Foreign Direct Investment, Economic Growth, and Financial Sector Development: A Comparative Analysis

Abstract

1. Introduction The issue of economic prosperity is often linked to massive inflows of foreign direct investment (hereafter referred to as FDI) into a nation, and the impact of FDI on economic growth has been argued considerably in the development and economic growth literature for many years. Many researchers have conducted studies to investigate the fundamental theories of FDI, various macroeconomic variables that influence FDI, the impact of economic integration on the movements of FDI, and the advantages and disadvantages of FDI (see Yusop 1992; Jackson and Markowski 1995; Cheng and Yum 2000; Lira and Maisom 2000). Most of them agree that there exists a positive causal relationship between FDI and economic performance, either in the short run, or in the long run, or both. Zhang (2001) has studied the causal relationship between FDI and economic performance in both East Asian and Latin American countries. Zhang's findings suggest that there is considerable cross-country variation and differences between East Asia and Latin America in the causal patterns of FDI-growth links. He further concluded that a key advantage created by FDI to recipient countries is technology transfer and spillover efficiency. This advantage, however, does not automatically occur, but rather depends on recipient countries' absorptive capabilities, such as a liberal trade policy, human capital development, and an export-oriented FDI policy. Investigations of the causal relationship between economic growth and FDI inflows have, therefore, a significant role in economic development. If there is a unidirectional causality from economic growth to FDI, this implies that national income growth can be treated as a catalyst in attracting inflows of FDI. Conversely, if the unidirectional causality runs from FDI to economic performance, this would strongly suggest that FDI not only stimulates the economic growth rate, but also leads to fixed capital formation and employment augmentation (Borensztein, De Gregorio, and Lee 1998; Lim and Maisom 2000; Zhang 2001). If a bi-directional causality exists between these variables, then both FDI and economic growth would have a reinforcing causal relationship. Nevertheless, these previous studies ignored the role played by domestic financial sector development in examining the long-run relationship, and short-run causality, between FDI and economic growth. Indeed, the speed of technological innovation and patterns of economic growth of a country are highly dependent on the evolution of the domestic financial sector, which acts as a mechanism to channel financial resources between surplus and deficit units, as well as transferring technology embodied in FDI inflows. Financial systems that are more effective at pooling the savings of individuals can profoundly affect economic development. Besides the direct effect of better savings on capital accumulation, better savings mobilization can improve resource allocation and boost technological innovation (Levine 1997). Although existing theories have not yet formally identified a direct link between financial development, economic growth, and foreign direct investment, Hermes and Lensink (1999) and Bailliu (2000) attempted to study the significance of both foreign capital inflows and financial development as a channel for promoting growth. Different from previous studies, both studies investigated the relationship between international capital inflows and economic growth through financial sector evolution, rather than simply focusing on the promotion of the domestic investment rate and spillover efficiency. They concluded that inflows have both a positive spillover efficiency and a significant impact on economic growth, if the domestic financial sector has achieved a certain minimum level of development. This article aims to re-estimate the links between FDI and economic growth by including the development of the domestic financial sector in three developed countries (Japan, the United Kingdom, and the United States) and select East Asian countries (Indonesia, Korea, Malaysia, the Philippines, Singapore, and Thailand). …