NBA SCHOOL OF BUSINESS

Does Foreign Direct Investment (FDI)

promote economic growth?
Paper Presentation

Syed Ahmed Bari (MBA Semester I, MDU Section A)
11/25/2011




The Concept of Foreign Direct Investment is now a part of Indias economic future but the term
remains vague to many, despite the profound effects on the economy. Despite the extensive
studies on FDI, there has been little illumination forthcoming and it remains a contentious topic.
The paper explores the uneven beginnings of FDI, in India and examines the developments
(economic and political) relating to the trends in key sectors. This paper examines whether the
effect of foreign direct investment (FDI) on economic growth is dependent upon different
absorptive capacities.
Does Foreign Direct Investment (FDI) promote economic growth?
Abstract
The Concept of Foreign Direct Investment is now a part of Indias economic future but the term
remains vague to many, despite the profound effects on the economy. Despite the extensive
studies on FDI, there has been little illumination forthcoming and it remains a contentious topic.
The paper explores the uneven beginnings of FDI, in India and examines the developments
(economic and political) relating to the trends in key sectors. This paper examines whether the
effect of foreign direct investment (FDI) on economic growth is dependent upon different
absorptive capacities. The empirical analysis shows that FDI alone plays an ambiguous role in
contributing to economic growth based on a sample of 62 countries covering the period from
1975 through 2000. Under the threshold regression, we find that initial GDP and human capital
are important factors in explaining FDI. FDI is found to have a positive and significant impact on
growth when host countries have better levels of initial GDP and human capital. Foreign direct
investment (FDI) is known as an important catalyst for economic growth in the developing
countries. It affects host countries economic growth by transferring technology, increasing
human capital formulation and by stimulating domestic investment, and access to global
markets. This paper is about characteristics of FDI in India and its role in rise of economy. The
main purpose of the paper is to investigate the impact of FDI on Indian economic growth since
1947.
By
Syed Ahmed Bari
MBA (MDU; Section A)













1 Introduction
Foreign direct investment (FDI) is usually viewed as a channel through which for technology is
able to spread from developed countries to developing countries. This frequently leads to the
following question: Does foreign direct investment (FDI) contribute to economic growth? The
answer to this is uncertain. In the theoretical literature, the role of FDI is that of a carrier of
foreign technology that can boost economic growth (Findlay (1978) and Romer (1993)). In the
empirical studies on FDI, however, the evidence is still divided. Aitken and Harrison (1999), for
instance, nd that the net eect of FDI on productivity is quite small. Borensztein(1998) and
Carkovic and Levine (2005) also arrive at similar results by nding FDI does not have an
unmitigated and positive eect on economic growth. On the other hand, Haddad and Harrsion
(1993), Kokko(1996), and Alfaro (2004) point out that FDI can increase the rate of growth in
the host economy through technology transfer.
Although the evidence on the relationship between FDI and economic growth is ambiguous,
several studies argue that the host countrys absorptive capacity plays an important role in
explaining FDI. For instance, Blomstrom (1994) state that FDI is positive and signicant only for
higher income countries and that is has no impact in lower income countries. Borensztein
(1998) point out that the contribution of FDI to economic growth is enhanced by its interaction
with the level of human capital in the host country. Balasubramanyam et al. (1996) argue that
FDI plays dierent role in the growth process due to the diering trade policy regimes. For
these reasons, in this paper we choose three threshold variables which are the initial GDP,
human capital and the volume of trade.
The main contribution of this paper is that it revisits the relationship between FDI and
economic growth using threshold variables. We apply an instrumental variable estimation of an
endogenous threshold model which as proposed by Caner and Hansen (2004). In their
approach, the estimator for the threshold value involves a two-stage least squared (2SLS) and
the estimates of the slope parameters are obtained using the generalized method of moment
(GMM). Im trying to resorts to endogenous threshold regression techniques rather than
arbitrarily assuming cut-o values. Using a cross-sectional survey of 62 countries over the
19752000 period, we nd that FDI does not accelerate growth based on the least squares (LS)
approach. Furthermore, in using the GMM method that takes endogenity into consideration, FDI
is not found to have a positive eect on growth. In threshold models, the results show that FDI
can inuence growth to dierent degrees based on dierent threshold variables. In addition,
FDI is found to have a positive and signicant eect on economic growth when the host
countries have higher level of initial GDP and human capital. Another important result is the
convergence club. When the threshold variable is initial GDP, we nd that the rich countries are
becoming richer and the poor ones are becoming poorer.
The remainder of this paper is organized as follows. Section 2 lays out the IV regression model
with the threshold that is proposed by Caner and Hansen (2004). Section 3 reports the data and
the empirical ndings. The conclusions are presented in Section 4.
2 Methodology
The pure cross-sectional analysis uses data averaged over 19752000. There is one observation
per country. The basic regression takes the form:
yi = Fi + Xi + ui . (1)
Where yi is the rate of growth, Fi equals FDI, and Xi presents a vector of conditional information
set.
As is widely known that the eect of FDI on growth give rise to the possibility of both
endogeneity and reverse causality of FDI, as a result of which both FDI and growth are
simultaneously determined and FDI is correlated with the error term. We then apply the
instrumental threshold regression proposed by Caner and Hansen (2004) to avoid the
endogeneity problem and investigate the threshold eect of FDI on economic growth. Hence,
equation (1) can take the following from:
yi = (1Fi + 1Xi)1(Ti ) + (2Fi + 2Xi)1(Ti > ) + ui. (2)
Fi = (1Wi + 1Xi)1(Ti ) + (2Wi + 2Xi)1(Ti > ) + vi..(3)
where 1() is the indicator function, Ti is the threshold variable and an element of the vector Xi,
is the threshold parameter, Wi is a vector of instrumental variables and the order condition is
satised. We estimate the parameters sequentially. First, we estimate (3) using LS, by
substituting the predicted values of the endogenous variable Fi into (2). Second, we estimate the
threshold parameter, , using LS. Finally, we estimate the slopes using GMM on the split
samples.

3 Empirical results
3.1 Data and Variables
This paper uses cross-sectional data for 62 countries over the period 19752000 to analyse the
relationship between foreign direct investment (FDI) and economic growth. FDI (Fi) equals net
FDI inows as a share of GDP. The economic growth rate (yi) equals the rate of real per capita
GDP growth. We also control other determinants (Xi), namely, initial GDP, human capital,
government consumption, black market premium, ination, and the volume of trade. In order to
deal with the endogenous problem, corruption, bureaucracy, the log of population, and
institutional quality are used as instrumental variables (Wi) for FDI. A detailed description of all
the variables is included in the Appendix.
Table 1 provides summary statistics for our sample. The mean of the per capita growth rate for
the sample is 1.4 % and ranges from 2.2% for Sierra Leone to 5.7% for Korea. The mean of the
FDI is 1.8% and ranges from 4.4% for Sierra Leone to 8.3% for Belgium.
3.2 Findings
Table 2 presents the results based on the LS and GMM methods. Each column of this table shows
the results for a selection of the conditioning information, Xi , and adds the interaction terms
into it. The interaction terms are FDI(initial GDP), FDI(human capital) and FDI(trade
volume). Columns 2 to 4 show that the coecients of FDI in these specications are not
statistically signicant. If we ignore the problem of endogeneity in terms of the relationship
between economic growth and FDI, FDI does not have a reliable impact on economic growth.
We can nd that the initial value of GDP is negative and

statistically signicant in this table. This nding points to conditional convergence, for it
predicts a higher growth in response to a lower starting per capita GDP, and has an important
inuence on the growth rate (Barro and Sala-i-Martin (2003)). Human capital also has a
signicant impact with the expected sign, as explained in Borensztein et al. (1998). The black
market premium is found to be signicantly negative and hurts economic growth in all of the
regressions.
Columns 6 to 9 of Table 2 report the results based on the GMM method that can avoid the
endogenity problem. We use corruption, bureaucracy, the log of population, and institutional
quality as instruments. It is clear that FDI is not signicantly linked with economic growth at all.
To further examine the contribution of FDI to economic growth, we analyse its relationship with
dierent threshold variables and dierent regimes. Table 3 summarizes the results of the
threshold regressions using Caner and Hansen (2004). Threshold values are estimated
using the 2SLS method and the coecients are estimated using GMM. The instrumental
variables are the same as for the GMM regression. The threshold value ( ) for initial GDP is
8.011, and there are 34 countries with values smaller and 28 countries with values larger than
. For human capital, is 2.108 with 42 countries smaller than it and 20 countries larger than it.
As for trade volume, is -0.813 with 17 countries smaller than it and other countries larger than
it. Column 2 indicates that the direct eect of FDI for higher income countries is signicantly
positive and the same as the results of Blomstrom (1994).Although the interaction term for
higher income countries is both negative and signicant, the direct eect of FDI is lager than the
indirect eect. Therefore, local rms are advanced enough to learn from foreigners when the
host country is a high income country. Another important nding concerns the initial GDP
which has signicantly dierent signs in dierent regimes. This means that there exist
convergence clubs (for example, Quah (1997)).This points to a group of convergent economies
and another group of divergent economies.
Columns 3 and 4 of Table 3 assess whether the level of human capital in the recipient country
inuences the relationship between FDI and economic growth. FDI is found to signicantly and
positively enter countries with higher human capital countries. This result is the same as in
Borensztein et al. (1998). They state that FDI has a positive growth eect once human capital is
greater than average human capital. Besides, we can only nd conditional convergence in this
case and human capital can boost economic growth.
Columns 5 and 6 assess whether the relationship between FDI and growth varies with the
degree of the volume of trade. The coecients for FDI and their interaction terms are not
signicant. We therefore cannot conrm the ndings of Balasubramanyam (1996) and
Balasubramanyam et al. (1999) that FDI can promote economic growth in the presence of a
liberal trade regime.
To sum up, we nd that FDI alone plays an ambiguous role in contributing to economic growth
when we use the LS and GMM regressions. Furthermore, we apply the threshold model
proposed by Caner and Hansen (2004) to discuss the role of FDI for the dierent levels of
threshold variables. The main result of this paper is that the eect of FDI on growth is
dependent upon the extent of the host countrys absorptive capacity. In particular, initial GDP
and human capital are the most important factors for FDI. Apart from this, we nd the
convergence club using initial GDP as the threshold variable.
4 Conclusions This paper examines the inuence of FDI on economic growth using threshold
variables that include the initial GDP, human capital, and volume of trade based a cross-
sectional study of 62 countries covering the period 19752000. We adopt the instrumental
variable estimation of a threshold regression approach developed by Caner and Hansen (2004).
The empirical evidence suggests that there are conicting eects of FDI. The results of the
threshold regression show that FDI can promote economic growth when the host country has
achieved a certain threshold of development, initial GDP and human capital. This is perhaps
indicative of the recipient countries learning and/or beneting from foreign investors. Thus,
initial GDP and human capital are important factors for FDI that are consistent with Blomstrom
(1994), and Borensztein (1998).
Other example is Foreign Direct Investment and Economic Growth in Asia
I. INTRODUCTION

Over the past two decades, many countries around the world have experienced substantial
growth in their economies, with even faster growth in international transactions, especially in
the form of foreign direct investment (FDI). The share of net FDI in world GDP has grown five-
fold through the eighties and the nineties, making the causes and consequences of FDI and
economic growth a subject of ever-growing interest. This paper attempts to make a
contribution in this context, by analyzing the existence and nature of causalities, if any, between
FDI and economic growth. It uses as its focal point the South and Southeast Asian region, where
growth of economic activities and FDI has been one of the most pronounced.
The literature on FDI and economic growth generally points to a positive relationship
between the two variables, and offers several, standard explanations for it. In principle,
economic growth may induce FDI inflow when FDI is seeking consumer markets, or when
growth leads to greater economies of scale and, hence, increased cost efficiency. On the other
hand, FDI may affect economic growth, through its impact on capital stock, technology transfer,
skill acquisition, or market competition. FDI and growth may also exhibit a negative
relationship, particularly if the inflow of FDI leads to increased monopolization of local
industries, thus compromising efficiency and growth dynamics. Empirically, the positive effect
of economic growth on FDI and also the positive and negative effects of FDI on economic growth
have been identified in the literature. However, very few studies attempt to directly test for
causality between FDI and growth. Two studies that do so include Basu, Chakraborty and
Reagle (2003), and Trevino and Upadhyaya (2003). Both find that FDI-to-growth causality is
more likely to exist in more open economies. In addition, an earlier study by Ericsson and
Irandoust (2000) explores the causal relationship between FDI and total factor productivity
growth in Norway and Sweden, and finds the two to be causally related in the long run.
This paper extends the line of work mentioned above, and provides a direct test of causality
between FDI and economic growth in one of the most dynamic regions of the world: South and
Southeast Asia. Using Granger causality tests, the analysis reveals substantial variation in the
FDI-growth causal relationship across countries, implying that generalization of any causality
between the two variables can be problematic. To better understand the cross-country
variation, the paper extends the analysis using regression techniques, and identifies
institutional variables that affect the FDI-growth relationship. The importance of institutions to
economic dynamics is now well recognized, and given the widespread but varying institutional
reforms across countries through the eighties and the nineties, the inclusion of institutional
factors is indispensable for the analysis at hand. To identify their relevance to the FDI-growth
relationship, separate from their direct effects on FDI or growth alone, the analysis focuses on
interaction effects involving the explanatory variables. The results show that FDI-to-growth
causality is reinforced by greater trade openness, more limited rule of law, lower receipts of
bilateral aid, and lower income level in the host country. Growth-to-FDI causality, on the other
hand, is reinforced by greater political rights and more limited rule of law.
The remainder of the paper is structured as follows. Section II discusses the background
literature on the determinants of and relationship between FDI and economic growth. It also
describes the sample used in the present analysis. Section III carries out the Granger causality
tests and establishes the cross-country variation in FDI-growth causality. Section IV extends the
analysis using regression techniques and identifies the economic and institutional factors that
help to explain the cross-country variation in the FDI-growth causal relationship. Finally,
Section V concludes. Relevant tables, with descriptive statistics and results of the analyses, are
presented in the appendix.
II. FOREIGN DIRECT INVESTMENT AND ECONOMIC GROWTH
Standard economic theory points to a direct, causal relationship between economic growth
and FDI that can run in either direction. On the one hand, FDI flows can be induced by host
country economic growth if the host country offers a sizeable consumer market, in which case
FDI serves as a substitute for commodity trade, or if growth leads to greater economies of scale
and cost efficiency in the host country. On the other hand, FDI itself may contribute to host
country economic growth, by augmenting the countrys capital stock, introducing
complementary inputs, inducing technology transfer and skill acquisition, or increasing
competition in the local industry. Of course, FDI may also inhibit competition and thus hamper
growth, especially if the host country government affords extra protection to foreign investors
in the process of attracting their capital.
Empirically, the positive effect of host country economic growth on FDI inflow has been
confirmed by various studies (see Veugelers, 1991; Barrell and Pain, 1996; Grosse and Trevino,
1996; Taylor and Sarno, 1999; Trevino et al., 2002). The effects of FDI on subsequent economic
growth has been shown to be both positive (Dunning, 1993; Borensztein et al., 1998; De Mello,
1999; Ericsson and Irandoust, 2000; Trevino and Upadhyaya, 2003) and negative (Moran,
1998). Generally, the positive growth effects of FDI have been more likely when FDI is drawn
into competitive markets, whereas negative effects on growth have been more likely when FDI
is drawn into heavily protected industries (Encarnation and Wells, 1986). Overall, though, FDI
turns out to be associated with greater domestic investment, not smaller. Moreover, this
positive association between FDI and domestic investment tends to be greater than that
between foreign portfolio investment and domestic investment (Bosworth and Collins, 1999).
Basu, Chakraborty and Reagle (2003) study a panel of 23 developing countries from Asia,
Africa, Europe and Latin America, and find the causal relationship between GDP growth and FDI
to run both ways in more open economies, and in only one directionfrom GDP growth to
FDIin more closed economies. Trevino and Upadhyaya (2003) find a comparable result,
based on their study of five developing countries in Asia, that the positive impact of FDI on
economic growth is greater in more open economies. Whether other factors, especially
institutional ones that directly affect FDI or economic growth, also influence FDI-growth
relationship remains an open question.
Generally speaking, FDI decisions depend on a variety of characteristics of the host
economy, in addition to its market size. These include the general wage level, level of education,
institutional environment, tax laws, and overall macroeconomic and political environment. The
impact of host country wage level or education level on FDI depends on the skill intensity of the
particular production process in question and, hence, may vary from case to case. The impact of
institutional quality, physical infrastructure, import tariffs, macroeconomic stability, and
political stability on FDI inflow is usually positive (see Wei, 1997; Mallampally and Sauvant,
1999; Trevino et al., 2002; Biswas, 2002), whereas that of corporate taxes tends to be negative
(see Wei, 1997; Gastanaga et al., 1998; Hsiao, 2001). Turning to economic growth, the standard
determinants include the rate of capital accumulation and variables that raise total factor
productivity, such as education level, institutional quality, macroeconomic stability, political
environment, and, potentially, trade openness. In studying the direct, causal relationship
between FDI and economic growth in this paper, we explore the relevance of some of these
economic and political economy variables just mentioned.
Our study covers the FDI-growth relationship in nine countries: Bangladesh, India, Korea,
Malaysia, Pakistan, the Philippines, Singapore, Sri Lanka and Thailand. The choice of this
sample was driven by our attempt to include an economically diverse set of countries in a
region that has been characterized by relatively high rates of economic growth and FDI over the
past two decades. Collectively, the sample countries have featured higher rates of foreign
investments, foreign aid, and commodity trade relative to their GDP than has the rest of world.
They also experienced significantly greater growth rates in GDP, foreign investments, and
commodity trade, compared to the rest of the world. Table 1 presents some of the key statistics
with respect to resource flows and commodity trade in the sample countries vis--vis the world
economy. Table 2 presents some data on cumulative growth rates of these flows.
TABLE 1. RESOURCE FLOWS AND COMMODITY TRADE: 19802001 AVERAGE
Country / Group FDI
(% of GDP)
FPI
(% of GDP)
Aid
(% of GDP)
Trade
(% of GDP)
Bangladesh 0.105 0.001 5.100 26.366
India 0.255 0.380 0.669 20.081
Korea, Rep. 0.552 0.998 0.026 68.461
Malaysia 4.316 1.378 0.387 152.059
Pakistan 0.606 0.362 2.490 35.495
Philippines 1.230 0.928 1.623 69.850
Singapore 10.038 n.a. 0.077 329.231
Sri Lanka 0.991 0.383 6.380 73.264
Thailand 1.898 0.734 0.801 75.885

Sample Countries 2.232 0.688 1.950 82.037
Low & Middle Income Countries 1.437 0.230 1.121 42.199
High Income Countries 1.118 n.a. 0.015 40.478
World 1.180 n.a. 0.244 41.514

Sources: World Development Indicators, Global Development Finance, and authors
calculations.
Notes: FDI refers to net inflows of foreign direct investment; FPI refers to foreign portfolio
investment. Aid measures the sum of official development assistance (ODA) and net official aid
flows.
TABLE 2. CUMULATIVE GROWTH RATES: 19802001
Country / Group GDP FDI FDI
(%GDP)
Aid Aid
(%GDP)
Exports Imports Trade
(%GDP)
Bangladesh 155 2472 898 -8 -64 482 164 34
India 144 3143 1218 -19 -67 419 302 83
Korea, Rep. 525 12225 1936 -172 -111 699 530 13
Malaysia 231 129 -29 -48 -84 659 480 101
Pakistan 116 419 140 15 -48 211 71 0
Philippines 111 4298 2370 84 -13 391 285 105
Singapore 539 474 -9 -98 -100 n.a. n.a. n.a.
Sri Lanka 262 234 -7 -26 -80 354 240 5
Thailand 245 1896 477 59 -55 832 566 128

Sample Mean 259 2810 777 -24 -69 506 330 59
Low & Middle Income 99 972 297 90 -4 156 150 64
High Income 201 2087 500 -15 -72 242 241 16
World 180 1783 442 85 -34 227 224 32

Source: Authors calculations.
Notes: Growth rates reflect cumulative growth from 1980-82 average (in current dollars) to
1999-2001 average.

Evidently, not all countries in the sample have been highly open to foreign investments or trade,
and not all countries have experienced similar growth in GDP or in international transactions.
In terms of GDP growth, Bangladesh, India, Pakistan, and the Philippines outperformed other
low and middle-income countries collectively, but they lagged behind the world average. As for
FDI, Bangladesh, India, Pakistan, Sri Lanka, and Korea tended to attract less investments
compared with other countries. However, over the years Bangladesh, India and Korea outpaced
most other countries in terms of FDI growth. As for trade, one finds lower-than-average
openness (defined as the ratio of total trade to GDP) in Bangladesh, India and Pakistan, with
Pakistan also lagging behind the rest of the world in terms of growth in trade.
A casual look at the data does not reveal any clearly discernible pattern involving GDP
growth and FDI. However, it seems consistent with a positive correlation between the two
variables. As already discussed, causality, if any, can run in either direction, and other variables
may also complicate these direct, causal relationships. We now turn to the empirical
examination of these relationships for our sample countries.
III. GRANGER CAUSALITY
In order to test for direct causality between FDI and economic growth, we perform a
Granger causality test using equations (1) and (2):
t
GDP
t
k
i
i t i
k
i
i t i
FDI GDP | o
1 1
+ + + =
=

=

(1)
t
FDI
t
k
i
i t i
k
i
i t i
FDI GDP q o |
1 1
+ + + =
=

=

(2)
where
t
GDP and
t
FDI are stationary time series sequences, and | are the respective
intercepts,
t
and
t
q are white noise error terms, and k is the maximum lag length used in each
time series. The optimum lag length is identified using Hsiaos (1981) sequential procedure,
which is based on Grangers definition of causality and Akaikes (1969, 1970) minimum final
prediction error criterion. If in equation (1)
=
k
i
i
1
| is significantly different from zero, then we
conclude that FDI Granger causes GDP. Separately, if
=
k
i
i
1
o in equation (2) is significantly
different from zero, then we conclude that GDP Granger causes FDI. Granger causality in both
directions is, of course, a possibility.
Since macroeconomic time-series data are usually non-stationary (Nelson and Plosser,
1982) and thus conducive to spurious regression, we test for stationarity of the data series
before proceeding with the Granger causality test. We employ two separate methods for the
stationarity test. First, we conduct an augmented Dickey-Fuller test (Nelson and Plosser, 1982)
by carrying out a unit root test based on the structure in (3):
t
X A
t
n
i
i t i i t i
X X t c u k
1
+ A + + + =
=

(3)
where X is the variable under consideration, A is the first difference operator, t captures any
time trend,
t
c is a random error, and n is the maximum lag length. The optimal lag length is
identified so as to ensure that the error term is white noise. If we cannot reject the null
hypothesis 0 = u , then we conclude that the series under consideration has a unit root and is
therefore non-stationary. Second, in addition to the Dickey-Fuller test, we perform the Phillips-
Perron test (Phillips, 1987; Phillips-Perron, 1988), using a non-parametric correction to deal
with any correlation in error terms.
The results of the stationarity tests are reported in Table 3. The unit root tests on the levels
of each variable reveal the corresponding series to be non-stationary for all countries.
Analogous tests on the first-difference measures of the variables, however, reveal both series to
be integrated in the first order and, hence, stationary at the first-difference level. We therefore
proceed with the Granger causality tests with equations (1) and (2) using first-differences of the
respective series.
According to the test results, reported in Table 4, the existence and direction of causalities
between GDP growth and FDI have varied significantly across the countries in our sample. In
Bangladesh and Malaysia, no direct causal relationship between the two variables seems to have
existed during the given period. In South Korea, Singapore, Sri Lanka, and Thailand, causality
ran from growth to FDI, but not in the reverse direction. In Pakistan, causality ran from FDI to
growth, and not from growth to FDI. In India and the Philippines, causality ran both from
growth to FDI and from FDI to growth.
It is thus evident that despite the above-average growth rates in both GDP and FDI in the
sample region, we cannot generalize any FDI-growth causal relationship for the region. Growth
seems to induce FDI in several, but not all, cases. Likewise, FDI seems to induce growth in some,
but not all, cases. Overall, the results indicate the presence of some FDI-growth causality in
seven of the nine countries, with the variation in the nature of this relationship pointing to
possible influence of other, institutional factors. We explore these possibilities in the next
section.
TABLE 3. UNIT ROOT TEST
Augmented Dicky Fuller Philip-Perron
Level First Diff. Level First Diff.
Bangladesh FDI -2.608 -3.572
***
-2.626 -4.595
*

GDP -1.069 -3.479
***
-0.544 -5.670
*

India FDI -2.512 -3.330
***
-2.106 -3.295
***

GDP -2.988 -3.759
**
-2.539 -4.000
**

Korea, Rep. FDI -2.892 -3.805
**
-2.777 -5.393
*

GDP -1.408 -3.877
**
-2.539 -4.648
*

Malaysia FDI -1.835 -3.937
**
-2.768 -5.894
*

GDP -1.877 -3.344
**
-1.800 -4.515
*

Pakistan FDI -2.691 -4.506
*
-3.019 -3.603
**

GDP -0.996 -4.261
**
-0.601 -7.650
*

Philippines FDI -1.723 -3.998
**
-3.046 -6.831
*

GDP --2.912 -4.126
**
-1.871 -3.937
**

Singapore FDI -2.434 -3.942
**
-2.615 -5.764
*

GDP -1.979 -3.736
**
-1.457 -3.920
**

Sri Lanka FDI -2.255 -4.618
*
-2.698 -8.603
*

GDP -1.955 -3.051 -2.076 -4.334
**

Thailand FDI -1.591 -3.259
***
-1.709 -4.051
**

GDP -1.707 -3.770
**
-0.947 -3.753
**

TABLE 4. GRANGER CAUSALITY TEST RESULT
FDI GDP GDP FDI F statistic. P value
Bangladesh No 0.1345 0.967
No 0.619 0.657
India Yes 2.497
****
0.119
Yes 2.593
****
0.117
Korea, Rep. No 0.233 0.915
Yes 2.477
***
0.089
Malaysia No 1.512 0.245
No 1.777 0.187
Pakistan Yes 3.953
**
0.039
No 0.624 0.611
Philippines Yes 7.111
***
0.069
Yes 4.437
***
0.085
Singapore No 0.413 0.855
Yes 2.409
***
0.098
Sri Lanka No 0.713 0.559
Yes 3.001
***
0.060
Thailand No 0.024 0.976
Yes 2.814
***
0.079
*
denotes significance at 99% confidence level;
**
denotes significance at 95%
confidence level
***
denotes significance at 90% confidence level;
****
denotes significance at 85%
confidence level


IV. INSTITUTIONAL FACTORS AFFECTING THE FDI-GROWTH RELATIONSHIP
Most studies investigating the causes of FDI or economic growth concentrate on identifying
factors that directly affect the variable under consideration. In this sense, the analysis in the
preceding section, which tests for a direct, causal relationship between FDI and growth, is
similar to existing studies. The key finding from the causality tests here that is of particular
significance is the cross-country variation in FDI-growth causality. Some of this variation is
likely due to cross-country differences in the predominant type of FDI inflow, that is, the
investors motivation behind FDI, such as access to host country consumer markets versus
locating low-cost production areas. Additional variation in the FDI-growth causal relationship
likely arises from cross-country differences in economic and institutional structures. Very few
studies have explored these host country influences. Examples include Basu et al. (2003) and
Trevino and Upadhyaya (2003), both of which find that the degree of trade openness of the host
country affects the extent to which growth and FDI affect each other. We extend this line of
work by considering a broader set of economic and institutional factors, and attempt to better
understand the variation in FDI-growth causalities observed within our sample.
In Table 5, we divide our sample countries into four sub-groups, based on the existence of
causal relationships between FDI and growth as established in Section III, and present a set of
economic and institutional data for each sub-group. A glance at these data, though cursory, is
somewhat revealing. A causal link from FDI to economic growth seems more likely to exist in
countries that receive less FDI, are less open, have more limited transparency and rule of law,
receive greater amounts of aid from the U.S., and have lower income per capita. On the other
hand, growth-to-FDI causality is more likely in countries that have greater political rights and
receive smaller amounts of bilateral aid overall. Of course, this cursory glance misses valuable
information contained in the time-series variation within the panel data, and is therefore only
suggestive. In order to draw more accurate inferences from the given data, we use basic
regression techniques and look at the interaction effects associated with the FDI-growth
relationship.
TABLE 5. FDI, GDP, AND INSTITUTIONAL VARIABLES: GROUP AVERAGES
FDI GDP 0 0 1 1
GDP FDI 0 1 0 1

Countries in Group

Bangladesh,
Malaysia
Korea,
Singapore,
Sri Lanka,
Thailand

Pakistan

India,
Philippines
FDI (% of GDP) 2.33 3.24 0.44 0.45
Growth in GDP-PC (%) 6.32 8.64 5.76 4.54
Open (% of Years) 0.50 0.87 0.00 0.20
Corruption 2.52 3.58 1.67 2.10
Rule of Law 2.61 3.20 1.70 1.93
Political Rights Index 3.77 3.48 4.93 2.97
Bilateral Aid (% of GDP) 0.42 0.35 0.35 0.37
ODA-USA (mil 1985$) 66 13 102 95
GDP-PC (PPP$) 2391 5073 1133 2064
Sources: Alesina and Dollar (2000), World Bank (2003), and authors calculations.
Notes: 0 for FDI GDP or GDP FDI denotes the absence of the corresponding granger
causality.
1 for FDI GDP or GDP FDI denotes the presence of the corresponding
granger causality.
GDP-PC refers to per capita GDP, measured at purchasing power parity exchange
rates. Political rights index is based on Freedom House reports, with lower values reflecting
more freedom.


Since FDI typically involves longer-term considerations, we divide the time-series data from
1980 through 1999 into sub-periods of five years each, and regress the dependent variable on
lagged independent variables. The explanatory variables in the growth model include FDI, trade
openness, rule of law, political rights, overall bilateral aid, bilateral aid from the U.S., and per
capital GDP. Additional terms include quadratic terms for FDI and per capita GDP, and
interaction terms involving FDI. The FDI model includes as explanatory variables per capita
GDP growth, trade openness, rule of law, political rights, overall bilateral aid, and bilateral aid
from the U.S. Additional terms include the interaction effects involving economic growth. The
results from the growth model are presented in Table 6, and those from the FDI model are
presented in Table 7.
For the sample as a whole, the effect of FDI on subsequent economic growth is not
statistically significant (Table 6), whereas the effect of growth on subsequent FDI inflow is
positive and significant (Table 7). It is worth noting, though, that inclusion of country dummies
in the growth model (not reported in the paper) reveals the growth effect of FDI to be positive,
diminishing, and statistically significant. More central to our analysis here are the interaction
effects in the two models. In this context, the growth model reveals that the effect of FDI on
economic growth is more positive in countries characterized by greater trade openness, more
limited rule of law, lower receipts of bilateral aid, and lower income level. The positive effect of
openness on FDI-to-growth causality is consistent with the findings by Basu et al. (2003) and
Trevino and Upadhyaya (2003), and likely reflects the importance of an open, competitive
economic environment required for productive investment. The negative interaction effect of
the rule of law, in our interpretation, is suggestive of a beneficial role of FDI within an
institutional environment that otherwise constrains the efficiency of investments.
TABLE 6. ESTIMATING PER CAPITA GDP GROWTH: FDI AND INTERACTION EFFECTS

Dependent variable GDP-PC Growth
R-Squared (%) 93.0
Adjusted R-Squared (%) 78.9
Constant 1131.5
****
(292.5)
Trade Openness t-1 0.1167
(0.1205)
Rule of Law t-1 4.654
***

(1.749)
Political Rights (PR) Index t-1 1.2038
(0.8593)
Bilateral Aid t-1 13.197
**

(6.503)
U.S. Aid t-1 0.03565
*

(0.02158)
GDP-PC t-1 0.004333
(0.002920)
(GDP-PC t-1)
2
0.44 E-06
*

(0.25 E-06)

FDI t-1 9.738
(9.353)
(FDI t-1)
2
0.7423
(0.6978)
Trade Openness t-1 FDI t-1 0.14579
***

(0.06380)
Rule of Law t-1 FDI t-1 3.151
**

(1.684)
PR Index t-1 FDI t-1 0.886
(1.348)
Bilateral Aid t-1 FDI t-1 13.505
**

(6.147)
U.S. Aid t-1 FDI t-1 0.01807
(0.02994)
GDP-PC t-1 FDI t-1 0.0018319
***

(0.0007693)

Year 0.5738
****

(0.1469)
Notes: Standard errors are in parentheses below the estimates.
****
denotes significance at 99% confidence level,
***
denotes significance at 95%
confidence level,
**
denotes significance at 90% confidence level, and
*
denotes
significance at 85% confidence level
TABLE 7. ESTIMATING FDI: PER CAPITA GDP GROWTH AND INTERACTION EFFECTS

Dependent variable FDI
R-Squared (%) 93.5
Adjusted R-Squared (%) 85.8
Constant 354.9
***

(135.6)
Trade Openness t-1 0.04079
(0.05447)
Rule of Law t-1 2.863
**

(1.472)
Political Rights (PR) Index t-1 1.960
*

(1.162)
Bilateral Aid t-1 8.596
(8.850)
U.S. Aid t-1 0.04373
(0.03266)

GDP-PC Growth t-1 1.5981
**

(0.8786)
Trade Openness t-1 GDP-PC Growth t-1 0.000246
(0.006869)
Rule of Law t-1 GDP-PC Growth t-1 0.3041
*

(0.1898)
PR Index t-1 GDP-PC Growth t-1 0.2712
*

(0.1671)
Bilateral Aid t-1 GDP-PC Growth t-1 1.336
(1.271)
U.S. Aid t-1 GDP-PC Growth t-1 0.005635
(0.004698)
GDP-PC t-1 GDP-PC Growth t-1 0.3003 E-04
(0.2286 E-04)

Year 0.17151
***

(0.06619)
Notes: Standard errors are in parentheses below the estimates.
****
denotes significance at 99% confidence level,
***
denotes significance at 95%
confidence level,
**
denotes significance at 90% confidence level, and
*
denotes
significance at 85% confidence level
It is plausible that due to structural reasons foreign investment has a greater degree of
immunity to domestic corruption and institutional weaknesses than does domestic investment,
and consequently the marginal productivity of foreign capital is relatively higher in an
environment with weaker legal infrastructure. In this sense, FDI and domestic rule of law
exhibit some substitutability in generating domestic economic growth. Finally, note that the
negative interaction effects associated with bilateral aid receipts and income level are
consistent with diminishing returns to resources.
Turning to the FDI model, the positive and significant effect of economic growth on
subsequent FDI inflow is found to be greater in the presence of greater political rights (lower PR
index) and more limited rule of law in the host country. Note, however, that the direct effect of
political rights on FDI inflows is negative, and that of domestic rule of law is positive. This
suggests that in the sample region FDI as a whole has been more likely in the presence of more
authoritarian regimes, perhaps reflecting greater stability, whereas market-seeking FDI, which
is induced by growth, prefers political competition in the host country. Similarly, well-
functioning institutions and legal systems attract FDI overall, but in the presence of institutional
weakness, the pull effect of economic growth on FDI inflow tends to be greater. Weak
institutions and economic growth thus exhibit some substitutability in inducing FDI, and it may
be that institutional weakness is more harmful to domestic investment than it is to foreign
investment and, consequently, growth induces greater FDI when domestic institutions are
weak.
V. CONCLUSION
We analyze in this paper the causal relationship between economic growth and increased
FDI in nine Asian countries. Using Granger causality test, we find evidence of FDI-to-growth
causality in three of the nine countries, and growth-to-FDI causality in six countries. Two of the
countries showed causality in both directions, while two showed no causality at all. This
variation in the FDI-growth relationship indicates that causality between the two variables
cannot be generalized and must be considered more carefully.
We extend our investigation of FDI-growth causality using regression techniques, and
identify institutional variables that may help to explain the cross-country variation. The results
show that FDI-to-growth causality is reinforced by greater trade openness, more limited rule of
law, lower receipts of bilateral aid, and lower income level in the host country. Growth-to-FDI
causality, on the other hand, is reinforced by greater political rights and more limited rule of
law.
Our findings are revealing of the substantial cross-country variation in FDI-growth causality
as well as some of the economic and institutional causes of such variation. Given the rapid
growth of both FDI and GDP around the world, and specifically in South and Southeast Asia,
these findings should be of significant interest to both scholars and policymakers in the arena of
international development. Of course, the present findings are region-specific, and further work
is needed to establish whether we may generalize the results for the global economy.