This document summarizes a research paper that examines the relationship between foreign direct investment (FDI) and economic growth in developing countries. The paper finds that FDI has a strong complementary effect on growth when combined with human capital in the host country. It also finds that FDI stimulates or "crowds in" domestic investment. Additionally, the interaction between FDI and human capital is shown to be particularly important for investment. The results suggest FDI transfers technology but requires a minimum level of human capital in the host country to be productive.

1. How does Foreign Direct
Investment Affect Economic
Growth
E. Borensztein,
J. De Gregorio,
J-W. Lee
Journal of International Economics 45 (1998) 115–135

2. Introduction
 Model of technology diffusion: the rate of economic
growth of a backward country depends on the extent
of adoption and implementation of new technologies.
 FDI is considered to be a major channel for the
access to advanced technologies
 Findly (1978): FDI increase the rate of technical
progress in the host country through a ‘contagion’
effect from the more advanced technology,
management practices, etc. used by foreign firms.
 Wang (1990) incorporate this idea into a model more
in line with the neoclassical growth framework, by
assuming the increase in “knowledge” applied to
production is determined as a function of FDI.

3. Objectives
 The purpose of this paper is to examine empirically
the role of FDI in the process of technology diffusion
and economic growth in developing countries
 We examine whether FDI interacts with the stock of
human capital to affect growth rates.
 We also test whether the level of FDI has an effect
on the overall level of investment in the country and
on the efficiency of investment.

4. Theoretical Framework
 Technical progress is the result of ‘capital deepening’
in the form of an increase in the number of varieties
of capital goods available, as in Romer (1990),
Grossman and Helpman (1991) and Barro and Sala-
i-Martin (1995)
A: exogenous state of technology
H is a given endowment of human capital
K: physical capital  capital accumulation takes place
through the expansion of the number of varieties
𝑌𝑡 = 𝐴𝐻𝑡
∝
𝐾𝑡
1∝

5.  The model highlights the roles of both the
introduction of more advanced technology
and the requirement of absorptive capability
in the host country as determinants of
economic growth, and suggests the empirical
investigation of the complementarity between
FDI and human capital in the process of
productivity growth

6. Model Specification
• FDI is measured as a ratio to GDP
• H is the stock of human capital
• The initial GDP variable (Y0) captures the
role of the ‘catch-up’ effect (N/N*)
• A is a set of other variables that affect
economic growth

7. Data
Variable Description Sources
GDP Growth Average annual rate of per capita real GDP over
each decades, 1970-79, 1980-89
Summers and Heston (1993)
Foreign Direct
Investment (FDI)
Gross FDI originated in OECD member
countries into developing countries
OECD Publication
Schooling (H) The initial-year level of average years of the
male secondary schooling
Barro and Lee (1993)
Government
Consumption
Average share of real government consumption
in real GDP
Summers and Heston (1993)
Investment Rate Domestic investment rate Barro and Lee (1994)
Black Market
Premium
Measure distortions in the trade regime
Assassinations and
Wars
A measure of political instability (political
assassinations and wars)
Financial Depth The ratio of the liquid liabilities of the financial
system to GDP, equal to M2/GDP
Inflation rate
Political Rights Index for freedom of speech and the press,
freedom to run for office, and vote in the country
(1 best, 7 worst)
Gastil (1987)
Institutions Quality of political institutions (1 worst, 10 best) Knack and Keefer (1995)
Panel data of 69 developing countries (1970-89)

8. Result
Strong
complementary
effects between
FDI and human
capital on the
growth rate of
income
1

9. Result

10. Result
The figure shows that,
for a given level of human
capital, an increase in FDI
raises the growth rates of
per capita income, except
for the economies with the
lowest level of schooling

11. Result
FDI stimulate or
“crowds in”,
domestic
investment
2

12. Result
Interaction
between human
capital and
investment is a
particular
characteristic of
FDI
3

13. Conclusion
 FDI is in fact an important vehicle for the
transfer of technology
 There is a strong complementary effect between
FDI and human capital
 FDI is complementary (crowds in) to domestic
investment
 FDI is more productive than domestic
investment only when the host country has a
minimum threshold stock of human capital

14. Important notes
 FDI data used here from BOP statistic, which is
only part of the resources invested through
another instrument (debt or equity).
 Thus, our measure of FDI underestimates the
total value of fixed investment made by a
multinational firm and the coefficients on FDI may
be proportionally overestimated.

15. For further research
 The results suggest that the beneficial effects on
growth of FDI come through higher efficiency
rather than simply from higher capital
accumulation.
 This suggests the possibility of testing the effect of
FDI on the rate of total factor productivity growth in
recipient countries

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