Three essays on foreign direct investment in developing countries

This dissertation explores the relationship between institutions and economic growth on the one hand and foreign direct investment (FDI) on the other. FDI is widely considered to be important for economic growth in developing countries and the quality of institutions is often believed to play a key role in attracting FDI. However, the true direction of causality between FDI and institutions and between FDI and growth has not been established. Focusing on this issue, the first essay analyzes the dynamics of the relationship between FDI and institutions. Our empirical results show that quality of institutions and FDI have a bi-directional cointegrating relationship in the long run while there is no evidence of short-run causality. The second chapter studies the relationship between FDI and growth. It is motivated by the lack of consensus on the strength and direction of this relationship in the existing empirical studies. After resolving econometric issues with various model specifications and techniques, we provide empirical evidence supporting the view that contemporaneous FDI is positively related to growth. However, there is no evidence that lagged FDI flows cause growth, questioning the true causality. This result suggests that the positive relationship between FDI and growth may reflect the dependence of FDI on the expected future growth of the host country market. The third chapter analyzes the effect of such expected future demand on the investment decisions of multinational enterprises. In particular, we examine the issue of the timing of switching between exporting and FDI in the host developing country. The model demonstrates that the optimal time for switching to FDI depends on the expected future demand and the degree of its uncertainty.