How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages

EXECUTIVE SUMMARY — Does FDI help developing countries as much as we think? While theoretical models imply that FDI is beneficial for a host country's development—a belief widely shared among policymakers—the empirical evidence does not support this view. This paper bridges the gap between theoretical and empirical literature with a model and calibration exercises that examine the role of local financial markets. Ultimately, Alfaro and colleagues contribute to existing research that emphasizes how local policies and institutions may actually limit the potential benefits that FDI could provide to a host country. Key concepts include:

• Research shows that an increase in FDI leads to higher growth rates in financially developed countries compared to rates observed in financially poor countries.
• Local conditions, such as the development of financial markets and the educational level of a country, affect the impact of FDI on economic growth.
• Policymakers should exercise caution when trying to attract FDI that is complementary to local production. The best connections are between final and intermediate industry sectors, not necessarily between domestic and foreign final goods producers.
• Human capital plays a critical role in achieving growth benefits from FDI.