Causality Tests for Cross‐Country Panels: a New Look at FDI and Economic Growth in Developing Countries
| Published date | 01 May 2001 |
| DOI | http://doi.org/10.1111/1468-0084.00214 |
| Author | Diana Weinhold,Usha Nair‐Reichert |
| Date | 01 May 2001 |
Causality tests for cross-country panels: a
new look at FDI and economic growth in
developing countriesy
Usha Nair-Reichert and Diana Weinhold
Georgia Institute of Technology
London School of Economics
I. Introduction
There is an ongoing debate about the economic impact of multinationals on
host countries, especially developing economies. This debate assumes special
importance in view of recent changes in the composition and direction of
foreign direct investment (FDI), and liberalization of government policies
towards FDI in developing economies. After a decline of about 4 percent
each year during 1980± 1985, the volume and share of FDI to developing
economies has risen signi®cantly. During the later part of the 1980s, FDI in
developing economies increased by 17 percent each year. In 1993, total FDI
to developing countries was $70 billion, and the value of in¯ows of FDI
increased by 125 percent in the ®rst three years of the decade (Lal (1998).
There is, however, con¯icting evidence in the literature regarding the
impact of multinational enterprises (MNEs) and FDI on both transitional and
long-term economic growth. While some studies, both theoretical and empir-
ical, indicate that FDI may have a strong positive effect on growth rates in
developing countries, others suggest that these positive effects may not be
unconditional and point to the lack of technological spillovers and the
possibility of enclave economies developing. Given that the relationship
between FDI and growth may be complex and heterogeneous across coun-
tries, this paper highlights the potential for serious errors in the analysis of
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 63, 2 (2001) 0305-9049
#Blackwell Publishers Ltd, 2001. Published byBlackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UKand 350
Main Street, Malden, MA 02148, USA.
153
yThe authors would like to thank Clive W. J. Granger, Andy Levin, Peter Pedroni, the editor, an
anonymous referee, the participants in Valery Ramey's and Hali Edison's group at the 1998
CCOFFE workshop in Chicago, Ill and the participants at the IEFS session at the 2000 ASSA
meetings at Boston.
the relationship if unrealistic homogeneity assumptions are imposed in the
econometric modeling.
We examine the possibility that the effect of FDI on growth could display
quite heterogeneous behaviour in a panel of 24 developing countries over 25
years, and ®nd that heterogeneity may be a serious issue. Thus we propose
the use of a mixed ®xed and random (MFR) coef®cient approach as an
aternative estimation method that allows for heterogeneity in the causal
relationship between FDI and growth. The key results of this econometric
analysis indicate that there is indeed considerable heterogeneity across
developing countries regarding the impact of FDI and other conditioning
variables on economic growth. The paper also highlights the fact that
allowing for heterogeneity in the MFR model produces substantially different
results from the traditional panel estimators, and suggests that results from
models that assume homogeneity across countries should be treated with
some caution.
The rest of the paper proceeds as follows. Section II reviews selected
literature on the relationship between FDI and growth, and Section III
describes both the traditional and MFR framework for causality testing. We
discuss the data in Sections IV and present the main results in Section V.
Section VI summarizes the key conclusions and policy implications.
II. FDI and Growth: a Discussion of the Empirical Evidence
The theoretical foundation for empirical studies on FDI and growth derives
from either neo-classical models of growth or endogenous growth models.
In neoclassical models of growth, FDI increases the volume of investment
and/or its ef®ciency, and leads to long-term level effects and medium-term,
transitional increases in growth. The new endogenous growth models con-
sider long run growth as a function of technological progress, and provide a
framework in which FDI can permanently increase the rate of growth in the
host economy through technology transfer, diffusion, and spillover effects.
Evidence in the existing empirical literature on the causal relationship
between FDI and economic growth is rather inconclusive. Most of these
studies conduct traditional causality tests, using single time series or panel
data. In the latter case, the relationship between FDI and growth is assumed
to be homogeneous across countries. In this section, we brie¯y review
selected papers that have investigated the causal relationship between FDI
and growth and note several drawbacks of these traditional approaches.
Micro studies at the ®rm level suggest that the impact of FDI on growth
may depend on many factors. Atkins and Harrison's (1999) study using panel
data from Venezuelan plants uncovers considerable heterogeneity at the
micro level. They ®nd that foreign equity participation is positively corre-
154 Bulletin
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