The bottom line thus seems to be that aid does affect growth positively, or at least has the clear potential to do so; but the effect is not unconditional. Aid effects on growth are most discernable when aid is given to states well suited to manage it; and when given in the form of productive (infrastructure or industry) investments. This is of course not a surprising conclusion.

# **7.3 Effects of foreign direct investment on growth**

A number of studies have attempted to find relationships between the level of foreign direct investment (FDI), and growth in the target country. Much of the evidence, in particular from studies focusing on possible technology spillovers from foreign to domestic firms, is however quite negative. In particular, several studies with a microeconomic orientation, from the early seminal study by Mansfield and Romeo (1980), to more recent work by Haddad and Harrison (1993) and Aitken and Harrison (1999), find no such effects. Carcovic and Levine (2002), applying a further refined empirical methodology, also find no independent, robust influence on GDP in the investment country. This rather pessimistic result seems to hold at all levels of development and education level of the public.

Some even more recent work, by Alfaro (2003) and Alfaro et al (2006), however points to some avenues for FDI to influence growth. In particular, Alfaro (2003) finds that FDI directed toward the manufacturing sector exhibits growth effects, while FDI in primary sectors does not: here FDI seems instead to have a negative effect on growth.<sup>27</sup> Service-sector FDI seems to have much less of a positive growth effect, than manufacturing FDI; this may seem logical in particular as relatively few technological spillovers can be anticipated from service-sector investments.

A related but separate issue is the relationship between FDI and governance factors such as political stability and the absence of corruption. An early study, by Schneider and Frey (1985), found substantial positive effects of “positive governance” factors on the level of FDI inflow (using data from 1976 to 1980), defined here by stability of government, real per capital GDP growth, and surplus in the balance of payments. Results on this issue for later literature is however mixed; e g Wheeler and Mody (1992) find no strong effect of governance factors on FDI by country for US firms; and Bevan and Estrin (2004) likewise for European firms. More recently, these relationships have been reevaluated by Méon and Sekkat (2007), who again find positive effects on FDI inflows for countries with stronger rule of law, lack of political violence, and better government efficiency. Admittedly, however, these relationships are not very strong, when correction is made for possible simultaneity bias (whereby FDI and governance variables may be simultaneously determined).

Of course, the fact that a country attracts a lot of FDI is no guarantee that FDI will have good growth effects on that country. Being able to attract FDI is however an indication that investing firms find the country interesting as a growth prospect for their business; this is in turn is likely to correlate positively with the growth effects of the FDI in the target country.

Two other factors that may impact on the effect of FDI on growth are the initial level of human capital among the population in the investment country, and the country’s level of financial development. Borensztein, De Gregorio and Lee (1998), and Xu (2000) find that technology brought by FDI translates into higher rates of growth when the host country has a minimum level of human capital stock, thus, presumably, being able to better process and exploit the technologies implied by the foreign investment. Durham (2004) and Alfaro et al (2006) find positive effects of more advanced financial development on the ability of FDI to influence growth.

The bottom line from this literature seems to be that economic development impacts of FDI are far from automatic and are dependent on a set of strong conditions. This closely mirrors the effects of ODA on growth, as discussed in the previous section. Among the reasons for this are, first, that growth

> 27 A decisive factor here could be that heavy FDI in the primary sectors leads to “feudalist” relationships whereby progressive and innovative ways of thinking and working is discouraged and suppressed.

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