Does Foreign Direct Investment Promote Economic Growth? Evidence from East Asia and Latin America

By Zhang, Kevin Honglin | Contemporary Economic Policy, April 2001 | Go to article overview

Does Foreign Direct Investment Promote Economic Growth? Evidence from East Asia and Latin America


Zhang, Kevin Honglin, Contemporary Economic Policy


KEVIN HONGLIN ZHANG [*]

Although there is considerable evidence on the link between foreign direct investment (ED!) and economic growth in developing countries, causal patterns of the two variables has not been investigated yet with a reliable procedure. This article provides an empirical assessment of the issue by using data for 11 economies in East Asia and Latin America. Although ED! is expected to boost host economic growth, it is shown that the extent to which ED! is growth-enhancing appears to depend on country-specific characteristics. Particularly, ED! tends to be more likely to promote economic growth when host countries adopt liberalized trade regime, improve education and thereby human capital conditions, encourage export-oriented EDI, and maintain macroeconomic stability. (JEL F21, F23, O53)

I. INTRODUCTION

The role of foreign direct investment (FDI) in developing countries has grown dramatically over the 1980s and 1990s, from $14 billion in 1985 to $166 billion in 1998, rising nearly 12-fold (UNCTAD, 1999). How does inward FDI interact with host economic growth? The literature on this issue can be divided into two broad categories. One group of studies is based on the growth theory in which FDI has been introduced as one of the factors explaining output growth (e.g., Borensztein et al. [1998]). The other group of studies is built on recent models of multinational enterprises in which FDI flows are primarily associated with income levels and market sizes of host countries. The statistical significance of the effects of income growth and market size on FDI has been tested with cross-country data (e.g., Wheeler and Mody [1992]).

The many existing studies on the subject have made useful contributions toward an understanding of the role of FDI in economic growth and the effect of economic performance on inward FDI flows. The statistical approach in these studies, however, raises a critical methodological issue. All of the investigations make an a priori presumption that FDI responds to or causes economic growth, and few studies have considered the feedback and the long-run equilibrium relationship between FDI and economic growth.[1] Investigation of the causal link between FDI and growth has important implications for development strategies. If there is a unidirectional causality from FDI to income growth, it would lend credence to the FDI-led growth hypothesis that FDI not only leads capital formation and employment augmentation but also promotes income growth in host economies. If the causal process runs in the opposite direction, it would imply that economic growth may be a prerequisite for developing countries to attract FDI and t he amount of FDI flows into a country depends on the country's absorptive capacity. If the causal process is bidirectional, FDI and growth would have a reinforcing causal relationship.

This article aims to investigate causality between FDI and economic growth for 11 developing countries in East Asia and Latin America, based on a theoretical framework and a estimation method that has been developed fairly recently. [2] To summarize the position, estimations of the cointegration tests show that the long-run FDI-GDP links exists for five countries. The results of error-correction model estimations for the five countries then indicate that FDI and GDP in two countries have feedback, and a unidirectional causality is found for the other three countries. For the six countries without FDI-GDP cointegration links, the conventional Granger causality test is conducted, suggesting that although no causal links exist in one case, unidirectional causal effects are found for the remaining five countries.

The most significant finding thus is that there is much cross-country variation and differences between East Asia and Latin America in the causal patterns of FDI-growth links. Regarding to the impact of FDI on host economies, FDI is found to boost economic growth in 5 of 11 countries, namely, Hong Kong, Indonesia, Singapore, and Taiwan in East Asia and Mexico in Latin America. …

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