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Do multinational companies generate positive externalities for the host country? The evidence so far is mixed varying from beneficial to detrimental effects of foreign direct investment (FDI) on growth, with many studies that find no effect. In order to provide an explanation for this empirical ambiguity, we formalize a mechanism that emphasizes the role of local financial markets in enabling FDI to promote growth through backward linkages. Using realistic parameter values, we quantify the response of growth to FDI and show that an increase in the share of FDI leads to higher additional growth in financially developed economies relative to financially under-developed ones.

Within policy circles, there is a widespread belief that foreign direct investment (FDI) enhances the productivity of host countries and promotes economic development. This notion stems from the fact that FDI may not only provide direct capital financing but also create positive externalities via the adoption of foreign technology and know-how. Yet, the empirical evidence on the existence of such positive productivity externalities is sobering.1 The macro empirical literature finds weak support for an exogenous positive effect of FDI on economic growth. Findings in this literature indicate that a country's capacity to take advantage of FDI externalities might be limited by local conditions, such as the development of local financial markets or the educational level of the country, i.e., absorptive capacities. Borensztein, De Gregorio, and Lee (1998) show that the technology FDI brings translates into higher growth only when the host country has a minimum threshold of stock of human capital. Alfaro, Chanda, Kalemli-Ozcan and Sayek (2004) provide evidence that only countries with well-developed financial markets gain significantly from FDI in terms of their growth rates. In terms of the micro empirical evidence, most of the studies using firm level panel data find no effect of foreign presence or they find negative productivity spillover effects from multinational enterprises (MNEs) to the developing country firms.2 Positive spillover effects are found only for developed countries.3 Based on these negative results, a new generation of studies argues that since multinationals would like to prevent information leakage to potential local competitors, but would benefit from knowledge spillovers to their local suppliers, FDI spillovers ought to be between different industries. Hence, one must look for vertical (inter-industry) externalities instead of horizontal (intra-industry) externalities. This means the externalities from FDI will manifest themselves through forward or backward linkages, i.e., contacts between domestic suppliers of intermediate inputs and their multinational clients in downstream sectors (backward linkage) or between foreign suppliers of intermediate inputs and their domestic clients in upstream sectors (forward linkage).4Javorcik, 2004 and Alfaro and Rodriguez-Clare, 2004, for example, find evidence for the existence of backward linkages between the downstream suppliers and MNEs in Lithuania; and Venezuela, Chile, and Brazil, respectively. Paralleling the macro evidence, Villegas-Sanchez (2009), using firm level data from Mexico, shows that domestic firms only enjoy productivity increases from FDI if they are located in financially developed regions. She further shows that domestic firms located in regions where access the credit is more problematic will experience a negative spillover effect from FDI. The purpose of this study is twofold. First, in a theoretical framework, we formalize one mechanism through which FDI may lead to a higher growth rate in the host country via backward linkages, which is consistent with the micro evidence found by the recent-generation studies described above. The mechanism depends on the extent of the development of the local financial sector. This channel is also consistent with the macro literature cited above that shows the importance of absorptive capacities.5 We are not aware of any other study that is consistent with both micro and macro empirical evidence. In the second half of the paper, using realistic parameter values, we use the model to quantitatively gauge how the response of growth to FDI varies with the level of development of the financial markets. To the best of our knowledge, the paper is unique in this respect. Our model is a small open economy characterized by two layers of industries. The downstream industry involves the production of a final consumption good by combining two intermediary goods/production processes, which are distinguished by their ownership — domestic or foreign (multinationals). These production processes, which are competitive, in turn, combine skilled labor, unskilled labor, and a range of differentiated inputs to produce their output. The latter differentiated inputs which form the second upstream industry layer are characterized by monopolistic competition. As with product variety endogenous growth models, the rate of expansion in the range of intermediates is the driver of economic growth.6 To operate a firm in the intermediate input sector, entrepreneurs must develop a new variety of intermediate input, 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 inputs leads to positive spillovers to the intermediary processes that constitute the final good sector. As a result, financial market development allows backward linkages between foreign and domestic firms to turn into FDI spillovers.7 Our model also implies the existence of horizontal spillovers in the final goods sector since the greater availability of intermediate inputs not only benefits the foreign firms but also raises the total factor productivity of the domestic firms in the final goods sector, thus creating a horizontal spillover as an indirect result of the backward linkage (e.g. Merlevede and Schoors, 2007). In our model, however, increases in foreign presence (proxied either by higher share of foreign firms in the economy or higher firm specific productivity of the existing ones), will also lead to a reallocation of resources away from domestic firms to the foreign firms. Therefore, the instantaneous effect will be a decline in domestic firms' share in final output. Assuming that foreign owned firms have higher firm specific productivity, the long run growth rate will be higher.8 In the long run, both domestic and foreign firms will benefit from the higher growth rate. However, in the short-run, the horizontal spillovers in the final goods sector, which indirectly result from the backward linkages between the foreign firm and the intermediate goods sector, exist only for the surviving domestic firms. Thus our setup can shed light on why empirical studies fail to find evidence of positive horizontal spillovers for developing countries and even find negative spillovers in some cases. Instead of these changes in the relevant market size for foreign and domestic firms, there can also be a crowding out effect, where foreign firms aggravate the existing credit constraints and cause domestic firms to exit. Indeed, Harrison and McMillian (2003) find that in the Ivory Coast for the period 1974–1987, borrowing by foreign firms aggravated domestic firms' credit constraints. However, Harrison et al. (2004) found that foreign investors tended to “crowd in” domestic enterprises. Harrison and Rodriguez-Clare (forthcoming) argue that these contrasting results point to the policy complementarities such as complementarities with financial markets. We then use the model to provide benchmark estimates on the effects of FDI on growth. We find 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 economies, and finally, c) growth effects are larger when goods produced by domestic firms and MNEs are substitutes rather than complements. The exercise highlights the importance of local conditions such as market structure and human capital, the so-called absorptive capacities, for generating the positive effect of FDI on growth. By varying the relative skill endowments–while assuming that MNEs use skilled labor more intensively–we obtain results consistent with Borensztein, De Gregorio, and Lee (1998) who highlight the critical role of human capital. The recent evidence from the work of Javorcik and Spatareanu (2005), among others, supports both our assumptions and findings. Their survey evidence reveals that one of the reasons multinationals in the Czech Republic, for example, do not source higher percentage of inputs domestically is the fact that local firms lack funding for investment necessary to become suppliers.9Javorcik and Spatareanu (2007) take one step forward and examine, using data from the Czech Republic, the relation between a firm's liquidity constraints and its supply linkages with multinational corporations. The empirical analysis indicates that Czech firms supplying MNEs are less credit constrained than non-suppliers. A closer inspection of the timing of the effect, however, suggest that this result is due to less constrained firms self-selecting into becoming MNE suppliers rather that benefits derived from the supplying relationship. Their findings suggest that well developed financial markets may be needed in order to take full advantage of the benefits associated with FDI inflows. Indeed, their results indicate that in the absence of well functioning credit markets, local firms may find it difficult to start business relationships with MNEs and thus may not be able to reap the benefits of productivity spillovers that such relationships bring.10 The importance of well-functioning financial institutions in augmenting technological innovation and capital accumulation, fostering entrepreneurial activity and hence economic development has been recognized and extensively discussed in the literature.11 Furthermore, as McKinnon (1973) stated, the development of capital markets is “necessary and sufficient” to foster the “adoption of best-practice technologies and learning by doing.” In other words, limited access to credit markets restricts entrepreneurial development. In this paper, we extend this view and argue that the lack of development of the local financial markets can limit the economy's ability to take advantage of potential FDI spillovers in a theoretical framework, a premise which is already supported by the empirical evidence. Before moving to the model, it is worth comparing our model to the ones in FDI and the growth literatures. To the best of our knowledge, neither literature looked at the role played by financial markets for the effects of FDI on growth. Theoretical models of FDI spillovers via backward linkages include Rodríguez-Clare, 1996 and Markusen and Venables, 1999. These are static models and do not focus on dynamic effects of FDI spillovers. Our paper focuses on the growth aspects of these linkages between the foreign and local buyers of intermediate inputs, where these linkages interact with financial markets in a certain way. This is the main contribution of the paper. Our model closely follows Grossman and Helpman, 1990 and Grossman and Helpman, 1991 small open economy setup of endogenous technological progress resulting from product innovation via increasing intermediate product diversity. We modify their basic framework to incorporate foreign owned firms and financial intermediation. The standard Grossman–Helpman setting is preferred since it provides the most transparent solution. Further, models of FDI such as the ones mentioned above also use the intermediate product variety structure in a static setting, thus making it a natural choice when moving to a dynamic framework.12 Our results on the importance of the financial markets also contribute to an emerging literature that emphasizes the importance of local policies and institutions for the benefits of FDI to be realized.13 The rest of the paper is organized as follows. Section 2 presents the model. Section 3 performs a calibration exercise using values for the parameters from the empirical literature. Section 4 concludes.

Although there is a widespread belief among policymakers that FDI generates positive productivity externalities for host countries, the empirical evidence fails to confirm this belief. In the particular case of developing countries, both the micro and macro empirical literatures consistently find either no effect of FDI on the productivity of the host country firms and/or aggregate growth or negative effects. In this paper, we try to bridge this gap between the theoretical and the empirical literatures. The model rests on a mechanism that emphasizes the role of local financial markets in enabling FDI to promote growth through the creation of backward linkages. When financial markets are developed enough, the host country benefits from the backward linkages between the foreign and domestic firms with positive spillovers to the rest of the economy. Our calibration exercises show that an increase in FDI leads to higher growth rates in financially developed countries compared to those observed in financially poorly developed ones. Moreover, the calibration section highlights the importance of local conditions (absorptive capacities) for the effect of FDI on economic growth. We find larger growth effects when goods produced by domestic firms and MNEs are substitutes rather than complements. Policymakers should be cautious when implementing policies aimed at attracting FDI that is complementary to local production. Desired complementarities are those between final and intermediate industry sectors; not necessarily between domestic and foreign final good produces. Finally, by varying the relative skill ratios–while assuming that MNEs use skilled labor more intensively–our results highlight the critical role of human capital in allowing growth benefits from FDI to materialize. Some caveats are in order. We have focused on only one kind of spillover. There are likely to be additional spillovers and technology transfers. Besides, our results are based on a model that takes FDI as given. The decision of a firm to outsource or invest abroad (and the potential to generate linkages) may depend on the conditions of the country and on the characteristics of the firm. Furthermore, the possibility of imported intermediate inputs would hinder the extent of backward linkages. Future research should allow for tradability of intermediate inputs, and for differential use of alternative sources of intermediate inputs across domestic and foreign firms.