The empirical literature finds mixed evidence on the
existence of positive productivity externalities in the host country
generated by foreign multinational companies. We propose a novel
mechanism, which emphasizes the role of local financial markets in
enabling foreign direct investment (FDI) to promote growth through
backward linkages, shedding light on this empirical ambiguity. In a
small open economy, final goods production combines the production
processes of foreign and domestic firms, which compete for skilled
labor, unskilled labor, and intermediate products. In order to
operate a firm in the intermediate goods sector, entrepreneurs must
first engage in R\&D to develop a new variety of intermediate good.
Innovation requires capital costs, which must be financed through
the domestic financial institutions. The more developed the local
financial markets are, the easier it is for credit constrained
entrepreneurs to start their own firms. Thus the number of varieties
of intermediate goods increases, causing positive spillovers to the
final goods sector. As a result the host country benefits from the
backward linkages between foreign and domestic firms since the local
financial markets allow these linkages to turn into FDI spillovers.
Our calibration exercise confirms our analytical results. For the
same proportion of foreign owned firms, countries with well
developed financial markets grow twice as fast compared to those
with poorly developed markets. Further the effect of an increase in
FDI on growth is higher for the countries with well developed
markets. The calibration exercise also shows the importance of the other local conditions such as market structure and human capital---the absorptive capacities---for the effect of FDI on economic growth.
How Does Foreign Direct Investment Promote Economic Growth?
Exploring the Effects of Financial Markets on Linkages