The Role of Financial Development in the Relationship Between Foreign Direct Investment and Economic Growth: A Nonlinear Approach

Abstract

Financial development is recognized as an absorptive capacity in the relationship between foreign direct investment (FDI) and economic growth. Therefore, FDI effect on economic growth is contingent with the level of financial development. However, existing studies also show that financial development dampens economic growth through the “too much finance harms economic growth” hypothesis. Hence, there is a question of how far financial development should be developed to optimize the benefits of FDI on economic growth. The novelty of this study is that it reexamines the role of financial development in FDI-growth relationship by including the interaction term between FDI and the nonlinearity of financial development on economic growth in the period following the 2007–2008 Global Financial Crisis. Interestingly, our results demonstrate that the nonlinear relationship of financial development on economic growth is a U-shaped curve by using data from the 2009–2013 period, for 65 developing countries, which contrast the findings from previous studies. The absorptive capacity effects work nonlinearly, in that FDI accelerates growth after reaching a certain level of financial development, and that the positive effect originates from a minimum level. The study thus suggests that the level of financial development needs to be increased since it serves as a form of absorptive capacity enabling the positive growth effects of FDI in the recipient countries.