Foreign Direct Investment and Economic Output: The Conditional Roles of Financial Development and Institutional Quality

Foreign direct investment (FDI) is widely promoted as a driver of economic output through mechanisms such as technology transfer, capital accumulation, and productivity spillovers. However, the empirical literature shows highly inconsistent results known as the “FDI-output puzzle.” We argue that these inconsistencies arise because the output-level effects of FDI are non-linear and depend crucially on the host country’s absorptive capacity. By analyzing a global panel of 172 sovereign nations from 2000 to 2022, we demonstrate that FDI’s output impact depends on a country’s financial development and institutional quality. Our baseline fixed effects models yield a positive and significant within-country FDI-output elasticity of 0.019–0.047. Furthermore, interaction models reveal that deeper financial markets and stronger legal institutions amplify FDI’s effect on real GDP levels. Two-stage least squares estimation confirms these relationships are not due to reverse causality. Following I employ a levels specification—regressing the natural logarithm of real GDP on the natural logarithm of FDI—that directly estimates output-level elasticities, capturing the steady-state relationship between FDI and the level of economic output. This dual-specification design is complemented by dynamic panel GMM estimation, which confirms the positive FDI–output relationship in a dynamic setting. Our findings show that attracting FDI alone is insufficient for expanding output; countries must also develop robust financial infrastructure and effective governance to fully benefit from foreign capital.