FDI and Growth: Does Democracy Matter?

This study investigates the role of democracy in moderating the growth effect of FDI, the interaction specification is used. Methodologically, this study adopts a dynamic GMM panel estimator which allows us to control problems associated with the country-specific effects, endogeneity and the inclusion of lagged dependent variables. The results illustrate that there is no direct impact of FDI on output growth. However, the findings show that the growth effect of FDI depends on the level of democracy in the host country. This suggests that the marginal impact of FDI on growth is increasing in the level of democracy. This finding is consistent with the growing view that countries with a better absorptive capacity are more likely to benefit from FDI inflows. We consider this is an important result as it suggests that democracy is an important element of a nation's absorptive capacity. Therefore, policymakers should weigh the cost of policies directed towards promoting FDI inflows versus those that seek to improve the level of democracy.