Institutions, Foreign Direct Investment, and Domestic Investment: crowding out or crowding in?

Kristine Farla, Denis de Crombrugghe & Bart Verspagen


Studies of the relationship between FDI and domestic investment levels reach contradictory findings. We revisit this empirical relationship and argue that some of the conflicting evidence may be explained by the use of poor proxies for the true underlying variables and by questionable methodological choices. Using more appropriate proxies and statistical models, we conclude that FDI inflows contribute positively to domestic investment levels. We also find weak evidence that `good governance', proxied with using the Worldwide Governance Indicators (and two rent seeking indicators we built), encourages investment. Theoretical arguments support either positive or negative interaction effects of `good governance' and FDI on investment, invoking either technological spillovers or rent seeking behaviour. We tend to conclude that the negative rent seeking effect is dominant.

Keywords: Investment, FDI, Institutions, Technology spillover, Rent seeking

JEL Classification: E02, F21, F62, O11, O30, O57

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