FDI and economic growth have an ‘unstable’ relationship, World Bank research finds
The relationship between foreign direct investment (FDI) and economic growth is unstable and varies over time, according to a recent paper by the World Bank.
In an April paper titled “The Elusive Link between FDI and Economic Growth”, Agustín Bénétrix, Hayley Pallan and Ugo Panizza re-examine the literature on the subject and find that the link is more “elusive” than previously thought. The paper analyses data from 1970 to 2018 across more than 80 countries tracking FDI through the balance of payments recorded by central banks.
Mr Panizza, professor of economics at the Graduate Institute of International and Development Studies, tells fDi that the link between FDI and growth is “unstable over time and we need to better understand the mechanisms” that underpin this relationship.
“There was a well-established story that FDI would bring growth through spillover via human capital and financial depth. Now, we still find a positive link between FDI and growth, but it doesn’t seem to go through these channels,” he explains.
Early empirical studies found that there was a strong relationship between FDI and growth if a country had sufficient levels of human capital (education) or financial development. Later research reported that there is no conclusive evidence to suggest that the two are linked. What this new paper illustrates is that the two are linked in ways that suggest that countries with weaker education and financial systems benefit economically from FDI the most.
The paper documents the “mediating effect of human capital and financial depth which had been established in the early literature on FDI and growth no longer holds in the post-1990 period”.
“What we find is that there is a relationship between FDI and growth for the average country if you look at data after 1995 or after 2000,” says Ms Pallan, economist at the World Bank. “The role of mediating factors like education or the financial system isn’t as important, yet there’s a stronger relationship between FDI and growth for countries with weaker levels of human capital or less developed financial systems.
“One reason for this … is that the effect of having a strong relationship between FDI and growth is amplified in countries that experienced a high rate of global value chain activity,” she adds.
Global value chains, understood as the fragmented processes by which multinational companies carry out their operations, have become one of the cornerstones of globalisation since the 1990s.
“Early empirical literature on FDI and economic growth was founded on economic theory, in which improvements to human capital and more financial capital (i.e. FDI) generate growth,” the paper reads.
“However, the rise of global value chains (GVCs) arguably breaks the link between FDI, absorptive capacities and growth, as what were once thought to be impediments to growth (weak human capital and low financial development), provide an attractive environment for multinationals to shift their activities (along with their investments),” it adds.
“The old view was that FDI would come in and if there was enough human capital in the country, creating higher gross domestic product growth through the spillover of knowledge. Our hypothesis is that since companies that are integrated in the GVC only delegate a fraction of their production process to poorer countries, there may be less of this spillover effect than was originally thought,” Mr Panizza says.
