Growth effect of FDI in developing economies: The role of institutional quality

JUDE, Cristina and LEVIEUGE, Gregory (2013): Growth effect of FDI in developing economies: The role of institutional quality.

Abstract

This paper investigates the effect of FDI on economic growth conditional on the institutional quality of host countries. We consider institutional heterogeneity to be an explanation for the mixed results of previous empirical studies and we develop several arguments to show that institutional quality modulates the intensity of FDI impact on growth. Using a comprehensive data set for institutional quality, we test this hypothesis on a sample of 94 developing countries over the period 1984-2009. The use of Panel Smooth Transition Regression (PSTR) allows us to identify both the heterogeneity and the threshold of institutional quality that influence the FDI growth effect. These results have significant implications for policy sequencing in developing countries. In order to benefit from FDI-led growth, the improvement of the institutional framework should precede FDI attraction policies. While some features of institutional quality have an immediate effect on fostering FDI-led growth, others need a consistent accumulation of efforts, therefore challenging the effectiveness of institutional reforms in developing countries.

• Item Type: MPRA Paper
• Language: English
• Keywords: FDI, growth, heterogeneity, institutional quality, PSTR, Developing economies
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C34 - Truncated and Censored Models ; Switching Regression Models; F - International Economics > F2 - International Factor Movements and International Business > F21 - International Investment ; Long-Term Capital Movements; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F43 - Economic Growth of Open Economies; O - Economic Development, Innovation, Technological Change, and Growth > O1 - Economic Development > O16 - Financial Markets ; Saving and Capital Investment ; Corporate Finance and Governance

References

Acemoglu, D., Johnson, S. & Robinson, J. (2001), ‘The colonial origins of comparative development: an empirical investigation’, American Economic Review 91(5), 1369– 1401.

Aghion, P., Alesina, A. & Trebbi, F. (2008), Democracy, technology, and growth, in E. Helpman, ed., ‘Institutions and Economic Performance’, Harvard University Press.

Aghion, P., Bacchetta, P., Rancière, R. & Rogoff, K. (2009), ‘Exchange rate volatility and productivity growth: The role of financial development’, Journal of Monetary Economics 56(4), 494–513.

Alfaro, L., Chanda, S., Kalemli-Ozcan, S. & Sayeknomics, S. (2004), ‘FDI and economic growth: The role of local financial markets’, Journal of International Economics 64(1), 89–112.

Alfaro, L., Kalemli-Ozcan, S. & Volosovych, V. (2008), ‘Why doesn’t capital flow from rich to poor countries? An empirical investigation’, Review of Economics and Statistics 90(2), 347–368.

Ali, F., Fiess, N. & MacDonald, R. (2010), ‘Do institutions matter for foreign direct investment?’, Open Economies Review 21(2), 201–219.

Arellano, M. & Bond, S. (1991), ‘Some tests of specification for panel data: Monte carlo evidence and an application to employment equations’, Review of Economic Studies 58(2), 277–297.

Balasubramanyam, V., Salisu, M. & Sapsford, D. (1996), ‘Foreign direct investment and growth in EP and IS countries’, The Economic Journal 106(434), 92–105.

Barro, R. (1991), ‘Economic growth in a cross-section of countries’, Quarterly Journal of Economics 106(2), 407–443.

Barro, R. & Sala-i-Martin, X. (1997), ‘Technological diffusion, convergence, and growth’, Journal of Economic Growth 2(1), 1–26.

Béreau, S., Lopez Villavicencio, A. & Mignon, V. (2012), ‘Currency misalignments and growth: a new look using nonlinear panel data methods’, Applied Economics 44(27), 3503–3511.

Blomström, M. & Kokko, A. (2003), ‘The economics of foreign direct investment incentives’, CEPR Discussion Papers (3775).

Blomstrom, M., Lipsey, R. & Zejan, M. (1994), What explains developing country growth?, in W. Baumol, R. Nelson & E. Wolff, eds, ‘Convergence and Productivity: Gross- National Studies and Historical Evidence’, Oxford: Oxford University Press, pp. 246– 262.

Blundell, R. & Bond, S. (1998), ‘Initial conditions and moment restrictions in dynamic panel data models’, Journal of Econometrics 87(1), 115–143.

Borensztein, E., De Gregorio, J. & Lee, J. (1998), ‘How does foreign direct investment affect economic growth?’, Journal of International Economics 45(1), 115–135.

Bruno, R. & Campos, N. (2013), ‘Reexamining the conditional effect of foreign direct investment’, IZA Discussion Paper (7458).

Buchanan, B., Le, Q. & Rishi, M. (2012), ‘Foreign direct investment and institutional quality: Some empirical evidence’, International Review of Financial Analysis 21, 81– 89.

Busse, M. & Groizard, J. (2008), ‘Foreign direct investment, regulations and growth’, The World Economy 31(7), 861–886.

Busse, M. & Hefeker, C. (2007), ‘Political risk, institutions and foreign direct investment’, European Journal of Political Economy 23(2), 397–415.

Carkovic, M. & Levine, R. (2005), Does foreign direct investment accelerate economic growth?, in T. Moran, E. Graham & M. Blomström, eds, ‘Does Foreign Direct Investment Promote Development?’, Center for Global Development and Institute for International Economics, Washington DC, chapter 8, pp. 195–220.

Farole, T. & Winkler, D. (2012), ‘Foreign firm characteristics, absorptive capacity and the institutional framework: the role of mediating factors for FDI spillovers in low and middle-income countries’, The World Bank Policy Research Working Paper Series (6265).

Fok, D., van Dijk, D. & Franses, P. (2005), ‘A multi-level panel STAR model for US manufacturing sectors’, Journal of Applied Econometrics 20(6), 811–827.

Fouquau, J., Hurlin, C. & Rabaud, I. (2008), ‘The Feldstein-Horioka puzzle: A panel smooth transition regression approach’, Economic Modelling 25(2), 284–299.

Gonzalez, A., Teräsvirta, T. & van Dijk, D. (2005), ‘Panel smooth transition regression models’, Research Paper, Quantitative Finance Research Centre, University of Technology, Sidney (165).

Granger, C. & Teräsvirta, T. (1993), Modelling Nonlinear Economic Relationships, Oxford University Press.

Grossman, G. & Helpman, E. (1991), ‘Quality ladders in the theory of growth’, The Review of Economic Studies 58(1), 43–61.

Hansen, B. (1996), ‘Inference when a nuisance parameter is not identified under the null hypothesis’, Econometrica 64(2), 413–430.

Hansen, B. (1999), ‘Threshold effects in non-dynamic panels: Estimation, testing and inference’, Journal of Econometrics 93(2), 345–368.

Harms, P. & Méon, P. (2011), ‘Good and bad FDI: The growth effects of greenfield investment and mergers and acquisitions in developing countries’, Proceedings of the German Development Economics Conference, Berlin, Verein fu ̈r Socialpolitik, Research Committee Development Economics (38).

Harrison, A., Love, I. & McMillan, M. (2004), ‘Global capital flows and financing constraints’, Journal of Development Economics 75(1), 269–301.

Hilber, C. & Voicu, L. (2010), ‘Agglomeration economies and the location of foreign direct investment: Empirical evidence from Romania’, Regional Studies 44(3), 355–371.

Javorcik, B. & Wei, S. (2009), ‘Corruption and cross-border investment in emerging mar- kets: Firm-level evidence’, Journal of International Money and Finance 28(4), 605– 624.

Kaufmann, D., Kraay, A. & Zoido-Lobaton, P. (1999), ‘Governance matters’, Policy Research Working Paper, The World Bank, Washington DC. 2196.

Keller, W. & Yeaple, S. (2009), ‘Multinational enterprises, international trade, and productivity growth: Firm-level evidence from the united states’, The Review of Economics and Statistics 91(4), 821–31.

La Porta, R., Lopez de Silanes, F., Shleifer, A. & Vishny, R. (1998), ‘Law and finance’, Journal of Political Economy 106(6), 1113–55.

Lipsey, R. & Sjöholm, F. (2005), The impact of inward fdi on host countries: Why such different answers?, in T. Moran, E. Graham & M. Blomstr ̈om, eds, ‘Does Foreign Direct Investment Promote Development?’, Center for Global Development and Institute for International Economics, Washington DC, chapter 2, pp. 23–43.

Lopez-Villavicencio, A. & Mignon, V. (2011), ‘On the impact of inflation on output growth: Does the level of inflation matter?’, Economic Modelling 33(3), 455–464.

Markusen, J. & Venables, A. (1999), ‘Foreign direct investment as a catalyst for industrial development’, European Economic Review 43(2), 335–356.

Méon, P. & Sekkat, K. (2008), ‘Institutional quality and trade: Which institutions? which trade?’, Economic Inquiry 46(2), 227–240.

Meyer, K. & Sinani, E. (2009), ‘Where and when does foreign direct investment generate positive spillovers? A meta analysis’, Journal of International Business Studies 40, 1075–1094.

Mody, A. & Murshid, A. (2005), ‘Growing up with capital flows’, Journal of International Economics 65(1), 249–266.

Morrissey, O. & Udomkerdmongkol, M. (2012), ‘Governance, private investment and for- eign direct investment in developing countries’, World Development 40(3), 437–45.

Nair-Reichert, U. & Weinhold, D. (2001), ‘Causality tests for cross-country panels: New look at FDI and economic growth in developing countries’, Oxford Bulletin of Economics and Statistics 63(2), 153–171.

North, D. (1990), Institutions, Institutional Change and Economic Performance, Cambridge University Press.

Omay, T. & Kan, E. (2010), ‘Re-examining the threshold effects in the inflation-growth nexus with cross-sectionally dependent non-linear panel: Evidence from six industrialized economies’, Economic Modelling 27(5), 996–1005.

Rodrik, D., Subramanian, A. & Trebbi, F. (2004), ‘Institutions rule: the primacy of institutions over geography and integration in economic development’, Journal of Economic Growth 9(2), 131–165.

Wang, M. & Wong, M. (2009), ‘What drives economic growth? the case of cross-border M&A and greenfield FDI activities’, Kyklos 62(2), 316–330.