This paper evaluates the role of foreign direct investment (FDI) in the transition from socialism to capitalism. Fixed-effects panel regressions indicate that FDI and domestic investment have an equal effect on growth in the first year of investment, but over time FDI is associated with greater growth than domestic investment. However, this positive impact of FDI turns out to be contingent upon the presence of a relatively well-functioning state in the host economy; in the absence of such a state, the net effect of FDI on economic development may be negative. All findings are robust in light of instrumental variable estimation, which is used to account for potential endogeneity problems.