Growth effects of FDI in 80 developing economies: the role of policy reforms and institutional constraints

Abstract

Theoretical and empirical literatures have identified several channels through which foreign direct investment (FDI) influences economic growth. This paper examines the impact of FDI on economic output growth per worker using aggregate production function augmented with FDI inflows, economic policy reforms and institutional constraints. The paper covers 80 developing countries over the period 1980–2006. We use panel data and employ fixed, random effects and GMM methods for estimation. Our results highlight the importance of FDI, policy reforms and institutional development for growth in developing economies. Finally, we demonstrate that irrespective of reforms and institutions, an increase in FDI affects output growth positively.

Keywords:

• FDI
• economic growth
• policy reforms
• institutional constraints

JEL Classifications:

• F21
• O4

Notes

1. For example, in Africa, Mali has a poverty rate of 73%. In Bangladesh, the poverty rate is around 50%.

2. For example, in Africa this is because of falling income and the burden of indebtedness.

3. For example countries like Nigeria, Algeria, Tanzania, Congo Democratic Republic and Zambia witnessed low economic policy reforms compared to the rest of Africa, but FDI inflows were considerably higher in these countries than some high reform countries in the region. The same is the case with Venezuela and Bolivia in the Latin region.

4. Notable examples of such FDI disasters in developing countries include the Enron‐Dhabol power project in Maharashtra in the early 1990s where billions of US dollars were invested, which later turned out to be a “sunk cost” of the company.

5. For detailed analysis of this survey, see Brunetti et al. (1998).

6. Both Aghion and Howitt’s (1992) and Romer’s (1990) models are called “capital deepening” models. The former is called “capital deepening via quality improvement” and the latter is known as “capital deepening via increase in the variety of capital goods”.

7. It should be noted that though FDI inflows have been flowing into many developing countries since the 1970s, it was only in the late 1980s and early 1990s that the FDI inflows actually started to surge. This surge can mostly be attributed to the policy reforms which most of the governments initiated during this period.

8. The rationale for selecting 5% as the depreciation rate is because usually in developed countries like the US, the average life of industrial equipment and non‐residential buildings is 16 and 31 years, which leads to an annual depreciation of 10% and 3%, respectively (Katz and Herman 1997). Since the Latin region is a mixture of developing and undeveloped countries, we assume the average life of the equipment and machinery assets to be 25 years which leads to a depreciation rate of 7%. Usually the majority of the capital stock is dominated by the manufacturing sector, which leads to an assumption of a 5% depreciation rate. Alternatively, we also tried with a 7% depreciation rate and there is not much change in the results.

9. The detailed information on data sources is given in Appendix 2.

10. Results are not shown here due to brevity, but are provided upon request from author.

The DO files of the empirical results can be obtained from Krishna Chaitanya Vadlamannati (corresponding author) on request.