Impact of foreign direct investment on economic growth in developing countries: The role of institutional quality

This paper empirically examines the impact of institutional quality on FDI-driven economic growth in 135 developing countries from 1996–2020. Given that improved institutions lower business costs, reduce uncertainty, and attract FDI inflow, the study hypothesizes that enhancing institutional quality will likely foster higher economic growth in developing countries through FDI. We apply dynamic and static panel estimation techniques for this investigation. The research employs six measures of institutional quality from the World Governance Indicators (WGI) and their interaction with FDI inflow to identify key institutional quality indicators for developing countries. Results indicate a positive and significant effect of FDI on economic growth in developing countries. Moreover, enhancements in three specific institutional quality indicators—government effectiveness, regulatory quality, and the rule of law—strengthen FDI’s impact on economic growth. The study also underscores the greater significance of institutional quality in driving FDI-led economic growth in developing countries, compared to its limited impact on all countries. Ultimately, the study recommends that policymakers in developing countries devise effective strategies to enhance government effectiveness, regulatory quality, and the rule of law to expedite economic growth through FDI.

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