Growth literature

The significant increase in FDI flows across countries is a clear indication of globalization of the world economies over the past 2 decades. Neoclassical model of growth as well as endogenous growth models provides the basis for most of the empirical work on the FDI-GROWH relationship. According to the neoclassical growth theory, economic growth generally comes from two sources: factors accumulation and total factor productivity growth (Felipe, 1997). Growth is easier to quantity and analyse while difficulties abound in the measurement of the Total Factor Production growth due to the lack of appropriate economic modeling techniques as well as lack of appropriate data. Neoclassical growth projected that based on aggregate production function that relates the total output of an economy to the aggregate amount of the labour, human capital, physical capital and level of technology, poor countries will grow faster than rich countries. Neoclassical growth theory implies that return on capital stock should be higher in poor countries than in rich countries. This implies that the impact of FDI is limited to its output growth effect in the short run, with no change in the long run growth rate.

On the other hand, the Endogenous growth literature state that FDI can not only contribute to the economic growth through capital formation and technology transfers (Blomstrom et al.1996) but also do so through the augmentation of the level of knowledge through labour training and skill acquisition ( De Mello, 1999). Endogenous growth models emphasize on other channels including human capital accumulation and externalities or spillover effect through which FDI can promote growth in the long run. (Romer 1986, Loungani and Razin,2001). The three channels identify through which FDI affects growth; First, FDI increases capital accumulation in the host country by introducing new inputs and technologies (Dunning, 1993; Blomstrom et al. 1996). Second, FDI may stimulate knowledge transfers, both in terms of labour training and skill acquisition and by introducing alternative management practices and better organizational arrangements (De Mello, 1997).Third, FDI increases competition in the host country by overcoming entry barriers and reducing the market power of existing firms.

Channels of Growth

When a country’s foreign investment increase international production also increase rapidly, and thus investment only contribute towards the expansion of national markets but also larger scale regional and global markets( UNCTAD,1990). It is obvious that FDI will convey many benefits to the host country; one of them is economic growth. Hermes and Lensink(2000) has summarized different channels through which positive externalities related with FDI can arise namely: i)competition channel where increased competition is likely to result in increased productivity, investment in human and physical capital and efficiency. Increased competition may lead to changes in the industrial structure towards more competitiveness and more export oriented activities. ii) Training channel through increased training of labour and administration. FDI can also increase the quality of domestic human capital and improve the knowhow and managerial skills of local firms. (learning by watching effect) iii) Linkages channel whereby foreign investment is often