Agricultural & Applied Economics Association

Impact of Foreign Direct Investment and Trade on Economic Growth: Evidence from Developing
Countries
Author(s): Shiva S. Makki and Agapi Somwaru
Source: American Journal of Agricultural Economics, Vol. 86, No. 3 (Aug., 2004), pp. 795-801
Published by: Oxford University Press on behalf of the Agricultural & Applied Economics
Association
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 IMPACT
OFFOREIGN
DIRECTINVESTMENT
AND
TRADEONECONOMIC
GROWTH: EVIDENCE
FROMDEVELOPING
COUNTRIES
SHIVAS. MAKKIANDAGAPISOMWARU

Foreigndirectinvestment(FDI) andtradeare results suggest that FDI, trade, human cap-

often seen as importantcatalystsfor economic ital, and domestic investment are important
growthin the developingcountries.FDI is an sources of economic growth for developing
importantvehicle of technologytransferfrom countries.We find a strong positive interac-
developed countriesto developingcountries. tion betweenFDI and tradein advancingeco-
FDI also stimulatesdomestic investmentand nomic growth.Our resultsalso show that FDI
facilitatesimprovementsin humancapitaland stimulatesdomesticinvestment.The contribu-
institutionsin the host countries.International tion of FDI to economic growthis enhanced
trade is also known to be an instrumentof by its positive interactionwith humancapital
economicgrowth(FrankelandRomer).Trade and sound macroeconomicpolicies and insti-
facilitatesmore efficientproductionof goods tutionalstability.
andservicesby shiftingproductionto countries
thathave comparativeadvantagein producing
them. Review of Literature
Even though past studies show that FDI
and tradehave a positiveimpacton economic Studiesbasedon the neoclassicalapproachar-
growth,the size of suchimpactmayvaryacross gue that FDI affects only the level of income
countries depending on the level of human and leaves the long-run growth unchanged
capital, domestic investment, infrastructure, (Solow, De Mello). They argue that long-run
macroeconomicstability,and trade policies. growth can only arise because of technolog-
The literaturecontinuesto debate the role of ical progressand/or populationgrowth,both
FDI and trade in economic growthas well as consideredexogenous.Thus,accordingto neo-
the importanceof economic and institutional classicalmodels of economicgrowth,FDI will
developmentsin fosteringFDI andtrade.This only be growth advancingif it affects tech-
lack of consensuslimits our understandingof nology positively and permanently.More re-
the role of FDI and tradepoliciesin economic cent endogenousgrowthmodels,on the other
growth processes and restrictsour ability to hand, imply that FDI can affect growth en-
developpoliciesto promoteeconomicgrowth. dogenously if it generates increasingreturns
This article analyzes the role of FDI and in productionvia externalitiesandspilloveref-
trade in promoting economic growth across fects.In these models,FDI is consideredto be
selected developingcountriesand the interac- animportantsourceof humancapitalandtech-
tion amongFDI, trade,and economicgrowth. nologicaldiffusion.FDI introducesnew man-
We examine data from sixty-six developing agementpracticesandorganizationalarrange-
countries over the last three decades. Our mentsin additionto providinglabortrainingin
the host countryproductionfacilities.FDI en-
Shiva S. Makki is senior research specialist, Department of Agricul- couragesthe incorporationof new inputsand
tural, Environmental, and Developmental Economics, Ohio State technologiesin the productionsystemsof host
University; and Agapi Somwaru is senior economist, Economic
Research Service, U.S. Department of Agriculture.
countries.
The authors gratefully acknowledge helpful comments received Applying endogenous growth theory to a
from Demcey Johnson, Mike Trueblood, Suchada Langley, Mary crosssectionof forty-sixdevelopingcountries,
Bohman, and V.V. Chari.
The views expressed herein are those of the authors and not Balasubramanyam, Salisu,and Sapsfordshow
necessarily those of the Economic Research Service or the U.S. that the growth-enhancing effects of FDI are
Department of Agriculture. stronger in countriesthat pursued a policy of
This article was presented at the ASSA winter meetings
(San Diego, CA, January 2004). Articles in these sessions are not exportpromotionratherthanimportsubstitu-
subjected to the journal's standard refereeing process. tion. Theireconometricanalysisindicatesthat
Amer. J. Agr. Econ. 86(3) (August 2004): 795-801
Copyright 2004 American Agricultural Economics Association

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796 August 2004
the elasticity of output with respect to FDI
exceeds that of domestic capital investment,
which implies that FDI is the drivingforce in
the growthprocess.
Borensztein,Gregorio,andLee examinethe
role of FDI in promotingeconomicgrowthus-
ing an endogenous growth model. They ana-
lyzed FDI flows from industrialcountries to
sixty-ninedeveloping countriesduring 197F
1989. Their results also show that FDI is
an importantvehicle of technology transfer,
contributingmore to economic growth than
domestic investment. They make a case for
a minimumthreshold stock of human capi-
tal necessary to absorb foreign technologies
efficiently.
Severalotherstudies,includingFeder,Ram,
and Salvatore and Hatcher, have analyzed
the export-led economic growth hypothesis.
They argue that exports increase factor pro-
ductivitybecause of better utilizationof ca-
pacity and economies of scale. They also
argue that exports are likely to alleviate
foreign-exchangeconstraintsand thereby fa-
cilitateimportationof bettertechnologiesand
productionmethods.Grossmanand Helpman
argue that open-trade regimes go hand-in-
hand with good investmentclimates,technol-
ogy externalities,and learningeffects.
Empirical studies by Dollar, Sachs and
Werner,andLipseygenerallysupportthe view
that open economies grow faster. There are
other studies,however,that questionthe wis-
domof tradeopenness.RodriguezandRodrik,
for example, present a critical view of the
link between open-tradepolicy and economic
growth. They argue that past studies fail to
account for institutional differences among
countriesresultingin an upwardlybiased es-
timate of trade and other policy restrictions.
Their analysis shows that the relationship
between average tariff rates and economic
growthis only slightlynegative and nowhere
near statisticalsignificance.
The question of whether FDI and trade
trigger economic growth or the economic
development brings FDI and trade is an
unresolved issue. Past studies either ana-
lyzed the impact of trade and FDI on eco-
nomic growth (Borensztein, Gregorio, and
Lee; Balasubramanyam, Salisu,and Sapsford)
or analyzedthe effects of economicgrowthon
FDI (Barreland Pain, Lipsey). A positive ef-
fect of FDI andtradeon economicgrowthmay
simply reflect the fact that FDI is attracted
to countriesthat are expected to grow faster
and follow open-tradepolicies.It is, therefore,
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Amer. J. Agr. Econ.
importantto understandthe interrelationships
amongFDI, trade,andeconomicgrowth.Since
theory is unclear,this issue has been the sub-
ject of empiricalstudies.
Methodologyand Data
Oureconometricmodel is derivedfroma pro-
ductionfunctionin whichthe level of a coun-
try's productivitydepends on FDI, trade, do-
mestic investment,human capital, and initial
grossdomesticproduct(GDP) per capita.The
model is based on endogenousgrowththeory,
in the traditionof Balasubramanyam,Salisu,
and Sapsfordand Borensztein,Gregorio,and
Lee, where FDI contributes to economic
growthdirectlythroughnew technologiesand
other inputs as well as indirectlythroughim-
provinghumancapital,infrastructure,and in-
stitutions(see Borensztein,Gregorio,andLee
for the theoreticalderivationof this model ap-
proach). To assess empiricallythe effects of
FDI andtradeon economicgrowth,we specify
the followingbasicformulation:
(1) g = a + b1FDI+ b2TRD+ b3HC
+ b4K+ bsGo+ c1FDI* TRD
+ c2FDI* HC + c3FDI* K
+ d1IRT+ d2TX+ d3GC+ e
where g is the per capita GDP growth rate;
FDI, the foreign direct investment;TRD, the
trade (exportsplus imports)of goods and ser-
vices; HC, the stock of humancapital;K, the
domestic capital investment; Go, the initial
GDP (initialstock);IRT,the inflationrate;TX,
the tax on income,profits,and capitalgainsin
the host country expressed as percentage of
currentrevenue;and GC is governmentcon-
sumption.The variablesFDI, TRD, K, GC are
measuredas ratiosto GDP.Ourmodelextends
the workof Borensztein,Gregorio,andLee to
includethe decadeof the 1990swhenFDI and
tradegrewrapidlyin the developingcountries.
We also account for interactionof FDI with
trade and domesticinvestment,in additionto
humancapital.
Past empiricalstudies have indicated that
FDI, trade, human capital, and domestic in-
vestmenthave a positive impacton economic
growthin developingcountries.We expect the
estimatedcoefficientsfor these variablesto be
positive. We also expect positive interactions
between FDI and trade and FDI and domes-
tic capitalinvestmentin promotingeconomic
growth.
Makkiand Somwaru
The stock of humancapitalin a host coun-
try is criticalfor absorbingforeignknowledge
and an importantdeterminantof whetherpo-
tentialspilloverswill be realized.Wepostulate
not only a positive relationshipbetween FDI
and the GDP growthrate but also a positive
interactionbetweenFDI andhumancapitalin
advancingeconomic growth.The application
of advancedtechnologiesembodiedin FDI re-
quiresa sufficientlevel of humancapitalin host
countries.Thatis,the higherthe level of human
capitalin a host country,the higherthe effect
of FDI on the country'seconomicgrowth.
One of the key questions regardingFDI
and economicgrowthis: "Whatis the interac-
tion between FDI and domesticinvestment"?
The answerto this question seems to be less
controversialin theory than in practice. As
argued before, FDI is an importantvehicle
for the transfer of capital, technology, and
knowledge to host countries,thereby gener-
ating high-growthopportunities.In practice,
however,the growth-enhancingimpactof FDI
depends criticallyon the absorptivecapacity
of a host country and whether FDI "crowds
out" its domesticinvestment.Thus,an impor-
tant questionto be addressedis: "Whatis the
extent to whichFDI substitutesfor or comple-
mentsdomesticinvestment"?In our empirical
model, we include FDI and domestic invest-
ment separatelyas well as an interactionterm
betweenFDI and domesticinvestment(FDI *
K). The interactionterm estimates the com-
bined impactof FDI and domesticinvestment
on growthand indicatesthe natureof the re-
lationshipbetween the two. A positive coef-
ficientfor the interactionterm would suggest
that FDI and domestic investment (K) rein-
force (complement)each other in advancing
economicgrowth.
The initial GDP,measuredin termsof con-
stantU.S.dollars,controlsfor preexistingeco-
nomic and institutionalconditionsin the host
economy. We expect the initial GDP (ex-
pressed in logarithms) to be negatively re-
lated with GDP growth rates. The inflation
rate is a key indicatorof fiscal and monetary
policies of a country.A lower inflation rate
should mean a better climate for investment,
trade,and,therefore,economicgrowth(Fisher
andModigliani,FrootandStein).Government
consumptionand tax on income, profits,and
capital gains are proxies for institutionsand
infrastructurein the host countries.Since our
objectiveis to quantifythe effects of FDI and
tradeon economicgrowth,we focus on devel-
oping countries.
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Foreign Direct Investment and Trade 797
Data for our analysis are obtained from
the World Development Indicators (WDI)
database. The WDI database, published by
the WorldBank and InternationalMonetary
Fund, includes variables such as GDP, per
capitaincome, GDP growthrates,FDI, trade
in goods and services,domesticcapitalinvest-
ment, humancapital,marketopenness,infla-
tion rate, tax income, and governmentcon-
sumption.The data cover sixty-six countries
for the years 1960through2000.However,we
limitouranalysisto 1971through2000because
the flow of FDI to most developingcountries
began in 1970s.All variablesrepresentthe av-
erage over the followingdecades:1971-1980,
1981-1990,and 1991-2000.
We estimate a system of three equations,
where the dependent variablesare the mean
values of per capita GDP growth rates in
each decade.We estimatethe systemof equa-
tions usingthe seeminglyunrelatedregression
(SUR) methodaswell as instrumentalvariable
(three-stage least squares, TSLS) approach.
The SUR estimation allows for different er-
rorvariancesin each equationandfor correla-
tion of these errorsacrossequations(Greene),
while the instrumentalvariabletechniqueal-
lows us to overcomepotentialbiases induced
by endogeneity problems between FDI and
economicgrowth.
EmpiricalResults
The purpose of our empirical investigation
is to analyze the effects of FDI and trade
on economic growth and to examine how
FDI interactswith trade, human capital, and
domestic investment in advancingeconomic
growth in developing countries. We control
for preexisting economic conditions by in-
cluding initial GDP as one of the explana-
toryvariables.We also accountfor differences
in macroeconomicpolicies and institutionsin
the host countriesby includingvariables,such
as inflationrate, tax burden,and government
consumption.
We test the effects of FDI and tradeon eco-
nomicgrowthin a frameworkof cross-country
equations utilizingdata from sixty-sixdevel-
oping countriesover the last three decades-
1971-1980, 1981-1990, and 1991-2000. The
system has three equations,where the depen-
dent variablesare the per capitaGDP growth
rates (mean value) in each decade. We con-
strained the model such that all three equa-
tions yield the same coefficients in the
798 August 2004 Amer. J. Agr. Econ.

Table 1. Interrelationshipbetween GDP Growthand FDI and Trade:EconometricResults

SUR Estimates
DependentVariable:
Per CapitaGDP GrowthRate DependentVarlable:
Domestic Investment
IndependentVariable 1.1 1.2 1.3 1.4
Intercept 0.5444 0.6232 1.0360a 0.7005a
(0.4844) (0.4654) (0.4293) (0.1757)
FDI 0.1856a 0.0475 0.0792 0.0716a
(0.0697) (0.0942) (0.0793) (0.0238)
Trade 0.0126 0.0111 0.0059 0.0031
(0.0115) (0.0111) (0.0096) (0.0038)
Humancapital 0.0089C 0.0086C O.009Sb -0.0020
(0 0055) (0.0053) (0.0047) (0.0023)
Domesticinvestments -0.0364 -0.0937 0.0419b
(0.0938) (0.0975) (0.2013)
InitialGDP per capita 0.0187 -0.0005 -0.0184 0.0087
(0.0213) (0.0195) (0.0167) (0.0081)
FDI * Trade 0.0OSOa 0.004fa 0.0011C
(0.0017) (0.0013) (0.0007)
FDI * Humancapital -0.0035 0.0058 -0.0016
(0.0109) (0.0106) (0.0034)
FDI * Domesticinvestment 0.0455C 0.0036
(0.0258) (0.0225)
Inflationrate -0.0047a -0.0001
(0.0009) (0.0003)
Taxrate _0.0040b -0.0001
(0 0021) (0.0007)
Governmentconsumption -0 0S74a 0.9018a
(0.1932) (0.0299)
SystemR2 0.0698 0.1175 0.2560 0.8903
a99% confidence level.
b95% confidence level.
C90%confidence level.

three time periods with the exception of the
intercepts.
Table 1 presents the econometric results
and compares alternativespecifications.Re-
gressions 1.1, 1.2, and 1.3, different variants
of equation (1) above, are estimated using
the SUR method. Regression 1.1 is our ba-
sic specificationwith explanatoryvariablesof
FDI, trade, human capital, domestic invest-
ment, and initialGDP.Regression1.2 extends
1.1 to include interactionof FDI with trade,
humancapital,and domesticinvestment.Re-
gression 1.3 (final specification)builds on re-
gression1.2by controllingforinflationrate,tax
burden,andgovernmentconsumption.Ourre-
sults show that most coefficientshave the ex-
pected signs, particularlyin specification1.3.
Note that signs change for some coefficients
across specifications.The estimated R2 are
generallylow but reasonablegiven the cross-
sectionalnatureof the data used.
Regression 1.1 reveals that FDI and trade
have a positive impact on economic growth
after controllingfor human capital,domestic
investment,and initial income (table 1). The
estimated coefficient for FDI is positive and
statisticallysignificantwhile the estimatedco-
efficient for trade is not statisticallysignifi-
cant.Sincethe coefficientof FDI is largerthan
the coefficient of trade, it indicates the dif-
ferentialimpact of FDI in the host country's
economic growth.The coefficientfor human
capital is positive, implyingthat human capi-
tal contributespositivelyto economic growth
(significantonly at a confidencelevel of 88%).
The coefficientsfor domestic investmentand
initialincome are not statisticallysignificant.
Including interactions between FDI and
trade, FDI and human capital, and FDI and
domestic investment not only improves the
overallperformanceof the estimationbut also
allows us to capture their interactioneffects

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Makkiand Somwaru
on economic growth (table 1). In regression
1.2, the interactionof FDI and trade yields a
positive and statisticallysignificantcoefficient
while the effects of FDI and trade,by them-
selves, are positive but not statisticallysignifi-
cant. Regression1.2 also reveals that the FDI
interactspositivelywith domestic investment
in advancingeconomicgrowth.The estimated
coefficient for domestic investment is posi-
tive and statisticallysignificantat a confidence
level of 90°/0.The estimatedcoefficientsindi-
cate thathost countriesbenefitpositivelyboth
fromFDI, itself,andthroughFDI'spositivein-
teractionwith tradeand domesticinvestment.
The interaction between FDI and human
capital, although positive, is not statistically
significant.
Regression1.3 includesadditionalvariables
to controlfor macroeconomicpolicies and in-
stitutionalstabilitythat could have a signifi-
cant impact on FDI and trade and, thus, on
economic growth.Recent literatureindicates
that FDI is greatly influencedby host coun-
trypolicies,suchas monetary,fiscal,andopen-
marketpolicies.We includeinfiationrates,tax
income, and governmentconsumptionto be
proxiesfor monetaryandfiscalpolicies,as well
as institutionsin the host nations. Inclusion
of these policyvariablessignificantlyincreases
the explanatorypowerof the estimatedsystem
(table 1).
The resultsof regression1.3 revealthatFDI
and trade contributepositively to economic
growth,but the estimatedcoefficientsare not
statisticallysignificant(table 1). The stock of
human capital and domestic investment, on
the other hand, have positive and statistically
significantcoefficients.The results also indi-
cate that FDI positively interactswith trade,
humancapital,and domesticinvestment.But
only FDI-trade interactionis statisticallysig-
nificant.Thisimpliesthat FDI and tradecom-
plementeachotherin advancinggrowthrateof
income in developingcountries.This result is
consistentwith the idea that flow of advanced
technologybroughtalongby FDI can increase
the growthrate of the host economy by inter-
actingwith that country'strade.
The diverse experiences from developing
countriessuggestthatFDI andtrade,by them-
selves, may not guaranteeeconomic growth.
A country'seconomic growthis also affected
by its macroeconomicpoliciesandinstitutional
stability.Sound macroeconomicpolicies and
institutionalstabilityare necessaryprecondi-
tions for FDI-driven growth to materialize.
The estimated coefficientsfor the three pol-
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ForeignDirectInvestmentand Trade 799
icy variables inflationrate, governmentcon-
sumption,andtax on income,profits,andcapi-
tal gains are negativeandstatisticallysignifi-
cant. This implies that lowering the inflation
rate, tax burden, and governmentconsump-
tion would promote economicgrowth.Lower
inflation rates would indicate that the host
country'smacroeconomicpolicies are stable
anddisciplined.Lowertaxburdenwouldmake
the investments,both foreign and domestic,
more profitable.Decreasing the government
consumption would leave more money for
investments.
FDI "Crowds-In"
DomesticInvestment
One of the importantquestionsraisedin the lit-
eratureis whetherFDI augmentsa host coun-
try'scapitalinvestmentor crowdsout domestic
investment.Even though not statisticallysig-
nificant,the positive interactionbetween FDI
and domesticinvestmentin regression1.3 im-
plies thatdomesticinvestmentis unlikelyto be
crowdedout in developingcountries.
To further strengthen our argument, we
estimate the contributionof FDI to domes-
tic investmentafter controllingfor trade,hu-
man capital,initialincome levels, and various
macroeconomicpolicy variables.Regression
1.4 in table 1 presents the results of this es-
timation using the SUR method. The results
indicate FDI has a positive effect on domes-
tic investment,as the estimatedcoefficientis
positive and statisticallysignificant.This pos-
itive relationshipimplies that FDI stimulates
or crowds-indomesticinvestment.Thisfinding
is consistentwith Borensztein,Gregorio,and
Lee. Even though trade, by itself, is not sta-
tisticallysignificant,trade interactspositively
with FDI on domestic investment.The esti-
mated coefficient for the FDI-trade interac-
tion termis positiveand significantat the 90°/O
confidencelevel.
EndogeneityProblems
The correlationbetween FDI and growthrate
couldarisefroman endogenousdetermination
of FDI. Thatis, FDI, itself,may be influenced
by innovationsin the stochasticprocess gov-
erning growth rates (Borensztein, Gregorio,
andLee). Forexample,marketreformsin host
countries could increase both GDP growth
rates and the inflowof FDI simultaneously.In
this case, the presenceof correlationbetween
FDI andthe country-specificerrortermwould
bias the estimatedcoefficients.
800 Aangusf2004 Amer. J. Agr. Econ.

betweenGDP GrowthandFDI andTrade:

Table 2. IntexTelationship
InstrumentalVariableEstimation
TSLS Estimates
Dependent Variable:
Per-capita GDP Growth Rate
Independent variable 2.1 2.2 2.3
Intercept 0.5490 0.6271 0.9965b
(0.4873) (0.4690) (0.4321)
FDI 0.1806b 0.0427 0.0805
(0.0698) (0.0946) (0.0794)
Trade 0.0115 0.0098 0.0066
(0.0116) (0.0112) (0.0096)
Human capital 0.0096 0.0093c 0.0094b
(0.0057) (0.0055) (0.0049)
Domestic investments -0.0361 -0.0912 0.0444b
(0.0942) (0.0980) (0.2025)
Initial GDP per capita 0.0195 0.0008 -0.0188
(0.0215) (0.0197) (0.0169)
FDI * Trade 00049a 0.0043a
(0.0018) (0.0013)
FDI * Human capital -0.0036 0.0065
(0.0110) (0.0105)
FDI *Domesticinvestment 0.0456C 0.0027
(0.0259) (0.0225)
Inflation rate -0.0043a
(0.0009)
Tax rate -0.0042b
(0.0021)
Government consumption _0.0600a
(0.1950)
System R2 0.0704 0.1175 0.2421
a99% confidence level.
b95% confidence level.
C90%confidence level.

The endogeneity problem is addressed Summaryand Conclusions

by using the instrumental variables (see
Borensztein,Gregorio,and Lee for more de-
tails). One of the majorproblemswith the in-
strumentalvariableestimationmethod is the
difficultyin identifyinginstrumentsthat are
highlycorrelatedwith FDI (or trade) but not
with the error term. We use lagged values of
FDI, lagged values of trade, and log value of
total GDP as instrumentsin a TSLS method.
The results of the TSLS model (reported in
table 2, regressions2.1-2.3) show that the in-
strumentalvariableestimationyields qualita-
tively similarresultsas those obtainedby the
SUR method. The estimated coefficients on
FDI and trade,by themselves,are positivebut
statisticallyinsignificant.The interactiveterm
of FDI andtradeis positiveandstatisticallysig-
nificant.This alternativeestimationalso sug-
gests that our resultsare robust.
Thispaperanalyzesthe role of FDI and trade
in economic growth of developing countries
within the endogenousgrowth-theoryframe-
work. Using cross-sectiondata relating to a
sample of sixty-six developing counties over
three decades, we show that FDI and trade
contributetowardadvancingeconomicgrowth
in developingcountries.Thereis a strong,pos-
itive interactionbetween FDI and trade.FDI
is often the main channel throughwhich ad-
vanced technology is transferredto develop-
ing countries.Our resultsimply that the ben-
efits from such investmentwould be greatly
enhancedif the host countryhas a betterstock
of humancapital.We also show thatFDI stim-
ulates domestic investment. Sound macroe-
conomic policies and institutional stability
are necessary preconditions for FDI-driven

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Makki and Somwaru ForeignDirectInvestmentand Trade 801

growth to materialize.Our results imply that tion."Weltwirtschaftliches

lowering the inflation rate, tax burden, and 33.
governmentconsumptionwould advanceeco- Frankel, J.A., and D. Romer. "Does Trade
nomic growthin developingcountries. Cause Growth?"AmericanEconomicReview
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