Using a panel cointegration framework, the article explores the two‐way link between FDI and growth for a panel of 23 developing countries. In addition, it investigates the impact of liberalization on the dynamics of the FDI and GDP relationship. A long‐run cointegrating relationship is found between FDI and GDP after allowing for heterogeneous country effects. The cointegrating vectors reveal a bidirectional causality between GDP and FDI for more open economies. For relatively closed economies, long‐run causality appears unidirectional and runs from GDP to FDI, implying that growth and FDI are not mutually reinforcing under restrictive trade and investment regimes.

The two-way link between foreign direct investment and growth for India is explored using a structural cointegration model with vector error correction mechanism. The existence of two cointegrating vectors between GDP, FDI, the unit labour cost and the share of import duty in tax revenue is found, which captures the long run relationship between FDI and GDP. A parsimonious vector error correction model (VECM) is then estimated to find the short run dynamics of FDI and growth. Our VECM model reveals three important features: (a) GDP in India is not Granger caused by FDI; the causality runs more from GDP to FDI; (b) trade liberalization policy of the Indian government had some positive short run impact on the FDI flow; and (c) FDI tends to lower the unit labour cost suggesting that FDI in India is labour displacing.

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