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faro et al. (2004) draw attention to financial markets as they find that FDI promotes economic growth in economies with sufficiently developed financial markets.

Choe (2003) results points towards bi-directional causality between FDI and growth, although he finds the causal impact of FDI on growth to be weak. Basu et al. (2003) addresses the question of the two-way link between growth and FDI. Basu et al. emphasize trade openness as a crucial determinant for the impact of FDI on growth, as they find two-way causality between FDI and growth in open economies, both in the short and the long run, whereas the long run causality is unidirectional from growth to FDI in relatively closed economies. There seems to be a strong relationship between FDI and growth and this relationship is highly heterogeneous across countries.

Tax incentives or free trade zones are used by some countries to attract investors, despite mixed evidence about their impact on FDI flows and the potentially high costs compared to the benefits (Piritta Sorsa, 2003). One lesson that Carkovic and Levine draw from their study is that “…do not support special tax breaks and subsidies to attract foreign capital”. FDI attracted by tax breaks or subsidies, especially if protection is part of the incentives, may be more likely to fit badly with the host country’s comparative advantages and may be less likely to be associated with enlarged trade. Moran’s (2005) paper gives many examples of such ill-fitting foreign investments.

Ahmed, Butt, and Alam (2003), found significant effect from FDI to domestic output. Calvo and Robles, (2003) concluded that FDI stimulates the investment in R&D. The work by, Xu (2000), and Alfaro et al. (2003) suggests that educational level, development of local financial markets, and other local conditions play an important role in allowing the positive effects of FDI to materialize. Borenztein et al. (1998) found that FDI raises growth, but only in countries where the labor force has achieved a certain level of education. Blomstrom and Kokko (2003) concluded that spillovers are not automatic, and local conditions influence firms’ adoption of foreign technologies and skills. Findlay (1978) argues that FDI increases the rate of technical progress in host countries through a “contagion” or knowledge diffusion effect from the more advanced technologies in parent countries. Chenery and Strout (1966) concluded, on the basis of empirical evidence from LDCs that foreign capital has a positive effect on economic growth. Rosenstein-Rodan (1943) and Hirschmann (1981). Markusen and Venables (1999) provide an explicit application to the case of FDI. The transfer of knowledge (know-how) is a strongly emphasized, point in the FDI literature.

De Mello (1999), found strong relationship between FDI, capital accumulation, output and productivity growth. He found that effect of FDI on growth or on capital accumulation and total factor productivity (TFP) varies greatly across the countries and the extent to which FDI is growth-enhancing depends on the degree of complementarity or substitution between FDI and domestic investment. De Mello (1997) lists two main channels through which FDI may be growth enhancing. First, FDI can encourage the adoption of new technology in the production process through capital spillovers. Second, FDI may stimulate knowledge transfers, both in terms of labor training and skill acquisi