Skip to Main Content
HBS Home
  • About
  • Academic Programs
  • Alumni
  • Faculty & Research
  • Baker Library
  • Giving
  • Harvard Business Review
  • Initiatives
  • News
  • Recruit
  • Map / Directions
Working Knowledge
Business Research for Business Leaders
  • Browse All Articles
  • Popular Articles
  • Cold Call Podcasts
  • About Us
  • Leadership
  • Marketing
  • Finance
  • Management
  • Entrepreneurship
  • All Topics...
  • Topics
    • COVID-19
    • Entrepreneurship
    • Finance
    • Gender
    • Globalization
    • Leadership
    • Management
    • Negotiation
    • Social Enterprise
    • Strategy
  • Sections
    • Book
    • Cold Call Podcast
    • HBS Case
    • In Practice
    • Lessons from the Classroom
    • Op-Ed
    • Research & Ideas
    • Research Event
    • Sharpening Your Skills
    • What Do You Think?
    • Working Paper Summaries
  • Browse All
    • COVID-19 Business Impact Center
      COVID-19 Business Impact Center
      How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages
      27 Sep 2006Working Paper Summaries

      How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages

      by Laura Alfaro, Areendam Chanda, Sebnem Kalemli-Ozcan and Selin Sayek
      Does FDI help developing countries as much as we think? While theoretical models imply that FDI is beneficial for a host country's development—a belief widely shared among policymakers—the empirical evidence does not support this view. This paper bridges the gap between theoretical and empirical literature with a model and calibration exercises that examine the role of local financial markets. Ultimately, Alfaro and colleagues contribute to existing research that emphasizes how local policies and institutions may actually limit the potential benefits that FDI could provide to a host country. Key concepts include:
      • Research shows that an increase in FDI leads to higher growth rates in financially developed countries compared to rates observed in financially poor countries.
      • Local conditions, such as the development of financial markets and the educational level of a country, affect the impact of FDI on economic growth.
      • Policymakers should exercise caution when trying to attract FDI that is complementary to local production. The best connections are between final and intermediate industry sectors, not necessarily between domestic and foreign final goods producers.
      • Human capital plays a critical role in achieving growth benefits from FDI.
      LinkedIn
      Email

      Author Abstract

      The empirical literature finds mixed evidence on the existence of positive productivity externalities in the host country generated by foreign multinational companies. We propose a mechanism that emphasizes the role of local financial markets in enabling foreign direct investment (FDI) to promote growth through backward linkages, shedding light on this empirical ambiguity. In a small open economy, final goods production is carried out by foreign and domestic firms, which compete for skilled labor, unskilled labor, and intermediate products. To operate a firm in the intermediate goods sector, entrepreneurs must develop a new variety of intermediate good, a task that requires upfront capital investments. The more developed the local financial markets, the easier it is for credit constrained entrepreneurs to start their own firms. The increase in the number of varieties of intermediate goods leads to positive spillovers to the final goods sector. As a result financial markets allow the backward linkages between foreign and domestic firms to turn into FDI spillovers. Our calibration exercises indicate that a) holding the extent of foreign presence constant, financially well-developed economies experience growth rates that are almost twice those of economies with poor financial markets, b) increases in the share of FDI or the relative productivity of the foreign firm leads to higher additional growth in financially developed economies compared to those observed in financially under-developed ones, and c) other local conditions such as market structure and human capital are also important for the effect of FDI on economic growth.

      Paper Information

      • Full Working Paper Text
      • Working Paper Publication Date: August 2006
      • HBS Working Paper Number: 07-013
      • Faculty Unit(s): Business, Government and International Economy
          Trending
            • 19 Jan 2021
            • In Practice

            Leadership Advice for Biden: Restore a Sense of Calm

            • 29 Oct 2020
            • Research & Ideas

            The COVID Gender Gap: Why Fewer Women Are Dying

            • 13 Jul 2020
            • Research & Ideas

            Merck CEO Ken Frazier Discusses a COVID Cure, Racism, and Why Leaders Need to Walk the Talk

            • 18 Jan 2021
            • Book

            How Thinking Like a Startup Helps Governments Solve More Problems

            • 25 Feb 2019
            • Research & Ideas

            How Gender Stereotypes Kill a Woman’s Self-Confidence

        Laura Alfaro
        Laura Alfaro
        Warren Alpert Professor of Business Administration
        Contact
        Send an email
        → More Articles
        Find Related Articles
        • Economics
        • Foreign Direct Investment
        • Globalized Economies and Regions
        • Multinational Firms and Management

        Sign up for our weekly newsletter

        Interested in improving your business? Learn about fresh research and ideas from Harvard Business School faculty.
        ǁ
        Campus Map
        Harvard Business School Working Knowledge
        Baker Library | Bloomberg Center
        Soldiers Field
        Boston, MA 02163
        Email: Editor-in-Chief
        →Map & Directions
        →More Contact Information
        • Make a Gift
        • Site Map
        • Jobs
        • Harvard University
        • Trademarks
        • Policies
        • Digital Accessibility
        Copyright © President & Fellows of Harvard College