Foreign Direct Investments, Economic Growth and Regulatory Quality in Developing Countries

Background and statement of the problem: Both economists and policymakers agree that Foreign Direct Investment (FDI) is an instrument for economic growth (hereafter growth). On the basis that efficient and effective Regulatory Quality (RQ) provides a better environment to utilize FDI for growth, the current study explores the effects of RQ on FDI and growth relationships. Research methodology and data: Annual data for a sample of 99 developing countries from 2000-2015 is analyzed using the two-step system Generalized Method of Moments (GMM) estimation method. The study has used the two-step system GMM to overcome the econometric issues that have weakened the earlier empirical analysis on the subject. The study has used the comprehensive and recent data of RQ provided by the World Governance Indicators (WGI). For robustness check, this study has used alternate measures of RQ and FDI. Research findings: The findings of the study can be summarized as follows. First, confirming the long-held theoretical and empirical proposition on the importance of FDI for growth, FDI had a robust, positive, and significant effect on the growth of developing countries. Second, RQ had a negative effect on growth, suggesting that tighter regulations reduce growth. Third, the effect of FDI on growth is decelerated by an increase in the level of RQ. The results suggest that tighter regulations in developing countries decrease the growth effects of FDI. While the findings of the RQ on FDI and growth relationship are robust to different measures of FDI, they are not robust to alternative measures of RQ. Fourth, the impact of RQ on FDI and growth relationship varied substantially across different sub-samples. Finally, alongside FDI, population and infrastructure had a positive, significant, and robust effect on growth. However, education showed an insignificant effect on growth, whereas trade had a negative impact. Policy implications: Based on the study results, policy initiatives aimed at attracting FDIs to developing countries are encouraged. Further, policies aimed at designing and implementing regulations that may simultaneously foster economic growth and enhance the growth benefits of FDI are encouraged.