The impact of Foreign Direct Investment in developing countries

There is increasing interest in development circles on measures to promote foreign direct investment in developing countres.   Thierry Mayer at the OECD has published a new study (pdf) of the interactions between aid, trade and investment policies to inform donor decisions about how to maximise foreign direct investment and its broader benefits.

The study draws some unexpected and disconcerting conclusions: 

  • The relationship between FDI and economic growth is not as strong as was previously claimed – indeed, while there is a correlation between inward FDI and growth, it is not possible statistically to invalidate the hypothesis that those two outcomes are results of a common cause – namely the pursuit of sound economic policies.
  • The benefits to the local economy of FDI are limited – and indeed FDI can have a negative effect on local industries.
  • There is no statistically significant relationship between bilateral aid and the amount of FDI (once you control for country characteristics).

The paper concludes that for FDI to have a beneficial impact, it is important to increase absorption capacity, by increasing human capital accumulation, increasing and improving transport infrastructure, improving market access for poor countries to increase trading opportunities, and facilitating trade between developing countries.  Mayer also calls for more detailed examination of the impact of investments in infrastructure and in education and the interaction with the benefits from FDI.

It is true that this paper looks only at middle income countries (because of data constraints in least developed countries).   Nonetheless, it should challenge to the development industry to consider carefully what we know about the impact of foreign direct investment on development, and to reappraise the policies we pursue both to promote FDI and to increase its beneficial impact.

Published by Owen Barder

Owen is Senior Fellow and Director for Europe at the Center for Global Development and a Visiting Professor in Practice at the London School of Economics. Owen was a civil servant for a quarter of a century, working in Number 10, the Treasury and the Department for International Development. Owen hosts the Development Drums podcast, and is the author Running for Fitness, the book and website. Owen is on Twitter and

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4 Comments

  1. I am deeply suspicious of any studies that aggregate FDI up to the macroeconomic level rather than industry- or product- specific. It’s clear that FDI in natural resources in poor African countries can have a deeply damaging effect on institutions and any broad-based concept of development. At the opposite end, the active intervention seen in East Asian countries to bring in sector-specific FDI and boost domestic input-output linkages and move up the value chain is great for industrial development and poverty reduction.

    Sitting back and passively waiting for FDI by creating an "enabling environment" is not how most successfully industrialising countries have done it. FDI comes in when there is profit to be made. It’s that simple. Whether society benefits from that profit depends on the society and government in question.

  2. Adam

    I agree.  Arguably, one of the great tragedies of many African countries is that their governments have been too weak and subject to pressure from special interests to pursue effective, time-limited sector-specific industrial policies.

    As you say, whether society benefits depends largely on the society and government in question: but I would add that rich country governments and firms can influence that a bit – for example, by being transparent about payments that we make to encourage accountability for how those revenues are used.

    Owen

  3. Definitely. I’d go even further and say in many cases it’s not so much a case of  "special interests" as a function of the way patronage and clientilism works in very weak polities. No way you can pursue sector-specific policies that are time-bound if you’re dependent on back-handers from those very same firms to pay off your clients and buy elections. I’m a big fan of Mushtaq Khan’s work on politics, corruption and industrial development in that regard.

    You’re absolutely right though that whilst we can’t (at least now anyway, maybe 50 years ago!) influence the underlying structural politics of very poor countries very easily, we can certainly try and ensure that our firms and indeed governments aren’t complicit in opaque payments.

  4. The silver bullet in this argument is that everyone knows that investment is investment, foreign or not, and the theory assumes FDI is especially good because the foreign direct investors bring technology and management skills into the country. OK. But surely they also bring their own errors?

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