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The Effect of Foreign Direct Investment on Domestic Investment(EP Vol.11 No.2)

Economic Research Institute (02-759-5407) 2009.01.02 1053

Author : Hyun Jeong Kim

Recently, domestic investment in Korea has been dwindling while outbound foreign direct investment (FDI) made by Korean enterprises has increased. This raises the issue of whether foreign direct investment replaces and suppresses domestic investment. The relationship between FDI and domestic investment, however, is not straightforward as many previous studies show. Some argue that outward FDI and domestic investment may substitute for each other via the resource constraint facing a multinational enterprise. Other studies stress that the two types of investment can be complementary through the relatedness of the production process or through a regionally created vertical division of labor. In addition, some researchers find that the relationship between FDI and domestic investment can vary across countries depending on their industrial structures. Therefore, the issue is empirical rather than theoretical. This paper tries to look at the relationship between outbound FDI and domestic investment of Korea.

It turns out that the analysis of quarterly data for the economy as a whole(1990.Q1∼n2006.Q4) does not provide a strong case for a substitution relationship between outbound FDI and domestic investment in the case of Korea. If anything, the relationship was complementary for the whole period, although the significance of the positive relationship weakened after the 1997 financial crisis. An analysis of manufacturing panel data (13 manufacturing industries, 1990∼ハ2005) also confirms the complementary relationship. By destination, however, the result was rather different. FDI in developed countries has no significant relationship with domestic investment, while that in developing countries was complementary to domestic investment. This results indicate that FDI in developed countries may be decided upon in independence from the decision-making on domestic investment, and that FDI in developing countries may take place while maintaining vertical connections with domestic investment and production. By period, the positive relationship between FDI outflow and domestic investment was weak over the whole period, but it became significant after the Asian crisis. This seems to be related with the fact that FDI in labor intensive industries was dominant before the crisis in Korea, while FDI in high-tech industries, which require vertical connectedness with domestic production, became more prevalent after the crisis.

JEL Classification Number : F21, F23, F41

Keywords : Foreign Direct Investment (FDI), Domestic Investment