An introduction to foreign direct investment, its history and a literature review of its relationship with economic growth in developing countries

What is foreign direct investment?

FDI is a category of cross-border investment made by an economic agent in one economy (the direct investor) to an enterprise in another. Traditionally, a foreign direct investment is a strategic manoeuvre with the objective of establishing a long-term, stable relationship with a foreign enterprise and between different economies. Such lasting interest is usually defined when the direct investor owns at least 10% of the voting power of the direct investment enterprise. When under certain policy climates, it serves to develop a local enterprise, improving both the host (recipient) and home (investing) economies. FDI differs from portfolio investors who do not have a significant influence on the enterprise’s management.

Once of little attention and concern, a radically different view of FDI has emerged. In recent decades, significant growth in FDI levels have reflected the growing emphasis and popularity in the size and number of FDI transactions, as well as the increasing diversification of enterprises across economies and industrial sectors. Traditionally, large multination enterprises (MNEs) have dominated FDI ventures, but recently, it has come to light that relatively smaller enterprises have taken an interest in FDI: it is now seen as advantageous, with most countries encouraging inward FDI flows through general and specific policies that embrace an economic climate that welcomes investment.

However, the effects of FDI are neither clearly established as good nor bad, for such binary conclusions overlook important determinants and their magnitudes. These include the type of FDI, firm characteristics, economic conditions and policies. FDI and growth are held together through the links of investment policies, motivations, trade, innovation and human resources.

 

Foreign direct investment within a historical context

FDI’s exact date of origin is unknown but ‘multinational enterprise headquartered in Europe [goes] back to the Middle Ages’ (Mira Wilkins 1977). However, most long term capital movements were portfolio investments: before World War I, Lipsey states that ‘descriptions of capital flows… either did not discuss direct investment at all (Iversen 1936) or combined it with portfolio investment, as in the compilation in Palgrave (1910, vol 2).’ Even by 1960, there was still no separate theory of foreign direct investment.

However, contrasting literature by Peter Svedberg (1978) argues that approximately 44% to 60% of the $19 billion of accumulated investment in developing countries in 1913-1914 was accounted for by FDI, blaming accounting methods for distorting the flow of stocks.

Yet, overall, the years preceding 1914 conform to the traditional picture. 80% of the stock of long-term investment in the United States was portfolio investment (Lewis 1938), where the government and railways were primarily the borrowers, with the borrowing of bonds rather than equity. Surprisingly, FDI was not avoided because foreign capital financed risky capital formations. In fact, early FDI went predominantly into government securities, deemed to be relatively safe. As well as lending to the government during the Civil War, later investments went towards social projects: railroads, canals and public utilities (Edelstein 1982).

Perhaps FDI was not widespread due to what Mira Wilkins (1989) called ‘free standing enterprises’. Manufacturing enterprises were often set up by foreign entrepreneurs; however, due to high transportation and communication inefficiencies, this usually led to the migration of the individual entrepreneur or their relatives to manage their enterprise, becoming more independent over time and losing the status of direct investments.

In more recent years, the globalisation of capital markets has meant that FDI flows grew at a rapid pace, with developed countries accounting for most of the foreign direct investment of the world. The industrial countries made up 94% of outflows and 70% of inflows by 2001.

However, middle income countries were severely affected by the debt crisis of 1982, and to a lesser extent by the 1994 Mexican crisis. On the other hand, low-income countries, due to their lack of well-developed financial markets, were less affected by such crises. As a result, developing countries have seen a rise in inflows of private capital. Towards the end of the 1970s these regions, especially Asia, became open to foreign capital. FDI flows to both middle and low income countries were still relatively modest at the beginning of the 1980s, around $5 billion, accounting for only 19% of all private capital flows to low income countries in 1981. FDI inflows into developing countries increased by 23% a year from 1990 to 2000, and from 1998 to 2001, averaged $225 billion a year.

 

Literature Review

Conclusions from extensive literature on the FDI-growth relationship diverge to the extremities. This literature review therefore provides an overview of the intellectual progression of the field, as well as the main arguments and relative positions of different economists over time. This will supplement our understanding of the main discussion and allow us to establish where my research fits within the larger field of study. We will also identify where gaps exist in how the FDI-growth relationship has been researched to date.

In order to achieve these aims and reflect the main bodies of FDI-growth research, this literature review will be classified under two general theories on the direction of causality: A. FDI to growth, and B. Growth to FDI. The former tries to explain how FDI affects growth, assuming that the causation runs positively from FDI to growth; the latter assumes the reverse direction of causality – namely, that high rates of economic growth attract investors, explaining any positive correlation between the two.

In terms of part A, although there seems to be a general agreement in the field that FDI stimulates economic growth, the conditions upholding this differs between economists. As such, the literature on FDI led growth will be organised under the main factors that different key economists believe to be important in determining FDI and growth: income, trade policy, the development of domestic financial institutions, the state of technology and technological gaps.

A. FDI to Growth

Income

Leading to diverging conclusions on income and its relation with FDI led growth, over the years, in the field of FDI research, there has been a rivalry between neoclassical growth theory and a newly emerging modern growth theory. Supporting the former, conventional Solovian growth theory suggests that the least affluent countries benefit most from FDI. A protagonist of this view is Findlay (1978), who claims that they are the most ‘backward’ and hence possess the most potential for improvement.

More recently however, we have Blomstrom et al (1994) on the other end of the spectrum, disagreeing with Findlay. Blomstrom— who works at the Stockholm School of Economics with 37 published papers on international finance —and Lipsey— a professor of Economics at Columbia University with 89 publications on FDI and international trade—contradicted Solovian growth theory with their publication for the National Bureau of Economic Research, titled ‘What explains developing country growth?’ Blomstrom et al. concluded that for developing countries of lower wealth, FDI has no effect on growth. They also concluded that a certain threshold level of development is needed if the host countries are to absorb new technology from FDI. Clearly competent and reliable due to their extensive experience as academics in the field, these economists and their publication was a key development in the world of FDI research as their position in the FDI field was one which rivalled neoclassical growth theory and shifted focus towards modern growth theory, which points out that a certain level of development is necessary in order to benefit from FDI, a sentiment that would go on to resonate in countless works by other economists, some of whom we shall later explore.

Human capital

Following Blomstrom et al (1994)’s ‘What explains developing country growth?’, their notion of a minimum threshold of requirement in the host country’s economic state (beneath which FDI does not notably stimulate growth) became more popular over time. In the same year of their publication, Benhabib and Spiegel (1994) found that FDI is indeed an important method of adopting new technologies in order to become more efficient and increase the level of economic growth so long as the host country has a minimum threshold stock of human capital. Both of these papers were internalised in the FDI field and later cited in a 1998 paper, titled ‘How does foreign direct investment affect growth?’ written for the Journal of International Economics by three credible authors: Borensztein (who, after gaining a PhD in Economics from MIT, is a senior staff on the International Monetary Fund), De Gregorio (the Governor of the Central Bank of Chile from 2007-2011 and a Senior Fellow at the Peterson Institute for International Economics) and Lee (who, after gaining a PhD and MA in Economics from Harvard University, is a consultant to the IMF and the World Bank). However, after reflecting on Blomstrom et al. and Benhabib and Spiegel, Borensztein et al. took a new stance to the FDI-growth conundrum, concluding that FDI not only fails to stimulate growth in developing countries with low levels of human capital, but it actually has a negative effect on them. Borensztein et al. are key economists widely published in the FDI field and this paper would later be cited by many, including Alfaro et al who emphasised the importance of human capital as a prerequisite to FDI led growth in their 2006 ‘Foreign direct investment and growth’.

Trade Policy

Contrary to the work of Blomstrom et al (1994), two years later, Balasubramanyam (1996), a Professor of Development Economics (specialising in international trade and investment) and a consultant to the OECD on the Global Forum on International Investment, published a paper titled ‘Direct foreign investment and migration’, stating that the effects of FDI depend not predominantly on income levels, but on an economy’s trade policy: host countries who pursue an outwardly oriented trade policy tend to reap the benefits of FDI on growth more so than their counterparts, particularly for export-promoting countries. Zhang (2001) agreed with this in ‘Does foreign direct investment promote economic growth?’ and concluded that trade liberalisation tends to improve education and thereby human capital conditions, whilst encouraging macroeconomic stability.

Development of Domestic Financial Institutions

Another region of the FDI-growth field focuses not on income and trade policy, but on the development of domestic financial institutions. Although most FDI, by its very nature, relies on capital from abroad, it is important to recognise that the spill-overs for the host economy might crucially depend on this factor. As such, several economists have concluded that a lack of development can limit an economy’s ability to take advantage and benefit from potential FDI spill-overs.

Neoclassical growth theory dictates that, due to the diminishing marginal utility of capital, poorer countries will experience greater magnitudes of FDI-led growth. However, almost a century ago, economists such as Goldsmith (1969) – who used to be a member of the National Bureau of Economic research, a professor at New York University and the author of 15 books on economic history, Mckinnon (1973)- who used to be an Economics professor at Stanford University and an author of eight books on economic development, and Shaw (1973)- also a former professor of Economics at Stanford and author of multiple economics books, recognised the importance of well-developed financial intermediaries in enhancing technological innovation, capital accumulation and economic growth, heavily reliant on external finance. In the FDI-growth field they are therefore credible sources, yet arguably out-dated. More recently however, their works have been supported by economists, who have concluded that FDI has a positive impact on economic growth, but only if the host country’s domestic financial markets and institutions are well developed. In 2003, Hermes and Lensink (2003) provided evidence that only countries with well-developed financial markets gain significantly from FDI in terms of their growth rates. Two years later, Durham (2004), and two years after that, Alfaro et al (2006) both published papers that arrived at a similar conclusion, emphasising the role of financial institutions in FDI led growth since the 1970s. Indeed, this aligns with the works of Goldsmith (1969), Mckinnon (1973) and Shaw (1973).

State of Technology and Technological Gaps

Another area of the field concerns itself with the state of technology in host countries and the role that this plays in FDI led growth. This area arguably comprises the most conflict and debate.

Firstly, several economists advocate for its importance: In 2009, Toulaboe, Terry and Johansen (2009) found that technological leaders benefit most, concluding “that absorptive capacity in the host country is important in allowing FDI to positively and fully impact economic growth”. Similarly, Blomstrom interpreted the findings as indicating that foreign presence forces local firms to become more productive in sectors where ‘best practice technology’ lies within their gaps. Before these works, Findlay (1978) had postulated that FDI increases the rate of technical progress in the host country (and hence stimulates growth) though a “contagion” effect from the more advanced technology used by foreign firms.

In direct contradiction to this, however, De Mello (1996) found only weak evidence for FDI effects on economic growth, and in the following year, he pointed out that if FDI is expected to impact growth through knowledge transfers and newer technologies, then the relative impact should be lower in technological leaders than in technological laggards (de Mello (1997)).

In disagreement with all of the aforementioned findings however, the Imbriani and Reganati study (1999) showed that FDI leads to higher productivity so long as the levels of technology in the host and investing countries are similar. Li and Liu (2005)’s main argument aligns with this in the sense that they also found a negative correlation between a technological gap between home and host countries, however, they concluded that there is indeed a complementary connection between FDI and growth, unlike Imbriani and Reganati.

B. Growth to FDI

Whilst the overwhelming majority of literature on the FDI-growth relationship focuses on how FDI may lead to growth, other literature instead studies the direction of causality between the two. After all, it is highly feasible that increasing growth rates are attracting investors. Knowing the direction of

causality is extremely important for policy makers when designing policies to stimulate economic growth and development.

Contrary to standard FDI led growth theory, no long run FDI to GDP causality is found in developing countries in a dissertation by Lund (2010) from the University of Utah. Lund finds that, in the short run, FDI stimulates growing GDP in high income nations, but in the long run, GDP attracts FDI. The short run effect he finds is at odds with previous literature that argues that the least developed countries have the greatest potential to benefit from FDI. Although he uses official data published by the United Nations Conference on Trade and Development (UNCTAD), making his empirical results reliable, his work has not been cited by others. His credentials are fewer than the other works we have mentioned. As a result, his thesis is not as convincing.

However, others have found similar results. For example, Choe (2003) has found evidence in favour of the economic growth to FDI causality link. Tsai (1999) had also found that growth rates were determinants of FDI inflows. Mottaleb (2007) also found that lower-middle income countries with larger GDP and high GDP growth rates were more successful in attracting FDI.

The policy implications of these findings are that the countries should place more weight on stimulating growth through other measures than those aimed at attracting FDI. Blindly reducing restrictions on FDI will most likely not result in long run growth. Policies directed at stimulating domestic investment in infrastructure, technology and exports may be the better alternative in terms of promoting economic growth. Only after a country has reached a certain level of development will FDI affect growth positively.

Overall however, in terms of quantity, there is far more literature and evidence supporting the idea that FDI leads to growth rather than the reverse chain of causality. The quality of the sources in part A in reference to their provenance exceed that of part B. However, we should point out the limitations of previous literature: gaps in the field do appear to exist in terms of dispute in certain sub-areas. For example, the divide and inconclusively of technology gaps and their relationships with FDI in developing countries is a point of contention.

Having considered the two main branches of focus in the FDI-growth field and concluded that there is more evidence and focus on FDI-led growth, we must note that that it is not the case that the two branches are mutually exclusive. Rather, it appears that they both exist, but the former is a more important study.

[to be continued in a later post….]

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