The Impact of FDI on Innovation in Developing Countries: The Mediating Role of Governance

Abstract

While most studies in the existing literature focused on the direct relationship between FDI and innovation, this paper further analyzes whether governance in developing economies mediates this relationship. A 25-year cross-sectional time-series data from 1995 to 2019 were collected from the World Bank Development Indicators and the Worldwide Governance Indicators (2019) databases. This panel dataset was estimated using a system GMM. A novel finding emerged from the investigation: the positive impact of FDI on domestic innovation is mediated by two governance variables: voice and accountability and regulatory quality. This suggests that the impact of FDI on domestic innovation is strengthened when combined with the effects of mediating variables. The results imply that, in the absence of high governance quality, the traditional policy prescription—such as increasing government spending on R&D and education—may not be adequate to promote FDI's innovation spillovers. The findings suggest that governments in developing nations should work to improve the voice & accountability and regulatory quality indicators by ensuring that citizens take part in the decision-making to promote the flow of knowledge and information that fosters innovation. This will help to strengthen the influence of FDI on domestic innovations. In addition, the governments should foster an environment that is welcoming to foreign investment and implement the appropriate regulatory reforms, such as those that strengthen competition protection, property rights protection, and transparency in the operations of the organizations implementing policies.