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Foreign direct investment, financial development and economic growth

Article in The Journal of Development Studies · February 2003

DOI: 10.1080/00220380412331293707 · Source: RePEc

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FOREIGN DIRECT INVESTMENT, FINANCIAL DEVELOPMENT AND

ECONOMIC GROWTH

Niels Hermes# and Robert Lensink##

#
Faculty of Management and Organisation; ## Faculty of Economics

University of Groningen, The Netherlands

Word count: 7,901

(To be published in The Journal of Development Studies, Vol.38, 2003)

 This paper argues that the development of the financial system of the

recipient country is an important precondition for FDI to have a positive

impact on economic growth. A more developed financial system positively

contributes to the process of technological diffusion associated with FDI.

The paper empirically investigates the role the development of the financial

system plays in enhancing the positive relationship between FDI and

economic growth. The empirical investigation presented in the paper

strongly suggests that this is the case. Of the 67 countries in data set, 37

have a sufficiently developed financial system in order to let FDI contribute

positively to economic growth. Most of these countries are in Latin America

and Asia.

1. INTRODUCTION

The contribution of foreign direct investment (FDI) to economic growth has been

debated quite extensively in the literature. This debate has focused on the channels

through which FDI may help to raise growth in recipient countries. In particular, it has

been discussed to what extent FDI may enhance technological change through

spillover effects of knowledge and new capital goods, i.e. the process of technological

diffusion. In this discussion, some have argued that the contribution FDI can make is

strongly dependent on the circumstances in the recipient countries. However,

empirical studies investigating the relationship between FDI and economic growth on

the one hand, and the role played by the circumstances FDI is confronted with

whenever it enters a recipient country on the other hand, are scarce.1

This paper argues that the development of the financial system of the recipient

2
country is an important precondition for FDI to have a positive impact on economic

growth. The financial system enhances the efficient allocation of resources and in this

sense it improves the absorptive capacity of a country with respect to FDI inflows. In

particular, a more developed system may contribute to the process of technological

diffusion associated with FDI. The main contribution of this paper is to investigate

empirically the role the development of the financial system plays in enhancing the

positive relationship between FDI and economic growth.

The paper is structured as follows. Section 2 provides a description of the

discussion of the contribution FDI can make to increased economic growth. The

section emphasises the importance of technological diffusion and the role of FDI. In

particular, it focuses on the contribution the financial system can make in this respect,

using a simple theoretical model. Section 3 discusses the data and the empirical

methodology. Section 4 discusses the outcomes of the empirical investigation. Finally,

section 5 provides a summary and concluding remarks.

2. FDI, THE FINANCIAL SYSTEM, AND ECONOMIC GROWTH:

A THEORETICAL FRAMEWORK

2.1 Review of the literature on FDI and growth

There is a huge literature emphasising the positive impact FDI may have on economic

growth.2 Next to the direct increase of capital formation of the recipient economy, FDI

may also help increasing growth by introducing new technologies, such as new

production processes and techniques, managerial skills, ideas, and new varieties of

capital goods. In the new growth literature the importance of technological change for

economic growth has been emphasised [Grossman and Helpman, 1991; Barro and

Sala-i-Martin, 1995]. The growth rate of less developed countries (LDCs) is perceived

3
to be highly dependent on the extent to which these countries can adopt and

implement new technologies available in developed countries (DCs). By adapting new

technologies and ideas (i.e. technological diffusion) they may catch up to the levels of

technology in DCs. One important channel through which adoption and

implementation of new technologies and ideas by LDCs may take place is FDI. The

new technologies they introduce in these countries may spillover from subsidiaries of

multinationals to domestic firms [Findlay, 1978]. The use of new technologies may be

important in contributing to higher productivity of capital and labour in the host

country. The spillover may take place through demonstration and/or imitation

(domestic firms imitate new technologies of foreign firms), competition (entrance of

foreign firms leads to pressure on domestic firms to adjust their activities and to

introduce new technologies), linkages (spillovers through transactions between

multinationals and domestic firms), and/or training (domestic firms upgrade the skills

of their employees to enable them to work with the new technologies) [Kinoshita,

1998: 2-4; Sjöholm, 1999a: 560].

The next question is what conditions in the host country are important to

maximise the technology spillovers discussed above? In the literature it has been

emphasised by some that the spillover effect can only be successful given certain

characteristics of the environment in the host country. These characteristics together

determine the absorption capacity of technology spillovers of the host country. Thus,

FDI can only contribute to economic growth through spillovers when there is a

sufficient absorptive capacity in the host country.

Several country studies have been carried out, providing diverging results on

the role of FDI spillovers with respect to stimulating economic growth. These studies

deal with the productivity effects of FDI spillovers on firms or plants using micro

4
level data. Whereas positive effects from spillovers have been found for, e.g. Mexico

[Blomström and Persson, 1983; Blomström and Wolff, 1994; Kokko, 1994], Uruguay

[Kokko, Tansini, and Zejan, 1996] and Indonesia [Sjöholm, 1999b], no spillovers were

traced in studies for Morocco [Haddad and Harrison, 1993] and Venezuela [Aitken

and Harrison, 1999]. These diverging results may underline the crucial role of certain

host country characteristics necessary to let FDI contribute positively to economic

growth through spillovers. They emphasise the difference in absorptive capacity

between countries to adopt FDI.3

Some authors argue that the adoption of new technologies and management

skills requires inputs from the labour force. High-level capital goods need to be

combined with labour that is able to understand and work with the new technology.

Therefore, technological spillover is possible only when there is a certain minimum,

or ‘threshold’ level of human capital available in the host country [Borensztein, et al.,

1998]. This suggests that FDI and human capital are complementary in the process of

technological diffusion. Other authors argue that the process of technological

spillovers may be more efficient in the presence of well-functioning markets. Under

these circumstances, the environment in which FDI operates ensures competition and

reduces market distortions, enhancing the exchange of knowledge among firms

[Bhagwati, 1978 and 1985; Ozawa, 1992; Balasubramanyam, et al., 1996]. Some

authors stress that the establishment of property rights – in particular intellectual

property rights – is crucial to attract high technology FDI [Smarzynska, 1999]. If

intellectual property rights are only weakly protected in a country, foreign firms will

undertake low technology investments, which reduces the opportunities for spillover

effects and improvements of productivity of domestic firms.

5
2.2 FDI and the domestic financial system

The previous discussion shows there may be several characteristics that may indeed be

important to promote the use of absorptive capacity of a country with respect to

maximising technology spillovers from foreign firms. Yet, this paper argues that one

crucial characteristic of the environment in the host country has not been mentioned in

the literature, i.e. the development of the domestic financial system. The importance

of the domestic financial system as a precondition for the positive growth effects of

FDI can be illustrated with a simple model of technological change.4

The model assumes that technical progress is represented through the variety

of capital goods available. There are three types of agents in the model: final goods

producers, innovators and consumers. Every producer of final goods rents N varieties

of capital good from specialised firms that produce a type of capital good (the

innovators). The producer has monopoly rights over the production and sale of the

capital goods. The purchase price Pj of the capital good is set by optimising the

present value of the returns from inventing (and producing in several periods), V(t).

This leads to a fixed mark-up over production costs. Barro and Sala-I-Martin [1995:

218], assuming free entry of inventors, show that in equilibrium with positive R&D

(at cost η) and increasing N, the (constant) rate of return (interest rate, r) is given by:

1 − α 2 /(1−α )
r = (1 / η ) LA1 /(1−α ) ( )α (1)
α

where α measures capital’s share of income (i.e. the coefficient in Cobb-Douglas

production function) and L is labour input. FDI is introduced in the model by

assuming that there are fixed maintenance costs, equal to 1, and fixed set up costs

(R&D costs, η). The costs of discovering a new variety of a good (costs of innovation)

6
are assumed to be the same for all goods. In line with Borensztein et al. [1998] the

costs of R&D depend on FDI: more FDI leads to a decline in the costs of innovation.

This reflects the idea that it is cheaper to imitate than to innovate [Borensztein et al.

1998], and that the possibility to imitate increases if more goods are produced in other

countries (i.e. when FDI is higher). So, the costs of discovering a new good can be

modelled as (using FDI = F): η =f(F), where ∂η/∂F < 0.

The impact of the financial sector enters the model via A, the level of

technology. It is well known that the financial sector may improve economic growth

by enhancing the average level of technology (see below). So, A is a function of the

development of the financial sector (H), A=h(H), where ∂A/∂H > 0. This implies that:

L 1 − α 2 /(1−α )
r=( )h( H )1 /(1−α ) ( )α (2)
f (F ) α

To introduce the link to economic growth we close the model by considering

behaviour of households. Households maximise a standard inter-temporal utility

function, subject to the budget constraint. This gives the well-known Euler condition

for the growth rate of consumption, gC = (1/θ)(r - ρ), where -θ is the elasticity of

marginal utility and ρ is the discount rate. In the steady state the growth rate of

consumption equals the growth rate of output, g.

Using the expression for r from (2) we finally get:

L 1 − α 2 /(1−α )
g = (1 / θ )[( )h( H )1 /(1−α ) ( )α − ρ] (3)
f (F ) α

7
It is now easy to see that an increase in FDI leads to an increase in the growth rate of

output (g) and that the effect of FDI depends on the development of the financial

sector. An increase in FDI lowers set-up costs (for technology adaptation) and raises

the return on assets (r). This leads to an increase in saving and so a higher growth rate

in consumption and output. This effect will be greater the higher the level of

technology in a country, i.e. the better the financial system is developed.

A crucial assumption in the above model is that the domestic financial system

influences growth through the level of technology. We need to specify further this

link, however. First of all, the financial system influences the allocative efficiency of

financial resources over investment projects. Thus, the financial system may

contribute to economic growth through two main channels (next to providing and

maintaining a generally accepted means of exchange). On the one hand, it mobilises

savings; this increases the volume of resources available to finance investment. On the

other hand, it screens and monitors investment projects (i.e. lowering information

acquisition costs); this contributes to increasing the efficiency of the projects carried

out (see, e.g., Greenwood and Jovanovic, [1990]; Levine [1991]; Saint-Paul [1992]).5

The more developed the domestic financial system, the better it will be able to

mobilise savings, and screen and monitor investment projects, which will contribute

to higher economic growth.

Second, investment related to upgrade existing or adopt new technologies is

more risky than other investment projects. The financial system in general, and

specific financial institutions in particular, may help to reduce these risks, thereby

stimulating domestic entrepreneurs to actually undertake the upgrading of existing

technology or to adopt new technologies introduced by foreign firms. Thus, financial

8
institutions positively affect the speed of technological innovation, thereby enhancing

economic growth [Huang and Xu, 1999]. This argument also holds for technological

innovation that results from one or more of the channels of technology spillovers from

FDI as described above. The more developed the domestic financial system, the better

it will be able to reduce risks associated with investment in upgrading old and/or new

technologies.

Third, when we reconsider the different channels through which technology

spillover may take place, it becomes clear that in many cases domestic firms will need

to invest when upgrading their own technology or adopting new technologies, based

either on a demonstration effect, a competition effect, and/or a linkage effect. The

same holds in case they aim at upgrading the skills of their employees (the training

effect). These investments should be financed, however. The development of the

domestic financial system at least partly determines to what extent domestic firms

may be able to realise their investment plans in case external finance from banks or

stock markets is needed.

Finally, the development of the domestic financial system may also determine

to what extent foreign firms will be able to borrow in order to extend their innovative

activities in the host country, which would further increase the scope for technological

spillovers to domestic firms. FDI as measured by the financial flow data may be only

part of the FDI to developing countries, as some of the investment is financed through

debt and/or equity raised in financial markets in the host countries [Borensztein et al.,

1998: 134]. Thus, the availability and quality of domestic financial markets also may

influence FDI and its impact on the diffusion of technology in the host country. This

diffusion process may be more efficient once financial markets in the host country are

better developed, since this allows the subsidiary of a MNC to elaborate on the

9
investment once it has entered the host country.

Thus, in conclusion, FDI and domestic financial markets are complementary

with respect to enhancing the process of technological diffusion, thereby increasing

the rate of economic growth. This hypothesis can be tested empirically, which will be

the subject of the next two sections.

3. DATA AND METHODOLOGY OF EMPIRICAL INVESTIGATION

The data set used in this paper applies to the 1970-95 period and contains 67 LDCs

(see Appendix 2 for a complete list of the countries). For this set of countries data is

available for all variables used in this study, which means that the estimations have

been carried out with a balanced data set. Table 1 provides basic descriptive statistics

for the dependent variable, i.e. the per capita growth rate (PCGROWTH) and the

crucial variable in this study, i.e. gross FDI inflows as a percentage of GDP (FDI).

Both variables (and all other variables in this study) are average values for the 1970-

95 period.

<INSERT TABLE 1>

The table shows that PCGROWTH and FDI are not normally distributed. The

distribution of these variables is skewed. With respect to PCGROWTH, 30 countries

have an average growth rate varying between zero and two percent, for 13 countries

the growth rate is between two and four, for five the growth rate is above four percent,

and for 19 countries the growth rate is negative. For 42 countries FDI as a percentage

of GDP is between zero and one, for 17 countries it is between one and two, for five

10
countries between two and three, and for three countries between four and five. The

largest recipients of FDI as a percentage of GDP are Swaziland, Trinidad and Tobago

and Malaysia.

The methodology of the empirical investigation follows the voluminous

growth regression literature, which was stimulated by the seminal paper of Barro

[1991]. Unfortunately, theory does not provide clear guidance concerning the set of

variables that should be included in the growth equation. Depending on the aim of the

study and the insights and beliefs of the author(s), different explanatory variables have

been included and found to be significant in the literature. Recently, some studies

have shown that only a few variables have a robust effect on economic growth (see,

e.g., Levine and Renelt, [1992] and King and Levine [1993a]), implying the

importance of stability tests. Sala-i-Martin [1997a and 1997b] provides a useful

method to test for the robustness of different variables in explaining economic growth.

The empirical analysis in this paper closely follows his approach. In particular, the

regression analysis for the cross-section of 67 countries is specified as follows:

PCGROWTH = αi + βi,jI + βmjM + βz,jZ + e (4)

where I, M and Z are vectors of variables and e is an error term. I is a vector of

variables that are ‘generally accepted’ to be important to explain economic growth. M

is a vector of variables containing the variables of interest in this study. In this study

these variables are the log of the FDI to GDP ratio (LFDI), and LFDI interacted with

the log of the private sector bank loans to GDP ratio (LCREDP). LCREDP is chosen

here as a measure of financial development (see below). The vector of Z variables

11
contains a limited number of variables from a large set of variables that have been

used in the literature to explain per capita economic growth. These variables are used

as control variables in the estimations.6

The vector of I variables contains variables that, according to Levine and

Renelt [1992], and King and Levine [1993a], have a robust effect on economic

growth. These variables are: the log of the initial level of the secondary enrolment rate

(LSECENR), the log of the initial level of GDP per capita (LGDPPC), the variable

proxying for financial market development over the 1970-95 period (LCREDP) and

the log of the investment share in GDP (LINVGDP). Table 2 presents the correlation

matrix for the I variables, PCGROWTH and LFDI.

<INSERT TABLE 2>

The choice of the I variables needs some further explanation:

(1) LSECENR measures human development

(2) The introduction of LGDPPC reflects the process of catch up.

(3) With respect to the choice of the financial development variable, we note that

several variables have been suggested in the literature to measure financial

development, depending on the specific characteristics of the financial system of

interest. These variables focus on the size, the efficiency and/or the relative

importance of different financial intermediaries in the total financial system. The

problem is that for several of these variables data are only available for a limited

number of countries. Therefore in the analysis the log of credit to the private sector

as a percentage of GDP (LCREDP) is used to measure financial development,

12
 since for this variable data are available for all countries in the data set. Moreover,

this variable is used in several other studies (see, e.g., Demirgüç-Kunt and Levine,

[1996]).

(4) With respect to LINVGDP, regression models are estimated including and

excluding this variable in the vector of I variables. The reason for this is that the

interpretation of a significant coefficient for a certain variable x depends on

whether or not LINVGDP is included in the regression model. If LINVGDP is

included and the coefficient of variable x is significant, this is interpreted as x

affecting growth via the ‘level of efficiency’. If LINVGDP is not included, it is

unclear whether variable x affects growth via investment or via efficiency. This

distinction is of importance to obtain more information with respect to how

exactly FDI is related to economic growth.

4. RESULTS OF THE EMPIRICAL INVESTIGATION

The analysis starts by estimating a number of base equations, i.e. the Z variables are

not yet included in the regression models. The results of these estimations are

presented in table 3 (without LINVGDP) and table 4 (with LINVGDP). Column [1] in

both tables shows the relevance of including the different I variables as determinants

of GDP per capita growth. The tables show that LGDPPC, LSECENR, LCREDP and

LINVGDP have a significant impact on economic growth. In column [2] LFDI is

added to this equation. This variable does not have a significantly positive direct effect

on economic growth. This may be interpreted as a confirmation of the view that

without additional requirements FDI does not enhance economic growth of a country.

13
<INSERT TABLES 3 AND 4>

As explained above, the aim of this paper is to empirically investigate the

hypothesis that FDI and domestic financial markets are complementary with respect to

enhancing the process of technological diffusion, thereby increasing the rate of

economic growth. Therefore, the empirical analysis focuses on the variables LFDI and

the interactive term LFDI*LCREDP, which represent the vector of M variables as

specified in equation (1). The model presented in column [3] of tables 3 and 4 directly

tests the central hypothesis of this paper. The outcomes in the tables show that the

interactive term LFDI*LCRED is positive and significantly related to the dependent

variable PCGROWTH, whereas LFDI alone is significantly negative.8 This supports

the view that FDI only has a positive effect on economic growth if the development of

the domestic financial system has reached a certain minimum level. Thus, we find

preliminary support for the central hypothesis of this paper.

It may be argued that the results presented in column [3] of tables 3 and 4 are

due to high multi-collinearity between LSECENR and LCREDP (see table 2). This

would mean that the results found are in fact due to the level of human development

in a country (i.e. the hypothesis forwarded by Borensztein et al., [1998])9, rather than

due to the level of financial development. To further investigate this issue we estimate

a model incorporating LFDI, LFDI*LCREDP, and LFDI*LSECENR. This model is

presented in column [4] of both tables. If we concentrate on the results for the model

including LINVGDP (table 4), the results of the estimation show that LFDI*LCREDP

remains significant; however, LFDI*LSECENR becomes insignificant. These results

can be interpreted as follows. First, it again confirms the hypothesis that a certain level

14
of financial market development is an important prerequisite for FDI to have a

positive effect on economic growth. Second, it suggests that the importance of a

certain level of human capital as a prerequisite for the growth effects of FDI (the

argument made by Borensztein et al., [1998]) is at least partly explained by the

existence of a well-developed financial sector. Moreover, the fact that the variable

LFDI*LCREDP remains significant in the models where LINVGDP is included

suggests that FDI affects economic growth mainly via the level of efficiency.10

What do the results of the analysis presented in tables 3 and 4 imply for the

countries in the data set? Based on the results of our empirical analysis we are able to

determine the threshold value of LCREDP above which LFDI starts to have a positive

effect on growth. In order to be able to this, we differentiate the model presented in

column [3] of both tables with respect to LFDI. We get:

PCGROWTH  LFDI = -1.587+0.621*LCREDP

(model without LINVGDP); and

PCGROWTH  LFDI = -1.839+0.685*LCREDP

(model with LINVGDP).

The threshold level of LCREDP above which LFDI has a positive effect on economic

growth can be calculated by setting the first derivative of the above equations equal to

zero. The threshold levels then equal: (1.587/0.621) = 2.56 and (1.839/0.685) = 2.68.

Since LCREDP is the logarithm of credit to the private sector as a percentage of GDP,

the results imply that LFDI (and hence also FDI) will have a positive effect on growth

in countries where credit to the private sector as a percentage of GDP is above 12.9

15
(when LINVGDP is excluded from the basic model) and 14.6 (when LINVGDP is

included). In other words, CREDP should be larger than 12 per cent in order for FDI

to have a positive effect on growth. In our data set 37 out 67 countries (or 55 per cent)

satisfy this threshold value for CREDP. Table 5 presents the countries for which the

domestic financial system has reached a sufficient level of development, i.e. for these

countries FDI contributes positively to economic growth. The table shows that for

most Sub-Saharan African countries it appears to be the case that the level of

development of their domestic financial system is insufficient, so that FDI probably

will not have a positive impact on their economic growth.

<INSERT TABLE 5>

5. FURTHER ANALYSIS OF THE RELATIONSHIP BETWEEN FDI,

FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH

The analysis of the relationship between FDI, financial development and growth may

be further investigated in several directions. We will discuss a number of these

directions below.11

First, we investigate whether the results found in column [3] of tables 3 and 4

also hold when using alternative indicators of financial development. As was already

discussed several variables have been used in the literature to measure financial

development. One alternative used extensively is the log of the average money and

quasi money to GDP ratio (LMGDP).12 We use this variable and present the results of

the analysis in table 6, columns [1] and [2] (with and without INVGDP). The

estimation results first of all show that LMGDP is positively and significantly related

to growth. Moreover, the interactive term LFDI*LMGDP has a positive and

16
significant coefficient, but only when INVGDP is included. These results seem to

support the view that FDI only has a positive effect on economic growth if the

development of the domestic financial system has reached a certain minimum level.

More precisely, it suggests that FDI affects economic growth mainly via the level of

efficiency.13

We also investigate whether the results we find in tables 3 and 4 are different for

specific geographic regions. To analyse this we redo the regression analysis of column

[3] in tables 3 and 4 and include country dummies for Africa (DUMAFR), Latin

America (DUMLA) and Asia and other countries (DUMAS), and present the results in

columns [3] and [4] of table 6. The outcomes of the estimation show that the main

results of tables 3 and 4 remain unchanged. At the same time, none of the country

dummies appears to have statistically significant coefficient. These results suggest that

the findings as presented in column [3] of tables 3 and 4 are not different for specific

country regions.

<INSERT TABLE 6>

Finally, we analyse whether our results remain the same when we average the

variables over five-year periods, instead of over 25 years as we did in the analyses

presented in column [3] of tables 3 and 4. For this analysis we create a panel data set

of four five-year periods (1975-79, 1980-84, 1985-89 and 1990-95). Because of

missing data for some of the variables, we do the estimations with an unbalanced

panel data set. We use three different estimation techniques: estimations with a

common constant, with fixed effects and with random effects. The results of the

estimations are shown in table 7. The results in columns [1] and [4] refer to the

17
estimations with a common constant; columns [2] and [5] refer the estimations with

fixed effects; and columns [3] and [6] show the outcomes for the estimations with

random effects. In general, the results we find using the panel data set are similar to

our results shown previously. This is especially true for estimations with a common

constant and with random effects. The estimations with fixed effects are less

satisfactory, since some of the control variables appear not to be significant; yet, even

these estimations show a statistically significant positive relation between

LFDI*LCRDEP and growth. Thus, also when we use a panel data set, the analysis

appears to confirm the central hypothesis of this paper on the relationship between

FDI, financial development and growth.14

<INSERT TABLE 7>

6. FURTHER STABILITY ANALYSIS

In this section we further investigate the robustness of the results, by conducting a

stability analysis in line with Sala-i-Martin [1997a and 1997b]. This stability analysis

tests whether the coefficients for LFDI and the interactive term LFDI*LCREDP

remain robust after adding a vector Z of a limited number of control variables to the

models presented in tables 3 and 4. We define a group of 14 variables from which the

additional control variables are taken. These variables are shown to be important for

explaining economic growth in several other studies. Since we aim at using a fully

balanced data set in our analysis, other possibly relevant variables were not taken into

account due to lack of observations. The additional variables we take into account in

our analysis are AIDGDP (development aid as a percentage of GDP), BANKL (bank

and trade related lending as a percentage of GDP), BMP (black market premium),

18
CIVLIB (index of civil liberties), DEBTGDP (the external debt to GDP ratio), DEBTS

(total external debt service as a percentage of GDP), EINFL (uncertainty with respect

to inflation), EGOVC (uncertainty with respect to government expenditures),

EXPGDP (exports of goods and services as a percentage of GDP), GOVCGDP

(government consumption as a percentage of GDP), INFL (the annual inflation rate),

PRIGHTS (index of political rights), STDINFL (the standard deviation of the annual

inflation rate), and TRADE (exports plus imports to GDP).15 In all estimates discussed

below, these variables have been transformed into logarithmic form.

The stability test starts by determining all possible combinations of a limited

number of the above-presented set of 14 variables. We have chosen to perform the

stability test by adding combinations of three, respectively four control variables to the

models discussed above. Next, we carry out regression analysis including all variables

presented in column [3] from table 3, respectively table 4, as well as all possible

combinations of three (respectively four) control variables. This means that in case of

three additional variables we estimate 14!/(11! 3!) = 364 different specifications of the

model presented in column [3] of tables 3 and 4 (i.e. with and without LINVGDP). In

case we use four additional variables the amount of different specifications equals

14!/(10!4!) = 1,001.

After having estimated all different equation specifications, the next step of the

stability test is to look at the distribution of the coefficients of the individual

equations, and calculate the fraction of the cumulative distribution function lying on

each side of zero. By assuming that the distribution of the estimates of the coefficients

is normal and calculating the mean and the standard deviation of this distribution, the

cumulative distribution function (CDF) can be computed.

19
 More precisely, if βj is the coefficient for a variable in the specification j of the

estimated model and σj is the standard error of the coefficient βj, we proxy the mean

and the standard deviation of the distribution by:

Σβj
β =
n

Σσ j
σ =
n .

The number of estimated equations is 364 (in case we add combinations of three Z

variables), respectively 1,001 (when we add combinations of four Z variables). In

table 8 the mean estimate is presented in the column entitled COEF and the mean

standard deviation is given in the column entitled STERR.

Next, we calculate the fraction of the cumulative distribution function lying on

the right or left-hand side of zero, using a table for the (cumulative) normal

distribution. The test statistic we use is defined as the mean over the standard

deviation of the distribution. The column entitled CDF in table 8 denotes the larger of

the two areas. Finally, as an additional stability test, the last column of the table

presents the percentage of all regressions for which the variable of interest (i.e. LFDI

or LFDI*LCREDP) is significant at the 95 per cent level.

The results presented in table 8 show that the coefficients for LFDI and the

interactive term LFDI*LCREDP are very robust. In the models including LINVGDP

as an additional I variable t-values for LFDI and LFDI*LCREDP are significant at the

95 per cent level in all cases. These results strongly suggest that FDI enhances

20
economic growth only if domestic financial markets are well-developed, thus

supporting the main hypothesis investigated in this paper.

<INSERT TABLE 8>

7. CONCLUSIONS

FDI may help to raise economic growth in recipient countries. Yet, the contribution

FDI can make may strongly depend on the circumstances in the recipient countries.

Few empirical studies have investigated the relationship between FDI and economic

growth and the role played by the circumstances FDI is confronted with whenever it

enters a recipient country. These studies focused on the role of human capital

available in and the export-orientedness of the recipient country. The original

contribution this paper makes is that it argues that the development of the financial

system of the recipient country is an important precondition for FDI to have a positive

impact on economic growth. A more developed financial system positively contributes

to the process of technological diffusion associated with FDI.

The paper empirically investigates the role the development of the financial

system plays in enhancing the positive relationship between FDI and economic

growth. The empirical investigation presented in the paper strongly suggests that this

is the case. Of the 67 countries in data set, 37 have a sufficiently developed financial

system in order to let FDI contribute positively to economic growth. Most of these

countries are in Latin America and Asia. Almost all other countries in our data set are

in Sub-Saharan Africa. These countries have very weak financial systems and

consequently FDI does not contribute positively to growth.

21
 The results of the empirical investigation in this paper provide a number of

policy-relevant conclusions. First, the results contradict the widely accepted view that

an increase in FDI may important to enhance economic growth of LDCs. This is only

true after these countries have improved their domestic financial systems. Second, the

analysis in this paper may contribute to the discussion on the order of economic

liberalisation in LDCs. The outcomes of the empirical investigation suggest that these

countries should first reform their domestic financial system before liberalising the

capital account to allow for enlarged FDI inflows.

22
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28
APPENDIX I: LIST OF VARIABLES USED IN THE ANALYSIS

AIDGDP = development aid as a percentage of GDP

BANKL = bank and trade related lending as a percentage of GDP

BMP = black market premium, calculated as (black market

rate/official rate)-1

CIVLIB = index of civil liberties

CREDP = credit to the private sector as a percentage of GDP

DEBTGDP = the external debt to GDP ratio

DEBTS = total external debt service as a percentage of GDP

DUMAFR = dummy for African countries

DUMAS = dummy for Asian (and other) countries

DUMLA = dummy for Latin American countries

EINFL = uncertainty with respect to inflation

EGOVC = uncertainty with respect to government expenditures

EXPGDP = exports of goods and services as a percentage of GDP

FDI = foreign direct investment as a percentage of GDP

GDPPC = GDP per capita in 1970

GOVCGDP = government consumption as a percentage of GDP

INFL = the annual inflation rate

INVGDP = average investment to GDP ratio over 1970-95 period

MGDP = average money and quasi money to GDP ratio over the 1970-

95 period

PCGROWTH = average real per capita growth rate over 1970-95 period.

PRIGHTS = index of political rights

29
SECENR = secondary school enrolment rate in 1970

STDINFL = the standard deviation of the annual inflation rate, calculated

from the inflation figures

TRADE = exports plus imports to GDP; measure of the degree of

openness

The source for all variables is World Bank [1997], which is available on CD-ROM,

except for BMP, CIVLIB and PRIGHTS. These variables are obtained from the data

set created by Barro and Lee [1994]. Moreover, EINFL and EXPGDP have been

calculated by the authors (see below). The variables from Barro and Lee [1994] refer

to averages for the 1970-90 period. Unless otherwise stated, all other variables refer to

averages over 1970-95 period. For all variables logarithmic transformations are used.

We need to explanation how the uncertainty variables EINFL and EGOVC have been

constructed. Both variables are constructed by using the standard deviation of the

unpredictable part of INFL and GOVC; see Bo [1999] for a survey of different

methods to measure uncertainty. We first specify and estimate a forecasting equation

to determine the expected part of INFL and GOVC. The standard deviation of the

unexpected part of INFL and GOVC (i.e. the residuals from the forecasting equation)

is used as a measure of uncertainty. We have used a second-order autoregressive

process, extended with a time trend, as the forecasting equation:

Pt = a1 + a2T + a3FDIt-1 + a4FDIt-2 + et,

30
where Pt is the variable under consideration, T is a time trend, a1 is an intercept, a3

and a4 are the autoregressive parameters and et is an error term. We estimate the above

equation for all countries in the data set. By calculating the standard deviation of the

residuals for the entire sample period for each individual country, we obtain the

variables EINFL and EGOVC.

31
APPENDIX II: COUNTRIES IN THE DATA SET

Africa:

Algeria, Benin; Burkina Faso; Burundi; Cameroon; Cape Verde; Central African Rep.;

Chad; Egypt; Gabon; Gambia; Ghana; Guinea-Bissau; Cote d’Ivoire; Kenya; Lesotho;

Madagascar; Mali; Mauritania; Morocco; Niger; Nigeria; Rwanda; Senegal; Sierra

Leone; Somalia; Sudan; Swaziland; Togo; Tunisia; Zambia; Zimbabwe

Latin America:

Barbados; Costa Rica; Dominican Rep.; El Salvador; Guatemala; Haiti; Honduras;

Jamaica; Mexico; Nicaragua; Panama; Trinidad and Tobago; Argentina; Bolivia;

Chile; Colombia; Ecuador; Paraguay; Peru; Uruguay; Venezuela

Asia and others

Bangladesh; China; India; Malaysia; Nepal; Pakistan; Philippines; Sri Lanka; Syria;

Thailand; Hungary; Malta; Fiji; and Papua New Guinea

32
Table 1: Descriptive statistics for per capita growth and FDI

PCGROWTH FDI

Mean 0.938 0.998

Median 0.529 0.693

Maximum 6.832 4.698

Minimum -3.134 0.003

Standard Deviation 1.923 0.989

Skewness 0.719 1.824

Kurtosis 4.120 6.686

33
Table 2: Correlation matrix

PCGROWTH LFDI LSECENR LINVGDP LCREDP LGDPPC

PCGROWTH
1

LFDI
0.21 1

LSECENR
0.43 0.30 1

LINVGDP
0.58 0.29 0.27 1

LCREDP
0.48 0.38 0.53 0.52 1

LGDPPC
-0.10 0.37 0.52 0.18 0.45 1

34
Table 3: Direct investment and economic growth

[1] [2] [3] [4]

LGDPPC -1.182*** -1.238*** -1.180*** -1.247***

(-5.15) (-5.29) (-5.20) (-4.98)

LSECENR 0.891*** 0.882*** 0.740*** 0.964***

(4.47) (4.45) (3.75) (4.09)

LCREDP 1.562*** 1.471*** 1.827*** 1.620***

(4.12) (3.97) (4.59) (4.02)

LFDI 0.156 -1.587** -1.574***

(1.11) (-2.60) (-2.68)

LFDI*LSECENR 0.215*

(1.69)

LFDI*LCREDP 0.621*** 0.429*

(2.85) (1.86)

C 1.376 2.127 0.943 1.386

(1.01) (1.47) (0.60) (0.85)

R2 0.46 0.46 0.51 0.51

F 19.94 15.32 14.53 12.46

NOTE: See Appendix A for abbreviations used. Dependent variable: PCGROWTH. Amount of

observations in all regressions: 67. Values in parentheses are White heteroskedastic adjusted t-values. *

denotes significance at the 10 per cent level; ** denotes significance at the 5 per cent level; *** denotes

significance at the 1 per cent level. R2 is the adjusted R2. F is the F-statistic.

35
Table 4: FDI and economic growth: effects via efficiency

[1] [2] [3] [4]

LGDPPC -1.117*** -1.148*** -1.081*** -1.113***

(-6.83) (-6.33) (-7.14) (-6.86)

LSECENR 0.868*** 0.863*** 0.706*** 0.805***

(5.40) (5.43) (4.64) (4.03)

LINVGDP 2.539*** 2.488*** 2.594*** 2.536***

(5.56) (5.55) (5.60) (5.25)

LCREDP 0.843** 0.807** 1.171*** 1.095***

(2.46) (2.40) (3.23) (2.86)

LFDI 0.085 -1.839*** -1.828***

(0.65) (-3.23) (-3.28)

LFDI*LSECENR 0.095

(0.807)

LFDI*LCREDP 0.685*** 0.599***

(3.45) (2.91)

C -4.437*** -3.910*** -5.473*** -5.125***

(-3.07) (-2.48) (-3.44) (-3.04)

R2 0.59 0.58 0.64 0.63

F 24.43 19.47 20.40 17.36

NOTE: see note to table 3.

36
Table 5: Relationship between FDI and growth and the role of the level

of development of the domestic financial system

No positive effect of LCREDP on relationship between LFDI and PCGROWTH

AFRICA:

Algeria; Benin; Burkina Faso; Burundi; Cameroon; Cape Verde; Central African Rep.;

Chad; Gabon; Gambia; Guinea-Bissau; Cote d’Ivoire; Kenya; Lesotho; Madagascar; Mali;

Mauritania; Niger; Nigeria; Rwanda; Senegal; Sierra Leone; Somalia; Sudan; Togo;

Zimbabwe

LATIN AMERICA:

Guatemala; Haiti

ASIA AND OTHER COUNTRIES:

Nepal; Papua New Guinea

Positive effect of LCREDP on relationship between LFDI and PCGROWTH

AFRICA:

Egypt; Ghana; Morocco; Swaziland; Tunisia; Zambia

LATIN AMERICA:

Barbados; Costa Rica; Dominican Rep.; El Salvador; Honduras; Jamaica; Mexico;

Nicaragua; Panama; Trinidad and Tobago; Argentina; Bolivia; Chile; Colombia; Ecuador;

Paraguay; Peru; Uruguay; Venezuela

ASIA AND OTHER COUNTRIES:

Bangladesh; China; India; Malaysia; Pakistan; Philippines; Sri Lanka; Syria; Thailand;

Hungary; Malta; Fiji

37
Table 6: FDI and economic growth: using alternative measure of financial

development and country region dummies

[1] [2] [3] [4]

LGDPPC -0.9014*** -0.929*** -0.979*** -0.999***

(-4.05) (-4.98) (-3.46) (-5.52)

LSECENR 0.610*** 0.676*** 0.522* 0.424*

(3.32) (4.32) (1.98) (1.84)

LINVGDP 2.236*** 2.587***

(4.45) (5.36)

LCREDP 1.648*** 1.053***

(4.79) (3.17)

LMGDP 2.409*** 1.615***

(5.75) (3.72)

LFDI -0.721 -1.532* -1.236*** -1.583***

(-0.80) (-1.74) (-2.27) (-2.90)

LFDI*LMGDP 0.277 0.498*

(1.04) (1.94)

LFDI*LCREDP 0.503*** 0.596***

(2.75) (3.35)

C -2.738* -6.957*** 2.046 -3.611**

(-1.76) (-3.93) (1.05) (-2.15)

DUMAFR -1.463 -1.631

(-1.38) (-1.59)

DUMLA -1.470 -1.159

(-1.54) (-1.22)

DUMAS -0.491 -0.689

(-0.45) (-0.66)

R2 0.55 0.64 0.52 0.65

F 17.30 20.39 10.07 14.80

NOTE: see note to table 3.

38
Table 7: FDI and economic growth: panel data estimations

[1] [2] [3] [4] [5] [6]

LGDPPC -0.828** -8.877*** -0.909** -1.007*** -9.600*** -1.135***

(-2.50) (-7.44) (-2.34) (-3.20) (-8.23) (-3.11)

LSECENR 1.028*** -0.771 0.779* 0.919*** -0.280 0.840**

(2.84) (-1.39) (1.90) (2.71) (-0.54) (2.19)

LINVGDP 2.275*** 1.676* 2.262***

(3.85) (1.79) (3.93)

LCREDP 1.581*** 0.656* 1.146*** 1.253*** 0.605 0.935**

(4.68) (1.67) (2.84) (3.71) (1.46) (2.37)

LFDI -1.443*** 0.0419 -0.745 -1.112** 0.018 -0.597

(-3.09) (0.069) (-1.23) (-2.37) (0.03) (-1.02)

LFDI*LCREDP 0.566*** 0.333* 0.399** 0.450*** 0.342* 0.325*

(3.47) (1.67) (1.99) (2.77) (1.65) (1.67)

C -1.696 1.195 -5.924*** -3.637

(-0.99) (0.55) (-2.77) (-1.60)

N 226 226 226 224 224 224

R2 0.14 0.47 0.39 0.21 0.49 0.33

F 8.51 66.43 11.04 55.79

NOTE: Dependent variable: PCGROWTH. Values in parentheses are White heteroskedastic adjusted t-

values. * denotes significance at the 10 per cent level; ** denotes significance at the 5 per cent level;

*** denotes significance at the 1 per cent level. The results in columns [1] and [4] refer to the

estimations with a common constant; columns [2] and [5] refer the estimations with fixed effects; and

columns [3] and [6] show the outcomes for the estimations with random effects. N is the number of

observations. R2 is the adjusted R2. In case of the estimations with random effects R2 refers to

unweighted statistics including random effects. F is the F-statistic. For the estimations with random

effects the F-statistic is not given.

39
Table 8: Stability test

NUMBER R2 COEF STERR CDF PERC

Without LINVGDP in the base model

LFDI 364 0.57 -1.348 0.544 0.993 1.000

LFDI*LCREDP 364 0.57 0.534 0.194 0.997 0.997

LFDI 1,001 0.58 -1.310 0.535 0.993 0.921

LFDI*LCREDP 1,001 0.58 0.519 0.192 0.997 0.983

With LINVGDP in the base model

LFDI 364 0.72 -1.620 0.505 1.000 1.000

LFDI*LCREDP 364 0.72 0.615 0.173 1.000 1.000

LFDI 1,001 0.73 -1.528 0.500 1.000 1.000

LFDI*LCREDP 1,001 0.73 0.603 0.172 1.000 1.000

NOTE: NUMBER denotes the number of equations tested. R2 is the adjusted R2. CDF is the cumulative

distribution function. COEF is the mean estimate of the coefficient of the variable of interest (i.e. LFDI

or LFDI*LCREDP). STERR is the mean standard deviation of the variable of interest. PERC is the

percentage of all regressions for which the variable of interest is significant at the 95 per cent level.

40
Endnotes

∗
The authors thank two anonymous referees and Gerard Kuper for their comments on an earlier version

of the paper. Please send comments to Niels Hermes: [email protected]

1
Exceptions are Balasubramanyam et al. [1996], Borensztein et al. [1998] and Lichtenberg and van

Pottelsberghe de la Potterie [1998].

2
For an overview of the literature on the relationship between FDI and economic growth, see De Mello

[1997] and World Bank [2001].

3
Görg and Strobl (2001) suggest that the econometric methodology used also has an important impact

on the results found. In particular, they report that studies using cross-section data may overstate the

spillover effects of FDI, since these studies do not take into account other time-invariant or firm-

specific effects. Yet, these effects may have an impact on the spillover effects of FDI on productivity.
4
This model is based on chapters 6 and 7 in Barro and Sala-I-Martin [1995].
5
See Levine [1997] or Berthelémy and Varoudakis [1996] for good surveys on the role of the domestic

financial system and its relationship to economic growth.

6
The list of Z variables used in this study will be discussed in the next section. See also Appendix I.

7
Below, we will also discuss the results of an analysis in which we have used the log of the average

money and quasi money to GDP ratio (LMGDP).

8
Borensztein et al. [1998] also find a statistically significant negative relationship between the linear

term of FDI and GDP per capita growth. Lensink and Morrissey [2001] find a positive relationship

between both variables, but they use a data set for developed and less developed countries. When we

redo their analysis by using only data for LDCs, we find that there is no statistically significant

relationship between FDI and growth (see also our results in column [2] of tables 3 and 4).
9
Lensink and Morrissey [ 2001] show that the results presented by Borensztein et al. [1998] are not

statistically robust.
10
We have also explored the relationship between LFDI and LFDI interacted with a financial

development variable as exogenous variables and total investment as a share of GDP as the endogenous

variable. In line with Borensztein, De Gregorio and Lee [1998] it appears that LFDI and LFDI

interacted with financial market development do not have a robust effect on investment levels. This

41
 confirms that FDI mainly affects growth via the level of efficiency.
11
Two anonymous referees suggested us to investigate the relationship between FDI, financial

development and growth in the directions discussed below. We thank them for these suggestions.
12
See for example the seminal studies by King and Levine on the relationship between financial

development and economic growth (King and Levine, 1993a and 1993b). For an overview of the

(empirical) literature on financial development, see Levine (1997).

13
We acknowledge that there are more variables to measure financial development. In particular, the

two variables we have used here (LCREDP and LMGDP) focus only on the banking sector. Ideally, we

would have liked to also use variables that focus on other financial markets, e.g. stock market variables.

Yet, using such variables would have led to a substantial reduction of the number of countries in our

data set due to lack of long-term time series data.

14
We also investigated whether the relationship between FDI and financial development is non-linear.

In particular, we included two new interactive terms LFDI*LCREDP2 and LFDI*LCREDP3 separately

into the regression models presented in column [3] of table 3 and 4 (i.e. with and without including

LINVGDP). The results from this analysis suggest that, using a specification in which the linear

interactive term is also included, none of the interactive terms have statistically significant coefficients.

The results of this analysis are available upon request from the authors.
15
See appendix I for the exact specification and data sources of these variables.

42

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