Foreign Direct Investment

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Foreign direct investment

in developing countries and
growth: A selective survey
Luiz R. de Mello Jr.
University of Kent , Canterbury, UK

Published online: 23 Nov 2007.
To cite this article: Luiz R. de Mello Jr. (1997) Foreign direct investment in
developing countries and growth: A selective survey, The Journal of Development
Studies, 34:1, 1-34, DOI: 10.1080/00220389708422501
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Survey Article
Foreign Direct Investment in Developing

Countries and Growth:
A Selective Survey
LUIZ R. DE MELLO, Jr.

This article surveys the latest developments in the literature on the
impact of inward foreign direct investment (FDI) on growth in
developing countries. In general, FDI is thought of as a composite
bundle of capital stocks, know-how, and technology, and hence its
impact on growth is expected to be manifold and vary a great deal
between technologically advanced and developing countries. The
ultimate impact of FDI on output growth in the recipient economy
depends on the scope for efficiency spillovers to domestic firms, by
which FDI leads to increasing returns in domestic production, and
increases in the value-added content of FDI-related production.
I. INTRODUCTION
The objective of this article is to survey recent developments in the
literature on the impact of cross-border investment and technology, or
knowledge transfers, on output growth in developing countries. This topic
deserves a more careful examination than the traditional closed-economy
growth-theoretic and international trade models have permitted [Grossman
and Helpman, 1991]. The focus of the former is almost exclusively on the
growth-enhancing sources of increasing returns in a closed-economy,
whereas the main object of the latter has been the examination of the
determinants of foreign direct investment (FDI) and the relocation of
production across international borders.
In traditional neo-classical growth models of the Solow [1956] type, the
extent to which FDI affects output growth is limited, given that, with
diminishing returns to physical capital, FDI can only affect the level of
Luiz R. de Mello, Jr., University of Kent at Canterbury, UK. The author is indebted to A.P.
Thirlwall and to an anonymous referee for helpful comments and discussions. The usual
disclaimer nevertheless applies.
The Journal of Development Studies, Vol.34, No.l, October 1997, pp.1-34
PUBLISHED BY FRANK CASS, LONDON
THE JOURNAL OF DEVELOPMENT STUDIES
income, leaving the long-run growth rate unchanged. The potential impact
of FDI on growth is confined to the short run, the magnitude and duration
of which depend on the transitional dynamics to the steady-state growth
path. Nevertheless, FDI can be shown to affect growth endogenously in so
far as it generates increasing returns in production via externalities and
productivity spillovers. The possibility of FDI being growth-enhancing in
the long run has motivated a growing theoretical and empirical literature on
the topic, which this paper surveys.
With regard to policy design and assessment, it is known from the
related growth literature that policy parameters are also expected to affect
long-run growth. These policies may have an indirect impact on FDI, which
may be growth-enhancing, or offsetting. The policy regime of the host
country constitutes a potentially important FDI determinant. The recent
literature has provided policy-makers in developing countries with more
adequate tools and more accurate benchmarks for cross-country
comparisons and policy evaluation.
Because the literature on FDI is large, we should begin by indicating the
limits of this survey. First, although the determinants of FDI are discussed,
their analysis does not constitute the core of the survey. It is assumed that
differentials in factor endowments (and hence rewards), cost structures, and
market and institutional characteristics of the recipient economy are the
main FDI determinants [Lall, 1978]. Foreign investors are motivated
primarily by international rent-seeking under standard profit-maximising
assumptions.
Second, it is not intended to examine the reasons for the dramatic
increase in FDI world-wide in recent years, but as a background we show in
Table 1 the current magnitudes of the flows in FDI, and their growth rates,
into developing countries, over the period 1980 to 1994.
It can be seen that FDI inflows into developing countries have been
concentrated in a few leading Southeast Asian and Latin American
economies, and the rate of growth of FDI inflows as a share of exports into
those economies has outpaced that of exports as a share of GDP. In fact,
according to the GATT/WTO, total FDI flows have increased ninefold
between 1982 and 1993, whereas world trade of merchandise and services
has only doubled in the same period. Also, according to the OECD [1991],
the growth rate of FDI outflows from the OECD countries in the 1980s
doubled compared to the 1970s.
The most important factors explaining the surge of FDI inflows into the
developing countries in recent years have been the foreign acquisition of
domestic firms in the process of privatisation, the globalisation of
production, and increased economic and financial integration [UNCTAD,
1996]. However, the growth of FDI flows into developing countries has not
FOREIGN DIRECT INVESTMENT IN DEVELOPING COUNTRIES
matched the flows into developed economies [Katseli, 1992], mainly due to
the international debt crisis faced by developing countries in the 1980s.
The survey is organised as follows. Section II presents the general
theoretical framework within which the links between FDI and growth can
be studied, and discusses the basic determinants of FDI; it acknowledges the
importance of country-specific effects, and outlines the vehicles through
which FDI promotes knowledge and technology transfers. Section III
formalises the concepts in section II with reference to both growth
accounting and intertemporal optimisation, which are the two standard
techniques used in the empirical literature. It also introduces the empirical
analysis which focuses on the time series and cross-section aspects of FDI
and growth. This section also discusses the relevance of panel data analysis,
in the light of the importance of country-specific effects suggested by case
studies. Section IV surveys the empirical literature, while Section V focuses
on FDI as a vehicle for technology transfers, both theoretically and
empirically. Section VI examines the direction of causation between FDI
and output growth. Section VII concludes.
TABLE 1
INWARD FDI FLOWS TO DEVELOPING COUNTRIES (DCs)
Export Share in GDP
%
FDI Share in Exports
Areas
1980 1990 1994
1980 1990 1994 %
AH DCs
30.3
21.2
24.4 -19.5
0.7
2.8
Pacific Rim
23.2
27.8
32.2
38.8
1.3
4.4
south Asia
10.8
10.9
17.0
57.4
0.8
1.4
1.4
Latin America
and Caribbean
Middle East
and N Africa
18.1
17.0
14.6 -19.3
4.8
4.4
8.5
50.7
34.9
37.8 -25.4
-1.5
1.0
1.5 200
Sub-Saharan
Africa
33.6
31.9
32.5
-3.3
0.0
1.0
2.7
E Europe and
Central Asia
14.0
13.7
0.0
0.2
7.4
6.7
% of Total FDI
Flows to DCs
1980 1988 1994
857.1
SE Asia and
Note:
10.2 684.6
15.3
39.4
56.4
75.0
2.2
1.7
1.1
77.0
71.9
41.2
24.9
0.4
5.9
3.0
0.1
0.2
9.3
% denotes the percentage change between 1980 and 1994. Constructed from Guntlach
and Nunnenkamp (1996).
II. THE THEORETICAL ARGUMENT
The Determinants ofFDI

FDI is conventionally defined as a form of international inter-firm cooperation that involves a significant equity stake in, or effective
management control of, foreign enterprises. Because a formal clear-cut
definition is difficult, FDI is considered, for the purpose of this survey, to
also encompass other, broader forms of non-equity co-operation involving
the supply of tangible and intangible assets by a foreign enterprise to a
domestic firm without foreign control. These broader collaborative
associations include most types of quasi-investment arrangements (such as
licensing, leasing, franchising, start-up and international production-sharing
agreements), joint ventures with limited foreign equity participation, and
R&D co-operation. Such a broad definition of FDI is justified given the
growth of FDI in the service sector in recent years.
Although it is not our main objective to survey the literature on the
determinants of FDI [Lall, 1978; Aggarwal, 1980], some treatment of this
topic helps to illustrate the basic hypotheses governing the motivations for
cross-border investment and production relocation, and more general types
of collaborative ventures. The international trade literature [e.g. Batra and
Ramachandran, 1980; Bhagwati and Srinavasan, 1983; Grossman and
Helpman, 1991] focuses on the allocative aspects of FDI and cross-border
production. In the context of multinational corporations (MNCs), FDI is
considered to be the outcome of broad corporate strategies and investment
decisions of profit-maximising firms facing world-wide competition, where
significant differences in cost structures, due to factor productivity and
remuneration differentials across countries, justify cross-border investment
and production relocation.
Here, the institutional features of the recipient economy are important
determinants of FDI, including the degree of political stability and
government intervention in the economy; the existence of property rights
legislation determining the legal rights of foreign firms and limitations on
foreign ownership; the property and profit tax system, and the extent and
severity of bureaucratic procedures. International agreements on trade and
investment also influence the volume and patterns of FDI [Morrissey and
Rai, 1995]. In addition, economic factors affect the attractiveness of a
country to FDI, such as the trade and investment regime, the 'openness' of
the host country, and the adequacy of basic infrastructure. At the same time,
local content and equity requirements and explicit performance criteria act
as deterrents to FDI.
Among policy-related institutional characteristics, country-specific FDI
incentives are often cited, such as fiscal incentives (tax rebates and
exemptions), financial incentives (subsidised loans and grants), and nonfinancial incentives (for example, basic infrastructure provision) [Antoine,
1979; him, 1983; Chen and Tang, 1986]. Fiscal incentives tend to prevail in
developing countries and technology transfer and equity requirements tend
to be stronger disincentives than local content or export requirements,
particularly when intellectual property legislation is not adequate or
leniently enforced. The latter requirements are expected to affect primarily
trade patterns but not the volume of FDI [OECD, 1991; Guisinger, 1992].
In general, although to a large extent country-specific FDI incentives tend
to reflect competition for foreign capital, the effectiveness of beggar-thyneighbour policies tends to be limited in scope and duration.
The volume and type of FDI inflows are also influenced by scale factors
affecting the absorptive capacity of the host country or, equivalently, the
size of the domestic market for the goods produced by FDI. The size of the
domestic market, in conjunction with the growth prospects of the host
country [Bhasin et al, 1994], play a role when foreign investors decide to
relocate production, or to engage in export-bound production in the host
country. FDI can also be very sensitive to balance of payments constraints
(such as the foreign debt burden, and restrictions on capital movements that
may limit access to foreign exchange and foreign remittances) and to factors
related to general macroeconomic performance, such as inflation, and fiscal
and monetary policies.
The cost structure of MNC affiliates is expected to differ from that of
their domestic counterparts in that there are significant fixed costs in
production relocation and that variable costs tend to be lower due to lower
factor costs. The decision on cost-minimising plant location and size is also
affected by the market structure of the host country. The degree of
monopolistic competition affects the extent to which the foreign investor
can cover the sunk costs of production relocation and prevents the entry of
other (foreign or domestic) firms, leading to a significant gain of market
share. Indeed, a high degree of protectionism in a sizeable market often acts
as an incentive for FDI [Guisinger, 1992].
The asymmetry in factor endowments and rewards between
technological laggards and leaders also determines the distribution of trade
between the two types of countries. The economy with the greater
endowment of human capital tends to provide the economic environment
for the globalisation of production, such that firms in technologically
advanced economies become multinational and specialise in the production
of goods and services that cannot be produced elsewhere. Trade between
MNC headquarters and affiliates consists primarily of services and
intermediate inputs, which increases exports to the countries hosting MNC
affiliates. The association between outward FDI and exports in
technological leaders is mirrored by the link between imports and inward

FDI in technological followers [Helpman and Krugman, 1985].
Recent Case Studies
The determinants of FDI are conventionally modelled in terms of locational
decision-making within MNCs. Demand variables, such as market size,
economies of scale, and relative factor prices are believed to be the main
determinants of FDI. Most empirical studies also postulate lagged responses
of FDI flows to domestic stock adjustments, and that the user cost of capital
in the recipient country plays a part in determining relocation decisions. A
brief summary of the case studies surveyed here is provided in Table 2.
With regard to the theoretical framework, Pain [1993] proposes a twosector model with two types of investment. One sector defines purchases of
inputs for foreign production, while the other establishes sales-related
distribution outlets (downstream services). Bajorubio and Sosvilla-Rivero
[1994] examine the composition of FDI between manufacturing and nonmanufacturing activities in Spain, and argue that FDI fosters integration into
world markets, and promotes faster output growth as a result. Inflation is
used as an ancillary variable to measure overall economic instability, which
is expected to increase the user cost of capital in the recipient economy and
to affect the profitability of FDI negatively, so acting as a FDI deterrent. In
the same vein, exchange rates are expected to affect FDI in so far as they
affect a firm's cash flow, expected profitability and the attractiveness of
domestic assets to foreign investors. A positive impact is expected when the
domestic currency is relatively weak compared to that of the foreign
investor, as in the case of China [Wang and Swain, 1995].
The hypothesis that MNC investment leads to the creation of a dual
economy is tested for the case of Ireland, by O'Sullivan [1993]. Foreign
firms are shown to have higher capital intensity, and tend to engage in
assembly-type activities with a higher export-to-sales ratio, and a higher
imported input content than domestic firms. When FDI production is geared
to export promotion, the hypothesis that domestic expenditure variables are
good FDI determinants is also examined by Wang and Swain [1995] in the
case of China and Hungary, and found to have a positive impact on FDI.
The positive impact is nevertheless not robust to model specification
alternatives in the case of China. Foreign demand variables are then
expected to be a more important FDI determinant in small open economies,
than in their larger counterparts.
The hypothesis that comparative advantage and competitiveness affect
FDI is tested by Milner and Pentecost [1996] in the case of US investment
in UK manufacturing. The former is defined as the ratio of exports to sales
or the net trade ratio, whereas the latter is measured by the sales

TABLE 2
CASE STUDIES SUMMARY
Study/Country/
Econometric
Technique
Sector
Statistically Significant FDI Determinants and

Coefficient Sign
Factor Cost
Market Size
Others
Bajorubio and
Sosvilla-Rivero
(1994),
Spain (1961-89),
Cointegration
Manufacturing
Nonmanufacturing
GDP +
Wages (only in nonmanufacturing)
Instability Trade Barriers -
O'SulIivan
(1993),
Ireland
(1960-80),
2SLS
Manufacturing
Foreign GDP +
Wages Exchange Rate -
Gov. Grants -
Wand and Swain

(1995),
China
(1978-92),
OLS
Manufacturing
GDP +
GDP Growth +
Wages +
Interest Rate Exchange Rate +
Trade Barriers -
Wang and Swain

(1995), Hungary
(1968-92), OLS
Manufacturing
GDP +
GDP Growth
(OECD)+
Wages +
Interest Rate Exchange Rate -
Milner and
Pentecost (1996),
UK (1989,
1990),Tobit
Manufacturing
Sales +
Competitiveness +
Comparative
Advantage +
Lee and
Mansfield
(1996),
US (1991),
OLS
Manufacturing
GDP +
Degree of
industrialisation +
Openness +
Weakness of
property law -
Braunerhjelm
and Svensson
(1996),
Manufacturing
GDP +
Population
engaged in
R&D +
Distance to host
country -
Sweden (1978,
1986, 1990),
Tobit, OLS
Agglomeration +
concentration ratio. Both variables are found to have a positive impact on

FDI. When the hypothesis that local country- or industry-specific factors
affect the geographical location of foreign production is tested,
Braunerhjelm and Svensson [1996] show that FDI in Sweden is highly
responsive to concentration or agglomeration patterns (measured as the
employment share of foreign firms). This is because firms tend to locate
manufacturing affiliates in geographically defined areas specialising in
similar production, such that overseas operations are positively affected by
host countries having large production in the same industry. The impact of
agglomeration is shown to be stronger, the more technologically advanced
the industry/sector hosting the foreign investment. With regard to the impact
of institutional characteristics of the host country on inward FDI, Lee and
Mansfield [7996] examine the hypothesis that intellectual property
protection influences the volume and composition of FDI, in the case of
outward FDI from the US. The negative sign of the coefficient is robust to
the inclusion of other explanatory variables, including the degree of
openness of the recipient economy [also Wheeler and Mody, 1992].
III. GROWTH EMPIRICS AND FDI
Growth-Theoretic Models and FDI

The advent of endogenous growth theory [Barro and Sala-i-Martin, 1995]
has encouraged research into the channels through which FDI can be
expected to promote growth in the long run. The basic shortcoming of
conventional neo-classical growth models, as far as FDI is concerned, is that
long-run growth can only result from technological progress and/or
population/labour force growth, which are both considered to be exogenous.
FDI would only affect output growth in the short run and, in the long run,
under the conventional assumption of diminishing returns to capital inputs,
the recipient economy would converge to its steady state, as if FDI had
never taken place, leaving no permanent impact on output growth. The only
vehicle for growth-enhancing FDI would be through permanent
technological shocks. An additional characteristic of endogenous growth
models is that long-run growth can be affected by policy actions of
government. In conventional neo-classical growth theory, policy variables
would only have a short-term impact on growth, and the success of FDIpromoting policies would be short-lived. If growth is endogenised, policy
can be more certain to induce permanent increases in the rate of output
growth by making the recipient economy more appealing to foreign
investment.
If growth determinants are taken as endogenous, and FDI is thought of
as a composite bundle of capital stocks, know-how and technology
[Balasubramanyam et al, 1996], there are different ways in which FDI can
be expected to affect growth in theoretical models. In general, the impact of
FDI on growth is expected to be manifold. The impact is expected to be
greater, the greater the value-added content of FDI-related production, and
productivity spillovers associated with FDI, by which FDI leads to
increasing returns in domestic production. Also, FDI is believed to be a very
important source of human capital augmentation and technological change
in developing economies, since it promotes the use of more advanced
technologies by domestic firms and provides specific productivityincreasing labour training and skill acquisition.
Through capital accumulation in the recipient economy, FDI is expected
to be growth-enhancing by encouraging the incorporation of new inputs and
technologies in the production function of the recipient economy. In the
case of new inputs, output growth can result from the use of a wider range
of intermediate goods in FDI-related production [Feenstra and Markusen,
1994]. In the case of new technologies, FDI is expected to be a potential
source of productivity gains via spillovers to domestic firms.
Technological change is generally defined in the trade literature in terms
of product innovations in technologically advanced economies or,
equivalently, the process by which new products are created via rentseeking R&D activities. Knowledge transfers to technological followers are
defined as the process of transformation of old domestically produced
goods into new FDI-related products [Krugman, 1979]. Because FDI allows
for some type of formal control of the technology or knowledge transferred
from technological leaders to followers, it is expected to be a major vehicle
for technological change in developing countries. Nevertheless, models in
international trade theory normally overlook the fact that human capital
augmentation via technology or knowledge transfers also leads to process
innovations, by which old goods are produced using newer technologies
transferred via FDI, leading to increasing returns. This is one of the main
channels of endogenous growth in the presence of FDI, to be analysed
below.
Through knowledge transfers, FDI is expected to augment the existing
stock of knowledge in the recipient economy through labour training and
skill acquisition and diffusion, on the one hand, and through the
introduction of alternative management practices and organisational
arrangements, on the other. Even without significant physical capital
accumulation, FDI can also be expected to promote knowledge transfers, in
the case of, for instance, quasi-investment arrangements' such as leasing,
licensing and start-up agreements, management contracts and joint ventures
in general [de Mello and Sinclair, 1995].
The scope for externalities of various types, and their impact on long-run
10
growth, is a common element in endogenous growth models [Romer, 1990].

Accordingly, even if diminishing returns prevail in individual firms, and
hence the marginal product of capital tends to decline as capital is
accumulated, the presence of externalities places a wedge between social
and private rates of return to investment. In the aggregate, the existence of
various forms of externality prevents the unbounded decline of the marginal
productivity of capital. In other words, externalities account for the nondiminishing returns needed to promote growth in the long run. As a result,
foreign investors may increase productivity in the recipient economy and
FDI can be deemed to be a catalyst for domestic investment and
technological progress. Due to greater potential externality effects than in
the case of new inputs, knowledge and technology transfers are expected to
be the most important mechanisms through which FDI promotes growth in
the host country. Unfortunately, in so far as growth accounting is concerned,
due to the difficulty of measuring the externality-induced growth, the
impact of FDI on growth remains less controversial in theory than in
empirical studies. Finally, it should be mentioned that, although attractive to
the foreign investor, property rights on innovations reduce the extent of
growth-enhancing spillovers, by ensuring rivalry and excludability of
technology or know-how transfers.
The Growth Accounting Approach
Growth empirics is concerned chiefly with the estimation of cross-country
and time series growth equations, and the conventional methodology used
is based on standard growth accounting, pioneered by Solow [1957] and
Denison [1962, 1967]. FDI is considered to be an additional input in an
augmented production function, and different hypotheses concerning the
association between FDI and growth can be tested either by conventional
measures of FDI or by incorporating ancillary variables in the estimating
equation, such as exports, imports, institutional dummies, etc.
Dropping the time indices for simplicity, the basic augmented
production function from which estimating equations are derived in a
growth-accounting exercise is:
Y=AO(K,L,F,Q),
(1)
where Y is output, K is capital, L is labour, F denotes FDI inflows, A

captures the efficiency of production, and Q. is a vector of ancillary
variables.
The inclusion of FDI flows in an augmented production function such as
equation (1) presents two immediate problems. First, all other explanatory
variables are stock variables, so that, strictly speaking, it would not be
11
correct to include FDI - a flow variable. Instead, an index of foreign-owned

capital stock, constructed by, for instance, the perpetual inventory method,
should be used in equation (1). An alternative option is to consider the
investment ratio as a proxy for the capital stock (K), which is a flow
variable, and hence compatible with the inclusion of FDI flows as an
additional input. In this case, other ancillary variables should also be
defined as flows, rather than stocks.
Second, as far as FDI data are concerned, FDI flows are available from
individual countries' national accounts, and measurement problems abound. It
can be argued that the FDI measures available from individual countries'
national accounts can only be taken to be a crude proxy for the impact of
foreign technologies and spillovers on growth, since they are financial flows
that capture (or obscure) transactions of foreign investors (typically MNCs) in
the recipient economy which may not be the ones expected to be growthenhancing. Also, FDI flow measures will be sensitive to cross-country
differences in the treatment of re-invested earnings and fluctuations in intrafirm transactions. The role of tax havens and offshore banking centres also
poses additional measurement complications. However, such flow variables are
the ones currently available and the most widely used in this line of research.
By standard growth accounting, taking logarithms and time derivatives
of an augmented Cobb-Douglas approximation of equation (1) yields the
following equation:
where g,- is the growth rate of i = A,y,k,f,co, (lower-case variables are defined
in per capita terms), and , \|/, and y are, respectively, the elasticities of
output with respect to physical capital, FDI and the ancillary variables.
In equation (2), gA = gy - gk - ygj- ygm defines total factor productivity
(TFP), or the Solow residual, which is the conventional measure of
technological change. If disembodied changes in technology are expected to
depend on time only, a time trend can be added to the right-hand side of
equation (2), in which case the residual can be interpreted as embodied
technological change.
Despite the simplicity of the growth accounting methodology, a lot of
attention in the literature on growth empirics has been focused on explaining
the high estimates of the elasticity of output with respect to capital [ in
equation (2)] obtained in cross-section and time series regressions. Although
the conventional neo-classical growth model in the Solow tradition predicts
that the elasticity of output with respect to capital should be equal to the
share of capital in total output, cross sectional estimates point to a much
higher value. Recently, those high estimates have been interpreted as
12
evidence of the importance of endogenous growth [Romer, 1990], and

explained on the grounds that capital should be understood in a broad sense
to incorporate additional inputs (for instance, human capital and R&D
spending) without diminishing returns [Mankiw, Romer and Weil, 1992].
This line of argument is consistent with the view that high capital elasticities
incorporate the externalities generated by those additional inputs [Benhabib
and Jovanovic, 1991; Benhabib and Spiegel, 1994].
On econometric grounds, however, the high elasticity estimates in
equation (2) can be attributed to omitted variables and simultaneity biases.
This is because it is well known that, in the case of cross-country and timeseries estimations, the capital stock can hardly be considered as an
exogenous variable and the error term (TFP) will be correlated with the
regressors in standard growth accounting-based production function
estimations. The correlation between the per capita capital stock and
technological change captured by the error term then leads to capital
elasticity estimates that are well above capital's share in output [Young,
1992; 1995].
FDI and Externalities
In the light of the above, FDI-related externalities can be shown to produce
high capital elasticity estimates in growth accounting equations. Consider
an alternative definition to equation (1), in which production is carried out
in the recipient economy by combining labour and physical capital of two
types: domestic (Kd) or foreign-owned (Kw), as a consequence of FDI. The
overall stock of knowledge of the recipient economy is denoted by H. In per
capita terms, for each time period, let the augmented production function of
the recipient economy be of the Cobb-Douglas type. For algebraic
tractability:
!!<i,
(3)
where j3 is the share of domestic physical capital and A captures the

efficiency of production.
Let P<\, such that there are diminishing returns to domestic capital. It is
assumed that the total stock of knowledge in the recipient economy depends
on domestic and foreign-owned physical stocks. In general, in the presence
of FDI, the recipient economy is granted access to a range of intangible nontradable assets [Dunning, 1981], which are expected to lead to increasing
returns and hence faster growth. Let H be represented by a Cobb-Douglas
function of the type:
H = [kky,
(4)
13
where a and TJ are, respectively, the marginal and the intertemporal

elasticities of substitution between foreign and domestically-owned capital
stocks. Also, let a> 0. If 7j > 0, intertemporal complementarity prevails and,
if 77 < 0, intertemporal substitution prevails.
By combining equations (3) and (4), we obtain:
t V
(5)
By equation (5), a general growth accounting equation can be defined as:

8y = 8A+IP + 77(1 - P)]gd + [ ^ ( 1 - P)]gw ,
(6)
where gd is the growth rate of the domestic capital stock and gw is the
growth rate of the foreign-owned capital stock. Again, gA denotes TFP
growth.
By equation (6), FDI is expected to affect the elasticity of output with
respect to capital as much as adding to knowledge and human capital, which
generates externalities. As in Benhabib and Jovanovic (1991), a high
estimate of the capital elasticity in growth equations, such as equation (6),
could be attributed to the presence of FDI in so far as FDI-related
externalities would inflate the capital elasticity estimate by 7](1 - p) if
complementarity prevails (77 > 0).
The Intertemporal Optimisation Framework
An alternative approach to growth accounting involves examining the
impact of FDI on growth in an intertemporal utility maximisation
framework, such that the supply orientation of growth accounting can be
complemented by explicitly modelling consumer behaviour, and hence
demand-related phenomena, in the recipient economy. This frame of
analysis has become standard in recent growth models (see Turnovsky
[1995] and Barro and Sala-i-Martin [7995] for further details).
Let the representative agent maximise a standard concave utility
function discounted over an infinite time period. Using equation (5), the
intertemporal utility maximisation problem becomes:
(P)
,~
max
s.t.
\_QU(c)e~p'dt
k^Ak^X^-c
M0)>0,
where p is the rate of time preference of the utility maximiser and c is

private consumption.
14
Letting w(c) = lnc, for simplicity, the rate of growth of consumption for
the recipient economy is:
-=A[p
c
+ 77(1 - j8)]* ( f + I ' { H > H C ( 1 ~ / > ) ~ P
<7>
By equation (7), the conditions for endogenous growth can easily be

derived. If /? + 77(1 - p)>l and 0:77(1 - p)<\, the dynamics of the problem
are equivalent to the case of exogenous growth in a Ramsey economy,
where growth is exogenous and diminishing returns prevail. If (i + 77(1 p)>\ and OTTJO - p)>\, long-run growth is explosive. If, however, p + TJ(1
- p)<\ and 0:77(1 - f3)>\, or vice versa, domestic capital accumulation and
FDI are offsetting.
Consider the case where the intertemporal complementarity between
FDI and domestic investment mitigates diminishing returns in domestic
production. Let domestic production exhibit constant returns in the presence
of FDI (that is, j8 + T](l - j3) = 1 which implies that 77 = 1). Equation (7)
becomes:
By equation (8), as long as limlm_>oeMZ(l~P)>p, the marginal product of

capital can be kept above p as the stock of FDI increases, and the long-run
growth rate depends positively on FDI. The long-run growth rate is affected
by the rate of time preference, the productivity of domestic capital, and the
degree of complementarity between capital stocks embodying domestic and
foreign technologies, but not by the domestic capital stock. Increases in the
stock of foreign-owned capital lead to temporary increases in the output
growth rate if diminishing returns prevail.
Linear endogenous growth models in which the elasticity of output with
respect to capital is unity (so called AK models) [Romer, 1990; Jones and
Manuelli, 1990] are motivated by the stylised fact of constant capital/output
ratios in the long run [Kaldor, 1961]. If a(V - /3) = 1, by equations (7) and
(8), problem (P) falls in the linear category of endogenous growth models.
The growth rates of the capital stock and output are constant and equal to
the growth rate of consumption in equations (7) and (8), and permanent
increases in FDI lead to permanent increases in output growth. In the FDI
model developed by Malley and Moutos [1994], the rate of technology
transfer only affects the level of national income and not the output growth
rate, as in the case of Solow's model, because diminishing returns prevail.
15
Panel Data Analysis

A recent approach in growth empirics consists of estimating growth
equations using panel data [Islam, 1995; Blomstrom et al., 1996], on the
grounds that many of the difficulties encountered in cross-country
estimations can be eliminated by correcting for country-specific differences
in technology, production and socio-economic factors, which are expected
to evolve through time. In panel data analysis [Hsiao, 1986], the existence
of unobservable growth determinants that are country-specific, such as
some of the determinants of FDI identified in section II, can be
acknowledged and taken into account in the estimation procedure.
The impact of FDI on growth can be estimated in a panel using the
following equation:
Sy,H=Cgk,H+8f,H+7S01,h+,
(9)
where h identifies the countries in the panel, and the remaining variables are
the ones in equation (2), and e is a white-noise disturbance term.
If unobservable country-specific growth determinants are to be taken
into account, then equation (10) can be estimated as follows:
Eyjk =Zk+
Cgk.H + V8/.H
Vgch + .
(10)
where ^h is a time-invariant individual country-effect term, or country

dummies (which avoid the requirement that countries in the panel should
have a common intercept).
In panel data growth-accounting analysis, Islam [1995] shows that the
capital elasticity estimates tend to be more in accord with the share of
capital in total output. Overall, as long as country-specific effects affect the
aggregate production function, panel data analysis allows for the
differentiation of an otherwise universal production function according to
the specific conditions of the environment in which it is applied. As a result,
the analysis benefits from greater realism.
IV. GROWTH ACCOUNTING-BASED EVIDENCE
FDI and the Trade Regime of the Host Country
In section II, it is argued that, in addition to factor endowment and reward
differentials and domestic demand-related factors, the trade regime of the
host country is the most important country-specific determinant of FDI.
Another line of research examines the impact of FDI on growth, given the
16
trade regime of the host country. FDI is shown to be more growthenhancing in countries that pursue export promotion (EP) than in those
promoting import substitution (IS) [Bhagwati, 1978]. The extent to which
export-led growth is determined by export promotion policies establishes
the link between trade regimes and long-run growth in the presence of FDI.
In general, openness and outward-orientation seem to be growth-enhancing
in the long run.
In developing economies, protectionist trade and investment policies are
often implemented to safeguard indigenous industries from foreign
competition. Sectors regarded as 'strategic', related to national defence or
sovereignty, are also frequently targeted by protectionist policies. These
policies nevertheless tend to distort social and private returns to capital and
hence reduce the efficiency of FDI. Balasubramanyam et al. [1996] include
exports as an ancillary variable in an augmented production function, such
as equation (1), and find that the elasticity of output with respect to FDI in
outward-oriented countries with EP trade policies is positive, statistically
significant, and higher than in countries promoting IS within an inwardoriented trade regime. However, the difficulties involved in trade regime
characterisation are numerous [World Bank, 1987].
An additional association between the trade regime of the host country
and FDI stems from the hypothesis that exports temporally precede FDI (see
section VI below for further discussion of the methodology of temporal
causality tests). Accordingly, FDI is expected to take place once there is
significant trade between the foreign investor and the host country to justify
advantageous production relocation in the light of factor reward
differentials, so that FDI and trade are expected to be complementary to
each other [Lipsey and Weiss, 1981; Markusen, 1983]. Optimal relocation
theory predicts the timing at which firms replace trade with foreign-located
operations [Buckley and Casson, 1981]. A competing theoretical hypothesis
of substitution between trade and FDI is that production relocation reduces
the scope for trade between the home country of MNCs and the host country
of MNC affiliates.
In the case of outward FDI, Pfaffermayr [1994] examines the direction
of causation between outward FDI and exports in the case of Austrian
MNCs in the post-1970 period and provides evidence of the temporal
precedence of exports. The hypothesis that outward FDI benefits exports is
tested for Taiwan and four ASEAN economies (Indonesia, Malaysia,
Philippines, and Thailand) by Lin [1995]. A positive impact of outward FDI
is found on both exports of the home country to the recipient economy and
imports of the host country from the home country. The finding suggests
that FDI enhances bilateral trade through a 'reversed import' effect. The
scope for complementarity between trade and FDI arises because MNC
17
affiliates may procure certain types of supplies (basic components and

intermediate goods, headquarter-specific inputs) from foreign manufacturers,
notably in the home country.
FDI and Human Capital Augmentation in the Host Country

The conventional approach to modelling the impact of human capital
accumulation on growth is to define TFP growth as a function of the level
of education or, equivalently, the human capital stock, measured in terms of
(secondary) school enrolment ratios, literacy rates, or real wages. This is
because there is very little evidence of a statistically significant impact of
human capital on growth, when the former enters a growth equation as a
separate input [Benhabib and Spiegel, 1994]. More intuitively, human
capital accumulation may be a poor explanatory variable in growth
equations, such as equation (2), because the crucial role of education in the
growth process is to generate externalities and spillovers in production,
which are hard to capture using standard growth accounting. Hence, growth
is due more often to the externalities and spillover effects of human capital
stocks than to human capital accumulation itself [Guntlach, 1995].
With regard to the effect of FDI by itself on human capital accumulation
in the recipient economy, it can be argued that the impact is likely to be
relatively small. An increase in the productivity of investment can only be
achieved if there is already a sufficiently high level of human capital in the
recipient economy. Accordingly, the human capital stock in the host country
is a prerequisite for production relocation across country borders. Local
production only takes place when the basic skills needed for production
with a minimum level of efficiency are present and further training is
possible, such that foreign investors can use domestic non-reproducible
inputs and labour of the quality level needed to set up operations in the host
country and sustain productive activities thereafter.
Labour has to be sufficiently well educated and trained, and domestic
non-reproducible inputs have to satisfy minimal quality standards, to justify
investment and technology transfers into the host country. The latter leads
to human capital augmentation in the presence of FDI, given that the host
country has passed the development threshold [Blomstrom et al, 1994;
Borensztein et al., 1995] needed for the existence of basic labour skills and
infrastructure. In this respect, human capital augmentation, rather than
human capital accumulation, seems to be a more plausible outcome of FDI.
The role of education in promoting faster growth in the presence of FDI
may be associated with the speed of technological catch-up and diffusion,
on the one hand, and the rate of domestic endogenous technological
innovation, on the other [Abramovitz, 1986].
If, for simplicity, the latter effect is considered to be of limited extent,
18
and if the endowment of complementary human capital is low in the

recipient economy, it may fail to attract sufficient physical capital in the
form of FDI. Alternatively, even if it does attract some FDI inflows, it may
be circumscribed to export processing areas, dissociated from the domestic
firms and hence with negligible scope for productivity spillovers and
externalities. The scope for human capital augmentation when FDI takes
place reinforces the view that existing factor endowments in the host
country are crucial FDI determinants, as suggested in section II.
FDI and Domestic Absorption in the Host Country

In general, aggregate demand, the user cost of capital, and credit availability
variables are positively related to investment, both domestic and foreign.
FDI can also be expected to depend on the investment environment of the
host country and hence on the same determinants as domestic investment.
Macroeconomic policy-related variables are expected to affect domestic
investment [Fischer, 1991; Thirlwall and Sanna, 1996] and to act as
determinants of FDI, as in section II.
In a sample of selected Latin American economies, de Mello [1996a]
finds lower estimates of the impact of FDI on growth when instruments
such as the terms of trade and the foreign debt are incorporated to proxy for
overall macroeconomic instability, international credit constraints, and
changes in international relative prices. In general, as in de Gregorio [1992],
high FDI elasticities might be capturing the effect of the availability of
capital inflows in developing economies, given that international credit
constraints are likely to be correlated with FDI. In the case of Latin
America, the 1980s were marked by severe international liquidity and
solvency constraints, erratic growth and unstable domestic investment
patterns.
In the open economy, it can also be argued that FDI may be detrimental
to growth if it is a substitute for domestic saving, in which case, FDI inflows
exacerbate balance of payments problems via foreign exchange remittances
[McCombie and Thirlwall, 1994; Fry, 1995]. In the case of China, Chen et
al., [1995] find a positive impact of FDI on output growth between 1968
and 90. The impact of FDI on domestic saving is nevertheless found to be
negative but statistically insignificant.
FDI and Convergence
If FDI is found to have a positive impact on GDP growth, a subsequent
question concerns whether that impact is strong enough to promote absolute
or conditional convergence across countries. The hypotheses of convergence
in growth rates and catch-up in income levels have rather often been used
interchangeably in growth empirics. In principle, a negative correlation
19
between initial income and subsequent growth rates provides justification

for either hypothesis [Durlauf and Johnson, 1995]. The intuition and
prediction of neo-classical growth theory is that low-income countries will
tend to grow faster because the marginal productivity of capital is higher
than in their high-income counterparts, leading to a progressive reduction in
the income differential.
In cross-section growth equations, a negative coefficient on initial
income alone indicates absolute or unconditional (beta) convergence.
However, the evidence for unconditional convergence is weak [Barro, 1991].
There is evidence, however, of conditional (beta) convergence [Barro and
Sala-i-Martin, 1992], once the variables affecting individual countries'
steady state levels of income have been controlled for. Alternatively, a
reduction in the cross-section variance of per capita income defines (sigma)
convergence. Although (sigma) convergence presupposes a common longrun equilibrium to which all countries should converge, the steady state level
may vary from country to country, such that convergence may occur towards
a country's individual long-run growth path and not to that of the world
economy at large (see Barro and Sala-i-Martin [1995] for further details).
Although there is very little evidence of unconditional convergence across
countries, it may be present within restricted groups of countries with
relatively similar country-specific effects. In this case, conditional
convergence within groups of 'similar' countries would be very close to the
concept of absolute convergence, thereby rehabilitating the conventional neoclassical growth model. Evidence of this type of convergence has led to the
use of the term 'convergence clubs' [Chatterji, 1993; Bernard and Durlauf,
1995], within which the rate of convergence (conditional or unconditional) is
faster than that observed for a broader sample of 'dissimilar' economies.
The basic testable hypothesis here is that backwardness coupled with
FDI-related spillovers jointly promote faster growth, such that per capita
income differentials due to existing factor endowment differentials tend to
disappear over time. By equation (7), FDI is expected to affect different
countries' steady states and hence contribute to accelerating the rate of
conditional convergence across countries with different capital
endowments. If the technology transfers brought about with FDI are
permanent, and productivity spillovers to domestic firms predominate, the
long-run growth rate of the recipient economy should be increased
permanently. As a result, the recipient economy would move from the old
FDI-free steady state to a new steady state characterised by higher FDIinduced growth rates. If FDI is the only source of higher steady state
growth, once it has been controlled for, conditional convergence is expected
to occur.
There are nevertheless various empirical difficulties. First, reliable FDI
20
data for a sufficiently long period of time are not available for most
countries to allow for the analysis of convergence, particularly in the case
of low-income countries, which are the ones for which a potential
convergence effect should be strongest. Second, if evidence of convergence
is found, conditional or unconditional, it is difficult to disentangle the
effects on growth of FDI itself from those of the determinants of FDI. This
is because the impact of FDI on growth, and hence on convergence, may be
due more to the associated productivity spillovers than foreign capital
accumulation per se.
V. DOMESTIC INVESTMENT AND TECHNOLOGICAL CHANGE
The Theoretical Argument

The degree of complementarity or substitution between FDI and domestic
investment is shown to affect output growth in theoretical models (given
parameters a and 77 in equation (4)). The importance of assessing the extent
of complementarity and substitution between domestic investment and FDI
lies in the fact that a simplistic Schumpeterian view of FDI-related
innovative investment, which emphasises creative destruction through
substitution, may overlook the scope for complementarity between FDI and
domestic investment. Under complementarity, innovations embodied in
foreign investment may create, rather than reduce, rents accruing to older
technologies [Young, 1993]. Also, if FDI is expected to affect growth
positively, it may be argued that it requires some degree of complementarity
with domestic investment, given that the existing factor endowments in the
host country act as a FDI determinant.
However, the period within which complementarity prevails may be
short-lived. Both productivity spillovers to domestic firms and innovations
embodied in further FDI may promote the incorporation of additional, more
modern, technologies that are also complementary to the FDI-related
innovations, and hence subsequently substitute for older technologies.
Phases of complementarity and substitution would alternate in the life-cycle
of FDI-related innovations. As a result, a faster rate of technological change
embodied in FDI-produced goods may lead to a higher rate of capital
obsolescence and scrapping. This may affect output growth via TFP growth,
in so far as, depending on the time path of investment, faster depreciation
reduces net capital accumulation, whereby increasing TFP growth [Young,
1992]. As a result, in terms of growth accounting, factor accumulation/
augmentation in the presence of FDI should lead to greater measured TFP
growth, particularly if technological transfers and productivity spillovers
abound.
In these respects, a distinction can be made between developing countries
21
(technological followers) and developed countries (technological leaders). In

developing countries, complementarity between old and new FDI-related
technologies predominates. FDI may be stimulated primarily as a means to
foster factor accumulation and hence lead to the set-up of a more diversified
productive base and ultimately faster growth. The benefits of FDI would be
viewed as essentially quantitative, in the sense that faster growth, due to
factor accumulation, would seem as a better indicator of overall development
than the more productive use of inputs. In more technologically advanced
economies, on the other hand, substitution predominates and the qualitative
aspect of FDI-related technological change may be more appealing to the
policy-maker. Growth, coupled with faster obsolescence of capital stocks
embodying older technologies, would indicate more efficient production and
more rapid absorption of new FDI-embodied innovations. By increasing the
degree of competition in the recipient economy, FDI forces inefficient firms
out of business and encourages efficient firms to be more efficient by
investing in physical and human capital.
Evidence
As for the impact of FDI-induced technological change on growth,
Blomstrom et al. [1994] consider imports of machinery and transport
equipment to be an ancillary variable in an augmented production function,
such as equation (1), given that it is expected to capture embodied
technological change in new capital, whereas FDI inflows would be a proxy
for disembodied technological change. They find that imports have no
impact on growth, and that the positive and statistically significant impact
of FDI is stronger the higher the level of development of the host country.
Coe et al. [1995] show that spillovers from R&D in industrial countries on
productivity in developing countries increase with imports from the
industrial countries, so that imports are a vehicle for technological change.
In general, these findings are suggestive that, for FDI to affect growth,
the recipient economy must have attained a level of development that allows
it to reap the benefits of higher productivity investment fostered by foreign
investment, thus reinforcing the development threshold hypothesis
[Borensztein et al., 1995] outlined above. Otherwise, the impact of FDI on
the productive capacity of the recipient economy may be circumscribed to
a particular industry, most often specialised in export processing activities
with virtually no growth-generating productivity spillovers to domestic
firms. The finding is also analytically similar to those of the association
between FDI and the trade regime of the host country discussed in section
IV.
An additional aspect of the association between FDI and capital
accumulation analysed by Blomstrom et al. [1994] is concerned with the
22
relative impact of both variables on growth. The authors find that, when FDI
is included in the regression, the significance of the fixed investment ratio
decreases. FDI may capture some of the explanatory power of fixed
investment [De Long et al, 1991; 1992] in growth accounting exercises, in
such a way that the qualitatively different capital accumulation process
brought about by FDI may have a stronger association with output growth
than the mere augmentation of existing capital stocks. Again, it is not so
much the quantitative nature of fixed capital accumulation in the presence
of FDI that accounts for faster growth. It is more the qualitative aspects of
investment embodying new technologies and augmenting human capital
stocks, with productivity spillovers and externalities to domestic
production.
Using panel data analysis for both technological leaders and followers,
de Mello [1996b] finds a positive impact of FDI on output growth in both
groups of countries, with and without country-specific effect terms, which
is suggestive of a dominant complementarity effect between FDI and
domestic investment. Also, FDI seems to have a positive impact on capital
accumulation in the panel of technological leaders. But, after the
incorporation of country effects, the relationship between FDI and capital
accumulation becomes negative. The results lend support to the hypothesis
of some degree of substitutability between FDI and domestic investment,
whereby in more advanced economies, the more productive and efficient
technologies embodied in FDI may lead to a higher rate of technological
obsolescence of the capital stocks embodying older technologies [de Mello,
1995]. By contrast, complementarity seems to prevail in technological
laggards. The latter finding is consistent with the analysis of Mortimore
[1995] for Latin America.
In the panel of technological leaders alone, FDI appears to have a
positive impact on technological change (measured by TFP). In the panel of
technological followers, however, there seems to be a negative relationship
between FDI and TFP, only when group dummy variables are incorporated
in the equation. It can be inferred that, in technological followers, FDI
reduces TFP because of the predominance of the complementarity effect,
although the converse cannot be inferred in the case of technological leaders
[also Young, 1995].
Industry-Specific Evidence
An alternative methodology to estimate the scope for spillovers is to take
specific case studies (for example, Caves [1971]; Findlay [1978];
Blomstrom and Persson [1983], among others). This line of research
focuses on the impact of FDI, or the presence of MNCs, on the productivity
of labour at the industry level in domestic firms. In theory, MNC affiliates
23
are expected to increase the efficiency of domestic firms via productivity

spillovers, as seen in section III. Technology and knowledge transfers are
expected to be highest, the higher the level of education of the labour force
in the host country (the complementarity hypothesis), the tougher the
competition with existing (domestic or foreign-owned) firms, and the fewer
the legal and institutional impediments to the operations of foreign firms.
In most case studies, the degree of complementarity between domestic
human capital and technology, coupled with country- or industry-specific
characteristics, are considered to be the main factors in determining the type
and amount of technology transfers. In fact, industry-specific, rather than
country-specific, characteristics appear to determine the incidence of
productivity spillovers and the type and amount of technological transfer
associated with FDI. Spillovers depend on the exposure of domestic firms
to foreign presence, given the degree of complementarity with domestic
human capital, coupled with industry-specific effects, particularly the
degree of concentration and agglomeration [Guntlach and Nunnemkamp,
1996; Braunerhjelm and Svensson, 1996].
Using cross sectional analysis for Mexican manufacturing industries,
Blomstrom and Persson [1983] and Kokko [1994] test the hypothesis that
the technological gap between leaders and followers determines the scope
for technology transfers and shows that productivity spillovers are least
likely to occur in industries where the technological gap is greatest and the
concentration of foreign firms is highest. This case is analytically equivalent
to that where FDI occurs in enclaves dissociated from domestic production
(as in the case of Ireland in O'Sullivan [1993]), due to the lack of
complementarity between domestic human capital and technological
transfers via FDI. The industry/market structure of the host country seems
to determine the extent of enclave characteristics of foreign production, and
hence the scope for technology transfers.
FDI is found to have a positive impact on labour productivity and
growth in the case of Brazilian [Bielschowsky, 1994] and Uruguayan [Kokko
et al., 1996] manufacturing industry. The latter study is conducted for a
panel of 159 locally-owned manufacturing plants, and the impact of FDI on
domestic labour productivity is shown to depend positively on the capacity
utilisation and capital intensity of the plant. However, when the
technological gap between foreign and domestic production is identified,
the impact of FDI on labour productivity, in the case of plants with a small
technological gap, is also shown to depend positively on plant size, the
share of management personnel in total employment, the share of foreign
production in total output and intellectual property payments per worker.
In general, foreign concentration is highest when foreign firms are
strong enough to dominate the market by imposing product differentiation,
24
and reaping the benefits of extensive economies of scale to drive their

domestic counterparts out of business. Although a development threshold is
still believed to exist in terms of the complementarity between domestic
human capital and foreign knowledge acquisition and diffusion, sizeable
technological gaps do not seem to be the main impediment to technological
transfers via FDI. Nevertheless, if the technological gap is so sizeable as to
preclude complementarity, innovations may render offshore production
based on obsolete technologies less competitive, efficient, and
commercially viable. Also, if innovations are cost-reducing because they
are labour saving, low labour cost countries become less attractive from an
efficiency wage point of view.
When technology transfers result from the import of foreign
technologies, evidence for China [Zhao, 1995] shows that the indigenous
technological capability is positively affected by technology imports; so is
output growth, R&D at home, and manufacturing exports. There is also a
tendency for the type of technology imports to shift over time from physical
capital-intensive technologies to those with a higher degree of human
capital-intensity. There is also a tendency towards greater diversification in
the sources of supply of and greater use of foreign loans to finance
technology imports.
Discussion
In the light of the above, it can be argued that the degree of complementarity
between old and new technologies in technological followers may suggest
that those economies are probably less efficient in the use of the new
technologies embodied in FDI-related capital accumulation. Alternatively,
FDI-related new technologies may not be deemed to be much more modern
or efficient than the ones existing in the recipient economy. In the latter
case, foreign investors are expected to select the technologies embodied in
FDI-related capital accumulation depending on the specific productive and
institutional characteristics of the recipient economy. If this is so, FDI may
be a less important vehicle for cross-border knowledge transfers than
previously thought. The technological gap between technological followers
and leaders may not inhibit knowledge transfers and spillovers, as long as it
is not sizeable enough to preclude complementarity between existing factor
endowments and FDI in the host country. The basic motivation for FDI may
well not be rent-seeking inventive activity in developing countries, which
may be carried out entirely in technologically advanced economies, and
subsequently transferred to the recipient economy, given country- and
industry-specific factors.
Moreover, the extent of complementarity between old and new FDIrelated technologies in developing countries depends on the degree to which
25
TABLE 3
CASE STUDIES SUMMARY
Impact of FDI on
Study/Country/
Econometric Technique
Domestic
Output Growth Investment
Blomstrom el al. (1994),

78 Summers and Heston,
OLS
Reduces the
Strong
impact of fixed
investment
deMello (1996a),
Selected Latin American
(1970-91),
IV, Granger Causality
Stronger in
small open
economies
de Mello (1996b),
OECD and non-OECD
(1970-92),
Panel Data Analysis
+ in
technological
laggards
+ in leaders
Balasubramanyam et al.
(1996),
Various (1970-85),
OLS, GIVE
Stronger under
export
promotion
Blomstrom and Persson

(1983),
Mexico (1970),
OLS
Kawai (1994)
Asia, Latin America,
OECD
OLS
Domestic
Technological Factor
Change
Productivity
Strong
Granger causes
TFP growth in
small open
economies
+ in
technological
laggards
- in leaders
- in
technological
laggards
+ in leaders
Depends
negatively on
technological
gap
Stronger under
export
promotion
Kokko (1994),
Mexico (1970),
OLS
- for most
regions
examined
Depends
negatively on
technological
gap
Evidence of
spillovers
Depends on
technological
gap
Kokko era/. (1996),

Uruguay (1988-90),
OLS
Bielschowsky(1994),
Brazil (1980s-1990s),
Descriptive
Strong
Kholdy (1995),
Various (1970-90),
Granger Causality
Evidence of
development
thresholds
Zhao (1995),
China (1960-91),
VAR
Strongly
affected by
imported
technology
Strong on
labour
productivity
Does not
Granger-cause
labour
productivity
Strongly
affected by
imported
technology
26
the latter technologies find large existing markets, or generate potential

demand for further technological transfers. If either condition is not
fulfilled, sizeable FDI inflows may be compatible with relatively negligible
technology transfers. As a result, the foreign presence would tend to create
technological enclaves in the host country, characterised by significant
productivity and plant size differentials, and limited productivity spillovers.
On the other hand, inter-firm technology partnerships in technologically
advanced economies may be motivated by the need to reduce innovation
time and the search for technological complementarities in an environment
where the technological gap is narrow. The exposure of domestic firms to
foreign competition, coupled with industry-specific effects, determines the
incidence of spillovers and technological transfers via FDI.
There also arises the question of the possible inefficiency of FDI in
technological laggards. This could occur for a number of reasons. First,
investment policies in developing economies tend to create price
distortions, particularly when faster (rather than more efficient) factor
accumulation is the main goal of policy-making. In this case, the degree of
inefficiency due to price distortions may determine the type of technology
transferred via FDI. In other words, if rents can accrue to the foreign
investor using older technologies due to price distortions, there is very little
incentive for the foreign investor to engage in inventive activities in the host
country or to transfer more modern technologies. In this case, the scope for
complementarity between FDI and domestic investment will depend on the
extent of distortions in the recipient economy.
Second, trade restrictions and tax incentives are also distortionary and
may obscure the otherwise limited commercial viability of new
technologies. Rent-seeking can be pursued in the host country without much
technological transfer, and technological stagnation may prevail in the long
run [Kawai, 1994; Balasubramanyam et al, 1996]. Complementarityinduced growth may prevail at certain stages of development, in which
faster factor accumulation is pursued, and substitution-induced growth may
characterise the outcome of FDI in technologically advanced economies,
where more efficient production may be the object of policy. The existence
of multiple steady states associated with development thresholds and nonlinearities in the relationship between FDI and growth is analysed by
Azariadis and Drazen (1990).
VI. WHAT COMES FIRST: FDI OR GROWTH?
The Methodology
Although the basic motivation for the theoretical and empirical papers
surveyed here is the potential scope for raising long-run growth rates
27
through FDI inflows in developing economies, the (sometimes strong)

association between growth rates and FDI does not prove causality or
temporal precedence between the two variables. The direction of causation
may run either way. For instance, FDI may take place in a developing
economy because its growth prospects have made it more attractive to
foreign investors. As a result, unobservable factors related to the growth
dynamics of the recipient economy may have a stronger association with
FDI and hence stimulate larger inflows.
An obvious example is the size of the consumer market in the recipient
economy, given that faster growth leads to rapid increases in the potential
purchasing power of consumers in the host country. In this respect, growth
itself may be an important determinant of FDI in addition to the ones listed
in section II. Also, inter-MNC competition for shares in new markets may
explain the increased interest in a fast-growing economy on the part of
foreign investors. This is very likely to be the case in Southeast Asia (see
Table 1).
Additional factors that may have a strong association with FDI inflows
are the ones considered in section IV, such as the degree macroeconomic
stability, the trade regime of the host country, and so on. In this case, a
potential FDI host becomes more attractive once it has implemented
monetary and fiscal discipline to control inflation, promoted trade
liberalisation reforms and provided the necessary institutional framework
for property rights and cross-border legal and financial settlements [OECD,
1991], All these factors can be deemed to foster growth, and the ensuing
higher growth rates may then attract larger FDI inflows. This may well be
the case in leading Latin American countries and eastern Europe, in the
1990s.
To test for temporal causality, the technique of Granger-causality can be
employed. FDI inflows can be said to Granger-cause output growth, if better
predictions of output growth can be made by including lagged values of FDI
in the conditioned information set, in addition to lagged values of output
growth rates, than vice versa. In more formal terms, the causality between
growth and FDI can be estimated using the following equations:
4, , (ID
and
AFDIt ~b0 +b{Agyt +2.J- ^i^S\t-i
^"zL- GiAFDIt_i +vt. (12)
where gy is the rate of growth of output, n and m denote the number of lags
chosen so that u and v are white noise disturbance terms.
28
By equation (11), FDI Granger causes output growth if a, = 0 and Ft ^.0

By equation (12), output growth Granger causes FDI if bx = 0 and G, * 0.
Conventional F-tests are used to test the hypotheses above [Enders (1995)].
Bi-directional Granger causality is obtained if ax = bx = 0 and F, ^.0 and G,
* 0, for some i.
Evidence
With regard to the Latin American experience [Cardoso and Fishlow, 1989;
Elias 1990], the recent surge of FDI in the region seems to be associated
with domestic policy variables, which have created a more favourable
macroeconomic environment for foreign investment, with renewed
confidence in the consolidation of market-oriented reforms [van
Ryckeghem, 1995]. Also, the removal or easing of most of the international
credit and liquidity constraints of the 1980s has encouraged the access of
Latin American countries to international financial markets and is likely to
have stimulated FDI in the region.
De Mello [1996a] tests the hypothesis of increasing returns due to FDI
for the five Latin American economies (Brazil, Mexico, Venezuela, Chile,
and Colombia) that absorbed most of the FDI in the region in the period
1970-91. The findings suggest that both directions of causality depend on
the recipient economy's trade regime, ranging from import substitution to
export promotion. Also, both open-economy performance variables (for
example, terms of trade, foreign debt, etc.) and domestic policy variables
are shown to affect FDI and growth in the long run. Overall, the findings
allow us to compare and contrast two extreme possibilities in the
relationship between FDI, TFP and output growth in Latin America.
In the case of Brazil, capital accumulation seems to precede output
growth, but the direction of causality between the latter and FDI cannot be
determined. However, TFP seems to precede FDI. On the other hand, Chile
can be located at the other extreme of the spectrum, in which FDI precedes
output and TFP, although the direction of causality between the capital stock
and output cannot be determined. The findings are not surprising, given
that, during most of the period under examination, Brazil pursued importsubstitution growth policies, whereas Chile opted for a more outwardlooking growth strategy based on export promotion. As a result, in Brazil, it
is not surprising that capital accumulation and TFP growth seem to precede
FDI, which lends support to the hypothesis that existing factor endowments,
scale effects, domestic investment and technological complementarity are
important FDI determinants. In Chile, on the other hand, FDI seems to play
a determinant role in increasing both output and TFP, which suggests a
positive externality of FDI in the growth process.
With regard to the direction of causality between FDI and technology
29
spillovers, Kholdy [7995] examines the theoretical hypothesis discussed

earlier that FDI increases the overall efficiency of domestic production,
measured in terms of labour productivity. He looks at selected high-FDI
inflow countries (Mexico, Brazil, Chile, Singapore and Zambia) in the
period 1970-90. He uses Granger-causality tests on the grounds that the
correlation between FDI and higher productivity may be spurious, given
that MNCs, the main vehicle of FDI, tend to demand higher-productivity
labour and physical capital, and hence select host countries on the basis of
existing factor endowments. The findings do not support the efficiency
spillover hypothesis, but reinforce the development threshold hypothesis;
that is, FDI is attracted to countries with larger factor endowments, internal
markets and more advanced technology in domestic production. The author
explains the lack of causality between FDI and efficiency spillovers mainly
in terms of price distortions and technology selection. Both explanations
reinforce the argument in section V that FDI-related production may be less
efficient in the host country than in the country of origin and that, to the
extent that FDI generates limited efficiency spillovers, it may be a less
important vehicle for technology and knowledge transfers than previously
thought.
Discussion
The findings above suggest that, in addition to the idea of a development
threshold implied by the results of Blomstrom et al. [1994] and Borensztein
et al. [7995], the direction of causation between FDI and growth may also
depend on existing factor endowments and scale effects, such that larger
economies are more attractive to FDI than smaller ones. In fact, scale effects
seem to be an important factor explaining MNC investment, along with
geographical location and infrastructure. Not only does a large economy
have a larger consumer market, but it can also host a wider range of foreign
investment. It tends to have a more diversified productive base and hence a
broader array of domestically-produced inputs and know-how needed for
foreign investment to take place.
In short, the direction of causality between FDI and growth seems to
depend, to a large extent, on the determinants of FDI. If the determinants
have a strong association with growth, growth may be found to cause FDI.
Conversely, the determinants of FDI may be present in the recipient
economy and, only after FDI takes place, does output grow faster via
externalities and productivity spillovers associated with FDI-related
productivity gains. Unfortunately, studies for Southeast Asia, which would
allow for a comparative analysis with Latin America, are lacking in the
literature.
30
VII. CONCLUSIONS
Whether FDI can be deemed to be a catalyst for output growth, capital

accumulation and technological progress is a less controversial hypothesis
in theory than in practice. The conclusions of this survey are manifold and
a summary follows.
First, on econometric grounds, it can be said that the growth-FDI nexus is
sensitive to country-specific factors that are unobservable in time series
analysis. Country-specific institutional determinants of FDI and trade and
policy regimes, combined with the existing factor endowments of the host
country, determine both the attractiveness of a country to foreign investment,
and the foreign investor's willingness to transfer newer technologies. Overall,
the impact of FDI on growth depends on various types of externalities and
productivity spillovers. These, in turn, depend on the degree of non-rivalry
and non-excludability of the innovations transferred via FDI, conferred by
intellectual property legislation, the amount of learning-by-doing, and the
value-added content of FDI-related production in the host country.
Second, if FDI is growth-enhancing in the long-run, via both knowledge
transfers and the accumulation of capital stocks embodying newer
technologies, then this impact should be lower in technological leaders than
in technological laggards. Also, the impact of FDI on growth seems to
depend inversely on the technological gap between leaders and followers.
Third, the degree of substitutability between capital stocks embodying
old (domestic) and new (FDI-related) technologies seems to be higher in
technologically advanced than developing recipient economies. The rate of
technological obsolescence of the capital stock embodying old technologies
is possibly increased in technologically advanced economies in the presence
of FDI. Alternatively, the existence of complementarity between old and
new technologies in developing economies may be suggestive that those
economies are less efficient in the use of the new technologies embodied in
FDI-related capital accumulation, or that the latter are not much more
modern or productive than the ones existing in the recipient economy.
Foreign investors can then be deemed to select the technologies embodied
in FDI-related capital accumulation depending on the specific productive
and institutional characteristics of the recipient economy. If this is so, FDI
may be a less important vehicle for cross-border knowledge transfers than
previously thought.
Fourth, some evidence on the direction of causality between FDI and
output growth highlights the importance of existing factor endowments,
thereby reinforcing the hypothesis of the development threshold as a crucial
determinant of FDI. The association between FDI determinants and actual
31
inflows may be stronger than that between FDI and growth such that
causality may well run from growth to FDI inflows.
Finally, in the light of the empirical findings of relatively limited
technology transfers incorporated in FDI, and if the desirability of FDI lies
in the scope for growth-enhancement via technology and knowledge
transfers, policy-makers in the developing world may want to consider the
limitations of FDI-led growth. Ensuring a better environment for domestic
investment would undoubtedly increase the country's ability to host foreign
investment. Otherwise, the success of policies designed to attract FDI may
be limited.
final version received February 1997
NOTE
1. In the case of quasi-investments, production relocation does not involve delocalisation of
production units. The latter refers to the situation in which outward FDI presupposes the
closure of a production unit in the home country parallel to setting up operations in the host
country.
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The Journal of Development

Foreign direct investment

University of Kent , Canterbury, UK

PLEASE SCROLL DOWN FOR ARTICLE

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Foreign Direct Investment in Developing

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LUIZ R. DE MELLO, Jr.

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THE JOURNAL OF DEVELOPMENT STUDIES

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FOREIGN DIRECT INVESTMENT IN DEVELOPING COUNTRIES

FDI Share in Exports

1980 1990 1994

1980 1990 1994 %

THE JOURNAL OF DEVELOPMENT STUDIES

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II. THE THEORETICAL ARGUMENT

The Determinants ofFDI

FOREIGN DIRECT INVESTMENT IN DEVELOPING COUNTRIES

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THE JOURNAL OF DEVELOPMENT STUDIES

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technological leaders is mirrored by the link between imports and inward

FOREIGN DIRECT INVESTMENT IN DEVELOPING COUNTRIES

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Statistically Significant FDI Determinants and

Wages (only in nonmanufacturing)

Instability Trade Barriers -

Wages Exchange Rate -

Wand and Swain

Wang and Swain

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THE JOURNAL OF DEVELOPMENT STUDIES

concentration ratio. Both variables are found to have a positive impact on

Growth-Theoretic Models and FDI

FOREIGN DIRECT INVESTMENT IN DEVELOPING COUNTRIES

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THE JOURNAL OF DEVELOPMENT STUDIES

growth, is a common element in endogenous growth models [Romer, 1990].

where Y is output, K is capital, L is labour, F denotes FDI inflows, A

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FOREIGN DIRECT INVESTMENT IN DEVELOPING COUNTRIES

correct to include FDI - a flow variable. Instead, an index of foreign-owned

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THE JOURNAL OF DEVELOPMENT STUDIES

evidence of the importance of endogenous growth [Romer, 1990], and

where j3 is the share of domestic physical capital and A captures the

FOREIGN DIRECT INVESTMENT IN DEVELOPING COUNTRIES

where a and TJ are, respectively, the marginal and the intertemporal

By equation (5), a general growth accounting equation can be defined as:

8y = 8A+IP + 77(1 - P)]gd + [ ^ ( 1 - P)]gw ,

where p is the rate of time preference of the utility maximiser and c is

THE JOURNAL OF DEVELOPMENT STUDIES

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+ 77(1 - j8)]* ( f + I ' { H > H C ( 1 ~ / > ) ~ P

By equation (7), the conditions for endogenous growth can easily be

By equation (8), as long as limlm_>oeMZ(l~P)>p, the marginal product of

FOREIGN DIRECT INVESTMENT IN DEVELOPING COUNTRIES

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Panel Data Analysis

where ^h is a time-invariant individual country-effect term, or country