Foreign Direct Investment, Governance and Economic Development in Developing Countries

By Mengistu, Berhanu; Adams, Samuel | The Journal of Social, Political, and Economic Studies, Summer 2007 | Go to article overview

Foreign Direct Investment, Governance and Economic Development in Developing Countries


Mengistu, Berhanu, Adams, Samuel, The Journal of Social, Political, and Economic Studies


How does foreign direct investment (FDI) affect domestic investment and economic growth? What is the importance of institutional infrastructure or governance in promoting growth in developing counties? This study empirically examines these issues for a cross section of 88 developing countries. Using ordinary least squares (OLS) and fixed effects (FE) estimation techniques, the study finds that FDI is positively and significantly correlated with economic growth. The study also finds that FDI has had a greater impact in Asia than in other developing countries. However, FDI has had a net crowding-out effect on domestic investment, which suggests that FDI promotes growth through its efficiency-inducing effects rather than its augmentation of domestic investment. Finally, the study found that a country's institutional infrastructure is positively and significantly correlated with economic growth.

Key Words: Foreign Direct Investment; Domestic Investment; Governance; Economic growth and developing countries

(ProQuest: ... denotes formulae omitted.)

1. Introduction

The inflow of foreign direct investment (FDI) around the world has increased dramatically in the past two decades. In the developing world, FDI has become the most stable and largest component of capital flows. As a result, FDI has become an important alternative in the development finance process (Global Development Finance, 2005). There are many reasons why FDI should promote economic performance, including: the injection of capital; transfer of production technology; employment creation; improved managerial and marketing competence; and enhanced competitiveness of domestic firms (Ngowi, 2001: Kobrin, 2005; Kumar and Pradhan, 2002). FDI can therefore be expected to contribute relatively more to growth compared to domestic investment in a host country (Kumar and Pradhan, 2002).

The empirical evidence to date of the effect of FDI on economic performance, however, is not conclusive. While some studies have indicated a positive impact of FDI on economic growth, other studies report otherwise. On the other hand, a third group of studies suggest that the effect of FDI on a host country's economy is dependent on the country's absorptive capacity in terms of its human capacity, the level of development, and financial development (Borenstein et al. 1998; Hermes and Lensink, 2004; Makki and Somwaru, 2004).

This paper contributes to the literature on FDI in three main ways. First, the focus on developing helps to reduce any bias that might result when developing and developed countries are included in the same regression (Al-Obaidan, 2002; Schneider, 2005). Second, the paper analyzes the mechanisms (efficiency and/or augmentation of domestic investment) by which FDI impacts economic growth in a large number (88) of developing countries. The study will therefore examine whether FDI crowded out domestic investment over the period of study. Finally, most of the literature that has examined the FDI-growth relationship does not control for the institutional or governance infrastructure and virtually none of the studies have considered the role of geographical location, which recent growth studies have shown are important determinants of growth. Accordingly, the inclusion of these variables may help to reduce the bias in the regression estimates that are caused by omitted variables.

The rest of the paper is organized as follows: Section two discusses the theoretical and empirical arguments for and against the impact of FDI on economic growth. Section three describes the data and measures used. Section four presents the empirical results and discusses the findings. Section five discusses the managerial and policy implications, makes suggestions for future research and offers concluding remarks.

Literature Review

There are many reasons why FDI could have either a positive or negative effect on a host county's development. …

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