Do countries really need to build absorptive capacity to benefit from FDI? Estimating policy-relevant interaction terms with panel data

This paper is number 200 in the Groningen Growth and Development's Research Memoranda series. Abstract Foreign direct investment is often promoted as a driver of economic growth. But its benefits are thought to depend on host countries’ ‘absorptive capacities’ such as human capital, financial development, trade openness, or institutional quality. We use recent advances in panel data econometrics to revisit this con- ventional wisdom that has shaped decades of policy advise. Our approach is the first in this literature that disentangles the effects of policy-relevant changes in ab- sorptive capacities from time-invariant country fundamentals that policies cannot alter. Using a sample of approximately 120 countries over five decades, we find that time-invariant country fundamentals explain most heterogeneity in the FDI- growth nexus. Among the four policy-relevant capacities examined, only greater trade openness plausibly enhances this nexus. And even in this case, fewer than 10% of countries fail to reach the threshold where FDI appears growth-enhancing. By contrast, improving human capital, financial development, and institutional quality do not robustly increase the benefits from FDI, and may even dampen them. These findings challenge the prevailing emphasis on broad absorptive ca- pacity building as a precondition for benefiting from FDI.