FOREIGN DIRECT INVESTMENT AND ITS EFFECT ON STRUCTURAL TRANSFORMATION IN DEVELOPING COUNTRIES

Abstract

The motivation for this study comes from evidence that the literature, particularly in developing countries, has paid less attention to the effect of foreign direct investment on structural transformation. Therefore, the main objective of this study was to estimate the effect of foreign direct investment on the structural transformation of developing countries. A panel data collected from 44 developing countries between 1990 and 2018 was analyzed using the one-step differenced Generalized Method of Moments. The study reveals that foreign direct investment has a significant positive effect on structural transformation. Following Principal Component Analysis, the study also examined the channels through which foreign direct investment affects structural transformation. Structure change accounts for 55.95 percent of structural transformation, followed by capital accumulation (37.92 percent) and economic growth (6.13 percent). After deciding on channels, the study further tried to examine four specific objectives. First, the effect of foreign direct investment on structural change was examined based on fixed effects panel. Foreign direct investment appears to drive structural change. Secondly, using a two-step system Generalized Method of Moments, the effect of sector-specific foreign direct investment on economic growth was investigated. The result shows that the industry sector foreign direct investment has a significant positive effect on economic growth while the service sector has a significant adverse effect on it. Thirdly, the study estimated the effect of foreign direct investment on labor productivity following Driscoll-Kraay estimation approach. It is found that foreign direct investment improves labor productivity significantly. Lastly, the study examined the factors that determine foreign direct investment inflows into developing countries using Driscoll-Kraay estimation technique. The estimation result identified institutional quality as the most important factor, followed by economic and social factors. Based on the study findings, developing countries’ governments are advised to take special steps to promote absorption capacity (like human capital), stabilize their political environments, upgrade their legal systems, and establish a minimum wage to promote foreign direct investment.