Foreign Direct Investment and Economic Growth: The Growth Accounting Perspective

By Wang, Miao; Wong, M. C. Sunny | Economic Inquiry, October 2009 | Go to article overview

Foreign Direct Investment and Economic Growth: The Growth Accounting Perspective


Wang, Miao, Wong, M. C. Sunny, Economic Inquiry


I. INTRODUCTION

During the past few decades, world foreign direct investment (FDI) flows have increased dramatically, with an annual average growth rate of over 20% in the 1980s and nearly 40% by the late 1990s (UNCTAD 2006). Such a significant expansion of foreign capital flows has captured the attention of both policy makers and researchers. Growth theories predict that physical capital accumulation and technology improvement lead to better economic growth performance (e.g., Aghion and Howitt 1992; Romer 1990; Solow 1956). This provides a promising prediction about the growth effect of FDI in the host country, since FDI is considered to transfer both physical capital and intangible assets such as better technology. As a result, policy makers and governments of many host countries have attempted to attract more inward FDI by giving special incentives, such as tax breaks, to multinational corporations (MNCs). According to the UNCTAD (2000), between 1991 and 1999, 974 FDI regulatory changes have been made in over 100 countries to attract inward FDI.

However, the existence of an absolute growth effect of FDI is often debated in the empirical literature (Carkovic and Levine 2005; Choe 2003). Recent researchers turn their attention toward whether FDI promotes economic growth given certain social and/or economic conditions. Two influential studies, Borensztein, De Gregorio and Lee (1998) (hereafter, BDL [1998]) and Alfaro, Chanda, Kalemli-Ozcan and Sayek (2004) (hereafter, ACKS [2004]), capture the positive effect of FDI on economic growth under two conditions: a sufficient level of human capital and a well-developed financial system, respectively. Based on data from 69 countries over the period of 1970-1989, BDL (1998) find that inward FDI promotes the host country's economic growth only when the host country obtains a threshold level of human capital, measured by average years of secondary schooling. ACKS (2004) argue that FDI alone does not necessarily contribute to economic growth in the host country. However, according to a sample of 71 countries between 1975 and 1995, the host country with a well-functioning financial system benefits significantly from inward FDI.

While these important previous studies have determined the conditions under which FDI will affect overall growth, there has not been investigation into which components of growth (i.e., productivity growth and capital stock growth) are affected by FDI. (1) Such evidence is important for understanding the mechanisms by which FDI affects growth and can better inform policy.

In this paper, we seek to shed light on the empirical literature of FDI growth in the perspective of growth accounting. (2) Based on the conjectures from BDL (1998) and ACKS (2004), which will be explained later, we study the effect of FDI on different growth components and how human capital and financial development affect the interaction between FDI and components of growth. To our knowledge, although some conjectures have been made in the FDI literature, there is no systematic research on this issue. We also provide a possible connection between the results in BDL (1998) and the results in ACKS (2004). Their conditions can be fundamentally different catalysts for FDI to promote economic growth. (3)

On the one hand, empirical results from BDL (1998) suggest the existence of complementarity between human capital and FDI on economic growth. The authors also find that FDI does not significantly simulate domestic investment. Hence, they conclude (page 118) that "... the main channel through which FDI contributes to economic growth is by stimulating technological progress, rather than by increasing total capital accumulation in the host economy." They conjecture that FDI drives technological progress only when there is a sufficient level of human capital in the host country. The idea is later echoed by Xu (2000), who tests the impact of FDI on technology transfer and finds that U. …

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