Monday, March 25, 2013

Does FDI promote economic growth?

Is FDI a good thing?

Almost every country in the world has an investment promotion agency to attract foreign direct investment (FDI). Countries lacking basic facilities crave FDI to build them. And the most developed economies continue to absorb massive quantities of FDI. So FDI is generally viewed positively, as contributing to economic development and job growth.

But does it? An alternative view is that FDI "crowds out" domestic investment, for example by monopolizing whole sectors of the economy or by discouraging domestic innovation.

This blog post summarizes a study that was conducted in 1997 but which is still highly relevant. It suggests that FDI can play a positive role in promoting growth, but only under certain conditions which can be affected by government policy actions.

In a paper by E. Borensztein, J. De Gregorio and J-W. Lee in 1998, the authors test the effect of FDI on economic growth by examining FDI flows from industrial countries to 69 developing countries over the previous two decades. Their main interest is in the extent to which FDI results in technological diffusion leading to capital deepening in the target countries.

Their results suggest that FDI is an important vehicle for transferring technology to developing countries, and demonstrably better at doing so than domestic investment, i.e. investment from within a country.

However, the higher productivity of FDI was found to exist only in those countries with a minimum threshold stock of human capital. "Human capital" refers to such things as educated, healthy manpower. (There has been a debate on how much "human capital investment" has contributed to economic growth which I will summarize in a later post.)

The clear policy implication of this study is that developing countries that wish to benefit from FDI need to focus on building effective education and healthcare systems rather than just on attracting FDI.

The paper also finds that FDI, far from "crowding out" domestic investment, actually has a "crowding in" effect, with one dollar of net FDI inflow promoting more than one dollar of domestic investment, but the evidence is not as strong as for the other findings.

What seems to be happening is that FDI brings in new technology which is then used by domestic entrepreneurs. Again, this is only possible once a country has reached a certain technological level, with an appropriately skilled workforce.

The firm conclusion of this study is thus that developing countries can benefit most from FDI if they concentrate first and foremost on investing in human capital, especially by ensuring that all citizens can have access to the best possible education. An educated, skilled workforce can be set to work with better equipment, raising their labor productivity (output per head). Higher productivity is the only secure guarantee of higher living standards. Higher skills can provide higher incomes. And a skilled workforce is itself a strong attractant for FDI.

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