Foreign direct investment and economic growth: is infrastructure an issue?

Author:Sathye, Suneeta

    Over past three decades, many countries across the world which had been so far resisting free movement of capital to and from the country, opened their doors to foreign direct investments. This increased the competition among the nations for the FDI inflows and also enabled the domestic businesses to take advantage of investment opportunities overseas. The foreign investment flows vary in magnitude among the regions. The following chart shows the region-wise FDI inflows to developing countries during the five-year period of 2004-08.


    The chart shows that the FDI inflows to the developing countries in Asia and Oceania region are large in volume and have persistently increased as compared to other developing countries during 2004-08. The main driver for this increase is China.

    Where contribution of FDI to a country's growth is concerned, Dunning (1981) showed five stages in a country's journey to development or the 'investment development path' in the context of net position of FDI inflows and outflows. This early study established the relevance and contribution of FDI to a country's economic growth. Although subsequent studies underlined the importance of FDI in a country's growth, the results were mixed and this deviation from the investment development path was attributed to certain other factors such as human capital (Borensztein et al 1998, Berthelemy and Demurger 2000), development of financial markets (Alfaro et al 2004), the sector in which the FDI is attracted (Alfaro 2003) and so on. The results of various studies suggested that these factors could be an important precondition in order to experience the benefits offered by FDI inflows. The present study investigates the role of infrastructure in the host developing country in deriving benefits from the FDI inflows.


    In an early study, Dunning (1981) examined the changing proportion of FDI inflows and outflows as a country moves from the early stage of development where the domestic industries possess no particular advantages, through to the fully developed stage. Subsequently, certain other factors were identified that could influence the potential economic benefits derived from the FDI inflows.

    Although FDI boosts economic growth and alleviates poverty in developing countries, at the same time it may widen the urban-rural income disparities (Nunnenkamp et al 2007).

    2.1 FDI and the investment development path

    An early study by Dunning (1981) identified five stages of development for a country on the basis of foreign investments. In the first stage of development, a country would be a mere recipient of FDI as the domestic industries are not yet developed. Passing through successive stages of development, the country would become both a destination and a source of FDI as the domestic corporations would have some ownership advantages which they will use for expanding their activities beyond the borders of their home countries. In the final stage of development, there will be equal amounts of FDI inflows and outflows experienced by a country. Later on, this investment development paradigm was used by many researchers to study behaviour and impact of FDI on a particular country or a group of countries.

    2.2 Causal relationship

    Some studies have examined the two-way causal relationship between FDI and economic growth. Those studies suggested mix results for a causal relationship between foreign investments and growth. For a sample of 80 countries, Choe (2003) suggested a two-way relationship, that is, the FDI causes economic growth and vice versa, however, the results suggested stronger causality from growth to FDI than from FDI to growth. The results of a case study of three countries (Chowdhury and Mavrotas 2005) suggested only one way causal relationship--from GDP to FDI for Chile and two-way relationship for Malaysia and Thailand. In order to have causal relationship from FDI to growth, domestic investments play an important role as in case of China (Tang et al. 2008).

    2.3 Influence of other factors

    All the FDI received by a country may not have the same impact on the country's growth as it gets modified by the recipient sector of the economy. The ability of the primary sector to form and benefit from linkages is less as compared to the manufacturing and services sectors (Hirschman 1958, p. 109). Later on, the empirical results of Alfaro (2003) suggested that only the FDI inflows in the manufacturing sector boosts economic growth, for services sector the results were ambiguous, whereas the foreign investment in primary sector suggested a negative impact on the growth of the host country. Even within the manufacturing sector, the FDI would cause growth only if the investments are made in particular type of industries while negative impact was suggested in some other type of industries, for example, leather goods (Axarloglou and Pournarakis 2007). The results of a recent study (Chakraborty and Nunnenkamp, 2008) also suggested negative impact for primary...

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