Foreign Direct Investment:

Aggregate and Regional Effects

Prepared By
Chris Vecchio

For
Dr. Simmons

EC 499

April 26, 2010

I. Introduction

Capital flows to developing countries can be placed into three categories, portfolio equity

investment, portfolio debt investment, and foreign direct investment. In portfolio equity

investment, a foreign entity will take ownership of part of an enterprise through purchase of

stocks or some other financial means. Portfolio debt investment “typically covers bonds and

short- and long-term borrowing from banks and multilateral institutions, such as the World

Bank.” (Kumar, 2007) A third type, foreign direct investment, is defined “as a long-term

investment in which a nonresident entity exerts significant management control over an

enterprise in the host country.” (Perkins, Radelet, & Lindauer, 2006) Alternatively, the

Organization for Economic Cooperation and Development (OECD) defines foreign direct

investment as “the objective of obtaining a lasting interest by a resident entity in one economy

(„„direct investor‟‟) in an entity resident in an economy other than that of the investor („„direct

700000
FDI to Developing Countries
600000

500000
Millions of Dollars

400000

300000

200000

100000

0
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Figure 1 FDI Inflows, 1982-2005, Source: UNCTAD Major FDI Indicators

2
investment enterprise‟‟).” The past two decades have seen a large increase in the flows of foreign

direct investment to developing countries. Foreign direct investment is currently the largest

source of external financing for developing countries. According to UNCTAD, in 2008, foreign

direct investment flows to developing countries were approximately 6.2 trillion dollars. (Figure

1) The UN Conference on Financing for Development that took place in Monterrey, Mexico in

2002, agreed that foreign direct investment can benefit developing countries when they stated

that

Private international capital flows, particularly foreign direct investment…are vital complements
to national and international development efforts. Foreign direct investment contributes toward
financing sustained economic growth over the long term. It is especially important for its potential
to transfer knowledge and technology, create jobs, boost overall productivity, enhance
competitiveness and entrepreneurship, and ultimately eradicate poverty through economic growth
and development. (United Nations, 2002)

One of the primary transmission methods for foreign direct investment is through the

activities of multinational corporations. Multinational corporations conduct operations in both

developed and developing countries. The abundance of low to zero skilled labor in developing

countries provides an incentive for corporations to relocate their labor intensive production

processes to those countries. Thus, their operations in developing countries tend to focus on the

production of textiles and other labor intensive goods.

Having a comprehendible idea of the effects of foreign direct investment can allow a

country to make decisions that will allow them to receive the benefits of foreign direct

investment and minimize the drawbacks. This study will

This paper is organized into seven sections. Section 2 will summarize the potential

benefits and costs that foreign direct investment can have on the host country. Section 3 will

consist of a review of academic literature and carefully selected news articles about the issue of

foreign direct investment and multinational corporations. The specification of the economic

3
 model and definitions of conceptual variables in the model will be in section 4. The specification

of the empirical model(s) and regression results is provided in section 5. Section 6 will discuss

the regression results and any econometric problems. Finally, the paper will argue that the

benefits that are received by the host countries and citizens far outweigh the potential costs. In

addition, it will provide suggestions for future research.

II. Foreign Direct Investment – Benefits and Costs

Foreign direct investment can have both positive and negative effects on the host country.

In developed countries, foreign direct investment frequently involves the acquisition of an

already established plant or firm. (Brown, Deardoff, & Stern, 2003) However, in developing

countries, the multinational must often construct new facilities in the host country. These so-

called “greenfield investments” have the added benefit of adding to the capital stock of the

country. (Brown, Deardoff, & Stern, 2003) In addition, even if a multinational acquires an

already constructed plant or firm, the multinational has the incentive to improve the plant or firm

to bring it in line with the parent company‟s standards and cost structure.

In addition to the creation of new capital, multinational corporations will often hire new

employees, many of whom have zero to few skills and must be trained. The literature provides

mixed results as to the impact of foreign direct investment on employment. This impact can vary

for a number of reasons. An important factor in determining the ultimate impact is the type of

manufacturing process the multinational corporation uses. If the firm produces using a capital

intensive process, the impact on unemployment will be less than that of a multinational that uses

a labor intensive process. However, as stated above, there is a potential for an increased level of

capital and technological specialization with the capital intensive process. In addition to a

4
potential unemployment decreasing effect, multinationals tend to pay higher wages than local

firms. (Graham, 2000)

Thus, a third benefit of foreign direct investment is that it can help increase the level of

specialization of host country manufacturers. This benefit comes from the ability of

multinational corporations to produce in countries that have a comparative advantage for

producing a specific product. For example, computer manufacturers can produce simple (i.e.-

labor intensive) computer parts such as buttons for computer mice in countries that have a lower

capital to labor ratio. They can then produce the more capital intensive products in countries that

have higher capital to labor ratios. With transportation costs having become minimal, this

specialization in production allows for the most efficient production process.

Most developing countries lack a large supply of managers trained to organize and

operate firms in large industries. (Perkins, Radelet, & Lindauer, 2006, p. 422) However, MNC‟s

have the ability to improve the knowledge and professionalism of local managers and

supervisors. In some cases, MNC‟s will send managers abroad to work at the parent company

headquarters for six months or more. Following this period, they will send the managers back to

the local affiliate as a senior manager. While the skills transferred to managers have the

immediate benefit of increasing efficiency and profitability of the local affiliate, they also has the

potential to create positive externalities in the local economy. This occurs when the employees

leave the multinational to pursue employment elsewhere. In this way, the benefits spillover even

if the multinational does not explicitly aid in the process. One example of this occurred during

the movement of textile companies from Korea and Taiwan to Indonesia in the 1980s. (Perkins,

Radelet, & Lindauer, 2006, p. 422) During the initial movement, most senior managers were not

Indonesian. However, over time, more Indonesians took “these positions, and eventually some

5
started their own companies that competed against the MNC.” (Perkins, Radelet, & Lindauer,

2006, p. 422)

While FDI can benefit the host country, it may also have negative effects. It is clear that

the production processes conducted by a MNC may create air/water pollution and environmental

damage in general. However, local companies also cause environmental damage, sometimes in

far greater quantities than the MNCs who are more likely to have the technology to control the

pollution. In addition, FDI can have a negative impact if it operates within inefficient or

protected activities. Firms operating under protection tend to use more outdated and inefficient

technologies. If firms do not have to compete with a global market, there is a tendency to

become “lazy.” (Perkins, Radelet, & Lindauer, 2006) Finally, there is a concern that FDI can

have the effect of crowding out local investment. The theory is similar to that of a government

spending crowding out effect; firms created as a result of FDI will displace local firms.

III. Literature Review

Despite having plausible economic grounds for theorizing a positive relationship between

FDI and economic growth and development, economists and researchers have reached mixed

conclusions regarding the impact of FDI on host countries. While most studies find a positive

link between foreign direct investment and various measures of economic growth and

development, economists have often struggled to find a significant relationship between foreign

direct investment and economic growth. A common conclusion is that the impact of FDI is

conditional on host country characteristics.

One issue encountered in this estimation is that FDI can be both a cause of and a result of

economic growth. The primary direction of causation hypothesized by researchers is that FDI

leads to (or detracts from) economic growth. However, economic growth also has the potential to

6
effect FDI levels “because foreign capital beats a path to the world‟s hottest developing-market

economies.” (Kumar, 2007) This direction of causation problem creates a concern of

endogeneity between FDI and economic growth rate measurements.

Borensztein et al. (1998) provide evidence that the impact of foreign direct investment

depends upon the level of human capital within the host country. They use an interaction term

between FDI and the level of human capital to account for this possibility. The level of human

capital, in the tradition of Barro and Lee (1993), is defined as “the initial level of average years

of the male secondary schooling.” (Borensztein, De Gregorio, & Lee, 1998) The authors found

that the higher the level of secondary education completed, the greater a positive impact foreign

direct investment will have. Referring back to the problem of the direction of causation, the

authors caution that an endogeneity problem may exist between the level of FDI and the growth

rate. An instrumental variables regression provided the same qualitative results as the primary

regression. Thus, the authors concluded that endogeneity did not appear to be a problem. In

addition, the authors found evidence of FDI having a crowding-in effect.1 Blonigen and Wang

(2004) also found evidence to suggest that FDI is more likely to crowd-in local investment in

less developed countries.

De Mello (1999) used panel fixed-effects estimation to study the impact of foreign direct

investment on capital accumulation, output and total factor productivity. The study used data for

32 OECD and non-OECD countries for the period 1970-1990. The results indicated that FDI can

lead to better technology and improved management in the host country. Non-OECD countries

tended to exhibit far greater cross-country diversity than OECD countries. This is a result of

varying abilities in non-OECD countries to effectively absorb and use capital and technologies

1
The authors noted that this effect was less robust than the other findings.

7
created by FDI. However, the research also indicated that the degree to which technology and

management skills were transferred to the host country depended upon the level of host-country

corruption.

In order to determine the relationship between economic growth and foreign direct

investment Choe (2003) examined 80 countries over the time period 1971-1995. The study

sought to determine if FDI was a Granger Cause for economic growth. The study concluded that

there was a two-way causality between FDI and economic growth with economic growth more

likely to cause FDI. In addition, there was strong positive relationship between economic growth

and foreign direct investment.

Johnson (2005) used a panel of 90 countries and hypothesized that FDI should have a

positive effect on economic growth. However, this impact was not primarily due to an increased

capital stock, but rather as a result of technology spillover. Performing both panel and cross-

section analysis, he found that FDI inflows enhance economic growth in developing economies,

but not in developed economies.

A more recent study conducted by Wijeweera, Villano, and Dollery (2010) estimated the

relationship between foreign direct investment and economic growth using a stochastic frontier

model. The study involved panel data from 45 countries over the period 1997 to 2004. The study

concluded that while foreign direct investment had a positive impact on economic growth, the

magnitude of the impact depended on the level of corruption and the amount of highly skilled

labor in the country. The greater the corruption level, the lower the positive impact of foreign

direct investment. Also, a larger quantity of highly skilled labor can lead to a greater impact.

Other studies have sought to determine if there are specific factors that attract

multinational corporations to specific countries. Rivoli (2003) determined that one of the

8
defining characteristics of a sweat shop is low wages. Rivoli notes that between 1990 and 1998,

employment in the textile and industry witnessed a rapid shift to lower wage countries. (Rivoli,

2003) According to Rivoli, this shift is in line with neoclassical trade theory. In fact, this shift

can be explained and is predicted by the Heckscher-Ohlin-Samuelson Model of trade. The two

assumptions of this model are that:

1. Under free trade, countries will tend to export those goods that use their relatively

abundant factor of production more intensively.

2. If free trade continues, in the long-run, factor prices will be equal in all countries.2

It is clear that the combination of labor intensive production processes and a relative

abundance of low skilled cheap labor will provide the incentives for corporations to relocate to

those countries. As noted in the introduction, workers in these countries often have few

alternatives to working in some form of a sweat shop. While the wages may be low in

comparison to Western wage standards, the wages provide the workers with a means of survival.

A related area of research is devoted to determining if multinational corporations pay

higher wages than their local counterparts. Pedro Martins (2004) used ordinary least squares

regression and found that after controlling for worker and firm characteristics, multinational

firms pay on average 11% higher wages. However, Martins also found that the characteristic of

being foreign or domestic was less important in explaining wage variation than were the

characteristics of the industry and the type of worker employed. Therefore, Martins suggests that

policy be structured to attract those types of multinationals that pay higher wages rather than

completely eliminating multinationals from a country. (Martins, 2004)

2
This second assumption is also known as the factor price equalization theorem. In order for it to hold, all eight
assumptions of the HOS model must hold. However, even if some of the assumptions are violated, the idea that
factor prices will eventually equal out is a powerful conclusion that cannot be dismissed.

9
 Debora Spar (1998) argued that multinational corporations actually export human rights.

Spar concluded that while local producers in developing countries can more easily get away with

human rights transgressions, multinationals, who are “in the spotlight” of the media and public,

cannot. Spar concluded that,

the old Leninist link between multinational firms and foreign exploitation seems

outmoded or even contradictory. Rather than having an interest in subverting human

rights, corporations -- particularly high-profile firms from open and democratic societies -

- may well see the commercial benefits of promoting human rights. (Spar, 1998)

It is clear that the impact of foreign direct investment is a subject of controversy. Whether

stemming from econometric problems or otherwise, researchers seeking to determine the effects

of foreign direct investment often reach different conclusions.

IV. Model

The primary empirical model of this paper has per-capita gross domestic product as its

independent variable. Per-capita GDP is one of the most widely used proxies for economic

growth. Its use as a proxy is based on the assumption that, all other things being equal, as per-

capita GDP increases, the standard of living increases. A second underlying assumption is that

the increase in GDP is distributed equally to all citizens. While this second assumption is clearly

debatable, it is not within the realm of this paper to discuss the argument. Indeed, per-capita

GDP is not a faultless measure of economic growth. However, it is one that is reported most

frequently and consistently. Thus, it is first of interest to investigate the relationship between

foreign direct investment and per-capita gross domestic product. The generalized functional form

of the primary model is as follows:

10
 GDP  f  FDI , HDI , INF , GOV , MORT , POP, LIFE 

Nunnenkamp (2003) argued that “results on the growth impact of FDI are ambiguous

because highly aggregated FDI data, used in virtually all previous empirical studies, blur the

differences between resource-seeking, market-seeking and efficiency-seeking FDI and ignore the

compatibility of different types of FDI with economic conditions prevailing in the host country.”

In addition, Blonigen and Wang (2004) argued that is incorrect to pool less developed and

developed countries when investigating the effects of FDI on growth. Thus, secondary

regressions will also be conducted to examine the disaggregated effect of foreign direct

investment in different regions of the world. For this study, the regions are as follows: Region 1:

Africa, Region 2: Central/South America and the Caribbean, Region 3: Asia.

For each region, the following disaggregated regression will be conducted:

GDPi  f  FDIi , HDIi , INFi , GOVi 

The variables are defined in the same manner as above. However, note that two variables

have been dropped. As will be discussed later, these variables were found to be highly collinear.

This did not affect the sign or significance of the coefficient on FDI. The region defined as

“Other” will not be examined as this region includes most developed countries.

The dependent variables

The variable FDI is the level of foreign direct investment for the year 2004 as a

percentage of GDP. This measure was chosen to correct for what Nunnenkamp says is a

misleading picture given by absolute measures of FDI as to the distribution of FDI between

countries. Based on the literature review, we have a priori expectation that foreign direct

investment and gross domestic product are positively related. That is, as the level of foreign

direct investment in a country increases, per-capita gross domestic product also increases.

11
The independent variables

The additional variables are included to control for other factors that explain differences

in per-capita GDP. A common problem with economic growth regression is that it is not always

clear which variables should be included in a model. Various studies reach differing conclusions

as to the solution to this problem. Mirestean and Tsangarides (2009) conducted a robustness

analysis on 15 possible determinants of economic growth. They found seven of the 15 potential

factors to be robust estimators and should therefore be included in a model of economic growth.

They claim that their estimators are superior to previous attempts because they account for model

uncertainty and/or endogeneity of variables that are assumed exogenous in the model. (Mirestean

& Tsangarides, 2009) This paper will use three of the seven robust predictors from the Mirestean

and Tsangarides study, namely, population growth, life expectancy, and inflation.

The human development index  HDI  is an index created by the United Nations

Development Programme. (UNDP) It “is a summary composite index that measures a country's

average achievements in three basic aspects of human development: health, knowledge, and a

decent standard of living.” (UNDP, 2010) Because the HDI is a composite measure, it used to

measure general factors influencing economic development in the host country. The use of an

index measure as an independent variable follows in the tradition of Kahai and Simmons (2005)

in which a “globalisation index” was used to measure the effects of globalization on income

inequality.

The hypothesized sign on the coefficient for the variable inflation  INF  is unknown.

Inflation here is measured by the GDP-deflator adjusted value reported in the World

Development Indicators. There are competing hypotheses on the effects of inflation on economic

growth and development. Most notably, in the 1950s and 1960s economists argued that a rate of

12
inflation between 8 and 12 percent promoted economic growth, although the adherents of this

policy are few and far between today. (Perkins, Radelet, & Lindauer, 2006) The government

effectiveness score  GOV  is calculated by the World Bank and

“measures the quality of public services, the quality of the civil service and the degree of
its independence from political pressures, the quality of policy formulation and implementation,
and the credibility of the government‟s commitment to such policies.” (The World Bank, 2009)

In line with the results of Wijeweera, Villano, and Dollery (2010) we expect a positive

relationship between the government effectiveness score and per-capita GDP.

Life expectancy (LIFE) is a measure of overall health outcomes in a country. Through the

implementation of modern health campaigns, life expectancy has increased in much of the

developing world. An increasing per-capita gross domestic product is highly correlated with an

increase in life expectancy. (Perkins, Radelet, & Lindauer, 2006) However, in places such as

Sub-Saharan Africa, life expectancy is still 32 years less than the average life expectancy for

high income countries. (Perkins, Radelet, & Lindauer, 2006) An increase in life expectancy is

expected to be positively related to per-capita GDP.

Another measure of health outcomes is the infant mortality rate per 1,000 live births.

(MORT) However, the infant mortality rate, unlike life expectancy, is an absolute measure of

health outcomes rather than an average. The hypothesized sign on the coefficient of MORT is

negative. One would expect a lower infant mortality rate in countries with higher per-capita

GDP.

The final independent variable of interest is the population growth rate. (POP) The sign

on this coefficient will depend on the specific situation of the region of interest. In developing

countries, the population is very youthful with very high dependency ratios (ratio of non-working

age population to working age population). There currently exists mixed evidence as to the
13
relationship between population growth and per-capita GDP. In general, countries with a greater

ability to support a growing population can realize economic benefits from a rapidly growing

population. However, many developing countries find it difficult to support a high dependency

ratio. Thus, we cannot determine the hypothesized sign on the coefficient for POP.

The following table summarizes the expected signs on the coefficients of the independent

variables:

Table 1 Expected Signs

Independent Variable Expected Sign

FDI +
HDI +
INF ?
MORT -
GOV +
POP ?
LIFE +

V. Data

Data were collected for the years 2004 and 2005 and for the countries listed in Table 1 in

Appendix A. The data were collected from the World Development Indicators Online and

UNCTAD‟s Major FDI Indicators. In addition, some missing data values were collected from the

CIA World Fact Book for 2005. 3 A lagged value of the independent variable FDI was used to

allow for lagged effects of FDI on the host country. The summary statistics for each independent

variable in the empirical model are presented in Table 2.

3
See UNCTAD, World Bank, and CIA World Fact Book.

14
 Table 2 Summary Statistics
Variable Mean Standard Deviation

GDP 9415.329 12123.00

FDI 5.7817 25.019
HDI 0.78072 0.16658
INF 5.7015 5.0785
MORT 26.877 30.128
GOV 0.3315 1.0421
POP 1.2541 0.87572
LIFE 71.17 9.5717

VI. Estimation Results

As a starting point, we use ordinary least squares regression to test the effect that foreign

direct investment has on per-capita gross domestic product. The following model is used to test

the initial hypothesis:

GDP  1  2  FDI   3  HDI   4  INF  5  GOV   6  POP   7  MORT   8  LIFE    i

Where:

GDP  per capita gross domestic product

FDI  foreign direct investment
HDI  human development index
INF  annual inflation
MORT  infant mortality rate
GOV  governance score
POP  population growth rate
LIFE  life expectancy at birth

GDP is per-capita gross domestic product from balance of payments sheets measured in

constant 2000 U.S. dollars for the year 2005. FDI is a lagged variable representing the level of

foreign direct investment inflows as a percentage of GDP for the year 2004. HDI is the human

development index score for 2005 provided by the United Nations Development Programme

15
(UNDP). INF represents the GDP deflator adjusted inflation for the year 2005. MORT is the

infant mortality rate per 1,000 live births for 2005. GOV is the governance score for 2005

calculated by the World Bank. POP is the annual population growth rate for 2005. LIFE

represents the life expectancy at birth in years. The results of the initial regressions are

summarized in Table 3.

Econometric Issues

The data was initially tested for the presence of heteroscedasticity using a visual

inspection of residual versus actual scatter diagrams. The summary index variables HDI and

GOV in particular showed signs of heteroscedasticity. (See Figures 2 and 3 in the appendix)

White‟s Test was then used to formally test for the presence of heteroskedasticity. The test result

indicated at the 1% level that heteroskedasticity was present in the data. In addition, the

Koenker-Bassett test indicated a presence of heteroskedasticity. Thus, the estimates reported in

table 3 have been corrected for heteroskedasticity using White‟s Heteroskedasticity-Consistent

Standard Errors. In general, correcting for heteroskedasticity improved the significance and

accuracy of the estimates.

16
 Table 3 OLS Estimates - Dependent Variable - GDP Per Capita
Coefficient and Standard Error of Independent Variables

Equation
Number Intercept FDI HDI INF GOV POP MORT LIFE R2 F-Stat Observations

-29281.0*** 113.820*** 35695.9*** 107.782* 6782.43*** 1708.59*** 120.739*** 19.7868

(1) (10383.6) (26.0871) (10092.8) (63.7425) (852.824) (565.559) (43.6405) (132.033) 0.75 37.68 88

-30211.9*** 113.027*** 38630.6*** 91.5497 6607.13*** 1753.67*** 128.465***

(2) (8759.42) (25.5969) (9708.70) (66.3821) (873.304) (585.165) (41.9738) 0.74 42.71 88

-4073.61 120.095*** 9631.54** 101.201 7243.23*** 1494.59**

(3) (3851.92) (25.6080) (4631.23) (104.098) (911.879) (594.756) 0.72 44.88 88

17
6968.97*** 178.699***
(4) (1187.69) 28.6226 0.30 38.98 88

-362.761 -66.3527 4554.12* 81.2372* 894.289** -341.274

(5) (1745.50) (39.2514) (2184.28) (44.2423) (219.740) (279.933) 0.91 38.11 20

-10591.9** 8.78694 17657.0*** 62.6215** 1114.42 -255.645

(6) (3798.00) (89.9251) (4591.39) (24.9027) (695.420) (405.651) 0.78 17.40 24

-15791.9 -3875.11*** 38312.1** -583.830* 3491.48 956.993

(7) (8893.85) (1083.64) (14199.1) (255.556) (2105.28) (1238.15) 0.67 5.93 13
*, **, and *** denotes significance at 10, 5, and 1% respectively.
Note: Values in parenthesis are standard errors.
Note: Reported R2 values are adjusted R2 values.
Note: Equation 5 is for Africa, Equation 6 is for South America/Caribbean/Central America, Equation 7 is for Asia
Note: Results have been corrected for heteroskedacticity.
 The condition index was used to test the primary data for potential multicollinearity. The

condition index used here is defined as CI  Maximum Eigenvalue . Here, CI  5.5326 . This CI
Minimum Eigenvalue

suggests that a serious collinearity problem is not present in the data. To further investigate

collinearity problems, the variance inflation factors were calculated for each independent

variable. Kennedy (2008), and Neter, Wasserman, and Kutner (2004) maintain that a VIF greater

than 10 indicates the presence of a harmful multicollinearity problem. As can be seen in Table 4,

the variance inflation factors in the primary model range from a low of 1.052 to a high of 17.077

(for the variable HDI). These results indicate potential collinearity between the variables HDI,

MORT, and LIFE.

Table 4 Variance Inflation Factors

Equation Number FDI HDI INF GOV POP MORT LIFE
1 1.052 17.077 1.409 8.404 3.662 1.988 6.724
2 1.052 12.555 1.378 3.524 1.811 7.795
3 1.052 3.613 1.374 3.218 1.811
5 1.996 5.058 2.030 1.691 5.306
6 2.485 2.107 1.205 4.340 1.258
7 1.257 3.318 3.611 7.285 2.073

Because these statistics are comparable measures of health outcomes, this result is not

surprising. Separate regressions were conducted with and without potential collinear variables

included. The significance and sign of the coefficient on FDI did not change significantly as a

result of this. In addition, the removal of the variables MORT and LIFE lowered the VIF on HDI

to 3.613 in equation (3). Multicollinearity did not appear to be a problem in the disaggregated

regressions with the highest VIF being 7.285 in equation (7).

18
VII. Discussion of Results

This paper has investigated the effects of foreign direct investment on per-capita gross

domestic product in an aggregate sample of countries and three geographic regions. The primary

area of interest was determining the relationship between foreign direct investment and per-

capita gross domestic product. As stated earlier, this measure is widely used as an indicator of

economic growth and development. The results of models (1), (2), and (3) allow us to reject the

null hypothesis that foreign direct investment does not have an effect on per-capita GDP. In

addition, the sign on the coefficient for FDI in the first three (aggregate) models was positive as

hypothesized and the coefficient on foreign direct investment is significant at the 1% level. This

result suggests that for countries in this sample, an increase in foreign direct investment as a

percentage of GDP will lead to an increase in per-capita GDP. These results are consistent with

recent findings in the literature. In addition, the positive sign of all but one coefficient is

consistent with the expected effects as indicated in the model section.

The explanatory variables in equation (3) account for 72% of cross-country variation in

per-capita GDP. In addition, the F-statistic is significant at the 1% level. After removing all

explanatory variables except FDI, equation (4) indicates that variation in FDI still accounts for

30% of the cross-country variation in per-capita GDP.

For the disaggregated regressions, equations (5), (6), and (7), the regression results for the

region of Central and South America and the Caribbean indicate a positive relationship between

foreign direct investment and per-capita GDP. While the sign on the coefficient for FDI in

regressions (5), and (7) is the opposite of the a priori hypothesized sign, the coefficient on FDI

in equation (5) is not statistically significant. However, the coefficient in equation 7 is significant

at the 1% level. Regressions (5) and (7) correspond to the disaggregated regions of Africa and

19
Asia. It would seem that foreign direct investment in these regions has a different effect than in

the other regions. To investigate this possibility further, a Chow Test for parameter stability was

conducted. The computed F-value indicates that there exists structural change between the

regions in regressions (5) and (7) and the remaining regions. This result is consistent with the

findings of Nunnenkamp (2003).

A possible reason for this is that the countries in those particular regions have not created

an environment that encourages productive use of capital. 4 One of the primary influences on the

productivity of investment is the quality of institutions and governance. “Stronger institutions

and better governance can help both reduce risks and lower costs, which should both encourage

greater investment and make investment more productive.” (Perkins, Radelet, & Lindauer, 2006,

p. 412) The regression results provide strong evidence that better governance has a positive

effect on per-capita GDP. For example, the regression coefficient for GOV is statistically

significant in only one of the three disaggregated regions, namely, Africa. The coefficient

indicates that as a country‟s government becomes more effective, other things equal, the

country‟s per-capita GDP will be higher. This finding is consistent with Wijeweera, Villano, and

Dollery (2010) who found that a lower corruption level was associated with a greater positive

impact of foreign direct investment. In addition, the simple correlation coefficient between GDP

and GOV is 0.83.

It is clear that African countries often suffer from long periods of civil war and

government instability. This higher level of risk can lower the incentives to invest in those

countries. In addition, lack of a stable or effective government does not allow the country to

4
It is also possible that the number of observations in these regions (especially in Asia) just barely exceeds the
number of parameters being estimated. This problem is known as “micronumerosity” and can promote misleading
results. For more information see Gujarati.

20
 enact policies to effectively harness the benefits of foreign direct investment. Thus, another

avenue of research would be to analyze the specific reasons for the negative relationship between

FDI and per-capita GDP in Africa.

VIII. Summary and conclusion

This paper investigated the effects of foreign direct investment on per-capita gross

domestic product. Our results show that the effect of foreign direct investment on per-capita

GDP when all sample countries are included is positive and statistically significant. An increase

in FDI as a percentage of GDP is associated with an increase in per-capita GDP. For the specific

regions of Africa and Asia, our results indicate that an increase in FDI is associated with a

decrease in per-capita GDP. This contradictory result can potentially be explained by differences

in government effectiveness and is consistent with Wijeweera, Villano, and Dollery (2010) and

Nunnenkamp (2003). In addition, there is a potential “micronumerosity” problem in the

disaggregated samples. A limitation of this study is that it used cross-sectional data. Better

results could be obtained by using panel data on all countries in the sample.

These results suggest that the effect of FDI depends on host-country characteristics.

Some important implications of these results are that the right balance of policies towards FDI

must be enacted. A mix of policies that ensure the host-country receives the benefits of FDI and

policies that provide incentives for MNCs to invest in the country is needed. In general, the

results suggest that a country should have a strong and corruption free government, capable

institutions, adherence to the rule of law, and “labor markets in which wages are matched by

productivity.” (Perkins, Radelet, & Lindauer, 2006)

While foreign direct investment may have positive effects on the host country, there are

also potential negative effects. These concerns must be addressed by governments and

21
international organizations. Ensuring that MNCs and FDI in general does not have an

exploitative effect on host country citizens can ensure the maximum benefit of FDI is realized.

The results of this study should provide important evidence in the debate on the effects of foreign

direct investment.

22
 Appendix

Table 5 List of Sample Countries

Argentina Greece Mexico St. Lucia
Australia Guatemala Mozambique Sudan
Austria Guyana Nepal Swaziland
Belgium Haiti Netherlands Sweden
Benin Honduras New Zealand Switzerland
Bolivia Hungary Nicaragua Syrian Arab Republic
Botswana Iceland Niger Thailand
Brazil India Norway Togo
Cameroon Indonesia Pakistan Tonga
Canada Iran, Islamic Rep. Panama Trinidad and Tobago
Chile Ireland Paraguay Tunisia
China Italy Peru Turkey
Colombia Jamaica Philippines United Kingdom
Costa Rica Japan Poland United States
Czech Republic Jordan Portugal Uruguay
Denmark Kenya Samoa Venezuela, RB
Dominica Korea, Rep. Senegal
Dominican Republic Luxembourg Seychelles
Ecuador Malawi Sierra Leone
Egypt, Arab Rep. Malaysia Slovak Republic
El Salvador Mali South Africa
Finland Malta Spain
France Mauritania Sri Lanka
Germany Mauritius St. Kitts and Nevis
Count: 88

23
 Figure 2 Residuals vs. Observed Values for HDI
Regression residuals (= observed - fitted gdppcc)
25000

20000

15000

10000
residual

5000

-5000

-10000

-15000
0.4 0.5 0.6 0.7 0.8 0.9
hdi

Figure 3 Residuals vs. Observed Values for GOV

Regression residuals (= observed - fitted gdppcc)
25000

20000

15000

10000
residual

5000

-5000

-10000

-15000
-1.5 -1 -0.5 0 0.5 1 1.5 2
gov

24
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