The Impact of Foreign Direct Investment and Portfolio Investment on Economic Growth in Developing and Developed Economies

Transcription

1 The Impact of Foreign Direct Investment and Portfolio Investment on Economic Growth in Developing and Developed Economies Houssem Rachdi, Ph.D. Faculty of Economic Sciences and Management of Tunis. University of Tunis El Manar. Tunisia rachdih@uvic.ca Hichem Saidi Faculty of Economic Sciences and Management of Tunis. University of Tunis El Manar. Tunisia hichem.saiidi@gmail.com ABSTRACT Capital account liberalization is often being regarded as an important way in order to promote economic growth both in industrialized and developing economies. Some results provided conflicting evidences on this issue. In order to provide an explanation for this empirical ambiguity, this paper fills the void in examining this impact on economic growth using foreign direct investment (hereafter FDI) and portfolio investment (hereafter PI). The relationship between FDI and PI hasn t been received considerable and growing attention in development literature and hasn t been extensively investigated in empirical literature by researchers for both developed and developing countries. Each is broadly thought to affect economic growth positively through facilitation of knowledge and technology transfers. Our empirical study is based on a sample of 100 developing and developed countries over the period reports the followings results: the estimation results seem to suggest a statistically significant and positive relationship between FDI and output growth when using GMM, WG and GLS estimators related to pooled, developed and developing countries. Also, we found the coefficient of PI is negative and not statistically significant in developing economies. However, this coefficient is positive and significant in developed countries when we use the GMM estimator. In the same countries, when we include the random effect in the specification, the coefficient is still positive but not statistically significant. In all countries, the coefficient of PI is negative and significant. Keywords: Economic growth, foreign direct investment, portfolio investment. 1. INTRODUCTION The overall nexus between financial liberalisation and economic growth has been the subject of a rather voluminous literature which goes back to the seminal work by McKinnon and Shaw in Since this work, there s a rough consensus that financial liberalization has salutary affects on economic growth. Several studies showed that capital account liberalization affects economic development and financial development. Following the progress of endogenous growth at the beginning of the Nineties, the new approaches supporting the interest of financial liberalization appeared with work of Harris et al. (1992), Jaramillo et al. (1992), King and Levine (1993), Caprio et al. (1994), Bandiera et al. (2000), Sancak (2002) and Bekaert et al. (2003, 2005). These studies show that there is strong evidence that financial liberalization has a positive impact on growth and they arrived at the same conclusion: the financial system must be liberalized to ensure its good performance, to increase financial savings, to start productive investments, to push technology innovation and to support the economic growth. Several studies support this hypothesis. Bussiere and Fratzscher (2008), Butkiewicz and Yanikkaya (2008), Klein and Olivei (2008), Quinn and Toyoda (2008), among others, find that capital account liberalisation is positively correlated to the economic growth. Gruben and Mcleod (1998), for a panel of 18 developing markets find that increases in the share of FDI and portfolio equity capital flows to GDP are positively and significantly related to output growth. Dhingra (2004) conclude in a group of 58 developing countries for the period that FDI and portfolio equity flows have positive effects on output growth. Bang Vu and Noy (2009) reported that FDI has positive, or no statistically discernible, effect on economic growth directly in OECD. Adams (2009) analyzes the impact of FDI on economic growth in Sub-Saharan Africa for the period and found that FDI is positively and significantly correlated with economic growth when using the ordinary least squares estimation and not in fixed effects estimation. Recently, Azman-Saini et al. (2010) investigate the systemic relationship between FDI and economic growth in a sample of 85 countries and affirms that FDI by itself has no direct (positive) effect on output growth. Given the conflicting views in many studies that have examined the relationship between FDI-economic growth nexus and PI- economic growth nexus in developing and developed countries, this paper will investigate those 10

2 relationships in a sample of 100 countries (69 developing countries and 31 developed countries) for the period Our empirical results, based on the generalized method-of moment system estimator, within-group (WG) estimator of the fixed effects model and generalized least squares (GLS) estimator of the random effects model, suggest that related for both industrial and developing countries the relationship between FDI and output growth is statistically significant and positive. The coefficient of PI is negative and not statistically significant in developing economies. However, this coefficient is positive and significant in developed countries when we use the GMM estimator and when we use the random effect in the specification, the coefficient is still positive but not significant. In naive model, the relationship between PI and real GDP per capita growth is negative and significant. The rest of this paper is structured as follows: Section 2 provides a brief review of the literature and discusses the relationship between foreign direct investment and portfolio investment on economic growth. Section 3 describes the empirical methodology and reports estimations results. The final section concludes. 2. THEORATICAL BACKGROUND During the past two decades, a large number of hypotheses have been offered regarding the interaction capital account liberalisation and growth nexus. Honig (2008) concludes that capital account liberalization has a positive effect on the economic growth and increases the good being of the countries in the process of development and the emerging countries. According to this author, the advantages of the mobility of the capital are clear: a better efficient allowance of savings, new additional sources for the financing of the domestic projects, new opportunities for the diversification of risks and the promotion of financial development. Indeed, the capital account liberalization ensures the promotion of efficiency and the development of intermediation of country. The latter contributes to the development of the financial system. Quinn (1997) affirms that capital account opening is positively related to the economic growth. According to Bussiere and Fratzscher (2008), the benefits of liberalization come from access to the external funding sources, but like first stage, the country in question must eradicate all the domestic restrictions. Those authors made an application on 45 countries, including 12 of Asia and 8 of Latin America, over the period , and they concluded that capital account openness increases the economic growth in right of 1.5% during the first five years. Butkiewicz and Yanikkaya (2008) conducted a study on a panel of 114 developed and developing countries over the period going from 1970 to The study has the aim of testing the contribution of capital account liberalization on the economic growth. These authors conclude that foreign direct investments, start the development process and of the growth in all the countries of the periphery. The second contribution of the study reveals that the countries which receive important volumes of direct investment flowing and portfolio investment will carry out a rapid growth. The authors affirm that if a country imposes restrictions on the capital what reduces its good being in terms of growth. Their results are corroborated with others like those of Rodrik (1998) and Klein and Olivei (2008), through two investigations of 100 countries respectively during the periods and These authors conclude that a country which does not impose a restriction on capital flows is lucky more to carry out a rapid growth than that closed. Bekaert et al. (2005) showed through an empirical study on 95 countries, that capital market liberalization offers the opportunity to the foreign investors of investing in the domestic equities. This situation emerges by an increase with the order in 1% in growth rate in economy. A study worked out by the Bank for international Settlements in 2006 showed that portfolio investments flows passed for 6.2 billions of dollars in 1987 to 37.2 billion of dollars in 1992 then billion of dollars during the period Klein and Olivei (2008) and Levine (2001) stipulate that the international financial integration makes the domestic financial systems very dynamic by a very intense competitiveness and an importation of the financial services which generate positive effects on economic growth. Chambet and Gibson (2008), in a study of 25 emerging markets from 1995 to 2004, approved the positive correlation between financial integration and foreign trade. This can support the economic growth and confirmed the contributions of capital account liberalization in Mexico. In 1985, the market capitalization represent 0.7% of the GDP, in 2000, it reached the threshold of 21.8% of the GDP. Dhingra (2004) concluded that FDI and portfolio equity flows have positive effects on output growth. Bang Vu and Noy (2009) reported that FDI has positive, or no statistically discernible, effect on economic growth directly in OECD. Adams (2009) analyzes the impact of foreign direct investment on economic growth in Sub-Saharan Africa and found that FDI is positively and significantly correlated with economic growth. Recently, Azman-Saini et al. (2010) investigate the systemic link between foreign direct investment (FDI) and economic growth approved that FDI by itself has no direct (positive) effect on output growth. 11

3 3. MODEL, DATA, STATSICAL RESULTS AND MAJOR FINDINGS The empirical evidence on the effect of foreign direct investment and portfolio investment on economic growth is less conclusive. Our empirical study is based on a sample of 100 countries over the period (The sample of countries used in the study is shown in appendix 1). The regression equation we estimate is specified as follows: ( ), ( ), ( ) Where Growth is the logarithm of real GDP per capita in country i during the period t; IC is income per capita; SEP is school enrollment primary (% large); SES is school enrollment secondary (% gross) * and CAL is the indicator of capital account liberalization measured by: FDI: Foreign direct investment, Net inflows (% of GDP) and PI: Portfolio investment (% of GDP). Data is obtained from the World Bank (World Development Indicators 2007). We will use the method of GMMin-System estimator of Blundell and Bond (1998). The Arellano and Bond test for autocorrelation has a null hypothesis of no autocorrelation and is applied to the differenced residuals. The test for AR (2) in first differences is more important, because it will detect autocorrelation in levels. The validity of the instruments is tested using a Hansen test of over-identifying restrictions and a test of the absence of serial correlation of the residuals. Also, we will use the fixed effect and random effect methods. Tables 1 and 2 present regressions of the impact of FDI and PI on economic growth. When we use the method of GMM-in-System estimator, the Wald-test indicates fine goodness of fit, the Hansen and serial-correlation tests do not reject the null hypothesis of correct specification (P-value of Hansen test and AR (2) test of Arellano and Bond are larger than 5%), lending support to our estimation results. The Hausman test confirms the appropriateness of the random-based effects estimation method used in this empirical study. Results in table 1 about FDI-growth nexus report that in all the sample (100 countries), developed (31 countries) and developed countries (69 countries), the coefficient of FDI is positive (0.006; and respectively in all, developed and developing countries) and statistical significant in line with results of much of the literature on this topic. For developing economies, this coefficient is statistically significant at the 1 % level and at the level of 5% for developed countries when we include the random effect in the specification. When we use GMM estimator all the estimated coefficients of FDI are statistically significant at the 5 % level, except for developed countries the coefficient is statistically significant at 1 % significance level. These findings confirm the belief that FDI flows enhances the productivity of host economies and leads to higher economic growth by the adoption of know-how and international technology for both industrialized and developing countries. Results in table 2 about PI-growth nexus show that the coefficient of PI is negative and not statistically significant at any level in developing economies. This result is approved by Klein and Olivei (2008) because they find that the policy of capital account openness is conductive to growth only for higher income economies. In the other hand, we can explain this finding by the fact that there is strong evidence that domestic financial market is less developed and banks are the brain of the economy in lower and upper income countries. However, this coefficient is positive (6.849) and significant at the 1% level significance in developed countries when we use the GMM estimator. In the same countries, when we include the random effect in the specification, the coefficient is still positive (3.799) but not statistically significant. In sample 1 about all countries, the coefficient of PI is negative (-0.072) and significant at the level of 5 %. 4. CONCLUDING REMARKS AND POLICY IMPLICATIONS During the late 1970s and the 19980s, several developing countries, like many other developed countries, underwent noteworthy financial reforms which, significantly, affected the domestic exchange market and the volumes of foreign direct investments in host economies. * Because of not availability of the values of those two variables for all the period, we proceed by giving the mean value for each empty box. 12

4 Using panel data analysis, we explored empirically the links FDI-economic growth, IP-economic growth. We used the most popular adopted econometric methods of the pooled, the fixed effects and the random effects models for both developed and developing countries covering the period Our empirical results seem to suggest that foreign direct investment has a significant positive impact on real per capita growth. Also, we found no evidence that PI enhances output growth in developing economies. However, this coefficient is positive and significant in developed countries when we use the GMM estimator and still positive but not statistically significant when we include the random effect estimator. For the entire sample, the coefficient of PI is negative and significant. This analysis suggests a clear set of policy implications for the developing countries. It is evident that increasing flows of PI, implying that PI can affect positively output growth. Also, governments of developing economies must enhance political stability, law and order, socioeconomic conditions and investment profile and must reduce the level of corruption to attract more FDI and PI because the generated value added in many sectors and reduced unemployment rate. Future work with institutional quality variables should be able to shed a light on the new channels that FDI and PI can enhance economic growth. References: 1. Adams, S., 2009, Foreign direct investment, domestic investment, and economic growth in Sub-Saharan Africa, Journal of Policy Modeling 31, pp Arellano, M. and Bond, O., 1991, Some tests of specification for panel data: Monte Carlo evidence and an application to employment equations, Review of Economic Studies 58, pp Azman-Saini, W.N, Zubaidi Baharumshah, A. and Law, S.H., 2010, Foreign direct investment, economic freedom and economic growth: International evidence, Economic Modelling 27, pp Bandiera, O., Caprio, G.J., Honohan, P. and Schiantarelli, F., 2000, Does financial reform raise or reduce saving, Review of Economics and Statistics 82, pp Bang Vu, T. and Ilan Noy, I. 2009, Sectoral analysis of foreign direct investment and growth in the developed countries, International of Financial Markets, Institutions and Money 19, pp Bekaert, G., Harvey, C.R. and Lundblad, C., 2003, Equity market liberalization in emerging markets, Federal Reserve Bank of Saint Louis Review. 7. Bekaert, G., Harvey, C.R. and Lundblad, C., 2005, Does financial liberalization spur growth? Journal of Financial Economics 77, pp Bussiere, M. and Fratzscher, M., 2008, Financial openness and growth: Short-run gain, Long-run pain? Review of International Economics 16, pp Butkiewicz, J.L. and Yanikkaya, H., 2008, Capital account openness, international trade, and economic growth: A cross-country empirical investigation, Emerging Markets Finance and Trade 44, pp Caprio, G., Atiyas, I., and Hanson, J.A., 1994, Financial reform: Theory and experience, Cambridge University Press. 11. Chambet, A. and Gibson, R., 2008, Financial integration, economic instability and trade structure in emerging markets, Journal of International Money and Finance 27, pp Dhingra, S., 2005, Equity markets versus capital account liberalization: A comparison of growth effects of liberalizations policies in developing countries, Annual Conference on Pacific Basin Finance, Economics and Accounting, pp Gruben W.C. and McLeod, D.,1998, Capital Flows, Savings and Growth in the 1990s., The Quarterly Review of Economics and Finance 38, pp Harris, J.R, Schiantarelli, F. and Siregar, M., 1992, The effect of financial liberalization on firm s capital structure and investment decisions: Evidence from a panel Indonesian manufacturing establishments , World Bank WP, N Honig A., 2008, Addressing causality in the effect of capital account liberalization on growth, Journal of Macroeconomics 30, pp Jaramillo, F., Schiantarelli, F. and Weiss, A., 1992, The effect of financial liberalization on the allocation of credit: Evidence from a panel of Ecuadorian firms, World Bank WP, N King, R., and Levine, R., 1993, Finance, entrepreneurship, and growth: Theory and evidence, Journal of Monetary Economics 32, pp Klein, M.W., and Olivei, G.P., 2008, Capital account liberalization, financial depth, and economic growth, Journal of International Money and Finance 27, pp

5 19. Levine, R., 2001, International financial liberalization and economic growth, Review of International Economic, pp McKinnon, R.I., 1973, Money and capital in economic development, The Banking institution. 21. Quinn, D., 1997, The correlates of change in international financial regulation, American Political Science Review 91, pp Quinn, D.P. & Toyoda, A.M., 2008, Does capital account liberalization lead to growth? Review of Financial Studies 21, pp Rodrik, D., 1998, Who needs capital-account convertibility? Essays in International Finance 207, Princeton University. 24. Sancak, C., 2002, Financial liberalization and real investment: Evidence from Turkish firms, IMF WP N Shaw, E.S., 1973, Financial deepening in economic development, New York Oxford University Press. 14

6 Table 1: The impact of Foreign Direct Investment (FDI) on economic growth Depend Variable: Real GDP per capita Sample 1 Sample 2 Sample 3 GMM FE RE GMM FE RE GMM FE RE L.growth (3.11)*** (3.46)*** (3.27)*** Log IC (0.48) (1.89)* (0.93) (0.77) (1.43) (0.87) (1.11) (1.84)* (3.21)*** Log SEP (0.61) (1.09) (1.77)* (0.47) (1.00) (1.66)* (0.90) (0.10) (0.95) Log SES (1.05) (0.52) (0.58) (1.10) (0.41) (0.84) (0.81) (0.22) (0.65) FDI (% GDP) (2.07) ** (8.03)*** (2.53)** (2.17) ** (3.40)*** (2.80)*** (1.76)* (2.33)** (2.05)** Constant (1.05) (2.27)** (1.06) (2.15)** (0.07) (0.81) Nbr. Of Obs Nbr. Of Countries R Wald test 948.7*** 381.8*** *** P-value AR(2) P-value Hansen test Hausman test Note: Estimation methods are GMM-in-System estimator (Xtabond2), fixed-effect (FE) and random effect (RE). Sample 1 (all countries), sample 2 (69 developing countries) and sample 3 (31 developed countries). AR (2): test of null of zero second-order serial correlation, distributed N (0, 1) under null. The null hypothesis is that errors in the first difference regression exhibit no secondorder serial correlation. Hansen = Hansen test for validity of over-identifying restrictions, distributed as indicated under null. This test of over-identifying restrictions is asymptotically distributed as χ² under the null of instrument validity. The numbers in parentheses are t-statistics. *, **, and *** indicate statistical significance at the 1%, 5%, and 10% level. 15

7 Table 2: The impact of Portfolio Investment (PI) on economic growth Depend Variable: Real GDP per capita Sample 1 Sample 2 Sample 3 GMM FE RE GMM FE RE GMM FE RE L.growth (3.00)*** (3.31)*** (3.69)*** Log IC (0.34) (2.68)*** (1.69)* (1.18) (2.51)** (2.71)*** (1.25) (1.01) (0.69) Log SEP (0.44) (1.00) (1.75)* (0.87) (1.11) (0.65) (2.18)** (0.39) (1.56) Log SES (0.69) (0.07) (0.36) (0.59) (0.72) (0.29) (2.16)** (1.57) (1.16) PI (% GDP) (2.19) ** (0.22) (0.69) (0.56) (0.41) (0.14) (5.48)*** (0.59) (0.77) Constant (1.20) (2.23)** (0.89) (0.74) (0.56) (2.33)** Nbr. Of Obs Nbr. Of Countries R Wald test 933.0*** *** 173.4*** P-value AR(2) P-value Hansen test Hausman test Note: Estimation methods are GMM-in-System estimator (Xtabond2), fixed-effect (FE) and random effect (RE). Sample 1 (all countries), sample 2 (69 developing countries) and sample 3 (31 developed countries). AR (2): test of null of zero second-order serial correlation, distributed N (0, 1) under null. The null hypothesis is that errors in the first difference regression exhibit no secondorder serial correlation. Hansen = Hansen test for validity of over-identifying restrictions, distributed as indicated under null. This test of over-identifying restrictions is asymptotically distributed as χ² under the null of instrument validity. The numbers in parentheses are t-statistics. *, **, and *** indicate statistical significance at the 1%, 5%, and 10% levels. 16

8 Appendix 1: List of countries Algeria Djibouti Luxembourg Russian Federation Angola Ecuador Madagascar Senegal Argentina Egypt, Arab Rep. Malawi Serbia and Montenegro Australia France Malaysia Sierra Leone Austria Gabon Maldives Singapore Azerbaijan Gambia, The Mali Slovak Republic Bahrain Georgia Malta Slovenia Belgium Germany Mauritania South Africa Benin Ghana Mexico Spain Bolivia Greece Morocco Sudan Brazil Guinea Mozambique Sweden Bulgaria Guinea-Bissau Namibia Switzerland Burkina Faso Hungary Netherlands Syrian Arab Republic Cameroon India New Zealand Thailand Canada Indonesia Niger Togo Central African Republic Iran, Islamic Rep. Nigeria Tunisia Chile Ireland Norway Turkey China Israel Oman Trinidad and Tobago Colombia Italy Pakistan Ukraine Congo, Dem. Rep. Japan Paraguay United Kingdom Congo, Rep. Jordan Peru United States Cote d'ivoire Korea, Rep. Philippines Uruguay Croatia Kuwait Poland Yemen, Rep. Czech Republic Liberia Portugal Zambia Denmark Lithuania Romania Zimbabwe 17