The theory underlying the relationship between FDI and economic growth is based on Neoclassical and Endogenous growth. In his discussion, De Mello (1997) summarizes that the former theory considers FDI to only play a role in accelerating income in the short term, assuming a diminishing return from physical capital. Meanwhile, the latter theory contends that FDI can stimulate long-term growth by increasing returns through externalities and production spillovers. In addition, domestic firms are critical economic agents in this context because they benefit from the technological externalities of FDI.
Furthermore, Aoki and Todo (2008) provided a more in-depth interpretation of these externalities. The possibility of FDI contributing positively to economic growth relies on two primary conditions. First, technology transfer from FDI should be free of charge. The costs here are for domestic enterprises' research and development (R&D) in absorbing technology transfer from foreign firms. Moreover, the other costs can come up from the government's efforts to increase human capital capacity to absorb technology transfer by foreign companies.
Second, FDI must be the sole channel for acquiring knowledge from abroad. In this context, imitation activities carried out by domestic enterprises in imitating products from foreign companies are critical to absorbing the transfer of technology and knowledge from FDI. However, domestic firms will only be able to successfully carry out this imitation activity to absorb technology if they have a sufficient level of technology. These two conditions imply that the effect of FDI on accelerating growth is not immediate and is determined by the level of absorption capacity of domestic firms.
Furthermore, the literature also pays attention to the role of sectors when explaining the possible effect of FDI on growth. An important argument for this can be reviewed from Aykut and Sayek's (2007) discussion. They argue that FDI in the primary sector is likely to harm growth because FDI projects in this sector have a weak link to the domestic sector. Meanwhile, FDI in the manufacturing sector is expected to boost growth because FDI in this sector is closely related to the domestic sector, such as job creation and knowledge transfer through employee training. Not to mention, FDI in this sector has a tight relationship with local intermediate products. Likewise, FDI in the service sector is also likely to contribute to growth positively. The argument is that FDI in this sector has a forceful link with forwarding linkage, where generally, the motive for FDI in this sector is market seeking.
However, empirical research findings based on sectoral data also show no agreement. For example, using cross-country data from 1981 to 1999, Alfaro (2003) discovered that FDI in the agricultural sector harmed economic growth. Likewise, Vu and Noy (2009) found a negative effect of FDI on the agricultural sector for the case of developed OECD member countries (use data from 1980-2003). Bunte et al. (2018) documented the insignificant effect of FDI in the agricultural sector for the case in Liberia during the period 2004-2015. In the recent empirical study, Abouelfarag and Abed (2020), employing data for the period 1985–2014, also find that FDI in the agricultural sector does not affect growth in Egypt. They argue that this non-significant result is likely due to the low spillover effects in agricultural FDI.
On the contrary, Chandio et al. (2019), employing data from 1991 to 2013 in Pakistan, demonstrate that agricultural FDI has a long-term enhancing effect on growth. According to their discussion, one of the primary motivations for this research is that 70% of Pakistan's rural population is heavily reliant on agriculture. They also argue that their finding implies that FDI in the agricultural sector can be the primary factor in sustaining Pakistan's economy in both the short and long term.
There are also consensus gaps in the empirical evidence analyzing the growth effects of FDI in the mining sector. Using a case study in Nigeria from 1970 to 2001, Akinlo (2004) documents that FDI in the extractive sector, such as the oil sector, contributed less to growth than FDI in the manufacturing sector. The author contends that FDI in the extractive sector has weak backward and forward linkages with the economy, owing to capital and technology-intensive and export-oriented. Chakraborty and Nunnenkamp (2008) found that FDI in the mining sector does not affect growth. Also, Vu and Noy (2009) found that FDI in the mining sector affects growth negatively.
In contrast, Bunte et al. (2018) found that FDI in the mining sector positively impacts growth. They argue that FDI in sectors that require more public goods, such as mining, is more likely to boost growth. In addition, Gochero and Boopen (2020), which use data in Zimbabwe from 1988-2018, found that FDI in the mining sector is associated with growth enhancement in the long run. They also find that FDI in the mining sector has a more remarkable effect than FDI in other sectors and more than domestic investment.
Similar to the effects of FDI in the agricultural and mining sectors, empirical research on the effects of FDI in the manufacturing sector also has less conclusive results. Chakraborty and Nunnenkamp (2008) and Vu and Noy (2009) found a positive effect of FDI in the manufacturing sector on growth. Doytch and Uctum (2011), using data cross-countries, also document a growth-enhancing effect of FDI in the manufacturing sector on growth.
In comparison, Inekwe (2013), in analyzing the effect of FDI on economic growth in Nigeria during the period 1990-2009, the author found that FDI in the manufacturing sector harms economic growth. The author argues that policymakers should selectively encourage which manufacturing sub-sectors are productive from these results. More recent research, such as Abouelfarag and Abed (2020), also found that manufacturing sector FDI had an insignificant impact on growth. They argue that the possibility is due to the low absorptive capacity of domestic companies in absorbing the spillover effects of FDI in the manufacturing sector.
The impact of FDI in the service sector is also inextricably linked to differences in previous studies' findings. Chakraborty and Nunnenkamp (2008) found that FDI in the service sector did not affect growth. They argue that the effects of FDI in the service sector may take time to impact growth. They also advanced another argument, claiming that due to the scarcity of data on FDI in the service sector in the sub-sector, thus it is difficult to obtain more accurate results in answering the mechanism for the effect of FDI in the service sector on growth. Recent empirical findings of Abouelfarag and Abed (2020) note that FDI in the construction sector does not contribute significantly to growth. The argument is that complicated procedures can stifle the impact of FDI in this sector.
In contrast, Inekwe (2013) found that FDI in the service sector positively impacts growth. Hanafy and Marktanner (2019) found that the interaction between domestic investment and FDI in the service sector positively impacts economic growth. This result implies a spillover effect from service sector FDI both horizontally and between sectors.
To sum up, past studies exploring the association between FDI and growth steam up debate can be rooted in the diversity of the sample countries and sectors studied and the different methods used. However, there is still a gap to sharpen the analysis results, where previous research has not deeply explored the use of data at a country's sub-national or provincial level. Using sectoral data at the provincial level is critical to account for the province's specific effects, which may vary, especially in Indonesia, which has a large area and different economic characteristics in each province. Hence, in this study, we attempt to dig deeper into the effect of FDI on growth with the unique data we collect, namely sectoral data at the provincial level.