Threshold effects of institutional quality on FDI-economic growth nexus: a panel smooth transition regression (PSTR) model

This study aims to investigate whether threshold effects exist in the tripartite relationship between foreign direct investment (FDI), institutional quality and economic growth. More specifically, it seeks to see whether a certain tipping (threshold) level of institutional quality should be reached to afford the maximal growth-enhancing benefits associated with FDI. The study applies the panel smooth threshold regression model to a sample of 160 countries for the period 2002-2021. The results show that the model has only one threshold for the six transition variables considered, revealing the contingent effect of institutional quality on the FDI-growth nexus. Above the estimated threshold, institutional quality has a positive impact on marginal growth effect of FDI. However, below the threshold, FDI has a significant negative effect on growth. This result supports the viewpoint that a better quality of institutions foster the transmission channels from FDI to host economy via technology transfer or knowledge diffusion, while poor institutional quality leads to a higher home country-uncertainty (i.e. higher cost of doing business) which undermine the FDI-induced growth. This study contributes by exploring the role of institutional thresholds in determining economic growth-FDI dynamics and provides useful insights to policymakers.