Foreign Direct Investment and Export Diversification in Low Income Nations

Abstract

This paper seeks to understand whether increased foreign direct investment (FDI) can help low income nations to diversify their export bases. Numerous governments in low income nations have sought to attract FDI with an aim of diversifying their export bases while many large multilateral development organisations have also advocated such policies. Using Melitz’s (2003) trade model, I identify a number of potential drivers of export diversification including firm productivity, the cost of trade, the fixed costs of export market entry and consumer preferences and incomes. In the literature on FDI, a number of theoretical and empirical studies link FDI to these drivers of export diversification. These linkages are primarily based on FDI leading to improved productivity in the host nation, together with a number of spillover benefits which help local firms to become export competitive leading to an increase in export diversification. I construct a rich panel dataset of 29 low income nations from 1990 to 2006 and employ an instrumented variables estimation technique using differenced data to test the link between FDI and export diversification. The results suggest a positive association between increases in FDI and increases in export diversification and provide support for the spillover argument. The results also find that this effect is reversed for nations which export a high proportion of oil and mineral resources. Furthermore, the value in signing free trade agreements with import partner nations is reinforced as these are found to be associated with improved export diversification.