_In theory, FDI can be considered as a positive contributor to economic development via various channels. However, empirical studies show that it is so difficult to find a relation between FDI and economic development. According to recent empirical studies, there are few cases that show that FDI leads development. In most cases, FDI has lagged behind economic growth instead of being a driving force for development.
Additionally, there are some studies which find negative effects of FDI on development. For instance, the study of Fry indicates that FDI positively affected economic growth of some Asian countries whereas it reduced economic growth of many other developing countries.
On the other hand, there is not sufficient evidence concerning FDI-led development but there is enough evidence when the direction of causality is reversed. That is to say, there is sufficient evidence when we say “economic growth leads to FDI” instead of “FDI leads to economic growth”. According to empirical studies, FDI has significant effect on development for higher-income countries but not for lower-income countries. Also, FDI is a reasonable part of development strategy for middle-income countries but not for poor countries.
FDI is not a “necessary condition” for economic growth. Countries can achieve high growth rates although they are closed to capital inflows. For instance, Mauritius, Botswana, and Sri Lanka were among the fastest growing economies during 1980-2000 even though they are not financially integrated.
At the same time, FDI is not a “sufficient condition” for economic growth. Countries which are open to capital inflows can experience negative economic growth instead of enjoying positive growth. In some cases, FDI is unable to protect countries from economic decline. For instance, Jordan and Peru were among the slowest growing economies during 1980-2000 even though they are open to capital inflows.
There are some important facts which prove why the net benefits of FDI are not enough for economic development.
First, there is no agreement concerning the technological spillover effects of FDI. It is empirically difficult to measure these effects and case studies, which have been done so, show the mixed results.
Second, FDI does not bring significant share of domestic capital formation in most developing countries. Although there was FDI growth in developing countries in 1990s, percentage of gross investment in these countries was too small.
Third, FDI tends to be acquisition of existing assets (namely ‘brownfield’) rather than creation of new investment (namely ‘greenfield’) in most developing countries. For instance, an IMF report indicates that the increase in FDI in developing countries during 1990s was because of mergers and acquisitions which mainly resulted from the privatization of state owned enterprises.
Fourth, FDI has mixed effects on the domestic country’s balance of payments.
Fifth, FDI tends to be hedged after financial market liberalization in developing countries. When hedged, FDI becomes more like portfolio capital flows and becomes more volatile.
Sixth, FDI has worsened wage equality in some developing countries.
Due to these factors, developing countries should consider their priorities before directing their limited resources. At first, countries should consider whether the benefits derived from FDI are sufficient to offset its costs or not. The available FDI flows are too small to meet the investment needs of developing countries; therefore, countries compete each other in order to attract FDI.
On the other hand, to take advantage of FDI benefits is a function of domestic absorptive capacity. FDI, by itself, is unable to lead a successful economic development. If country does not have a certain level of absorptive capacity, it cannot enjoy the benefits of FDI and it can experience a lower growth rate because of FDI. Therefore, at the first stage, developing countries should focus on building absorptive capacity through improving quality of governance, having good institutions, creating good legal framework, and providing low levels of corruption, high degree of transparency, and financial sector supervision. These are preconditions for developing economies to take advantage of the benefits of FDI. Empirical studies also support this view: According to Borenzstein, De Gregorio, and Lee (1998) “positive effects of FDI can be detected when countries have a sufficiently high level of human capital”. This means that countries need to build up a certain level of “absorptive capacity” (in terms of human capital, domestic financial market, quality of governance, and macroeconomic policies) in order to attain the benefits of FDI.
In this context, the ultimate goal should be increasing absorptive capacity instead of attracting FDI. If this goal is achieved, FDI will absolutely come on its own because there is a connection between country’s quality of governance and its ability to attract FDI. There is evidence which indicates that FDI goes to countries with good human capital and governance. Therefore, developing countries should direct their resources to improve absorptive capacity like promoting domestic investment, building the required infrastructure, and investing in human capital development in order to create macroeconomic stability first. Such an environment will benefit the developing economies in the long-term and ensure that the economies can reap the benefits of FDI.
Prasad, Eswar, Kenneth Rogoff, Shang-Jin Wei and M. Ayhan Kose (2003), “Effects of Financial Globalization on Developing Countries: Some Empirical Evidence,” Washington, DC: International Monetary Fund .
Milberg, W. (1999) “Foreign Direct Investment and Development: Balancing the Costs and Benefits”, in International Monetary and Financial Issues for the 1990s, Vol. XI. Geneva: UNCTAD.