How Important is Foreign Direct Investment in the Economic Growth of Developing Countries?

Foreign direct investment is crucial in driving economic growth in developing countries. FDI provides an important source of external capital to supplement limited domestic savings and investment in these nations (Ayenew, 2022). From 2005 to 2018, the developing countries in Emako et al.'s (2022) sample had average FDI inflows of $842.8 million in the primary sector, $1,469 million in the secondary sector, and $2,560 million in the tertiary sector. Ayenew (2022) notes that FDI accounted for 39% of total incoming capital in developing economies in 2018. Foreign direct investment (FDI) significantly boosts economic growth in developing countries through investments in the manufacturing sector. However, its impact depends on the host country's domestic conditions, such as financial development, infrastructure, and human capital.

Manufacturing FDI has the Greatest Growth Impact

The effect of FDI on economic growth depends on which sectors receive the investment. Emako et al.'s (2022) two-step system GMM analysis of 19 developing countries from 2005-2018 found that a 1% increase in secondary (manufacturing) sector FDI boosted GDP growth by 0.022% (p<0.05). In contrast, a 1% increase in tertiary sector FDI reduced growth by 0.068% (p<0.05), while primary sector FDI had a negative but insignificant effect. This suggests that developing countries should prioritize attracting FDI to manufacturing. Emako et al. (2022) argue that manufacturing FDI is especially beneficial due to "modern technology, significant forward and backward linkage with local enterprises, consumption of a big number of labor, and tradebele [sic] goods natures of its product" (p. 7). Manufacturing FDI enables technology transfer, creates jobs, and boosts exports. It has strong linkages with domestic firms, allowing knowledge spillovers. In comparison, primary sector FDI is often in isolated enclaves with limited linkages, while tertiary FDI may crowd out domestic firms. Therefore, channeling FDI into manufacturing appears to be the most effective strategy for accelerating economic growth in developing countries.

FDI Spurs Growth Through Multiple Channels

FDI enhances economic growth through multiple channels beyond just contributing financial capital. Ayenew (2022) explains that FDI enables "technology transfer, human capital development, job creation, increased competitiveness, and it improves export" (p. 1). The transfer of advanced technology and knowledge from foreign firms allows domestic companies to upgrade their production capabilities. FDI also develops human capital in the host country by providing training and skill development opportunities for the local workforce. Additionally, the entry of foreign firms stimulates competition in the domestic market, pushing local firms to become more efficient and innovative. Emako et al. (2022) assert that manufacturing FDI is particularly advantageous because it introduces modern technology, creates extensive connections with local businesses, employs a large workforce, and produces tradable goods. FDIs in the manufacturing sector create strong linkages with local suppliers and buyers, often generating positive spillover effects throughout the economy and creating jobs for low-skilled workers.

Domestic Conditions Shape FDI's Growth Impact

The domestic conditions in the host country are often the most significant determinant of the extent to which FDI inflows grow the economy. Ayenew (2022), for instance, posits that the host country's "infrastructure, financial development, and human capital development are critical" for realizing the full benefits of FDI inflows (p. 2). This finding has been empirically corroborated by Emako et al.'s (2022) regression analysis—they found that "a 1 point increase in the financial development index correlates with a 0.314% increase in economic Growth" (p. 396). From this relationship, it can be concluded that countries with more developed financial systems are better able to absorb and allocate FDI inflows productively. In addition to financial development, Emako et al. (2022) identified the availability of arable land and trade openness as important determinants of the impact of FDI inflows on economic growth. Countries that have adopted an open trade policy utilize the export-boosting effects of FDIs better than their less open counterparts. On the other hand, the availability of arable land provides resources that would productively absorb FDI inflows.

Conclusion

Emako et al. (2022) and Ayenew (2022) provide empirical evidence demonstrating that FDI, especially in the manufacturing sector, can significantly accelerate economic growth in developing countries. However, the domestic conditions of the host countries determine the extent to which these foreign investments grow the economy. These local conditions include domestic financial development, infrastructure, and human capital. Therefore, policymakers in developing nations should focus on attracting manufacturing FDI while simultaneously investing in these key enabling factors. Pursuing both FDI and domestic reforms can help maximize and sustain rapid economic growth.