Does FDI Promote Economic Growth

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Table of Contents:

Chapter 1: Introduction 1

Chapter 2: Literature Review 3

Chapter 3: Methodology 7

Chapter 4: Data and Variable Construction 9

Chapter 5: Estimation and Results 10

Chapter 6: Conclusion 16

References;



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List of Tables

Table 01: Main Regression Table 10

Table 02: Ramsey Reset Test



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Abstract: This work investigates that whether the foreign direct investment (FDI) affects the economic

growth based on the time series data for the country Pakistan from 1970 to 2010. Ordinary Least

Square technique is applied to examine the relationship between FDI and economic growth. A

significant positive relationship was found between FDI and economic growth. The interaction

of FDI with Human capital has a significant negative impact on the economic growth.

Key words:

Economic growth, foreign direct investment

JEL Classification:

F21; G11; F43



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Chapter 01 Introduction

In the various research works much of the attention has been given to determine the impact

of FDI on economic growth. In the endogenous growth theories Technology was taken as

endogenous and also explained the population growth and income differences among the

countries which the exogenous growth theories failed to explain. Investment and savings are

one of the main tools of the Solow Model to promote growth. When foreign direct

investment is in the form of technological diffusion from the developed to the host country

and when the host country has the absorptive capacities then FDI diffusion can promote

growth (Borensztein, Gregoria, and Lee, 1998). As various studies have shown different

relationship between FDI and economic growth. Some researchers have detected positive

while some have detected the negative impact of FDI on the economic growth. It is due to

the health of the data. FDI can attract more FDI and have strong impacts on the economic

growth when there is political stability i.e. maintaining financial institutions stability and

providing the property rights. in the Host country or when the host country has large market

size. To get positive impacts of FDI on economic growth it is crucial to maintain an

exemplary Judiciary, Financial institutions stability and giving property rights. Here the

work encompasses the country Pakistan. A large sample of time series data set from 1970 to

2010 was taken in order to detect the impact of FDI on the economic growth. As the country

has faced much political instability during various decades therefore, the magnitude of FDI

inflow varies during different time periods. Terrorism and instable regimes has also the

negative impact on the FDI inflow and since 2000 the country is involved fighting war



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against terrorism. Beside these tensions the country is also trapped in a curse of corruption.

And the corruption has negative impacts on the economic growth as well as the FDI inflows.



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when a country has the absorptive capacities such as Human Capital and large market size as Li

and Liu (2005) found that there is a strong complementary relationship between FDI and

Economic growth in both developed and developing countries. FDI has a positive relationship

with economic growth both directly and indirectly. There is also a strong positive relationship of

FDI with Human capital and strong negative relationship with the technology gap on economic

growth in the developing countries. To attract FDI host country must have a large market size. In

addition human capital and technology absorptive ability are important for inward FDI to

positively promote growth in developing countries. Beside these impacts of FDI on economic

growth a negative impact of corruption on the FDI was also shown as Cazurra (2008) shows that

corruption has a negative impact on FDI because it increases the costs and uncertainty. Pervasive

corruption has a larger negative impact on the FDI while, arbitrary corruption has less negative

impact on FDI in transition economies. Most of the research has shown a positive impact of FDI

on economic growth i.e. FDI promotes economic growth as in the work of Bangvu and Noy

(2008) that FDI has a positive and significant effect on the economic growth both directly and

through its interactions with labor. This affect is not equally distributed across the countries and

sectors. However, in some sectors no evidence was found that FDI enhances economic growth

but results will be found if a comprehensive aggregate sectorial data is available. The impact of

FDI is also shown in the large economies like China as Lee at al (2009) that when the source

country makes investment in China there is a decrease in the relative income between the source

and the recipient country. However, there is an increase in the unemployment rate in the source

country and decrease in the income disparity. For small source country FDI outflows to China

decreases the Export to GDP ratio in the source country. FDI has different positive impacts on

different host countries. It can generate more growth in the countries which are more financially



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developed then less financial developed countries as Alfaro et al (2009) that FDI leads to higher

growth rates in the financially developed countries as compared to those which are less

financially developed. The host country has an absorptive capacity in order to get the positive

impact of FDI on economic growth. Also Adams (2009) shows that FDI is positively and

significantly correlated to the economic growth. The result shows that contemporaneous FDI is

negatively correlated with economic growth while lagged FDI is positively correlated with the

economic growth. FDI doesn’t have a positive impact on the economic growth . This is due to the

low level of development of financial markets in Sub Saharan African countries. Domestic

Investment is positively related to economic growth. FDI is negatively and significantly

correlated with the Domestic Investment. While lagged FDI is positively related with Domestic

Investment. FDI impact depends on the overall structure of the host country. A country is to be

cautious and critical in the kind of FDI it attracts; that open door policy to attract all kinds of FDI

will not yield the desired level of benefits. Without FDI there is a possibility that a country could

be poorer. A country’s advantage from FDI depends on the initial conditions of education level,

basic physical infrastructure and appropriate institutions. More recently Saini at al (2010) they in

their research article shows that the impact of FDI on economic growth is presented by numerous

researchers. As different studies shows that absorptive capacities of the recipient countries has a

key role. Here it is shown that FDI has no direct impact on the economic growth. Economic

freedom is found to be an important driver in the long run economic growth. Countries that

promote economic freedom had gain more from FDI. As in such countries the firms easily

absorb and adopt new technology and other benefits associated with the FDI inflows. Security of

property rights and market regulations are all important elements of a country absorptive

capacity. Property rights and legal structure can be improved by promoting judicial



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independence and establishing a trusted legal framework for private businesses. To achieve the

better results of FDI on economic growth financial institutions of the country must be organized

as Alguacil at al (2010) found that to measure the impact of FDI on economic growth we have to

consider internal and external macroeconomic stability as well as the quality of institutions.

Secondly the impact of FDI on growth is positive in low income countries as compared to the

more developed countries. Policies for attracting FDI are not sufficient if institutional conditions

and macroeconomic stability are not improved. FDI and Private investment are in favourable

regimes as Morrissey and Udomkerdmongkol (2011) show that private investment and FDI is

higher under favorable regimes. Secondly FDI crowds out Private Domestic Investment more

incase of good governance whereas the poor governance discourages FDI hence private domestic

investment must be higher to compensate. It was also found that FDI crowds out private

domestic investment do not imply that FDI is not beneficial. It simply reflects the fact that

profitable opportunities are limited.



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Chapter 03 Methodology

The Model:

The main explanatory variables which were identified in the various studies include the GDP,

Human Capital, Population growth, corruption and Investment. These were taken together with

FDI. Keeping the above explanatory variables in mind I have selected the following form of

model.

t t t t t t t t X X P X E X Y

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In the above model on the right hand side Yt is the dependent variable which is the real GDP.

On the left hand side there is a set of explanatory variables. Xt is the variable showing FDI and

EtXt is the interaction term of FDI and total secondary enrollment. The interaction term of FDI

and Human Capital taken in the model is to determine the absorptive effect of foreign investment

through Human Capital on the real GDP. Here in the model the total secondary enrollment is

proxy of Human Capital as data on the Human Capital is not easily available therefore, I proxy

the Total Secondary Enrollment as a Human Capital. Human Capital can increase as the level of

education increases and when the technical education is provided to the population of the country

so, as to absorb the foreign direct investment. It was used by many researchers as (Li and Liu

2005) had taken the secondary enrollment as a proxy for Human Capital. Pt is Public investment.

It is taken as an interaction term with FDI. A lag value of FDI is also taken in the above model.

All the variables taken in the model are real. The above model is estimated through a method



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Ordinary Least Square (OLS). This method is used because of its simplicity. I applied Ramsey

Reset test to check the specification of the model. This test tells us that whether the model is

correctly specified or not. According to this test when the probability after conducting the test is

more than 0.1 than it can be concluded that the model is correctly specified. And I found the

probability greater than 0.1 so, I concluded that the model I selected is correctly specified.



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Chapter 04 Data and Variable Construction

The Data:

The Time Series data is about Pakistan covering the period from 1970 to 2010. This data set is

mainly obtained from the source World Bank WDI data base and State Bank of Pakistan. Data of

the variable real GDP, Total Secondary Enrollment, Public Investment, Foreign direct

investment (FDI), GDP Deflator, Official Exchange Rate and Total Investment were obtained

from the above sources. The data of the variable Human Capital was not available then it was

proxy by total Secondary Enrollment.

Variable Construction:

All the variables used in model are taken in US dollar except the variable total secondary

enrollment. As the data of Public investment was taken from the source State Bank of Pakistan.

It was in million rupees. Latter I converted the data of public investment into million US dollar

simply dividing it by the Official Exchange Rates. All the data is in constant 2000 US dollar.

Real GDP data was obtained from the nominal GDP dividing nominal GDP by the GDP deflator

and multiplying it with 100. Similarly data of FDI was also obtained from the State Bank of

Pakistan, it was in million rupees and before introducing it into the model it was converted into

constant 2000 US million dollars by dividing the FDI with official exchange rates and then by

GDP deflator constant 2000 and multiplying it with 100.



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Chapter 05: Estimations and Results

In this section the estimation results are discussed. The results are presented in the given tables.

Table 01: Main Regression table.

Dependent Variable: GDP

Method: Least Squares

Date: 12/20/11 Time: 19:21

Sample(adjusted): 1973 2009

Included observations: 37 after adjusting endpoints

Variable Coefficient Std. Error t-Statistic Prob.

C 2.88E+10 4.89E+09 5.886215 0.0000

FDI 160.7489 32.63940 4.924996 0.0000

ENROLL*FDI -1.22E-05 3.02E-06 -4.020759 0.0003

PUBINVST*FDI -9.50E-09 1.66E-09 -5.738778 0.0000

FDI(-1) 20.70642 5.012944 4.130591 0.0002

R-squared 0.828442 Mean dependent var 5.54E+10

Adjusted R-squared 0.806997 S.D. dependent var 2.77E+10

S.E. of regression 1.21E+10 Akaike info criterion 49.40404

Sum squared resid 4.72E+21 Schwarz criterion 49.62173

Log likelihood -908.9747 F-statistic 38.63146Durbin-Watson stat 0.953886 Prob(F-statistic) 0.000000

As the model was specified keeping GDP as dependent variable. I have to find the impact of FDI

on the GDP. A regression line was run and as a result of this regression the above table results

are obtained. First I observed the coefficients and t-statistics of the model. I observed that all the

t-statistics of the model are statistically significant. But when I observed the coefficients it was

not as I was expecting. The coefficient of FDI was statistically significant and has a positive

sign. This shows the positive impact of FDI on the economic growth. The coefficient of the

interaction term Enroll*FDI is negative. This shows that its combine effect on GDP is negative.



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This result was not according to the theory. As theory suggests that Human Capital that is proxy

by Enrollment has appositive effect on the GDP. When it is higher than the host country can

easily absorb the FDI thus then FDI will have a positive impact on the economic growth in the

long run. When a regression of GDP as dependent variable was run keeping Enrollment as

independent variable then a coefficient with a high positive value was obtained. It was according

to the theory that enrollment or the Human Capital has a positive impact on the economic

growth.

Then I checked the Durbin-Watson statistics and R- square of the model. After observing the R-

square I concluded that there is no multicollinearity in the model. But I obtained too low value of

the Durbin Watson Statistics. In normal conditions it is almost or near to two. But here it is less

then two so there is an auto-correlation problem in the model. The low statistics of the Durbin

Watson statistics is due to the less number of explanatory variables on the right hand side of the

model.

I then applied Cochrane- Orkut Iteration test to remove the auto-correlation problem from the

model. When I run a regression including AR (1) then I obtained the results with statistically

insignificant t-statistics. R-square and the probability were too high. It created the problem of

multicollinearity. Then I dropped the AR (1) from the model. I applied Histogram Normality test

and obtained the above given graph. I observed the Skewness, Kurtosis, Jarque-Bera and

probability. As the probability is greater then 0.1 it suggests that the residual are normally

distributed.



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Table 02: Ramsey Reset test.

Ramsey RESET Test:

F-statistic 1.972860 Probability 0.157284Log likelihood ratio 4.719924 Probability 0.094424

Test Equation:Dependent Variable: GDPMethod: Least SquaresDate: 12/20/11 Time: 23:46Sample: 1973 2009Included observations: 37

Variable Coefficient Std. Error t-Statistic Prob.

C 2.01E+10 2.38E+10 0.844998 0.4050FDI 121.5447 551.8261 0.220259 0.8272

ENROLL*FDI -7.17E-06 4.03E-05 -0.177727 0.8602PUBINVST*FDI -8.54E-09 3.40E-08 -0.251014 0.8036

FDI(-1) 24.10747 75.36308 0.319884 0.7513ESGDP10^2 -4.49E-12 1.73E-11 -0.258904 0.7975FITTED^2 1.65E-11 2.50E-11 0.659172 0.5150FITTED^3 -1.37E-22 1.39E-22 -0.985685 0.3324

R-squared 0.911046 Mean dependent var 5.54E+10Adjusted R-squared 0.889574 S.D. dependent var 2.77E+10S.E. of regression 9.19E+09 Akaike info criterion 48.90940Sum squared resid 2.45E+21 Schwarz criterion 49.25771Log likelihood -896.8240 F-statistic 42.42997Durbin-Watson stat 1.169827 Prob(F-statistic) 0.000000

After obtaining the negative coefficient of the interaction term enroll*FDI I applied a Ramsey

Reset Test to check the specifications of the model I made. As this test tells us that whether the

model is correctly specified or not. After applying the test I obtained the results and observed the

probability. Ramsey reset test suggests that when the probability is greater than 0.1 then the

model is correctly specified. I obtained the probability greater than 0.1 and I concluded that the

model which I constructed is correctly specified.



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Figure 01: Histogram Normality Test.

I then applied Cochrane- Orkut Iteration test to remove the auto-correlation problem from the

model. When I run a regression including AR (1) then I obtained the results with statistically

insignificant t-statistics. R-square and the probability were too high. It created the problem of

multicollinearity. Then I dropped the AR (1) from the model. I applied Histogram Normality test

and obtained the above given graph. I observed the Skewness, Kurtosis, Jarque-Bera and

probability. As the probability is greater then 0.1 it suggests that the residual are normally

distributed.

0

2

4

6

8

2.0E+10 -1.0E+10 0.00000 1.0E+10 2.0E+10 3.0E+10

Series: Residuals

Sample 1973 2009Observations 37

Mean -1.39E-06

Median -2.35E+09

Maximum 2.58E+10

Minimum -1.88E+10

Std. Dev. 1.15E+10

Skewness 0.451639

Kurtosis 2.412971

Jarque-Bera 1.789128

Probability 0.408786



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Figure 02: Cusum Stability test.

Figure 03: Cusum of Squares Stability Test.

I applied the Cusum test and Cusum of squares. As from the figures the line falls in between the

significance level. The Cusum is normal but there is a problem in the Cusum of squares. As

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0

10

20

80 85 90 95 00 05

CUSUM 5% Significance

-0.4

0.0

0.4

0.8

1.2

1.6

80 85 90 95 00 05

CUSUM of Squares 5% Significance



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when the Cusum is normal and the problem is in Cusum of squares then the problem is due to a

shock. Beyond the observation 85 the shock starts and it is up to the 00. As here the line crosses

the significance level.

Research work of the researcher had showed that there is a reverse causality between FDI and

economic growth. As (Hansen and Rand 2006) showed that economic growth can cause the FDI

inflow. Countries which experience high economic growth can attract more FDI inflows thus

there also exists a reverse causality between FDI and Economic growth. Beside this uncertainty

and the regimes also affect the economic growth. Because of the unavailability of the data on

uncertainty I can not included its impact in the model in order to judge its impact on FDI and

economic growth.

.



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Chapter 6: Conclusions:

It can be concluded that in this research work it was tried to show the relationship between FDI

and economic growth. As various studies had showed both positive and negative impacts of FDI

on the economic growth. Here, a significant positive impact of FDI on the economic growth was

seen. FDI has strong positive impact on the economic growth when there is availability of the

Human Capital in the host country. The availability of the Human capital then strongly absorbs

the FDI inflow thus giving an economic growth in the Log Run. But the coefficient sign of the

interaction term of FDI with enrollment was not according to my expectations. It was due to the

less availability of the data. Also corruption, no better financial institutions and uncertainty or

instable regimes have different negative impacts on the FDI inflow and economic growth. There

is also a reverse causality between FDI and economic growth. Sometimes the strong economic

growth can attract FDI inflows. The host country has to promote financial institutions and to

setup an exemplary judicial system in order to catch foreign direct investment. Also it has to arm

the population with technical education in to order to cope the FDI which is in the form of

technology diffusion. Then the fact of strong positive relationship between foreign direct

investment and the economic growth can not be denied.



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References:

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Saharan Africa. Journal of Policy Modeling 31, 939-949.

Alfaro, L., Chanda, A., Ozcan, K.S., and Sayek, S. (2009). Does foreign Direct Investment

promote growth? Exploring the role of financial markets on linkages. Journal of Development

Economics 91, 242-256.

Alguacil, M., Cuadros, A., and Orts, V. (2011). Inward FDI and growth: The role of

macroeconomic and institutional environment. Journal of Policy Modeling 33, 481-496.

Borensztein, E., Gregorio, D. J., and Lee, W. J. (1998). How does foreign direct Investment

affect economic growth? Journal of International Economics 45, 115-135.

Cazurra, C. A. (2008). Better the devil you don’t know: Types of corruption and FDI in

transition economies. Journal of International Management 14, 12-27.

Frenkel, M., Funke, K., and Stadtmann, G. (2004). A Panel analysis of bilateral FDI flows to

emerging economies. Economic Systems 28, 281-300.

Gastanaga, M. V., Nugent, B. J., and Pashamova, B. (1998). Host Country Reforms and FDI

Inflows: How much Difference do they make? World Development 26 (7), 1299-1314.

Lee, Y. H., Lin, S. K., and Tsui, C. H. (2009). Home country effects of foreign direct

Investment: From a small economy to a large economy. Economic Modeling 26, 1121-1128.



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Li, X., and Liu, X. (2005). Foreign Direct Investment and Economic Growth: An Increasingly

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Mah, S. J. (2010). Foreign direct Investment inflows and economic growth of China. Journal of

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Morrissey, O., and Udomkerdmongkol, M. (2011). Governance, Private Investment and Foreign

Direct Investment in Developing countries. World Development xx(x), xxx-xxx.

Saini, A. W. N. W., Baharumshah, Z. A., and Law, H. S. (2010). Foreign direct

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