Introduction

Foreign Direct Investment (FDI) has emerged as the most
important source of external resource

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flows to developing countries over the years and has become
a significant part of capital

formation in these countries, despite their share in global
distribution of FDI continuing to

remain small or even declining. The role of the foreign
direct investment (FDI) has been widely

recognized as a growth-enhancing factor in the developing
countries (Khan, 2007). The effects

of FDI in the host economy are normally believed to be;
increase in the employment, augment in

the productivity, boost in exports and amplified pace of
transfer of technology. The potential

advantages of the FDI on the host economy are; it
facilitates the utilization and exploitation of

local raw materials, introduces modern techniques of
management and marketing, eases the

access to new technologies, foreign inflows can be used for
financing current account deficits,

finance flows in form of FDI do not generate repayment of
principal and interests (as opposed to

external debt) and increases the stock of human capital via
on the job training.

Many policy makers and academics contend that foreign direct
investment (FDI) can have

important positive effects on a host country’s development
effort. In addition to the direct capital

financing it supplies, FDI can be a source of valuable
technology and know-how while fostering

linkages with local firms, which can help jumpstart an
economy. Based on these arguments,

industrialized and developing countries have offered
incentives to encourage foreign direct

investments in their economies.

Recently, however, the special merits of FDI and
particularly the kinds of incentives offered

to foreign firms in practice have begun to be questioned.
Fueling this debate is that empirical

evidence for FDI generating positive spillovers for host
countries is ambiguous at both the micro

and macro levels. In a recent survey of the literature,
Hanson (2001) argues that evidence that

FDI generates positive spillovers for host countries is
weak. In a review of micro data on

spillovers from foreign-owned to domestically owned firms,
Gorg and Greenwood (2002)

conclude that the effects are mostly negative. Lipsey (2002)
takes a more favorable view from

reviewing the micro literature and argues that there is
evidence of positive effects. Surveying the

macro empirical research led Lipsey to conclude, however,
that there is no consistent relation

between the size of inward FDI stocks or flows relative to
GDP and growth. He further argues

that there is need for more consideration of the different
circumstances that obstruct or promote

spillovers.

Although the theoretical work on FDI points to advantages,
conceivably, spillovers could

nevertheless be small.

On the other hand it could be that we are looking in the
wrong places. For

example, the macro empirical work that has analyzed the
effects of aggregate FDI inflows-stocks

on host economies does not, mostly due to data limitations,
control for the sector in which FDI is

involved. Although it might seem natural to argue that FDI
can convey great advantages to host

countries, such gains might differ across primary,
manufacturing, and services sectors.

UNCTAD World Investment Report (2001:138), for instance,
argues, “in the primary sector, the

scope for linkages between foreign affiliates and local
suppliers is often limited…. The

manufacturing sector has a broad variation of linkage
intensive activities. In the tertiary sector

the scope for dividing production into discrete stages and
subcontracting out large parts to

independent domestic firms is also limited.”

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