Copyright © UNU-WIDER 2005
* Both authors are affiliated with the Institute of Economics, University of Copenhagen and Development
Economics Research Group (DERG)
This is a revised version of the paper originally presented at the WIDER Conference on Sharing Global
Prosperity, 6-7 September 2003, Helsinki.
UNU-WIDER gratefully acknowledges the financial contributions to its research programme by the
governments of Denmark (Royal Ministry of Foreign Affairs), Finland (Ministry for Foreign Affairs),
Norway (Royal Ministry of Foreign Affairs), Sweden (Swedish International Development Cooperation
Agency—Sida) and the United Kingdom (Department for International Development).
ISSN 1810-2611 ISBN 92-9190-710-3 (internet version)
Research Paper No. 2005/31
On the Causal Links between FDI
and Growth in Developing Countries
Henrik Hansen and John Rand*
June 2005
Abstract
We analyse the Granger causal relationships between foreign direct investment (FDI)
and GDP in a sample of 31 developing countries covering 31 years. Using estimators
for heterogeneous panel data we find bi-directional causality between the FDI-to-GDP
ratio and the level of GDP. FDI has a lasting impact on GDP, while GDP has no long-
run impact on the FDI-to-GDP ratio. In that sense FDI causes growth. Furthermore, in a
model for GDP and FDI as a fraction of gross capital formation (GCF) we also find
long-run effects from FDI to GDP. This finding may be interpreted as evidence in
favour of the hypotheses that FDI has an impact on GDP via knowledge transfers and
adoption of new technology.
Keywords: economic growth, foreign direct investment, Granger causality, panel data
JEL classification: O4, F21, C33
The World Institute for Development Economics Research (WIDER) was
established by the United Nations University (UNU) as its first research and
training centre and started work in Helsinki, Finland in 1985. The Institute
undertakes applied research and policy analysis on structural changes
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Camera-ready typescript prepared by Liisa Roponen at UNU-WIDER
The views expressed in this publication are those of the author(s). Publication does not imply
endorsement by the Institute or the United Nations University, nor by the programme/project sponsors, of
any of the views expressed.
1
1 Introduction
The inflow of foreign direct investment (FDI) increased rapidly during the late 1980s
and the 1990s in almost every region of the world revitalizing the long and contentious
debate about the costs and benefits of FDI inflows. On one hand many would argue that,
given appropriate policies and a basic level of development, FDI can play a key role in
the process of creating a better economic environment. On the other hand potential
drawbacks do exist, including a deterioration of the balance of payments, as profits are
repatriated having negative impacts on competition in national markets. At present the
consensus seems to be that there is a positive association between FDI inflows and
economic growth, provided that receiving countries have reached a minimum level of
educational, technological and/or infrastructure development. However, as in many
other fields of development economics, there is not universal agreement about the
positive association between FDI inflows and economic growth.
Even if one accepts the positive association there is still the question of causality. Does
FDI cause (long-run) growth and development or do fast growing economies attract FDI
flows as transnational companies search for new market and profit opportunities?
Theoretically, neither of the links can be ruled out and this is probably the reason why
the causality issue has been the topic of so many recent studies. As documented in
section 2, at least six studies precedes our study, and it is reasonable to ask if there is a
need for yet another look at causality between FDI and growth in developing countries.
We aim to contribute to the existing literature in three dimensions: First of all we take a
close look at the model specification. This is motivated by results obtained by Carkovic
and Levine (2002) who argue that once country-specific level differences, endogeneity
of FDI inflows and, in particular, convergence effects are taken into account, there is no
robust impact from FDI on growth. In essence, Carkovic and Levine change the model
specification from a relationship between the FDI-to-GDP ratio (FDI ratio, for short)
and the growth rate of GDP to a relationship between the FDI ratio and the log-level of
GDP. This change in model formulation makes sense for two reasons. First, the model
for the FDI ratio and GDP-growth is a sub-model of the model for the FDI ratio and
(log) GDP. Hence, in a statistical sense the second model encompasses the first model.
A second reason for starting with Carkovic and Levine’s specification is that standard
neoclassical growth models with well-defined steady states predict a long-run relation
between the levels. Therefore, the model including only the growth rate of GDP
excludes the neoclassical growth models by assumption, instead of including these
models in conjunction with the endogenous growth models. Thus, when testing for
Granger causal relationships between FDI and growth, we specify a vector
autoregressive model for the log of GDP and the FDI ratio. We test for Granger
causality using annual data and, therefore, include country-specific trends in addition to
country-specific levels. This is a natural consequence of analysing the log-level of GDP.
Our empirical results, based on estimators that allow for country-specific heterogeneity
of all parameters, indicate a strong causal link from the FDI ratio to GDP, also in the
long run, whereby mean changes in the FDI ratio cause changes in the level of GDP.
GDP also Granger-causes FDI, but we find no impact on the long-run level of
the FDI ratio. This result is at odds with other recent studies of Granger causality
between FDI and growth. We believe the main reason for the new result is the change in
model formulation.
2
The second issue we address is the economic significance of FDI inflows, which is
natural in light of our finding of statistical significance. In assessing the economic
importance of FDI we use the standard Solow model as benchmark. In a Solow model
in which capital’s share is 1/3 the elasticity of steady state income with respect to the
savings ratio is 1/2. Evaluated at a savings ratio of 20 per cent this means that a one
percentage point increase in the savings ratio causes a 2.5 per cent increase in the steady
state level of income. Our empirical results indicate that a one percentage point increase
in the mean of the FDI ratio, on average, causes a 2.25 per cent increase in the GDP
level. Hence, FDI appears to be no more or no less growth enhancing than domestic
investments.
Knowledge transfers and adoption of new technology are often emphasized as two of
the main growth enhancing channels of FDI inflows. But the importance of these
channels is not easily quantified in models using (log) levels of FDI or the FDI-to-GDP
ratio.
1
Consequently, in assessing the importance of such channels we reformulate the
model and look at FDI as percentage of gross capital formation (GCF). The idea is that
the FDI/GCF ratio ‘isolates’ the knowledge and composition effects of FDI inflows as
we condition on gross capital formation. We find FDI/GCF to Granger-cause GDP,
indicating a statistical significant composition effect of FDI.
Finally, inspired by previous results on the impact of FDI on growth, we look for
systematic patterns in the size of the long-run impact of FDI/GCF on GDP. Based on
simple graphical analyses (and regressions) we find no systematic relations between the
total impact of FDI and development indicators such as the level of GDP per capita,
education, trade or credit. Even though our sample of 31 countries is too small to make
conclusive decisions, we do think this is an interesting observation when policymakers
and their experts design policies to attract foreign direct investments.
The study is organized as follows: section 2 provides a brief literature review of the
association between FDI inflows and economic growth. Section 3 discusses the model
used for testing Granger causality, and section 4 summarizes our empirical results.
Section 5 concludes.
2 Recent literature
During the last decade a number of interesting studies on the role of foreign direct
investment in stimulating economic growth has appeared. In an excellent survey de
Mello (1997) lists two main channels through which FDI may be growth enhancing.
First, FDI can encourage the adoption of new technology in the production process
through capital spillovers. Second, FDI may stimulate knowledge transfers, both in
terms of labour training and skill acquisition and by introducing alternative management
practices and better organizational arrangements. A survey by OECD (2002) underpins
these observations and documents that 11 out of 14 studies have found FDI to contribute
positively to income growth and factor productivity. Both de Mello and OECD stress
one key insight from all the studies reviewed: the way in which FDI affects growth is
1
de Mello (1999) looks at FDI impact on total factor productivity, which is one way of assessing the
importance of knowledge transfers. We take a different route that does not rely on TFP calculations.
3
likely to depend on the economic and technological conditions in the host country. In
particular, it appears that developing countries have to reach a certain level of
development, in education and/or infrastructure before they are able to capture potential
benefits associated with FDI.
Four studies, relying on a variety of cross-country regressions, have looked into the
conditions necessary for identifying FDI’s positive impact on economic growth.
Interestingly, they stress different, though closely related, aspects of development. First,
Blomstrom, Lipsey and Zejan (1994) argue that FDI has a positive growth-effect when a
country is sufficiently rich in terms of per capita income. Second, Balasubramanyam,
Salisu and Sapsford (1996) emphasize trade openness as being crucial for acquiring the
potential growth impact of FDI. Third, Borenztein, De Gregio and Lee (1998) find that
FDI raises growth, but only in countries where the labour force has achieved a certain
level of education. Finally, Alfaro et al. (2004) draw attention to financial markets as
they find that FDI promotes economic growth in economies with sufficiently developed
financial markets. However, when Carkovic and Levine (2002) estimate the effects of
FDI on growth after controlling for the potential biases induced by endogeneity,
country-specific effects, and the omission of initial income as a regressor, the results of
these four papers appear to break down. Carkovic and Levine conclude that FDI has no
impact on long-run growth.
Another strand of the literature has focused more directly on the causal relationships
between FDI and growth and, at least, six studies have tested for Granger causality
between the two series using different samples and estimation techniques. Zhang (2001)
looks at 11 countries on a country-by-country basis, dividing the countries according to
the time-series properties of the data. Tests for long-run causality based on an error
correction model, indicate a strong Granger-causal relationship between FDI and GDP-
growth. For six counties where there is no cointegration relationship between the log of
FDI and growth, only one country exhibited Granger causality from FDI to growth.
Chowdhury and Mavrotas (2003) take a slightly different route by testing for Granger
causality using the Toda and Yamamoto (1995) specification, thereby overcoming
possible pre-testing problems in relation to tests for cointegration between series.
2
Using data from 1969 to 2000, they find that FDI does not Granger cause GDP in Chile,
whereas there is bi-directional Granger causality between GDP and FDI in Malaysia and
Thailand.
De Mello (1999) looks at causation from FDI to growth in 32 countries of which 17 are
non-OECD countries. First he focuses on the time-series aspects of FDI and growth,
finding that the long-run effect of FDI on growth is heterogeneous across countries.
Second, de Mello complements his time-series analysis by providing evidence from
panel data estimations. In the non-OECD sample he finds no causation from FDI to
growth based on fixed effects regressions with country-specific intercepts, and a
negative short-run impact of FDI on GDP using the mean group estimator.
Nair-Reichert and Weinhold (2001) test causality for cross-country panels, using data
from 1971 to 1995 for 24 countries. Like de Mello, they emphasize heterogeneity as a
serious issue and, therefore, use what they refer to as the mixed fixed and random
(MFR) coefficient approach in order to test the impact of FDI on growth. The MFR
2
By fitting the VAR in levels, problems with identifying orders of integration are avoided.
