Foreign Direct Investment, Terms of Trade, and Quality Upgrading: What Is So Special about South Asia?

The existing literature has highlighted the positive effect of foreign direct investment (FDI) on export upgrading and associated terms of trade in developing economies. However, the FDI effect has been found to be negative in South Asia. In this paper, we elaborate on the South Asia-specific effect by emphasizing the role of human capital in the positive link between FDI and terms of trade. We argue that education levels in South Asia have lagged behind those in East Asia and other developing regions. This has resulted in a world market integration strategy in South Asia that specializes in less skills-intensive products and generates associated FDI flows. We demonstrate these patterns for two South Asian economies (Bangladesh and Pakistan) and two East Asian economies (Malaysia and Thailand) for which historical breakdowns of FDI data are available.