Effect of foreign direct investment on the economy of developing countries: Case of Latvia

Abstract

The aim of this paper is to determine and evaluate the effect of FDI stock on the Gross Domestic Product per capita and on labor productivity per person, which would give an understanding of the causality of investment in the development of the country. Although foreign investment plays a positive role in the development of several countries, promoting competition, development of employment, and acquiring new knowledge, experience, and technologies, in other countries FDI does not bring significant changes. Summarizing the literature, the authors conclude that there are no unambiguous econometric results on the causal relationship between FDI and economic development in developing, developed, or transition economies, so the authors' research will provide additional insight into the interaction of transition economies with FDI. Within the framework of the conducted research, an adapted Granger causality testing methodology is applied, to find out whether there exists and in which direction a causal relationship can be observed between the income level of Latvian residents, labor productivity, and foreign direct investment. The results of the analysis, which are based on a special VAR compilation mechanism and a modified Wald test, show that foreign investment in Latvia has no causal relationship either with the level of welfare or with labor productivity. The authors conclude that in Latvia there is a correlation between the attraction of foreign investment to the service sectors and the lack of transfer of national knowledge, which is reflected in the lack of a causal relationship between FDI and the level of national income. The authors conclude that in order to improve the welfare level of Latvian residents, the able-bodied population should improve their productivity, aside from attracting additional foreign investment.