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No. 36: Foreign Direct Investment and Domestic Capital Formation
by Walid Hejazi and Peter Pauly, University of Toronto, April 2002
Canada has traditionally been a major host economy for foreign direct investment (FDI). In 1970, the ratio of the inward FDI stock to GDP was 30 percent, whereas the ratio of the outward FDI stock was only 7 percent. By 1998, these figures had changed dramatically: the outward FDI ratio had increased to 27 percent and the inward FDI ratio had fallen to 24 percent. These changes have raised important policy questions about their impact on several aspects of the Canadian economy. The analysis presented here addresses only the impact of these changes on capital formation in Canada. Using annual industry-level data for the period 1983 to 1995 and panel data techniques we estimate the link between FDI and domestic capital formation. For the economy as a whole, the results show no statistically significant link between outward FDI and domestic investment. In contrast, inward FDI is found to supplement Canadian domestic capital formation. However, there is heterogeneity when gross fixed capital formation is broken down in its components, by industry and by trading partner. The policy conclusions are multi-facetted and are discussed in the paper. Overall, policymakers should not consider policies that would restrict outward FDI to certain regions of the world, but rather should focus on the factors that enter into firm-level decision making that undertake direct investment abroad. Furthermore, given that inward FDI is found to supplement capital formation in Canada regardless of the source country, policies should aim at encouraging inward FDI.
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