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.

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.