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FDI and Economic Growth: Lies, Damned Lies, and Statistics

Our previous blogs have looked at the impact of FDI on individual elements of local economies. In this blog I try to answer whether FDI has an observable impact on economic growth overall. Unfortunately, there are no clear answers for policy-makers considering FDI as a route to growth. It seems that the debate on FDI and economic growth offers as much certainty as the debate on the effectiveness of ODA.[1]

The idea is very simple. Theoretically, economic growth is related to the level of technology and the amount of capital in an economy.[2] FDI contributes to this by (1) increasing domestic investments and (2) transferring technology to the host country. Technology transfer can happen in several ways. Domestic companies may imitate foreign companies, competition between domestic and foreign firms might force domestic firms to improve their businesses, and transactions between domestic and foreign firms can lead to spillovers.[3] Straightforward as this may seem, empirical research has been wildly inconclusive. Some studies indicate strong links while others deny any link at all.[4]

Several studies have indicated there may be preconditions that a country must fulfill before FDI can actually lead to technology transfer.[5] These preconditions include having (1) a sufficient level of capital, (2) a sufficiently developed financial sector, (3) sufficiently protected property rights, (4) a sufficient level of local competition, and (5) a sufficient level of trade openness. So, which problem should countries attack first? Therein lies the rub: no papers indicate the relative importance of these factors and whether any of these factors might be sufficient on their own.

Moreover, many papers use different statistical techniques, with different assumptions and different data sets. As a result they come to different conclusions. In one instance, the same type of regression was conducted twice. The first time, the research indicated a strong link between FDI and economic growth. The second time, the same research but with more of the same data led to a far weaker link between FDI and economic growth.[6] Unfortunately, assessing the merits of the different studies is a mission impossible for those without a PhD in econometrics.  Furthermore, none of the papers provide any practical tips on what a policy maker can do with their research.

In short, the research on FDI and economic growth leaves us wanting more. It provides little help for those out there seeking to make a tangible contribution to the developing countries. As so often happens, theory clearly indicates what should happen but reality won’t follow suit. Hypothetically, FDI can foster economic growth, but in practice it is unclear how. Alas, the silver bullet remains unfound. Fortunately, that provides us with an even bigger drive to continue our research on the social and economic impact of FDI.

[1] Abhijit V. Banerjee and Esther Duflo. Poor Economics. Public Affairs: New York, 2011. P. 3.

[2]  Niels Hermes and Robert Lensik. “ Foreign Direct Investment, Financial Development and Economic Growth.“ The Journal of Development Studies 40 1 (2003) 142-163. P. 143.

[3] Ibid., pp. 143, 144.

[4] Dierk Herzer et al. “In search of FDI-led growth in developing countries: The way forward.” Economic Modelling 25 (2008) 793-810; Rifat Baris Tekin, “Economic growth, exports and foreign direct investment in Least Developed Countries: A panel Granger causality analysis.” Economic Modelling 29 (2012) 858-878; Henrik Hansen and John Rand. “On the Causal Links Between FDI and Growth in Developing Countries.” The World Economy 29 1 (2006) 21-41.

[5] Hermes and Lensink, “Foreign Direct Investment,” p. 142; E. Borensztein et al. “How does foreign direct investment affect economic growth.” Journal of International Economics 45 (1998) 115-135; United Nations Conference on Trade and Development. Foreign Direct Investment and Development. Geneva and New York, 1999; Peter J. Buckley et al. “FDI, regional differences economic growth: panel data evidence from China.” Transnational Corporations 11 1 (2002) 1-28; Beata K. Smarzynska. “Composition of Foreign Direct Investment and Protection of Intellectual Property Rights in Transition Economies.” Unpublished work. Yale University: New Haven, 1999.

[6] William Easterly et al. “New Data, New Doubts: Revisiting ‘Aid, Policies, and Growth.’” Working Paper 26 (2003), Center for Global Development.

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