Essays on foreign direct investment

Abstract

This dissertation comprises three different studies that investigate the impact of Foreign Direct Investment (FDI) on separate macroeconomic issues. The first paper examines the effect of FDI on Total Factor Productivity growth. Although the role of FDI in facilitating technology transfer is well-known in the literature, empirical evidence regarding the effect of FDI on growth is mixed. Contradictory results in the literature may be due to the failure of accounting for endogeneity and the absorptive capacity of the hosting countries. Using panel data for 49 countries over the 1974-2008 time period, and the existence of investment promotion agencies in the receiving countries as an instrument, the results show that FDI leads to higher productivity growth. The results also indicate a significant positive effect on the interaction between FDI and distance to the technological frontier, suggesting that the ability of technologically backward countries in absorbing technologies developed at the frontiers increases as more FDI stock accumulates. The second paper deals with capital flows and export diversification. Casual inspection of available evidence suggests that the magnitude of FDI is correlated with the extent of export diversification. Yet, little is known about the nature of this link. To bridge this gap in the literature, I propose an inframarginal 2*2*2 Heckscher-Ohlin model of trade that allows capital mobility and technological differences across countries. The model shows that trade costs determine the equilibrium trade structures. When trade costs are too high, autarky emerges as general equilibrium. However, an initial reduction in trade costs triggers trade in commodities based on comparative advantage. Further decline in transaction costs leads to the movement of capital (inward FDI) to the capital scarce country, enabling it to export a greater variety of goods under certain conditions. Finally, the third paper empirically studies the causal effect of FDI on export diversification. The existing literature, which is still at infancy, has not dealt with the problems of endogeneity and aggregation bias in estimating the effects of FDI on export diversification. In this paper, I provide more robust evidence with 2SLS regression using a novel instrument for FDI as well as a highly disaggregated measure of export diversification with U.S. imports data (at the 10-digit level of Harmonized System classification). Overall results confirm the export diversifying effect of FDI. However, further tests reveal that FDI only acts as a catalyst of export diversification in developing countries, while advanced countries do not show an increase in the variety of exports due to multinationals.