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Foreign direct investment (FDI) has been for a while now an acronym associated with improvement in competitiveness and economic growth. To assess the expediency of FDI, it is imperative to answer the following question: what is the dynamic effect of FDI on total investment? In other words, what is the effect of FDI on domestic investment (DI); does it crowd in or out domestic investment? Research addressing this question is relatively recent and its empirical findings are ambiguous. This paper attempts to dodge the pitfalls in the theoretical and especially the empirical literature in assessing the link between FDI and domestic investment. The paper develops a simple theoretical model which is commonly used in the literature to come up with a reduced-form equation. Using data on 16 emerging countries over a 30-year period, the empirical model is estimated as a system of equations where each equation represents a country. Grouping all individual country regression in one system of equations aims to take into account the common contemporaneous errors associated with global shocks affecting FDI flows. This system of equations is estimated using 3SLS to account for both the existence of contemporaneous errors among individual country equations as well as the endogeneity of FDI. Results show that in general the effect of FDI on DI is country specific; however, in most countries, on impact, FDI has a positive and significant effect on DI. In subsequent periods, FDI may crowd out DI. In most countries included in the sample, FDI has a neutral long-term effect on DI. Crowding in or crowding out effect of FDI on DI is only found in few countries. This indicates that the rule is the neutrality of FDI on DI and the exception is otherwise (whether crowding in or out).

Does FDI Crowd in or out Domestic Investment? New Evidence from Emerging Economies