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Foreign direct investment in a macroeconomic framework : finance, efficiency, incentives, and distortions

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  • Fry, Maxwell J.

Abstract

Does foreign direct investment (FDI) increase domestic investment, or does it provide additional foreign exchange for a pre-existing current account deficit, or some linear combination of the two? The author investigates this question for a group of five Pacific Basin countries and a control group of 11 other developing countries. For the sample of all 16 developing countries, the author finds that FDI does not provide additional balance of payments financing for a pre-existing current account deficit. In the control group of 11 developing countries, FDI is associated with reduced domestic investment - implying that FDI to those countries is simply a close substitute for other capital inflows. For the five Pacific Basin market economies, however, FDI raises domestic investment by the full extent of the FDI inflow. The author finds that FDI has a significantly negative impact on national saving in the sample of all 16 developing countries. For the control group, this negative effect is similar in magnitude to FDI's negative effect on domestic investment - implying a zero effect on the current account. But FDI's negative effect on national saving in the five Pacific Basin developing market economies implies that FDI could have more of a negative effect on the current account than through increased domestic investment alone. The author also investigates the impact of FDI on economic growth in these 16 countries, taking into account distortions in the economies. He estimates reduced-form current account equations, and presents an analytical framework for estimating FDI's effect on economic growth in the presence of incentive-disincentive packages and other economic distortions. He illustrates his framework using indicators of foreign trade and financial distortions. His main conclusion: the effect of FDI differs markedly from one group of countries to another. FDI has a negative effect on economic growth in the control group. It has the same positive effect on growth as domestically financed investment does in the Pacific Basin countries. The main cause for the different effect is the low level of distortion in the Pacific Basin countries.

Suggested Citation

  • Fry, Maxwell J., 1993. "Foreign direct investment in a macroeconomic framework : finance, efficiency, incentives, and distortions," Policy Research Working Paper Series 1141, The World Bank.
  • Handle: RePEc:wbk:wbrwps:1141
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    References listed on IDEAS

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    Cited by:

    1. Gnimassoun, Blaise, 2015. "The importance of the exchange rate regime in limiting current account imbalances in sub-Saharan African countries," Journal of International Money and Finance, Elsevier, vol. 53(C), pages 36-74.
    2. Adams, Samuel, 2008. "Globalization and income inequality: Implications for intellectual property rights," Journal of Policy Modeling, Elsevier, vol. 30(5), pages 725-735.
    3. Khatun, Fahmida & Ahamad, Mazbahul, 2015. "Foreign direct investment in the energy and power sector in Bangladesh: Implications for economic growth," Renewable and Sustainable Energy Reviews, Elsevier, vol. 52(C), pages 1369-1377.
    4. Arslan Razmi, 2005. "The Effects of Export-Oriented, FDI-Friendly Policies on the Balance of Payments in a Developing Economy: A General Equilibrium Investigation," UMASS Amherst Economics Working Papers 2005-03, University of Massachusetts Amherst, Department of Economics, revised Sep 2006.
    5. Chuhan, Punam & Claessens, Stijn & Mamingi, Nlandu, 1998. "Equity and bond flows to Latin America and Asia: the role of global and country factors," Journal of Development Economics, Elsevier, vol. 55(2), pages 439-463, April.

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