The effect of foreign direct investment on capital accumulation in developing countries

Abstract

The purpose of this study is to examine whether foreign direct investments are a blessing or a curse for capital accumulation in developing countries. Data were collected for 16 developing countries over the period 2005–2018. An Arellano-Bover/Blundell-Bond dynamic panel estimation method was adopted to analyze the physical capital accumulation effect of foreign direct investments. Our analysis indicates that for every percentage increase in foreign direct investment inflows to developing countries, physical capital increases by 2.31 percent. In addition, a random-effect panel estimation was implemented to analyze the effect of foreign direct investments on human capital. For a one-percent increase in foreign direct investments, human capital increases by 2.38 percent. The results of our regressions show that not only the volume but also the type of foreign direct investment matters for capital formation in developing countries. Specifically, foreign direct investments in the secondary sector have a statistically significant positive effect on both physical and human capital. By contrast, foreign direct investments in the primary and tertiary sectors have a negligible effect. Our analysis suggests that developing countries would benefit from investing more resources in education and opening up their economies to attract foreign direct investments, particularly in the manufacturing sector.