Foreign Direct Investment and Economic Growth: The Importance of Institutions and Urbanization

Abstract

where g denotes the equilibrium rate of growth, s denotes the capital-formation rate, and b is the productivity of capital. Foreign direct investment (FDI) adds gross capital formation and, hence, raises s. The FDI also raises the productivity of capital, b, through improved competition, positive technological externalities, and accelerated spillover effects. Therefore, many developing countries have been aggressive in their efforts to attract FDI. However, most theories of FDI determination are developed from the perspective of a multinational corporation. This article argues that, in addition to the standard factors affecting the cost-benefit analysis of an investment project, there are intangibles, such as bureaucracy, degree of openness, stability of the institutions, and urbanization, and that these are just as important in attracting FDI. We use a panel data of 23 developing countries from 1976 through 1997 to analyze factors determining foreign direct investment. We also provide a statistical analysis of the relationship between economic growth and the inflow of FDI. Moreover, China, since its opening up in the late 1970s, has been the greatest recipient of FDI among developing countries (US$346.703 billion received from 1979 to 2000) and has stood as the second largest recipient of FDI in the world, next to the United States. However, FDI distribution in China has also been extremely uneven (see table 1). During the 1985–91 period, 89.49% of actually used FDI was absorbed by nine coastal provinces