Does Foreign Investment Drive Growth? The Complex Reality of FDI in Developing Nations

By Jaya Prakash Pradhan December 6, 2005 669

Print Article

Type	Book chapter
Title	“Foreign Direct Investment, Externalities and Economic Growth in Developing Countries: Some Empirical Explorations”
Authors	Nagesh Kumar & Jaya Prakash Pradhan
In	E. M. Graham (ed.), Multinationals and Foreign Investment in Economic Development, pp. 42–84 · Palgrave Macmillan, 2005
Coverage	107 developing countries · 1980–1999
Read	Publisher (DOI) · PDF

This is a plain-language summary of “Foreign Direct Investment, Externalities and Economic Growth in Developing Countries: Some Empirical Explorations” (Kumar & Pradhan, in Multinationals and Foreign Investment in Economic Development, 2005).

In short:

Across 107 developing countries (1980–99), the study models FDI’s effect on growth as dynamic: an initial adverse competitive effect, then a usually more favourable effect through backward linkages — with the net outcome depending on FDI quality.
Two findings complicate the optimistic story: causality often runs from growth to FDI (growth attracts investment) rather than the other way, and FDI tends to crowd out domestic investment in net terms — though not everywhere.
The upshot is that FDI is no automatic engine of growth; host-country policy and capabilities decide whether it helps.

The question

Foreign direct investment is the largest source of external finance for many developing countries, and it’s widely assumed to drive their growth. This influential chapter by Nagesh Kumar and Jaya Prakash Pradhan — the most-cited work in this body of research — tests that assumption across 107 developing countries over 1980–1999, and finds a picture far more nuanced than “FDI is good for growth.”

A dynamic effect, not a fixed one

The chapter’s conceptual contribution is to treat FDI’s impact as something that changes over time rather than as a single fixed effect.

In the first phase, the arrival of foreign firms tends to hurt local businesses: well-resourced multinationals take market share and can push domestic competitors out, so the immediate effect is often adverse. In the second phase, more positive effects emerge — local firms learn from foreign ones, backward linkages with domestic suppliers develop, workers gain skills that diffuse through the economy, and export opportunities open up. Crucially, the net result of this dip-then-rise pattern depends on the quality of the FDI — what kind of investment it is, and what linkages it builds with the local economy. This dynamic framing is the chapter’s signature idea.

What the data actually showed

When the authors took this model to the panel data, two results stood out — and both cut against the simple “FDI drives growth” narrative.

First, on causality: although a production-function estimation did suggest a positive association between FDI and growth, formal causality tests found that in a majority of cases the direction was not pronounced, and in a substantial number of cases the causation actually ran from growth to FDI — meaning fast-growing economies attracted foreign investment, rather than foreign investment producing the growth. That reverses the usual assumption. Second, on domestic investment: consistent with the dynamic model (negative early, positive later), the study found that in net terms FDI generally tended to crowd out domestic investment — though some countries experienced a favourable net effect, which the authors read as evidence that host-country policy can change the outcome.

Recommended readingMultinationals and Foreign Investment in Economic DevelopmentView on Amazon →

Regional texture

Beneath the global averages, the chapter discusses variation across regions — with FDI’s growth and crowding-out effects playing out differently in Latin America, Asia, and Africa, reflecting differences in absorptive capacity and the kinds of linkages local economies could form. (These regional characterisations are part of the chapter’s discussion; the precise regional patterns are best read in the paper itself — see the note below.)

Why it matters

The chapter’s enduring influence comes from its refusal to treat FDI as a development shortcut. Its lessons are consistently “capabilities first”: build the absorptive capacity — through education, skills, and supplier development — that lets an economy convert foreign investment into lasting gains; attend to the quality of FDI rather than just its quantity; and design policies that foster linkages between foreign and domestic firms, since those linkages are what turn the second, favourable phase on. The authors close with remarks aimed at the policy debate of the time, including the then-live effort to write investment rules within the WTO — cautioning that the evidence does not support treating liberalised FDI as automatically development-friendly. It’s the cross-country, whole-economy statement of the “absorptive capacity” theme that runs throughout this research: investment rewards those equipped to use it.

About this chapter

This chapter analyses the relationships between FDI, growth, and domestic investment for 107 developing countries over 1980–99. It posits a dynamic effect of FDI on host-country growth — an initial, generally adverse competitive effect followed by a subsequent, usually more favourable effect through backward linkages — with the net effect depending on the quality of FDI. Panel-data estimations in a production-function framework suggest a positive effect of FDI on growth; however, causality tests find that in a majority of cases the direction of causation is not pronounced, and in a substantial number of cases it runs from growth to FDI. Further estimations support the proposition that FDI affects domestic investment dynamically — a negative initial effect followed by subsequent positive effects — for the panel and for most individual countries. Although FDI appears to crowd out domestic investment in net terms in general, some countries have experienced a favourable net effect, suggesting a role for host-country policies. The chapter concludes with policy remarks, including lessons for the then-ongoing attempt to write investment rules within the WTO framework. It appears in E. M. Graham (ed.), Multinationals and Foreign Investment in Economic Development (Palgrave Macmillan, 2005).

Cite this chapter

Kumar, N., & Pradhan, J. P. (2005). Foreign direct investment, externalities and economic growth in developing countries: Some empirical explorations. In E. M. Graham (Ed.), Multinationals and Foreign Investment in Economic Development (pp. 42–84). New York: Palgrave Macmillan. https://doi.org/10.1057/9780230522954_3

Publisher (DOI) → · Read the PDF →