Using Generalized Method of Moments (GMM) panel data analysis to examine the relationship between Foreign Direct Investment (FDI), financial development and economic growth in a group of 70 developed and developing countries from 1988 to 2002, it is found that the impact of FDI on economic growth is ambiguous. FDI may either increase or decrease the growth rate of the economy, depending on the financial market development indicators used in the study. The findings, however, support the notion that a certain level of financial sector development is a significant prerequisite for FDI to have a positive effect on economic growth. Policy implications are clear that since it has been stated that the economic performance depends to some extent on the development of domestic financial sector, effort should be made to reform and improve the development of domestic financial and banking sector in order to benefit more from the presence of FDI.
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There are few channels through which Foreign Direct Investment (FDI) permanently affects the growth rate, depending on the different models of economic development. In Solow-type standard neoclassical growth models, FDI is traditionally viewed as a crucial source in increasing the capital stock of a country. According to this school of thought, there is no difference between domestic and foreign capital in affecting economic growth. Moreover, it is suggested that, with the assumption of diminishing returns to capital, the impact of FDI on growth is crucial in the short run, but not persistent in the long run (Barro and Sala-i-Martin, 1995).
In endogenous growth models, the potential of FDI in influencing growth is greater. In the literature, the role of FDI in growth can be explored through production function. Different from Solow-growth model, foreign capital will influence the path of domestic capital significantly, that is, either crowd-in or crowd-out domestic investment. If foreign capital produces a crowdin effect on domestic capital (or the relationship is complementary), then the impact of FDI on growth will be larger. Furthermore, if the presence of FDI affects local capital differently, for example, by the way of expanding the variety of intermediate and capital goods, then it can lead to improvement in the productivity level of the recipient country (Borensztein et al., 1998). Besides, FDI also affects labor via job creation.
The role of FDI, nevertheless, is more significant in transferring technology and know-how that are embodied in human capital. The effect of FDI would be limited if the recipient country does not meet the minimum threshold of the absorptive capacity in terms of human capital, technological skills and domestic financial development (De Mello, 1997; Levine, 1997; and Borensztein et al., 1998). Therefore, the presence of FDI inflows will entail crucial knowledge transfer in terms of training, skill acquisition, new management practices and organizational arrangements. All of these will contribute to a higher level of productivity and efficiency of human capital or labor, which will lead to a higher level of economic growth.
In line with the findings, single-country studies for Australia (Caves, 1974), Canada (Globerman, 1979), and Mexico (Blomstrom and Persson, 1983) found that the presence of Multinational Enterprises (MNEs) had positive effects on local productivity. In contrast, studies for Morocco (Haddad and Harrison, 1993) and Venezuela (Aitken and Harrison, 1999) concluded that there was no evidence that MNEs had a positive effect on the productivity growth of local firms. In another study, Kholdy (1995) determined the causality relationship between FDI and spillover efficiency, as defined by higher labor productivity and capital formation, in Mexico, Brazil, Chile, Singapore and Zambia. However, he argued that there is no causality linkage between FDI and labor productivity in the countries under consideration. …