importance in promoting economic growth and, it is actively sought by virtually all countries. The direction and volume of FDI across countries and regions, however, suggest that its attractiveness and efficacy depends on institutional and countryspecific factors, including the country’s openness to trade; investment in basic infrastructure and human capital; factor endowment; financial structure; and macroeconomic, political, and social stability. The hypothesis that FDI can play a key role in improving the economic growth of the host country may require, therefore, that a more conducive environment in terms of a sufficient absorptive capability of the advanced technologies be available in the host economy (Borensztein et al, 1998). According to UNCTAD (2006), only one-third of FDI flows in 2006 went to developing countries. In the developing world during the period 2003-05, Asia and Oceania received 21.4 percent of the world FDI inflows, Latin America and the Caribbean received 11.5 percent, and Africa 3.0 percent. In countries that cannot capture the spillover effects from the presence of foreign firms (due to a lack of favorable economic, political, and social climate), FDI may have little or even an adverse effect on economic growth. It appears, therefore, that given the economic, social, and political disparities across countries, the growth effect of FDI will differ across countries. In this context, it is tempting to hypothesize that in East Asian and Latin American countries, with Southwestern Economic Review 156 admittedly higher levels of development and more favorable macroeconomic environments, FDI-led growth will be more pronounced than in Sub-Saharan African countries with relatively low levels of development and less favorable business climates. The findings of Blomstrom et al (1994), Coe et al. (1995), and Borensztein et al. (1998) seem to lend support to that hypothesis. According to Kumar (2007), the gap between the world’s rich and poor countries largely comes down to the financial and physical assets that create wealth and, consequently, a key aspect of economic advancement lies in poorer nations’ capacity to acquire more capital and scale the technological ladder. However, as pointed out by de Mello (1997), the role of FDI as a catalyst for output growth is a less controversial hypothesis in theory than in practice. If FDI is expected to impact growth in the long run through both knowledge transfers and the accumulation of capital stocks embodying newer technologies, then the relative impact should be lower in technological leaders than in technological laggards. The objective of this study is to investigate the impact of foreign direct investment on economic growth, and to test the hypothesis that the beneficial effect of FDI inflows, in terms of enhanced economic growth, is stronger in those countries with higher level of economic development. Using recent data and a large number of countries, we conduct a comparative empirical investigation to determine the importance of FDI in explaining economic growth in least advanced versus more advanced developing countries. In the next section, we review theoretical considerations. Then, we present the model and interpret the empirical results. The final section summarizes our conclusions and discusses some policy lessons. THEORETICAL CONSIDERATIONS From a corporate perspective, the decision to make a foreign direct investment is a capital budgeting decision. Corporations make capital investments to maximize shareholder wealth. Operationally, absent capital rationing, a wealthmaximizing investment is a positive net present value (NPV) investment. If a capital project has a positive NPV, then it is expected to create shareholder wealth on a riskadjusted basis. Corporations process prospective FDI just as they do any investment. In the case of FDI, there are unique incremental costs that must be charged to the capital project. For example, if the required infrastructure (transportation, communications, energy supplies, skilled labor, management talent, etc.) is lacking in the host country, then the cost to the company of providing this infrastructure must be charged to the project. Additionally, new product distribution channels must be established and with them will come greater shipping and handling costs that must be charged to the project. If the corporation is moving production, there will be costs (and benefits) of closing an existing production facility (providing severance pay to existing workers or retraining them, etc.). New operational controls and managerial infrastructure must be established, which will also impose incremental costs. There may also be, and probably are, externalities that an FDI will cause (costs or benefits not born by or charged to the project). For instance, multinational firms operating in emerging markets transfer technology to local suppliers to increase their productivity and to lower input prices, inducing entry and more competition in the supply market (Blalock and Gertler, 2008). Externalities can in turn lead to domestic political costs. These considerations, in addition to international risks (political, economic, and foreign exchange), must be weighed against competitive pressures if other Foreign Direct investment and Economic Growth In Developing Countries 157 corporations are also exploiting FDI to gain competitive advantage. In total, properly assessing the costs and benefits of an FDI decision is clearly complex from the corporate perspective. Foreign direct investment has grown at an exponential rate since the early 1980s. Its attractiveness and distribution reflect, among other things, its profitability and the conditions in the recipient countries. Although East Asia and Latin America have experienced phenomenal inflows of FDI, especially from the mid-1980s, FDI inflows to Africa and other least-developed countries remain low in absolute and relative terms (Figure 1). The high FDI inflows to the more advanced developing countries are generally attributed to the outward-oriented policies and more fertile environment in those countries. While real per capita GDP growth in East Asia and Latin America in the past couple of decades averaged 7.1 percent and 1.5 percent, respectively, Africa recorded a growth rate of just 0.5 percent. This disappointing economic performance for Africa reflects many macroeconomic variables including real per capita income. In Africa, for the last couple of decades, average annual real income per capita was $518 compared to $912 and $3,790 in East Asia and Latin America, respectively. Individual country analysis reveals even more disturbing results. During the past decade, realizing that restricting FDI is an ineffective or even counterproductive policy, many low-income countries have removed their restrictions on and adopted economic reforms more favorable to FDI. Figure 1 Foreign Direct Investment (Millions of US.$) 0 5000