Working Paper: NBER ID: w12522
Authors: Laura Alfaro; Areendam Chanda; Sebnem Kalemli-Ozcan; Selin Sayek
Abstract: 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 mechanism that 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 is carried out by foreign and domestic firms, which compete for skilled labor, unskilled labor, and intermediate products. To operate a firm in the intermediate goods sector, entrepreneurs must develop a new variety of intermediate good, a task that requires upfront capital investments. The more developed the local financial markets, the easier it is for credit constrained entrepreneurs to start their own firms. The increase in the number of varieties of intermediate goods leads to positive spillovers to the final goods sector. As a result financial markets allow the backward linkages between foreign and domestic firms to turn into FDI spillovers. Our calibration exercises indicate that a) holding the extent of foreign presence constant, financially well-developed economies experience growth rates that are almost twice those of economies with poor financial markets, b) increases in the share of FDI or the relative productivity of the foreign firm leads to higher additional growth in financially developed economies compared to those observed in financially under-developed ones, and c) other local conditions such as market structure and human capital are also important to generate a positive effect of FDI on economic growth.
Keywords: Foreign Direct Investment; Economic Growth; Financial Markets; Backwards Linkages; Productivity Spillovers
JEL Codes: F23; F36; F43; O40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| FDI (F23) | economic growth (O49) |
| financial market development (O16) | FDI (F23) |
| financial market development (O16) | economic growth (O49) |
| financial market development (O16) | increased varieties of intermediate goods (F12) |
| increased varieties of intermediate goods (F12) | economic growth (O49) |
| FDI (F23) | increased varieties of intermediate goods (F12) |
| financially developed economies (G00) | economic growth (O49) |
| increased share of FDI (F23) | economic growth (O49) |
| relative productivity of foreign firms (F23) | economic growth (O49) |