Foreign direct investment and growth: Can different regional identities shape the returns to foreign capital investments?

Abstract

In this paper we argue that informal institutions, or more generally, what is called social capital, can act as one of the mediating factors determining the size and the direction of foreign direct investment-induced spillovers on growth and productivity at regional level. The idea is that when a foreign firm sets up a new production plant in a location, the nature and the quality of its relationships with local workers and firms are affected by the endowment of social capital of that location. A ‘wrong’ social capital may make these relationships difficult, thus limiting the capacity of the host economy to convert foreign direct investment-induced spillovers into local competencies conducive to growth. We operationalized informal institutions in terms of generalized trust, associational activity, and cultural closeness and we found that spillover effects do not arise: (1) when generalized trust is too ‘self-referential’, (2) the level of associational activities is low, and (3) cultural closeness towards foreigners and external culture dominate the society. We also found that foreign presence is not universally beneficial, since positive spillovers are associated with EU-originating foreign firms and foreign direct investment in services only. These results have policy implications for the EU regions. In order to maximize the returns from foreign direct investment, the issue of the origin of foreign investors as well as the sectoral composition of foreign direct investment inflows should be carefully considered. Furthermore, investments in education may help regions to benefit more from the foreign presence because human capital and social capital are likely to be complementary.