## _wp10132

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### I. Introduction — scope and research questions
- Research focus:
  - How do external factors, particularly economic developments in advanced countries, affect FDI flows to low-income countries?
  - How have FDI flows contributed to economic growth in low-income countries in the pre-crisis period, and what role do country-specific features and initial conditions play in explaining cross-country variations in the growth benefits of FDI?
- Definitions and sample note:
  - “Low-income countries” refers to all countries, excluding India, shown on the IMF’s list of countries eligible for the Poverty Reduction and Growth Trust (PRGT) at end-December 2009.
  - FDI comprises equity investment, reinvested earnings and intra-company debt transactions; equity investment is considered FDI only if the foreign company has a minimum 10 percent share.
- Key summary findings previewed:
  - Low international interest rates, rather than real-side external factors, were the most important drivers of FDI outflows to low-income countries.
  - Increased importance of advanced-country economic conditions on FDI outflows to low-income countries since the mid-1990s.
  - FDI outflows to low-income countries contract during recessions in advanced countries.
  - The association between FDI inflows and growth in low-income countries strengthened in the globalization period.
  - Cross-country variations in growth benefits of FDI are explained by differences in economic fundamentals, strength of economic reforms, and commitment to macroeconomic discipline.

### II. Pre-crisis trends in FDI flows to low-income countries
- Aggregate trends and drivers:
  - Net FDI inflows to low-income countries more than quadrupled since 2000, growing at an average annual rate of 20 percent during 2000–2008.
  - Surge occurred amid strong global economic growth, favorable financing conditions, and strong terms of trade.
  - World Bank (2010) reports that the sharp increase in global FDI flows before the financial crisis largely reflected a surge in inexpensive debt financing.
- Financial-intermediation and M&A dynamics:
  - Cross-border syndicated bank borrowing and international bond issuance for mergers and acquisitions rose almost 10-fold between 2003 and 2007.
  - Almost 30 percent of global merger and acquisition deals were carried out by high-income investment banks, hedge funds, and other private equity firms.
  - Low global interest rates and resultant fall in borrowing costs during 2003–07 contributed to almost 70 percent of the increase in capital inflows, including FDI, into developing countries.
- Source-country evolution and South-South linkages:
  - Emerging market investors increased importance as FDI sources for low-income countries.
  - It is estimated that one third to one half of total FDI inflows reported by developing countries came from other developing countries in the last decade.
  - In 2008, between 20 and 30 percent of FDI to ASEAN low-income countries came from ASEAN source countries.
  - China’s outward FDI: fourfold increases in both bilateral trade and Chinese FDI in Africa between 2001 and 2005; outward FDI from China nearly doubled in 2008.
- Geographic and sectoral patterns:
  - Mid-1990s: strong FDI into Eastern Europe and Central Asia and market-oriented reforming Asian countries.
  - More recently, rapid rise in FDI to Africa concentrated in a few countries and targeted mainly at extractive sectors, particularly petroleum.
  - The share of FDI in the services sector, including tourism and banking and financial services, increased significantly in the run-up to the crisis.

### III. Conceptual channels — how external factors can affect FDI
- Push vs. pull factors:
  - Pull: host-country characteristics (market size, institutions, policy reforms).
  - Push: source-country economic conditions (global liquidity, interest rates, business cycle).
- Cyclical channels:
  - Income effect: recessions in advanced countries lower earnings, inducing firms to reduce investment at home and abroad — FDI procyclical.
  - Substitution effect: recessions in advanced countries may make foreign investment relatively more attractive — FDI countercyclical.
- Interest-rate and financing channels:
  - Cyclical movements in advanced-country interest rates affect funding costs for FDI because foreign operations are often funded in international financial markets.
  - Low or negative world real interest rates underpin commodity prices and thus can stimulate commodity-related FDI.
  - Countercyclical monetary policy in advanced countries during recessions lowers funding costs and can support outward FDI.

### IV. Empirical specification, data, and estimation issues
- Sample and periods:
  - Annual bilateral FDI flows from G7 countries to over 100 developing countries between 1985 and 2007, including 52 low-income countries.
  - Medium-run growth analysis: five-year averages using panel 1974–2008 with up to 7 observations per country (1974–78, 1979–83, etc.).
- Baseline empirical approach:
  - Augmented gravity-model framework for bilateral FDI flows.
  - Main regressors: host and source nominal GDP, bilateral trade, source-country measures of economic activity (GROWTH, OUTPUT GAP), and source-country real interest rate (RIR).
  - Country-pair fixed effects and time trend included.
- Measurement and data handling:
  - OUTPUT GAP: log difference between real GDP and its log-linear trend.
  - REAL INTEREST RATE (RIR): three-month nominal T-bill rate minus CPI inflation.
  - Bilateral trade lagged by one period.
  - Many bilateral observations contain zeros and negatives; semi-log transformation g(x) = x / (1 + |x|) used; Tobit used as robustness check.
- Data sources:
  - Gross bilateral FDI flows: OECD International Direct Investment Statistics.
  - GDP variables: IMF’s World Economic Outlook (WEO).
  - Bilateral trade: UN COMTRADE.
  - Other variables drawn from WDI, IFS, PWT, ICRG as listed in Appendix 1.

### V. Empirical results — determinants of FDI outflows
- Gravity determinants:
  - Market size (nominal GDP) in both source and host countries increases FDI to developing countries.
  - Bilateral trade is positive and significant, indicating complementarity between trade and FDI.
- Source-country cyclical and interest-rate effects:
  - Real GDP growth and OUTPUT GAP in source countries are positively and significantly associated with FDI outflows.
  - Low international interest rates were identified as a particularly important driver of FDI outflows to low-income countries (contrast with middle-income countries).
  - Evidence of heightened importance of advanced-country economic conditions on FDI outflows to low-income countries since the mid-1990s.
  - FDI outflows to low-income countries contract during recessions in advanced countries.
- Subsample and heterogeneous findings:
  - Middle-income countries:
    - FDI flows positively associated with host GDP and size of source economy.
    - Higher growth in source countries positively associated with FDI to middle-income countries.
    - Interest rates in the source do not have a contemporaneous impact on FDI to middle-income countries.
  - Low-income countries (including SSA):
    - Domestic market size is not a significant determinant of FDI flows.
    - Bilateral trade–FDI positive association is highly significant for middle and low-income samples but less important for SSA.
    - Financial market conditions in G7 play a dominant role: lower interest rates in the G7 tend to increase FDI outflows.
      - Point estimate: a one-percentage point decrease in real interest rates in G7 countries is associated with a 10 percent increase in FDI flows to low-income countries.
      - Effect is even more pronounced for the SSA sub-sample.
- Sensitivity to lags and post-1993 period:
  - Economic growth in the G7 has a contemporaneous effect on FDI to middle-income countries, but affects low-income countries with a lag.
  - Restricting the sample to post-1993:
    - Sensitivity of FDI outflows to low-income countries to advanced-country economic conditions increased.
    - Point estimate: a one-percentage point increase in advanced country growth is associated with over 30 percent increase in FDI outflows within two years.
    - Response to lower interest rates in the source increased: a one percentage point decline in real interest rates in advanced countries leads to a 20–25 percent contemporaneous increase in FDI outflows.
- Impact of recessions and expansions:
  - RECESSION dummy defined as fall in real growth relative to trend in the 10th percentile of country-specific distribution.
  - Advanced country recessions do not have a contemporaneous effect on FDI outflows to all developing countries, but tend to have a lagged negative impact.
  - Point estimates: FDI outflows to low-income countries decline on average by 25 percent in the transition from a recession to an expansion, with larger effects for middle-income countries.
  - Regional heterogeneity: contemporaneous significant negative effect for Europe and Central Asia; lagged effects for most other regions; highest impact for Latin America and the Caribbean.
- Robustness checks:
  - Local (host) determinants introduced: real GDP growth; macro stability (public consumption/GDP, CPI inflation); financial depth (private credit/GDP); institutional quality (ICRG index).
  - For full sample and middle-income sub-sample: productivity growth, macro stability, and better institutional quality significantly associated with higher FDI outflows from advanced countries.
  - For low-income countries: volume of FDI flows negatively and significantly associated with institutional quality, reflecting concentration in resource-rich countries with weaker institutions.
  - Main conclusions on role of advanced-country economic and financial conditions are robust across samples and specifications.
  - Handling of zero-value flows via exclusion or Tobit estimation does not change main conclusions.

### VI. Growth impact of FDI in low-income countries
- Methodology for medium-run growth:
  - Dynamic-panel growth regressions using five-year averages; dependent variable log real per capita GDP; system GMM (Blundell and Bond, 1998) used to address endogeneity and reverse causality.
  - Controls include inflation variability, government consumption/GDP, secondary school enrollment, trade openness, private credit/GDP, population growth, and lagged average investment/GDP.
- Baseline findings:
  - For all developing countries, the coefficient on FDI is significantly positive.
  - For low-income countries overall, FDI does not enter significantly.
  - For non-fuel exporting low-income countries, FDI is significantly and positively associated with growth.
    - Point estimate: a one-percentage point increase in the ratio of FDI to GDP is associated with a 0.5–0.7 percentage point increase in growth over a five-year period.
  - Time sensitivity:
    - Beneficial impact of FDI on growth positive but significant for middle-income countries in 1974–1993.
    - Positive and significant effect of FDI on growth for all developing countries, including non-fuel exporting low-income countries, strengthened in the 1989–2008 period.
  - Robustness: alternative controls and exclusion of subgroups produce similar signs and magnitudes for the FDI coefficient.

### VII. Thresholds and conditioning factors shaping FDI growth dividends
- Financial sector development:
  - Positive and significant FDI coefficient preserved only for countries with high levels of financial sector development; for low financial development the coefficient is much smaller and not statistically significant.
  - Estimated private credit threshold above which FDI effect on growth is positive corresponds to private credit ratio of over 20 percent.
    - Median private credit to GDP in sample:
      - middle-income countries: 39 percent
      - low-income countries: 16 percent
    - Share of sample with private credit ratio over 20 percent:
      - all countries: 59 percent
      - middle-income countries: 83 percent
      - low-income countries: 35 percent
  - Literature comparison: estimated credit to GDP thresholds of 13 to 48 percent.
- Economic diversification and sector composition:
  - Countries with more diversified export structures (higher percent of non-primary exports) show higher and statistically significant FDI coefficients; concentrated commodity exporters show no significant association.
  - FDI concentrated in extractive sectors may have limited spillovers compared with manufacturing or services.
- Infrastructure, institutions, and trade:
  - Better infrastructure (proxied by phone diffusion) and higher institutional quality (control of corruption index) associated with statistically significant positive FDI coefficients; poorer infrastructure and institutions show no statistical significance.
  - Trade openness: no measurable difference in growth impact across high/low trade openness groups in 1989–2008.
- Macroeconomic stability:
  - FDI impact on growth is statistically significant and positive only for countries with lower inflation.
  - Inflation threshold: effect of FDI on growth positive when annual inflation is 8 percent or lower.
- Economic reforms:
  - Trade liberalization and capital account liberalization tested; no measurable difference in FDI growth impact across groups for 1989–2008.
  - Over full sample (1973–2008), positive and significant FDI coefficient preserved only for countries with more liberalized trade regimes.

### VIII. Discussion of results, observed shocks, and medium-term risks
- Determinants and channels:
  - Economic conditions in advanced countries matter; recessions in the G7 contract FDI flows to low-income countries.
  - Low-income countries particularly sensitive to interest rate movements and financing conditions in advanced countries; sensitivity increased in the recent period.
  - FDI concentrated in extractive sectors is sensitive to real interest rates and commodity price dynamics and often financed via inter-company debt.
- Observed shock:
  - FDI to low-income countries on average fell by over 30 percent in 2009, relative to pre-crisis levels.
- Two key medium-term risks:
  - Rising international interest rates as monetary easing is withdrawn and new regulatory measures constrain global liquidity.
  - Direct negative impact of G7 recessions on FDI outflows leading to a sustained reduction of flows.

### IX. Policy implications and recommendations
- Diversify and seek alternative FDI sources:
  - Potential partial offset from South-South FDI (China, South Africa, Russia, Brazil), though these flows remain small relative to total FDI; South-South FDI may be more resilient due to state-owned enterprises and limited reliance on international debt markets.
- Strengthen domestic preconditions to raise growth dividends of FDI:
  - Promote financial development to increase growth benefits of each unit of remaining FDI (private credit and stronger financial intermediation).
  - Improve policies, regulatory, and supervisory frameworks to boost domestic financial intermediation and efficiency.
  - Advance reforms to diversify economic structures, improve infrastructure, strengthen institutions, and maintain macroeconomic stability (lower inflation).
- These domestic policy steps can mitigate negative effects of reductions in external FDI and improve medium-term growth prospects even amid tighter global financing conditions.

### X. Methodology, robustness, and data (Appendix 1 highlights)
- Estimation and identification:
  - System GMM approach of Blundell and Bond (1998) used in dynamic panel estimations; lagged levels and lagged first differences of regressors included as instruments; instrument count limited following Roodman (2009).
- Key samples and time windows:
  - Bilateral FDI analysis: annual 1985–2007, G7 to >100 developing countries, 52 low-income countries.
  - Growth analysis: five-year averages, panel 1974–2008, up to 7 observations per country.
- Variable definitions and sources (selected):
  - FDINet: FDI to GDP ratio — Source: WEO (IMF).
  - GDP: GDP, USD bn — Source: WEO (IMF).
  - Output gap: gap between GDP and its (log-linear) trend — Source: WEO (IMF) and IMF staff calculations.
  - Real interest rate: Interest rates on 3-months t-bills deflated by the CPI index — Source: WEO, IFS (IMF).
  - Private credit: Domestic credit to private sector to GDP — Source: WDI (World Bank).
  - Institutional quality: Simple average of three indices — Source: ICRG.
  - See Appendix 1 for the full list of variables and sources.

### XI. Research agenda and open questions
- Further delineation of channels through which financial conditions in advanced countries influence FDI outflows to low-income countries.
- More definitive identification and economic significance of thresholds that drive growth dividends of FDI.
- Investigation of complementarity and substitutability among different threshold conditions (e.g., financial development vs. institutional quality).

*Source: _wp10132 (excerpts from sections I–VI, Appendix 1, and References contained in the PDF file _wp10132).*

### Appendix 1.Variable Definition and Sources ..........................................................................38

### Appendix 1.Variable Definition and Sources ..........................................................................38

### Appendix listing
- Appendix 1.Variable Definition and Sources ..........................................................................38

*Appendix 1.Variable Definition and Sources ..........................................................................38*

### References .............................................................................................................

### _wp10132 - References

### I. Introduction: scope and research questions
- Research focus:
  - How do external factors, particularly economic developments in advanced countries, affect FDI flows to low-income countries?
  - How have FDI flows contributed to economic growth in low-income countries in the pre-crisis period, and what role do country-specific features and initial conditions play in explaining cross-country variations in the growth benefits of FDI?
- Definitions and sample note:
  - “Low-income countries” refers to all countries, excluding India, shown on the IMF’s list of countries eligible for the Poverty Reduction and Growth Trust (PRGT) at end-December 2009.
  - FDI comprises equity investment, reinvested earnings and intra-company debt transactions; equity investment is considered FDI only if the foreign company has a minimum 10 percent share.
- Key summary findings previewed:
  - Low international interest rates, rather than real-side external factors, were the most important drivers of FDI outflows to low-income countries.
  - Increased importance of advanced-country economic conditions on FDI outflows to low-income countries since the mid-1990s.
  - FDI outflows to low-income countries contract during recessions in advanced countries.
  - The association between FDI inflows and growth in low-income countries strengthened in the globalization period.
  - Cross-country variations in growth benefits of FDI are explained by differences in economic fundamentals, strength of economic reforms, and commitment to macroeconomic discipline.

### II. Pre-crisis trends in FDI flows to low-income countries
- Aggregate trend and drivers:
  - Net FDI inflows to low-income countries more than quadrupled since 2000, growing at an average annual rate of 20 percent during 2000–2008.
  - Surge occurred amid strong global economic growth, favorable financing conditions, and strong terms of trade.
  - International interest rates remained low over a sustained period; the World Bank (2010) reports that the sharp increase in global FDI flows before the financial crisis largely reflected a surge in inexpensive debt financing.
- Financial-intermediation and M&A dynamics:
  - Cross-border syndicated bank borrowing and international bond issuance for mergers and acquisitions rose almost 10-fold between 2003 and 2007.
  - Almost 30 percent of global merger and acquisition deals were carried out by high-income investment banks, hedge funds, and other private equity firms (UNCTAD, 2009).
  - Low global interest rates and resultant fall in borrowing costs during 2003–07 contributed to almost 70 percent of the increase in capital inflows, including FDI, into developing countries (World Bank, 2010).
- Source-country evolution and South-South linkages:
  - Emerging market investors increased importance as FDI sources for low-income countries.
  - It is estimated that one third to one half of total FDI inflows reported by developing countries came from other developing countries in the last decade (Aykut and Goldstein, 2007).
  - In 2008, between 20 and 30 percent of FDI to ASEAN low-income countries came from ASEAN source countries (ASEAN, 2009).
  - China’s outward FDI: Foster et al. (2008) note fourfold increases in both bilateral trade and Chinese FDI in Africa between 2001 and 2005; Davis (2009) reports outward FDI from China nearly doubled in 2008. Official Chinese FDI numbers vary due to definitional issues.
- Geographic and sectoral patterns:
  - Mid-1990s: strong FDI into Eastern Europe and Central Asia and market-oriented reforming Asian countries.
  - More recently, rapid rise in FDI to Africa concentrated in a few countries and targeted mainly at extractive sectors, particularly petroleum (IMF, 2010).
  - FDI as a share of GDP increased broadly across regions since 2003, covering a diverse set of countries.
  - Sectoral composition data are limited; however, the share of FDI in the services sector, including tourism and banking and financial services, increased significantly in the run-up to the crisis (IMF, 2008; ECLAC, 2008).
- Country characteristics associated with higher inflows:
  - Non-resource-rich countries with above-median trade liberalization (index of trade freedom) had higher FDI inflows.
  - Non-resource-rich countries with above-median institutional quality—measured by greater control of corruption and economic freedom—attracted more FDI.
  - Resource-rich countries attracted high levels of FDI despite poorer institutional quality and weaker reform performance.

### III. Do external factors drive FDI flows to low-income countries? — Conceptual channels
- Push vs. pull factors:
  - Pull factors: host-country characteristics (market size, institutions, policy reforms).
  - Push factors: source-country economic conditions (global liquidity, interest rates, business cycle).
- Cyclical channels:
  - Income effect: recessions in advanced countries lower earnings, inducing firms to reduce investment at home and abroad — FDI procyclical.
  - Substitution effect: recessions in advanced countries may make foreign investment relatively more attractive — FDI countercyclical (Solow-type reasoning).
- Interest-rate and financing channels:
  - Cyclical movements in advanced-country interest rates affect funding costs for FDI because foreign operations are often funded in international financial markets.
  - Low or negative world real interest rates underpin commodity prices and thus can stimulate commodity-related FDI.
  - Countercyclical monetary policy in advanced countries during recessions lowers funding costs and can support outward FDI.
- Empirical literature highlights:
  - Reinhart and Reinhart (2001), Calvo et al. (2001): FDI flows to developing countries higher when U.S. economy expanding and monetary policy is expansionary.
  - Levy-Yeyati et al. (2007): outward FDI countercyclical with respect to output and interest rate cycles in the United States and Europe, mildly procyclical in Japan.
  - Albuquerque et al. (2005): increases in interest rates in advanced countries are significantly and negatively associated with FDI flows to developing countries.
- Gap addressed by this paper:
  - Most literature focuses on emerging markets; less attention to low-income countries integration via FDI linkages with advanced economies.

### IV. Empirical specification, data, and estimation issues
- Sample and period:
  - Annual bilateral FDI flows from G7 countries to over 100 developing countries between 1985 and 2007, including 52 low-income countries.
- Baseline empirical approach:
  - Augmented gravity-model framework for bilateral FDI flows (specification closest to Levy-Yeyati et al., 2007).
  - Main regressors: host and source nominal GDP (market size), bilateral trade, source-country measures of economic activity (GROWTH, OUTPUT GAP), and source-country real interest rate (RIR).
  - Country-pair fixed effects uij capture time-invariant bilateral factors (distance, common language, legal origin, bilateral investment treaties).
  - Time trend vt included to control for positive FDI trend common across countries.
- Measures and variable construction:
  - OUTPUT GAP defined as the log difference between real GDP and its log-linear trend.
  - Real interest rate (RIR) defined as the difference between the three-month nominal interest rate on T-bills and CPI inflation.
  - Bilateral trade lagged by one period to mitigate reverse causality between trade and FDI.
- Data sources:
  - Gross bilateral FDI flows: OECD International Direct Investment Statistics.
  - GDP variables: IMF’s World Economic Outlook.
  - Bilateral trade: UN COMTRADE database.
- Treatment of zero and negative flows:
  - Many bilateral-flow observations contain zeros and some negative values (divestments).
  - Semi-log transformation used: g(x) = x / (1 + |x|) (as described in the text).
  - Tobit model used as a robustness test to address potential censoring due to investment indivisibilities and fixed costs.

### V. Empirical results (summary of key findings)
- Gravity determinants:
  - Market size (nominal GDP) in both source and host countries increases FDI to developing countries.
  - Bilateral trade is positive and significant, indicating complementarity between trade and FDI in the sample.
- Source-country cyclical and interest-rate effects:
  - Real GDP growth in source countries is positively and significantly associated with FDI outflows to developing countries.
  - Output cycle (OUTPUT GAP) in source countries similarly associated with outward FDI.
  - Low international interest rates were identified as a particularly important driver of FDI outflows to low-income countries (contrast with middle-income countries where different factors matter).
  - Evidence of heightened importance of advanced-country economic conditions on FDI outflows to low-income countries since the mid-1990s.
  - FDI outflows to low-income countries contract during recessions in advanced countries.
- Robustness and heterogeneity:
  - Results examined on the full sample of emerging and low-income countries and on sub-samples (e.g., fuel-exporting vs. non-fuel-exporting countries, non-fuel exporting SSA countries).
  - Semi-log transformation and Tobit estimation used to address zero and negative bilateral-flow observations and potential censoring.

### VI. Growth impact of FDI in low-income countries
- Dynamic-panel growth regressions:
  - The association between FDI inflows and growth in low-income countries strengthened in the globalization period.
  - Empirical finding aligns with prior studies documenting a positive impact of FDI on economic growth in developing countries.
- Importance of supporting conditions (thresholds):
  - Differences in economic fundamentals, strength of economic reforms, and commitment to macroeconomic discipline are important in explaining cross-country variations in the growth benefits of FDI.
  - The paper provides a policy-relevant assessment of structural and policy characteristics that can enhance direct and indirect growth benefits of FDI in low-income countries.

### VII. Implications highlighted in the paper
- Vulnerability to advanced-country downturns:
  - Given that FDI is the dominant form of private capital inflows for low-income countries, a reversal in these flows would affect external financing needs and have implications for investment and growth.
- Policy-relevant messages:
  - Sustaining the growth benefits of FDI requires attention to domestic fundamentals, structural reforms, and macroeconomic discipline.
  - Because external factors (advanced-country cycles and international interest rates) importantly influence FDI to low-income countries, countries should consider policies that enhance resilience to possible contractions in external financing.

*Source: Excerpts from the IMF paper (sections I–III and related figures and tables referenced) contained in the PDF file _wp10132 - References.*

### Section II, FDI flows to fuel-exporting low-income countries appears to behave differently from what one would

### Section II, FDI flows to fuel-exporting low-income countries appears to behave differently from what one would expect, in particular, they appear more robust to unfavorable local conditions.

### Determinants of bilateral FDI outflows from G7 countries
- Coefficient on the output gap is positive and significant, suggesting that FDI flows from G7 countries are procyclical (Column 2).
- Financial market conditions in source countries, as measured by the real interest rate, are negatively and significantly associated with FDI outflows; this holds after controlling for the positive effects of output growth on FDI outflows.
- Sample split results (Columns 3–8):
  - For middle-income countries:
    - FDI flows are positively and significantly associated with domestic market size (GDP in the host country) and the size of the source economy (Columns 3–4).
    - Higher growth in source countries is positively and significantly associated with FDI flows to middle-income countries.
    - Interest rates in the source do not have a contemporaneous impact on FDI outflows to middle-income countries.
  - For low-income countries (including SSA):
    - Domestic market size is not a significant determinant of FDI flows (Columns 5–8).
    - Bilateral trade–FDI positive association is highly significant for middle and low-income samples but less important for the SSA sub-sample.
    - FDI to low-income countries does not appear to vary with economic activity in the G7 in the period under consideration (Columns 4–8).
    - Financial market conditions play a more dominant role: lower interest rates in the G7 tend to increase FDI outflows; effect is economically significant.
      - Point estimate: a one-percentage point decrease in real interest rates in G7 countries is associated with a 10 percent increase in FDI flows to low-income countries.
      - Effect is even more pronounced for the SSA sub-sample.

### Sensitivity to lags and time-period (post-1993)
- Re-estimation findings (Table 3):
  - Economic growth in the G7 has a contemporaneous effect on FDI flows to middle-income countries, but affects low-income countries with a lag (Columns 2–3).
  - Restricting the sample to the post-1993 period:
    - Sensitivity of FDI outflows to low-income countries, including SSA, to economic conditions in advanced countries increased (Columns 7–12).
    - This holds for both real growth and the output gap in advanced countries.
    - Point estimate: a one-percentage point increase in advanced country growth is associated with over 30 percent increase in FDI outflows within two years (Column 9).
    - Response to lower interest rates in the source increased in the post-1993 period:
      - Point estimates indicate a one percentage point decline in real interest rates in advanced countries leads to a 20–25 percent contemporaneous increase in FDI outflows (Columns 9–12).

### Impact of recessions and expansions in source countries
- Methodology:
  - Growth cycle measure: difference between current and trend real growth.
  - RECESSION dummy = 1 if fall in real growth relative to trend lies in the 10th percentile of the country-specific distribution.
  - Analysis focuses on the post-1993 period capturing 1998–99 Japan, 2001 US, and 2002–2003 recessions in other G7 countries.
- Results (Table 4):
  - Advanced country recessions do not have a contemporaneous effect on FDI outflows to all developing countries, including low-income countries (Columns 1, 3, and 5).
  - Advanced country recessions tend to have a lagged impact on FDI outflows to all countries.
  - The negative and significant recession dummy implies FDI outflows decline disproportionately during economic contraction in the North.
  - Point estimates: FDI outflows to low-income countries decline on average by 25 percent in the transition from a recession to an expansion, with larger effects for middle-income countries.
- Regional heterogeneity (Table 5, post-1993):
  - Advanced country recessions have a contemporaneous significant and negative effect on FDI outflows to Europe and Central Asia.
  - All other regions are affected with a lag.
  - Impact of recessions is highest for Latin America and the Caribbean, reflecting strong linkages with the United States.

### Robustness checks
- Inclusion of host country characteristics (local determinants of FDI):
  - Local determinants introduced: real GDP growth; macroeconomic stability (public consumption relative to GDP and consumer price inflation); financial depth (credit to private sector as % of GDP); institutional quality (ICRG index).
  - Explanatory variables (except institutional variable) are lagged by one period.
- Findings:
  - Local conditions are important in explaining FDI outflows to middle-income countries; less significant for low-income countries in the full sample (Table 6).
  - For full sample and middle-income sub-sample:
    - Productivity growth, macroeconomic stability (proxied by lower government consumption to GDP), and better institutional quality are significantly associated with higher FDI outflows from advanced countries.
  - For low-income countries:
    - Volume of FDI flows is negatively and significantly associated with institutional quality, possibly reflecting concentration of FDI in resource-rich countries with weaker institutions.
  - In the post-1993 period (not reported): with the exception of institutional variables, local conditions are not statistically significant.
  - Main conclusions on the role of economic and financial conditions in advanced countries in explaining FDI outflows to developing countries hold for all samples and time periods.
- Addressing zero-value FDI flows:
  - Two strategies:
    - Remove null (zero) values from the sample (assume they contain no useful information).
    - Assume zero entries are non-random and run a Tobit estimation.
  - Replaced trend with time dummies in baseline specification.
  - Main conclusions are robust to these modifications (available upon request).

### FDI and medium-run growth implications for low-income countries
- Context:
  - FDI expected to yield significant growth benefits via augmented investment and productivity gains through technology and managerial transfers.
  - A reversal of FDI flows could adversely affect growth momentum achieved in low-income countries over the past decade.
- Empirical approach (section IV overview):
  - Study focuses on net FDI inflows to developing countries using five-year averages to analyze medium-run growth.
  - Panel data: 1974–2008 for up to 104 countries (same middle and low-income countries as previous section).
  - Non-overlapping five-year periods yield up to 7 observations per country (1974–78, 1979–83, etc.).
- Dynamic panel growth specification:
  - Dependent variable: y_i,t = log real per capita GDP.
  - Includes lagged level y_i,t-1 to control for convergence.
  - FDI_it = net FDI inflows in percent of GDP.
  - X_i,t = control variables; μ_t = time dummies; η_i = country fixed effects; ε_i,t = error term.
- Control variables included (standard determinants of per capita GDP growth):
  - Degree of variation in consumer price inflation.
  - Average ratio of government consumption expenditures as a percent of GDP.
  - Secondary school enrollment (proxy for human capital).
  - Trade openness (exports + imports of goods and services as a percent of GDP).
  - Financial sector development (private sector credit to GDP).
  - Population growth.
  - Lagged average investment (percent of GDP).

### Selective literature summary on FDI and growth, and conditioning factors
- Theoretical and empirical background:
  - Direct benefits: FDI flows from capital-rich to capital-poor economies should complement limited domestic savings and augment growth.
  - Indirect benefits: productivity gains through technology transfer, skill acquisition, competition, and export expansion.
  - Empirical evidence is mixed; cross-country studies often inconclusive due to differences in sample coverage, methodologies, and periods.
- Conditioning/threshold factors that affect whether FDI yields growth benefits:
  - Financial sector development: deep domestic financial markets facilitate allocation of foreign flows and provide credit to exploit spillovers.
  - Institutional quality: protection of property rights and absence of corruption affect allocation to long-gestation, investment-intensive projects and interaction with local firms.
  - Sectoral composition of inflows: FDI in extractive sectors may have limited spillovers compared with manufacturing or services.
  - Trade openness: facilitates transfer of know-how and can crowd in domestic investment.
  - Capital endowments: minimum levels of human capital or physical infrastructure may be required to realize technology spillovers.
  - Macroeconomic policies: sound policies raise the marginal product of new investment and enable technology diffusion.
- Literature implication:
  - Growth dividends of FDI depend on local absorptive capacities and initial conditions; pooling countries at different development levels can bias inference.

*Italic: Source: _wp10132 - Section II, FDI flows to fuel-exporting low-income countries appears to behave differently from what one would expect, in particular, they appear more robust to unfavorable local conditions.*

### Appendix 1 for a description of variables and data sources used.

### _wp10132 - Appendix 1 for a description of variables and data sources used.

### Methodology
- Use of system GMM approach of Blundell and Bond (1998) to address reverse causality and endogeneity in dynamic panel estimations with unobserved country fixed effects.
- Inclusion of suitable lagged levels and lagged first differences of the regressors as instruments.
- Refinements to limit the number of instruments following Roodman (2009).

### Baseline results on FDI and growth
- For all developing countries, the coefficient on FDI is significantly positive, implying higher FDI flows are associated with GDP growth.
- For low-income countries overall, FDI does not enter the growth regressions significantly.
- For non-fuel exporting low-income countries, FDI is significantly and positively associated with growth.
  - Point estimate: a one-percentage point increase in the ratio of FDI to GDP is associated with a 0.5–0.7 percentage point increase in growth over a five-year period.
- Time-period sensitivity:
  - Beneficial impact of FDI on growth is positive but significant for middle-income countries in 1974–1993.
  - Positive and significant effect of FDI on growth for all developing countries, including non-fuel exporting low-income countries, strengthened in the 1989–2008 period.
- Robustness checks:
  - Alternative basic controls (replace lagged average investment with national savings; add proxy for infrastructure quality) and exclusion of different country groups (including transition economies) produced similar signs and magnitudes for the FDI coefficient.

### Threshold effects: how country characteristics shape FDI growth benefits
- Analysis period focused on 1989–2008 to capture strengthened significance of FDI for growth in low-income countries.
- Countries split into above- and below-median groups for each five-year period and regressions run separately.

Economic fundamentals
- Financial sector development:
  - Positive and significant FDI coefficient preserved only for countries with high levels of financial sector development; for low financial development the coefficient is much smaller and not statistically significant.
- Economic diversification:
  - Countries with more diversified export structures (higher percent of non-primary exports) show higher and statistically significant FDI coefficients; concentrated commodity exporters show no significant association.
- Infrastructure and institutions:
  - Better infrastructure (proxied by phone diffusion) and higher institutional quality (control of corruption index) are associated with statistically significant positive FDI coefficients; poorer infrastructure and institutions show no statistical significance.
- Trade openness:
  - No measurable difference in growth impact across high/low trade openness groups in the 1989–2008 period.

Economic reforms
- Trade liberalization (average tariff index) and capital account liberalization (subcomponent from Abiad et al. (2008), normalized 0–1) were tested using lagged indices.
  - No measurable difference in FDI growth impact across groups for 1989–2008.
  - Over the full sample period (1973–2008), positive and significant FDI coefficient preserved only for countries with more liberalized trade regimes (not reported in tables).
  - No notable difference found for capital account liberalization groups.

Macroeconomic stability
- FDI impact on growth is statistically significant and positive only for countries with lower inflation (Columns 15–16 in the analysis).

Key threshold levels and sample statistics
- Private credit threshold: estimated threshold above which FDI effect on growth is positive corresponds to a private credit ratio of over 20 percent.
  - Literature comparison: estimated credit to GDP thresholds of 13 to 48 percent (see Kose et al, 2009b).
  - Median private credit to GDP in sample:
    - middle-income countries: 39 percent
    - low-income countries: 16 percent
  - Share of sample with private credit ratio over 20 percent:
    - all countries: 59 percent
    - middle-income countries: 83 percent
    - low-income countries: 35 percent
- Inflation threshold: effect of FDI on growth positive when annual inflation is 8 percent or lower.

### Discussion of results and risks for low-income countries
- Determinants of FDI outflows to low-income countries:
  - Economic conditions in advanced countries matter; recessions in the G7 contract FDI flows to low-income countries.
  - Low-income countries are particularly sensitive to interest rate movements and financing conditions in advanced countries; this sensitivity has increased in the recent period.
- Channels and financing modes:
  - FDI concentrated in extractive sectors is sensitive to real interest rates and commodity price dynamics.
  - Extractive-sector FDI financing often relies on inter-company debt, which is volatile and sensitive to international financing conditions.
  - FDI in services (tourism, financial services) is also sensitive to borrowing conditions in advanced countries.
- Observed shock:
  - FDI to low-income countries on average fell by over 30 percent in 2009, relative to pre-crisis levels.
- Two key medium-term risks to low-income country outlook:
  - Rising international interest rates as monetary easing is withdrawn and new regulatory measures constrain global liquidity.
  - Direct negative impact of G7 recessions on FDI outflows leading to a sustained reduction of flows.

### Policy implications and recommendations
- Diversify and seek alternative FDI sources:
  - Potential partial offset from South-South FDI (China, South Africa, Russia, Brazil), though these flows remain small relative to total FDI; South-South FDI may be more resilient due to state-owned enterprises and limited reliance on international debt markets.
- Strengthen domestic preconditions to raise growth dividends of FDI:
  - Promote financial development to increase the growth benefits of each unit of remaining FDI (private credit and stronger financial intermediation).
  - Improve policies, regulatory, and supervisory frameworks to boost domestic financial intermediation and efficiency.
  - Advance reforms to diversify economic structures, improve infrastructure, strengthen institutions, and maintain macroeconomic stability (lower inflation).
- These domestic policy steps can mitigate negative effects of reductions in external FDI and improve medium-term growth prospects even amid tighter global financing conditions.

### Research agenda and open questions
- Further delineation of channels through which financial conditions in advanced countries influence FDI outflows to low-income countries.
- More definitive identification and economic significance of thresholds that drive growth dividends of FDI.
- Investigation of complementarity and substitutability among different threshold conditions (e.g., financial development vs. institutional quality).

*Source: _wp10132 - Appendix 1 for a description of variables and data sources used.*

### References

### _wp10132 - References

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### Appendix 1. Variable Definition and Sources
- Variable: FDINet
  - Description: FDI to GDP ratio
  - Source: WEO (IMF)
- Variable: GDP
  - Description: GDP, USD bn
  - Source: WEO (IMF)
- Variable: GDP per capita
  - Description: GDP per capita (constant 2000 US$)
  - Source: WDI (World Bank)
- Variable: GDP per capita growth
  - Description: Annual growth of real GDP per capita (constant 2000 US$)
  - Source: WDI (World Bank)
- Variable: Bilateral trade
  - Description: Sum of bilateral exports and imports, USD mn
  - Source: COMTRADE (UN)
- Variable: Trade openness
  - Description: Exports and imports ratio to GDP
  - Source: WEO (IMF)
- Variable: Real growth
  - Description: Rate of growth, gross domestic product, constant prices
  - Source: WEO (IMF)
- Variable: School enrollment
  - Description: School enrollment, secondary (% gross)
  - Source: WDI (World Bank)
- Variable: Output gap
  - Description: Gap between GDP and its (log-linear) trend
  - Source: WEO (IMF) and IMF staff calculations
- Variable: Real interest rate
  - Description: Interest rates on 3-months t-bills deflated by the CPI index
  - Source: WEO, IFS (IMF)
- Variable: Recession
  - Description: Dummy variable (see text)
  - Source: IMF staff calculations
- Variable: Private credit
  - Description: Domestic credit to private sector to GDP
  - Source: WDI (World Bank)
- Variable: Population
  - Description: Population growth (annual %)
  - Source: WDI (World Bank)
- Variable: Government
  - Description: General government final consumption expenditure (% of GDP)
  - Source: WDI (World Bank)
- Variable: Fixed investment
  - Description: Average investment to GDP
  - Source: PWT
- Variable: CPI
  - Description: Consumer price index, annual
  - Source: WEO (IMF)
- Variable: Institutional quality
  - Description: Simple average of three indices
  - Source: ICRG
- Variable: Corruption
  - Description: Control of Corruption index
  - Source: World Bank Governance Indicators

- Notes: WEO" World Economic Outlook database; PWT: Penn World Tables (version 6.3); WDI: World Development Indicators

*Source: _wp10132 - References (PDF).*

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