The recent surge in cross-border financial flows has generated an intense debate among economists and policymakers on the benefits and costs of the ongoing international financial integration. In principle, financial integration can promote productivity growth by allowing a country to borrow to finance productive domestic investment and increasing access to foreign advanced technologies. However, it can be accompanied with macroeconomic volatility and even financial crises. Fuelling this debate, the empirical evidence on the effects of financial integration on growth has been mixed (Kose et al. 2006).
Yet, recent financial crises led policymakers to rethink appropriate policies for growth. It is widely believed that the short-term debt is the most volatile source of foreign capital and can contribute most to instability of financial markets at a time of crisis, whereas foreign direct investment (FDI) is the most stable form of capital inflows. Importantly, FDI has long been regarded to be a major vehicle of technology transfer. More than ever, countries seek to leverage FDI for development. FDI represents the largest share of external capital flows to developing countries (United Nations Conference on Trade and Development 2007). (1) This seems to be driven by the belief that FDI brings positive effects to the economy, such as technology transfer, introduction of new production processes, and advanced management practices. However, it still remains to be an important empirical question whether and how FDI affects productivity growth in countries at various stages of development.
In this article, we study total factor productivity (TFP) in relation to technology diffusion through FDI for a couple of important reasons. First, debates over the relative importance between factor accumulation and TFP in raising income per capita took a dramatic turn. Recent studies found that more than half of the cross-country variation in both income per capita and its growth results from differences in TFP and its growth, respectively (Caselli 2005; Easterly and Levine 2001; Hall and Jones 1999; Klenow and Rodriguez-Clare 1997; Parente and Prescott 2001). (2) This finding suggests that, in order to understand the growth of nations, it is important to develop a better understanding of the forces that shape TFP.
Technological change is an important determinant of TFP. This was Robert Solow (1957)'s original view as well as the view of many economists in the literature (Helpman 2004). Endogenous growth models provide rigorous theoretical frameworks for understanding the economic forces underlying technological change. The models have focused on two important types of technological change: (1) innovation through research and development (R&D) and (2) technology diffusion through assimilating and adapting advanced foreign technology (see Barro and Sala-i-Martin 2003; Coe, Helpman, and Hoffmaister 1997; Grossman and Helpman 1991; Romer 1990, 1992 among others). Many of the earlier empirical studies focused on the effects on growth of innovation (measured by R&D expenditure or the number of scientists). The evidence on the positive impact on growth of innovation, especially at the microlevel, is substantial (Helpman 2004).
The other channel of technological change, technology diffusion, has received relatively less attention in the empirics. In a typical model of technology diffusion, technological change of a less-developed country depends on the extent of adoption and implementation of new technologies that are in use in the advanced countries (technology diffusion). That is, technological change largely consists of assimilating and adapting foreign technology. FDI is an important way to access advanced foreign technology. Beyond adding more capital to a receiving country, FDI can be the conduit to the production technology, cutting edge of R&D, and management expert. International technology diffusion can also take place through import of capital goods embodied with high technology (Eaton and Kortum 2001). …