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

The empirical literature finds mixed evidence on the existence of positive productivity externalities in the host country generated by foreign multinational companies. We propose a novel mechanism, which emphasizes the role of local financial markets in enabling foreign direct investment (FDI) to promote growth through backward linkages, shedding light on this empirical ambiguity. In a small open economy, final goods production combines the production processes of foreign and domestic firms, which compete for skilled labor, unskilled labor, and intermediate products. In order to operate a firm in the intermediate goods sector, entrepreneurs must first develop a new variety of intermediate good. Innovation and imitation both require capital costs, which must be financed through the domestic financial institutions. The more developed the local financial markets are, the easier it is for credit constrained entrepreneurs to start their own firms. Thus the number of varieties of intermediate goods increases, causing positive spillovers to the final goods sector. As a result the host country benefits from the backward linkages between foreign and domestic firms since the local financial markets allow these linkages to turn into FDI spillovers. Our calibration exercise confirms our analytical results. In particular, the results show that the same amount of increase in FDI, regardless of the reason of the increase, generates three times more additional growth in financially well-developed countries than in financially poorly-developed countries. The calibration exercise also shows the importance of the other local conditions such as market structure and human capital–the absorptive capacities–for the effect of FDI on economic growth.