The relationship between foreign direct investment (FDI) and economic growth is unstable and varies over time, according to a recent paper by the World Bank.
Policymakers in both developing and advanced economies agree that foreign direct investment (FDI) is a key element of a successful development strategy. The European Commission states: “FDI is a driver of competitiveness and economic development”. In the midst of the COVID-19 pandemic, the World Bank described FDI as key to crisis recovery. This sentiment is not new – an International Monetary Fund article from 1999 noted, “Recognizing that FDI can contribute to economic development, all governments want to attract it.”
The enthusiasm of policymakers is somewhat in contrast with the academic literature. While a few papers exist that find a positive link between FDI and economic growth, there is now a consensus that FDI flows alone are not enough and that complementary inputs such as human capital and financial depth play a central role in the link between FDI and economic growth.
New evidence on FDI and growth
In a recent paper, we reassess the literature on FDI and growth: we re-examine the relevant evidence by replicating the results from a set of influential papers, study how the link between FDI and GDP growth changes when we estimate those baseline models over different time periods and models, and introduce a new instrument aimed at assessing the causal effect of FDI on GDP growth.
We found that the relationship between FDI and economic growth is far from stable. We also document that the mediating effect of human capital and financial depth, which had been established in the early literature on FDI and growth, no longer holds in the post-1990 period. Additionally, we found that ordinary least squares and instrumental variable estimates yield similar results—suggesting that our findings are unlikely to be driven by endogeneity.
The results in the paper suggest that FDI has a positive association with growth in countries that experience high GVC activity growth and have initial low levels of human capital or financial development. While this result suggests that countries with weak absorptive capacities do benefit from FDI, it also indicates that the FDI’s positive effect is driven by the low-value-added components of GVCs. Strengthening human capital and improving financial development may be key to attracting and benefit from high-value-added components of GVCs and associated FDI. Further research in this area would better inform policymakers of these issues, particularly against the backdrop of potential FDI fragmentation and the post-COVID period.