Growth Effect of Foreign Direct Investment in Developing Economies: The Role of Institutional Quality

• Author: Gregory Levieuge,Cristina Jude
• Published date: 01 April 2017
• DOI: http://doi.org/10.1111/twec.12402
• Date: 01 April 2017

Growth Effect of Foreign Direct

Investment in Developing Economies:

The Role of Institutional Quality

Cristina Jude

1,2

and Gregory Levieuge

2

1

International Monetary Relations, Banque de France, Paris, France and

2

Laboratoire d’Economie d’Orl

eans, University of Orleans, Orleans, France

1. INTRODUCTION

WHEN searching for solutions to boost economic growth in developing countries,

foreign direct investment (FDI) is seen as an important stimulus for productivity

gains through the introduction of new processes and know-how, managerial skills, employee

training and access to international markets. Endogenous growth theory supports the idea of

a multiplier mechanism of FDI spillovers to domestic firms, which leads to positive effects

on aggregate productivity and economic growth (Grossman and Helpman, 1991; Liu, 2008).

Since developing economies often suffer from liquidity constraints, FDI also acts as a sub-

stitute for local investment in the capital accumulation process (Mody and Murshid, 2005).

As a result, FDI inflows were particularly encouraged by governments in developing coun-

tries, leading to an increasing share of FDI in total capital flows. Nevertheless, the empirical

evidence on the growth-enhancing effect of FDI is less conclusive. The consensus emergi ng

from this literature is that the growth effect of FDI seems conditional on a minimum level

of absorptive capacity, as given by features like trade openness, human capital or financial

development.

In line with the recent emphasis on the role of institutions in economic growth,

1

weak

institutions are likely to be responsible for several economic problems in developing coun-

tries, like lower investment, slower productivity growth, lower per capita income and overall

slower output growth. Adversely, good institutions

2

ensure efficient factor allocation, enable

investment in higher-return activities, reduce uncertainty and frictions, favour convergence

between private and social returns and ease economic agents’ coordination.

If we relate this framework to the mechanisms by which FDI fuels economic growth, it

appears natural to expect institutions to act like a feature of the local absorptive capacity

and thus to modulate the FDI–growth relationship. A good level of institutional develop-

ment can favour synergies between FDI and local firms and hence promote productivity

spillovers. Additionally, it can induce complementarities between foreign and domestic

investment and therefore increase capital accumulation. On the contrary, an underdeveloped

institutional framework can disrupt productive activities and may prevent the exploitation of

knowledge spillovers by domestic firms. If this is the case, countries with the same level of

1

See Glaeser et al., 2004, Rodrik et al., 2004, Acemoglu et al., 2005, Aghion et al., 2008, and

Flachaire et al., 2014.

2

The literature focusing on institutions uses different labels to refer to basically the same data: Hall and

Jones (1999) use the concept of ‘social infrastructure’, Persson (2005) use ‘structural policies’ and Ace-

moglu et al. (2005) refer to ‘economic institutions’, while Rodrik et al. (2004) simply call ‘institutions’.

We stick to the label used by Rodrik et al. (2004).

©2016 John Wiley & Sons Ltd 715

The World Economy (2017)

doi: 10.1111/twec.12402

The World Economy

FDI may experience very different growth outcomes depending on their institutional

quality.

While a number of studies investigate the role of institutions in attracting FDI flows, there

is very limited research dealing with institutions in explaining FDI effects (Durham, 2004;

Busse and Groizard, 2008; Farole and Winkler, 2012). To provide some insights on this issue,

in this paper we investigate the conditionality of the FDI growth effect on several featur es of

institutional quality, like political risk, law enforcement, bureaucratic quality, corruption or

expropriation risk. We argue that well-developed institutions enhance the overall benefits of

FDI on economic growth. As Nair-Reichert and Weinhold (2001), we consider host country

heterogeneity, in its wider form, to be a plausible explanation for the mixed results of empiri-

cal studies.

Our research has several original features compared to the existing literature. First, we

develop several theoretical arguments to show that institutional quality modulates the two

main channels of FDI impact on economic growth, namely knowledge spillovers and capital

accumulation. Second, while existing empirical studies use limited measures of institutions,

we use a comprehensive set of 11 indicators that allow us to capture all features of institu-

tional quality. Third, the use of panel smooth transition regression models (PSTR) allows us

to highlight the heterogeneity of the FDI effect on economic growth, as given by institutional

quality. Previous studies generally use interaction terms, which would imply a linear interac-

tion between FDI and institutions in generating growth. Adversely, we show that institutional

improvement does not have the same impulse on the marginal effect of FDI over the entire

span of the institutional variable. For robustness checks, we rely on the generalised method of

moments (GMM) estimator. Finally, the PSTR method also allows us to reveal endogenous

threshold values for institutional indicators associated with a shift in the FDI—growth rela-

tionship.

Our empirical analysis shows that institutional quality modulates the effect of FDI on

economic growth in developing countries. While FDI alone has no significant growth effect,

there is a minimum level of institutional quality that induces a growth-enhancing effect.

We thus highlight the importance of non-linearity in analysing the FDI–growth relationship,

as we show the existence of two extreme regimes linked by a more or less smooth transi-

tion function. This has two significant policy implications for developing countries. First,

sequencing is needed in implementing economic policies: governments should first improve

the regulatory framework before engaging in FDI attraction policies. Second, in designing

institutional reforms, some features of institutional quality prove to pay off faster in terms

of marginal effect on growth. Therefore, priority should be given to these specific features,

as further institutional complementarities would eventually lead to an incremental effect on

growth.

With the drop in global FDI flows in the turmoil of the recent economic crisis, competition

among developing countries has intensified to attract foreign investors. Since large amounts of

public funds have been devoted to FDI attraction policies, identifying the specific conditions

that favour the returns on FDI is thus of great importance for policymakers in developing

countries. Seeking to provide some guidance to this end, our paper is organised as follows.

Section 2 is dedicated to the main arguments in favour of a conditioning role of institutions

in the FDI–growth relationship. Section 3 describes the data and the methodology being used,

while Section 4 presents the results and discusses their robustness. Section 5 highlights the

main conclusions and policy implications for developing countries.

©2016 John Wiley & Sons Ltd

716 C. JUDE AND G. LEVIEUGE