How does Foreign Direct

Investment Affect Economic

Growth

E. Borensztein,

J. De Gregorio,

J-W. Lee

Journal of International Economics 45 (1998) 115–135

Introduction

Model of technology diffusion: the rate of economic growth of a backward country depends on the extent of adoption and implementation of new technologies.

FDI is considered to be a major channel for the access to advanced technologies

Findly (1978): FDI increase the rate of technical progress in the host country through a ‘contagion’ effect from the more advanced technology, management practices, etc. used by foreign firms.

Wang (1990) incorporate this idea into a model more in line with the neoclassical growth framework, by assuming the increase in “knowledge” applied to production is determined as a function of FDI.

Objectives

The purpose of this paper is to examine empirically

the role of FDI in the process of technology diffusion

and economic growth in developing countries

We examine whether FDI interacts with the stock of

human capital to affect growth rates.

We also test whether the level of FDI has an effect

on the overall level of investment in the country and

on the efficiency of investment.

Theoretical Framework

Technical progress is the result of ‘capital deepening’

in the form of an increase in the number of varieties

of capital goods available, as in Romer (1990),

Grossman and Helpman (1991) and Barro and Sala-

i-Martin (1995)

A: exogenous state of technology

H is a given endowment of human capital

K: physical capital capital accumulation takes place

through the expansion of the number of varieties

𝑌𝑡 = 𝐴𝐻𝑡∝𝐾𝑡

1∝

The model highlights the roles of both the

introduction of more advanced technology

and the requirement of absorptive capability

in the host country as determinants of

economic growth, and suggests the empirical

investigation of the complementarity between

FDI and human capital in the process of

productivity growth

Model Specification

• FDI is measured as a ratio to GDP

• H is the stock of human capital

• The initial GDP variable (Y0) captures the

role of the ‘catch-up’ effect (N/N*)

• A is a set of other variables that affect

economic growth

Data

Variable Description Sources

GDP Growth Average annual rate of per capita real GDP over

each decades, 1970-79, 1980-89

Summers and Heston (1993)

Foreign Direct

Investment (FDI)

Gross FDI originated in OECD member

countries into developing countries

OECD Publication

Schooling (H) The initial-year level of average years of the

male secondary schooling

Barro and Lee (1993)

Government

Consumption

Average share of real government consumption

in real GDP

Summers and Heston (1993)

Investment Rate Domestic investment rate Barro and Lee (1994)

Black Market

Premium

Measure distortions in the trade regime

Assassinations and

Wars

A measure of political instability (political

assassinations and wars)

Financial Depth The ratio of the liquid liabilities of the financial

system to GDP, equal to M2/GDP

Inflation rate

Political Rights Index for freedom of speech and the press,

freedom to run for office, and vote in the country

(1 best, 7 worst)

Gastil (1987)

Institutions Quality of political institutions (1 worst, 10 best) Knack and Keefer (1995)

Panel data of 69 developing countries (1970-89)

Result

Strong

complementary

effects between

FDI and human

capital on the

growth rate of

income

1

Result

Result

The figure shows that,

for a given level of human

capital, an increase in FDI

raises the growth rates of

per capita income, except

for the economies with the

lowest level of schooling

Result

FDI stimulate or

“crowds in”,

domestic

investment

2

Result

Interaction

between human

capital and

investment is a

particular

characteristic of

FDI

3

Conclusion

FDI is in fact an important vehicle for the transfer of technology

There is a strong complementary effect between FDI and human capital

FDI is complementary (crowds in) to domestic investment

FDI is more productive than domestic investment only when the host country has a minimum threshold stock of human capital

Important notes

FDI data used here from BOP statistic, which is

only part of the resources invested through

another instrument (debt or equity).

Thus, our measure of FDI underestimates the

total value of fixed investment made by a

multinational firm and the coefficients on FDI may

be proportionally overestimated.

For further research

The results suggest that the beneficial effects on

growth of FDI come through higher efficiency

rather than simply from higher capital

accumulation.

This suggests the possibility of testing the effect of

FDI on the rate of total factor productivity growth in

recipient countries

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