| Abstract: |
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 mechanism that 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 is carried out by foreign and
domestic firms, which compete for skilled labor, unskilled labor, and
intermediate products. To operate a firm in the intermediate goods sector,
entrepreneurs must develop a new variety of intermediate good, a task that
requires upfront capital investments. The more developed the local financial
markets, the easier it is for credit constrained entrepreneurs to start their
own firms. The increase in the number of varieties of intermediate goods leads
to positive spillovers to the final goods sector. As a result financial
markets allow the backward linkages between foreign and domestic firms to turn
into FDI spillovers. Our calibration exercises indicate that a) holding the
extent of foreign presence constant, financially well-developed economies
experience growth rates that are almost twice those of economies with poor
financial markets, b) increases in the share of FDI or the relative
productivity of the foreign firm leads to higher additional growth in
financially developed economies compared to those observed in financially
under-developed ones, and c) other local conditions such as market structure
and human capital are also important for the effect of FDI on economic growth. |