Policy Coherence for Development : A Background Paper on Foreign Direct Investment

Increasing the flow of foreign direct investment (FDI) to developing countries is a cornerstone of new international development commitments. Accordingly, this paper reviews the state of knowledge regarding i) the factors that lead firms to build a plant overseas and ii) the influence that other policies (notably foreign aid) might have on those decisions. There are two broad motives for FDI: a “horizontal” motivation (to gain access to markets in the recipient country) and a “vertical” one (to exploit differences in production costs at various points in the production process). The clear message of the empirical literature (much of it focused on FDI flows between rich countries) is that market access is quantitatively far more important than production costs. What are the lessons for policy coherence? Positive effects of FDI on growth depend on a country’s absorptive capacity; aid can be used to promote human-capital accumulation while trade policies can facilitate the export orientation of the host economy. Both of these actions increase the likelihood of reaping rewards from FDI inflows. In particular, aid policies can aim at improving a recipient country’s communication infrastructure and institutional capacity. These policies attract FDI in turn, as they lower production costs and improve the prospects for productivity gains. Finally, trade facilitation between poor countries (to enlarge the market access represented by a given FDI destination) and temporary non-reciprocal market access improvements granted by rich countries could help attract FDI.