Academic journal article Journal of Agricultural and Applied Economics

Causality among Foreign Direct Investment and Economic Growth: A Directed Acyclic Graph Approach

Academic journal article Journal of Agricultural and Applied Economics

Causality among Foreign Direct Investment and Economic Growth: A Directed Acyclic Graph Approach

Article excerpt

With the aim of examining the causal structure between foreign direct investment (FDI) and economic growth, this study derives inductive causal inference using the directed acyclic graph approach, which makes no a priori causal assumptions. There are three major findings of this study. First, economic growth causes FDI inflows for developing countries, whereas FDI induces economic growth for developed countries. Second, trade is an important intermediary to facilitate the interaction between FDI and other factors. Third, the stock market is found to be an intermediary that amplifies the influence on FDI from many causal variables of FDI for developed countries.

Key Words: causality, economic growth, DAG, FDI

JEL Classification: F21

Foreign direct investment (FDI) is believed to be an important factor contributing to economic growth. However, previous studies find conflicting results regarding the relationship between FDI and economic growth. Some studies find a positive relationship between FDI and economic growth (see, e.g., Neuhaus, 2006) and argue that FDI boosts growth through capital accumulation and through technology transfer spillover effects, whereas other studies conclude that FDI can distort resource allocation, that the effect is highly conditional on country-specific trade policies and other institutional factors, and that in some cases, FDI can actually inhibit economic growth (see, e.g., Boyd and Smith, 1992; Brecher, 1983; Brecher and Diaz-Alejandro, 1977).

Conflicting findings in earlier studies have aroused interest in identifying the causal patterns between FDI and economic growth to better understand their interaction. FDI-led growth is a long-held causal assumption backed by both endogenous growth theory and many empirical studies (De Mello, 1999). Endogenous growth theory proposes that long-run economic growth is determined by forces that are internal to the economic system and that create technological knowledge. These forces may result from research and development undertaken by profit-seeking firms; from economic policies with respect to trade, competition, education, and taxes; and from accumulation of intellectual property. Because FDI is expected to encourage the use of new inputs/technologies and investment in human capital, one might expect that FDI should lead to economic growth in the recipient country, yet both endogenous growth theory and the FDI-led growth assumption have been challenged in recent years (Barro and Sala-i-Martin, 1992; Evans, 1996; Mankiw, Romer, and Weil, 1992), and a growth-driven FDI hypothesis has been developed as an alternative, which argues that economic growth attracts FDI by opportunistic investors.

We argue that neither the endogenous growth nor growth-driven FDI explanations may serve as absolute rules and instead opt for a more institutional explanation. When making investment decisions, investors may take into account many more factors than those that classical theories suggest (Laudicina, Gott, and Phol, 2010; Laudicina and Pau, 2008). For example, concerns regarding political, social, and environmental risks likely play a large role in both attracting FDI and its effectiveness in stimulating economic growth. Large developed economies such as United States and Germany attract FDI from investors seeking safety, whereas emerging economies such as China, India, and Brazil likely draw investors seeking access to new markets. Safe markets are those characterized as having stable macroeconomic environments (e.g., low currency volatility, interest rate risk, and energy prices) and governments/institutions but usually are quite competitive and developed. On the other hand, emerging markets usually have a large untapped consumer base, low labor costs, abundant natural resources, and the potential for faster economic growth but often lack the institutional structures and investment necessary to realize their potential.

This institutional view is supported by recent industry approaches to evaluating FDI opportunities. …

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