The role of external debt in the foreign direct investment–growth relationship

Abstract

AbstractThis paper investigates the relevance of external debt as a factor inhibiting economic growth gains to be accrued from foreign direct investment (FDI). We develop a model that formalizes a mechanism to allow for the influence of external debt in the transmission of FDI‐generated externalities and conduct threshold regressions to test the existence of a debt contingency effect that limits the positive impact of inward FDI on growth. With the use of annual as well as 5‐year averaged data for 39 developing countries over the period 1984–2010, our findings support the hypothesis that FDI‐induced growth is dependent on the external debt constraint. In particular, we show that beyond a certain threshold high indebtedness constrains economies from reaping growth benefits from FDI as they seek to reduce their debt levels. In this scenario, the evidence also shows that increasing financial development can mitigate the negative influence of high external debt on the FDI–growth nexus.