Foreign Investment and Economic Growth: Exploring the Relationship In 2023

The importance of FDI (Foreign Direct Investment) in developing countries has grown over the past two decades, as many developing countries have successfully attracted large and increasing FDI. Economic theory has identified several channels through which FDI inflows can benefit host economies. However, the empirical literature needs to catch up and has more problems identifying these advantages in practice. More importantly, several empirical papers have examined the relationship between FDI growth and GDP, but their results are inconclusive. 

Despite the lack of strong conclusions, it is surprising that most countries continue to follow policies encouraging more foreign direct investment flows strongly. However, FDI in the primary sector tends to harm growth, while investment in manufacturing is positive. In addition, evidence from the service sector is equivocal.

Foreign Direct Investment and Growth

Most studies conclude that FDI gives more to host country factor productivity and income growth than domestic investment typically contributes. However, it is more difficult to assess the magnitude of this effect, not least because large FDI inflows to developing countries often coincide with unusually high growth rates due to unrelated factors. Others have concluded that FDI may increase domestic investment. In any case, even if crowding out occurs, the net effect remains generally favorable, not least because substitution frees up scarce domestic funds for other investment purposes.

The link between foreign direct investment and growth

Solow was the originator of the theory of extrinsic growth. The theory holds that economic growth results from governance and regulation through the accumulation of external factors of production, including capital and labor stocks. Empirical studies of economic growth using external models typically use aggregate production functions. The aggregate production function is modeled in terms of capital inputs (domestic and foreign), labor inputs, and the rate of technological progress over time. Through this framework, it has been shown that the direct contribution of capital accumulation to economic growth is proportional to the share of capital in national production.

In addition, the economy’s growth depends on the increase in the labor force and the advancement of technology. According to this theory, FDI increases the capital stock of the host country; this, in turn, affects economic growth. If FDI introduces new technologies that increase the productivity of labor and capital, then this will lead to more stable returns on investment, and labor will grow externally. A positive relationship exists between capital accumulation and production; FDI stimulates economic growth by increasing domestic investment. Through external or neoclassical growth models, it is found that FDI can directly affect economic growth through capital accumulation and the incorporation of new inputs and foreign technologies into the host country’s production function. Thus, the neoclassical growth model suggests that FDI promotes economic growth by increasing investment quantity and efficiency in the host country.

Integration into the global economy

A positive relationship exists between increased FDI and the speed at which host countries integrate into global markets. This is because a larger proportion of FDI is invested in host countries’ tradable sectors, boosting export performance and bringing in much-needed foreign exchange. This can be achieved by diversifying the export basket, maintaining high export growth rates over time, increasing the technological and skill content of export activities, and expanding the capacity of local firms to compete globally. However, the same report emphasized that to achieve this goal, local governments must develop coherent policies and strategies to attract export-oriented multinational companies. 

Direct Foreign Investment enters through multinational companies, which can help local enterprises reduce the cost of entering foreign markets. This is made possible by the increasing opportunities for local companies to mimic the export operations of MNCs and can take advantage of their distribution networks, delivery infrastructure, and international marketing know-how. Increased exports and global integration have also brought other benefits to domestic firms, including increased productivity, better capacity utilization, and access to economies of scale. However, global integration induced by FDI can have a negative impact on the host economy, leading to current account deficits. In addition, FDI can be a conduit for transmitting global economic challenges to now-open host economies.

Technology transfer

The economic literature regards technology transfer as the most important channel through which the presence of foreign firms can generate positive externalities in developing host economies. Multinational corporations are the most important source of R&D activities of enterprises in developed countries. They usually have a higher level of technology than developing countries, so they may have a significant technological impact.

However, technology transfer is an essential aspect of the existence of TNCs, especially through vertical linkages. Technology transfer and dissemination occur through four interrelated channels: vertical linkages with suppliers or buyers in host countries; horizontal linkages with competing or complementary firms in the same industry; skilled labor migration; and internationalization of R&D. The evidence for positive effects is strongest and most consistent in the case of vertical connectivity in developing countries. Multinational companies often provide technical assistance, training, and other information to improve the quality of suppliers’ products. In addition, many MNCs assist local suppliers in sourcing raw materials and intermediate products and modernizing or upgrading production facilities.

Enterprise Development

Foreign direct investment can significantly stimulate the development of host country enterprises. The immediate impact on the target organization includes:

  • The realization of synergies within the acquiring company.
  • Improving the target organization’s efficiency and reducing costs.
  • Developing new activities.

Furthermore, efficiency gains in unrelated organizations can be realized through supply-side effects and similar consequences leading to technological and human capital consequences.

Existing evidence suggests that firms acquired by MNEs are significantly more economically efficient, with specificities varying by country and sector. Integrating individual businesses into larger corporate entities often yields important efficiency gains. Acquisitions often lead to beneficial upgrades in governance and management, as a balance must be struck between foreign and local capabilities. Coordinated outside acquisitions led to changes in management and corporate governance. Multinational companies generally impose their corporate policies, internal reporting systems, and information disclosure principles on the acquired company and often have multiple foreign directors involved in the acquisition. Empirical studies have found that if the practices of foreign firms are superior to those of the host economy, this may increase firm efficiency. However, regarding country-specific capabilities, it is an asset to the managers of the subsidiary companies that MNCs should adopt.

Enterprise development 

FDI has the potential to spur enterprise development in host countries significantly. The direct impact on the targeted enterprise includes the achievement of synergies within the acquiring MNE, efforts to raise efficiency and reduce costs in the targeted enterprise, and the development of new activities. In addition, efficiency gains may occur in unrelated enterprises through demonstration effects and other spillovers akin to those that lead to technology and human capital spillovers. 

Available evidence points to a significant improvement in economic efficiency in enterprises acquired by MNEs, varying by country and sector. In addition, takeovers generally lead to beneficial upgrades of governance and management, whereby a balance between foreign and domestic competencies must be struck. 

MNEs generally impose their company policies, internal reporting systems, and principles of information disclosure on acquired enterprises, and several foreign managers normally come with the takeover. However, to the extent that country-specific capabilities are the asset of the sub-manager, MNCs should strive for an optimal mix of local and foreign management.

FDIs and Environmental and Social Issues

FDI can bring social and environmental benefits to host economies by disseminating good practices and technologies within MNEs and their spillover effects on local firms. However, there is a risk that foreign-owned companies may use FDI to “export” products that are no longer certified in their home countries. In such cases, especially when host country authorities are keen to attract FDI, there is a risk of lowering or freezing regulatory standards. However, technology transfer to developing countries associated with FDI is often more modern and environmentally friendly than that available domestically. In addition, positive externalities are noted as a result of local imitation, job mobility, and supply chain requirements leading to overall environmental improvements in the host economy. In some cases, however, multinational corporations have transferred equipment deemed unsuitable for the environment by the country of origin to their subsidiaries in developing countries.

Final thoughts  

The role of FDI in economic growth has been debated in recent decades. However, current experimental studies have produced conflicting results. In this paper, we offer some explanations for these contradictory results. We contribute to the literature exploring the transmission mechanism of FDI to economic growth. To this end, we use the Bayesian stochastic boundary analysis framework to analyze the output variation.

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