With the drying-up of commercial bank lending to developing economies in the 1980s, most countries eased restrictions on foreign direct investment (FDI) and many aggressively offered tax incentives and subsidies to attract foreign capital (Aitken and Harrison, 1999; World Bank, 1997a,b). Along with these policy changes, there was a surge of non-commercial bank private capital flows to developing economies in the 1990s.
Private capital flows to emerging market economies exceeded $320 billion in 1996 and reached almost $200 billion in 2000. Even the 2000 figure is almost four times larger than the peak commercial bank lending years of the 1970s and early 1980s. Furthermore, FDI now accounts for over 60 percent of private capital flows. While the explosion of FDI flows is unmistakable, the growth effects remain unclear.
Theory provides conflicting predictions concerning the growth effects of FDI. The economic rationale for offering special incentives to attract FDI frequently derives from the belief that foreign investment produces externalities in the form of technology transfers and spillovers. Romer (1993), for example, argues that there are important "idea gaps" between rich and poor countries. He notes that foreign investment can ease the transfer of technological and business know-how to poorer countries. These transfers may have substantial spillover effects for the entire economy.
Thus, foreign investment may boost the productivity of all firms not just those receiving foreign capital (Rappaport, 2000). In contrast, some theories predict that FDI in the presence of pre-existing trade, price, financial, and other distortions will hurt resource allocation and slow growth (Brecher and Diaz-Alejandro, 1977; Brecher, 1983; Boyd and Smith, 1999). Thus, theory produces ambiguous predictions about the growth effects of FDI and some models suggest that FDI will only promote growth under certain policy conditions.
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Does Foreign Direct Investment Accelerate Economic Growth?
