important vehicle for the transfer of technology, but that the host country can benefit from it only if it has a stock of human capital which is beyond a minimum threshold level. They test this idea using data for 1970-89 and find that gross FDI inflows are not significantly correlated with economic growth but that the interaction between FDI flows and the stock of human capital is positively and significantly correlated with economic growth. Wang and Wong (2011) corroborate the original result of Borensztein et al. (1998) by focusing on the same period but by using a measure of education quality rather than quantity.

Alfaro et al. (2004) and Alfaro et al. (2010) also explore the role of local conditions but focus on the role of the domestic financial sector. They suggest that FDI creates positive spillovers and promotes growth through backward linkages and that a well-working domestic financial sector facilitates this mechanism because it allows local entrepreneurs to start new firms that produce intermediate goods for foreign multinational companies. Alfaro et al. (2004) use cross-country data for 1975-95 and show that net FDI flows are not significantly correlated with GDP growth but that the interaction between net FDI flows and financial depth (proxied by credit to the private sector over GDP) is positively and significantly correlated with long-run growth. AzmanSaini et al. (2010) build on the work of Alfaro et al. (2004) and, using a threshold regression model and data for 91 countries over 1975-2005, also find that financial depth matters for the link between FDI and growth.

As mentioned above, a recent meta-analysis by Bruno et al. (2018) qualifies these results and suggests that there is a positive correlation between FDI and growth which does not necessarily depend on local conditions. Bruno et al. (2018) also argue that firm-level studies tend to underestimate the positive effect of FDI on economic performance. In their view, the sum of vertical and horizontal spillovers measured in microeconomic studies underestimates the overall benefits of FDI because technologies and managerial competencies may travel across industries which do not belong to the same supply chain.

There are endogeneity issues associated with measuring the link between FDI and growth. On the one hand, the fact that countries with brighter growth prospects are more likely to attract FDI flows can generate a positive bias, leading to an overestimation of the positive effect of FDI on growth. On the other hand, standard measurement error can lead to an attenuation bias. Measurement error might have become particularly important in recent years as FDI data are affected by multinational firms’ strategies aimed at minimizing their global tax bill through the reallocation of headquarters, profit shifting, or the use of shell companies as special purpose vehicles. As there is no reason why these “phantom FDI” (Damgaard et al. 2019) should stimulate economic growth, their inclusion in FDI statistics is likely to create a downward bias in the estimated relationship between FDI and growth. Moreover, FDI flows also include cross-border intragroup lending, making them closer to portfolio flows (Blanchard and Acalin 2016).

Existing work tried to address endogeneity by instrumenting FDI flows with their lagged value, the real exchange rate, country size, political stability, and institutional quality (see Borensztein et al., 1998 and Alfaro et al., 2004). There are, however, doubts about the validity of these instruments as they are likely to have a direct effect on GDP growth. In this paper, we propose a new instrument that addresses this concern.

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