FDI Contributes to Output Growth in the U.S. Economy

Journal of US-China Public Administration, ISSN 1548-6591 January 2011, Vol. 8, No. 1, 104-109 FDI Contributes to Output Growth in the U.S. Economy Lucyna Kornecki, Vladislav Borodulin Embry-Riddle Aeronautical University (ERAU), Florida, USA The introductory part of this study analyzes inward FDI (foreign direct investment) flow and inward FDI stock as a percentage of GDP (gross domestic product) indicating important role of foreign capital in the U.S. economy. The next part of this research has empirical character and focuses on the impact of inward FDI stock on output growth in the U.S. economy. The introduced regression model of economic growth proved the strong impact of FDI stock on output growth and verified the hypothesis that FDI stock, as compared with domestic capital, labor, export and multifactor productivity, constitutes an essential factor of economic growth in the U.S. economy. Keywords: FDI, economic growth, U.S. economy Literature Review The continuing growth of inward FDI in the U.S. economy brought a growing interest in examining its impact on the economic growth. The immense literature on economic growth in the United States is composed of studies that concentrate on measuring the domestic variables that affect U.S. economic growth. However, the impact of FDI on the economic growth of the United States has not received the attention that it deserves (Asheghian, 2004). This research provided empirically tested evidence on the effect of FDI on economic growth in the U.S. It examined the link between inward FDI stock and economic growth and found that FDI has a significant impact on the U.S. economic growth. A number of empirical studies on the role of FDI in host countries suggest that FDI is an important source of capital, complements domestic private investment, and is usually associated with new job opportunities and enhancement of technology transfer, and boosts overall economic growth in host countries (Chowdhury & Mavrotas, 2006). The relationship between growing FDI stock and economic growth has motivated a voluminous empirical literature in developed and developing countries. FDI has been acknowledged as most crucial factor in enhancing economic development and the standard of living for emerging economies. Based on references, the consensus seems to be that there is a positive correlation between FDI inflows and economic growth, provided that the receiving countries have reached a minimum level of educational, technological and/or infrastructure development (Hansen & Rand, 2006). South Korea, Singapore and Taiwan are examples of nations outside the OECD countries that have greatly benefited from FDI and the integration in the global economy. In recent years, China and India have made Corresponding author: Lucyna Kornecki, Ph.D., professor, Department of Economics, Finance and Information System, College of Business, Embry-Riddle Aeronautical University; research fields: foreign direct investment (FDI), economic growth in developed and developing countries. E-mail: korneckl@erau.edu. Vladislav Borodulin, MBA, Department of Economics, Finance and Information System, College of Business, Embry-Riddle Aeronautical University; research fields: globalization, air transportation. 104

FDI CONTRIBUTES TO OUTPUT GROWTH IN THE U.S. ECONOMY 105 remarkable progress in attracting FDI and realizing technological and economic success. A number of studies find that FDI inflows have a strong and positive effect on economic growth in China (TIAN, LIN, & LO, 2004). In Russia, FDI appears to have been an essential force in supporting the economy during the initial chaos of transition (Brock, 2005). The CEE countries increased their participation in the world economy since the fall of communism, particularly over the last few years. They accepted the challenge of trade openness and attracted significant foreign direct investment (Cernat & Vranceanu, 2002). The CEE countries acknowledge FDI as an essential tool in the development and modernization of their economies (Kornecki & Raghavan, 2008). Salehizadeh, Asheghian and others confirm the existence of a positive and significant relationship between FDI and the economic growth in the United States (Asheghian, 2004). Asheghian examined the determinants of economic growth in the United States over time using a model based on the postulates of de Mello and found a causal relationship between FDI growth and economic growth running from economic growth to FDI and a causal relationship between FDI growth and total factor productivity growth running from FDI to total factor productivity. According to the U.S. Bureau of Labor Statistics, a rapid inflow of foreign investment in the U.S. economy paralleled the brisk productivity growth, suggesting a positive link between the growth of productivity and foreign capital. Applying a Cobb-Douglas production function to data from 1988 to 1999, it is found that foreign capital accounted for almost 16% of overall U.S. productivity growth (Goss, Wingender, & Torau, 2007). Salehizadeh regression estimates confirm the existence of a positive and significant relationship between FDI and U.S. economic growth rates (Salehizadeh, 2005). Research Methodology This research focuses on the relationship between foreign capital stock and U.S. economic growth, and includes FDI stock as one of the most important determinants influencing growth of the U.S. economy. Starting from 1960s, the theories of FDI tried to find out the elements that stimulated a U.S. firm s decision to invest abroad, as most of the FDI originated from the United States and were connected to the U.S. multinational corporation. Most empirical study has concentrated on assessing the factors that induce a U.S. firm to invest in a foreign country. In the early 1970s, the direction of FDI changed and the United States became a significant recipient of FDI. The U.S. became a host for foreign affiliates as well as a home for multi-national firms (Hendriks, 1990). The past studies did not attempt to relate FDI to productivity growth. Instead, researchers focus was on FDI impact on manufacturing sector and employment (Goss, Wingender, & Torau, 2007). Recently, the research methodology related to FDI and economic growth relationship in the literature has been based mostly on the production function model (Brock, 2005). The production function model investigates the relationship between labor (L), capital (K) and the economic growth, with the GDP shown as a function of labor and capital (Sawyer, 2006). The model assumes that inward FDI helps to increase capital stock in the U.S. economy which in turn increases the rate of growth. In our model, a modified Cobb-Douglas production function was used. The model is based on a pooled cross section data for the U.S. economy in the period of time between 1981 and 2007, and includes the impact of inputs such as labor, domestic capital, inward FDI stock, export and multifactor productivity on economic growth. It shows economic growth coupled with the growth in FDI stock and found that foreign capital accounted for almost 23.28% of overall U.S. economic growth in the analyzed period of time.

106 FDI CONTRIBUTES TO OUTPUT GROWTH IN THE U.S. ECONOMY Data base in this research is obtained from the United Nations Conference on Trade and Development (UNCTAD), Bureau of Economic Analysis, Bureau of Labor Statistics, United Nations Economic Commission for Europe (UNECE), World Investment Reports, as well as other selected databases. FDI Stock as a Percentage of GDP FDI refers to an investment made to acquire lasting interest in enterprises operating outside of the economy of the investor. The investor s purpose is to gain an effective voice in the management of the enterprise. Some degree of equity ownership is almost always considered to be associated with an effective voice in the management of an enterprise, and a threshold of 10% equity ownership qualifies an investor as a foreign direct investor (International Monetary Fund, 1993). The period between 1978 and 2000 was characterized by a major influx of foreign direct investment to the United States. The inward FDI as a percentage of GDP in the U.S. increased sharply from 1% in 1996 to 3.25% in 2000. Inward FDI flow measures the amount of FDI entering a country during a one-year period, the FDI stock is the total amount of productive capacity owned by foreigners in the host country. FDI stock grows over time and includes all retained earnings of foreign-owned firms held in cash and investments (Kornecki & Rhoades, 2007). According to the data in Figure 1, the inward FDI stock as a percentage of GDP in the U.S. economy climbed from 2% to 6% during 1980s and from 6% to 10% during 1990s, reaching a peak of almost 15% in 2005 (it bottomed out in 1992 and 2002, the years following the recessions). The relatively high percentage of the FDI stock in GDP indicates important role of the FDI in the U.S. economy. 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Inward FDI Stock As % of GDP Years Figure 1. U.S. inward FDI stock as a percentage of real GDP, 1980 to 2005. UNCTAD World Investment Report 2006 Annex Tables, http://www.unctad.org/templates/page.asp?intitemid=3277&lang=1 Regression Model A modified Cobb-Douglas production function based on a pooled cross section data for the U.S. economy (1981-2007) was used to study the impact of inputs such as labor, domestic capital, FDI stock and multifactor productivity (MFP) on economic growth. Multifactor productivity index reflects the joint effects of many factors including new technologies, economies of scale, managerial skill and changes in the organization production. It portraits state of economic environment and includes factors of productivity, other foreign direct investment and export.

FDI CONTRIBUTES TO OUTPUT GROWTH IN THE U.S. ECONOMY 107 Our production-function model is explained below. Y C MFP K L e Where, Y = Real Gross Domestic Product (GDP); C = Scale Parameter; MFP = Multifactor Productivity; K = Gross Fixed Capital Formation (GFCF); L = Labor Force; e logr = The Rate of Productivity Change Over Time. Rewriting (1) in terms of the rate of change over time: a b log R = (1) Y = MFP+ ak+ bl+ R (2) In the model, the productivity change (R) is assumed to be positively influenced by both the foreign direct investment stock (FDI) and the export growth (X). The productivity change (R) is defined as X growth plus FDI growth: R = cx+ dfdi (3) Substituting equation (3) into equation (2) we have: Y = MFP+ ak+ bl+ cx+ dfdi (4) Where, Y = The Average Annual Rate of Growth of GDP; MFP = The Average Annual Rate of Growth of MFP; K = The Average Annual Rate of Growth of Capital (GFCF); L = The Average Annual Rate of Growth of Labor Force; X = The Average Annual Rate of Growth of Export; FDI = The Average Annual Rate of Growth of Inward FDI Stock. Table 1 Results of Production Function Estimation (1981-2007) 2 Constant Capital Labor Export Inward stock MFP R A 0.0095 0.1591 * 0.4482 0.0172 0.0519 * 0.6010 * 0.8668 (4.358) (1.303) (1.022) (2.630) (5.132) Notes. * Variables are significant at the 5 percent level; t-values are shown in brackets; R A denotes adjusted R 2 adjusted for degrees of freedom. All the examined variables in Table 1 except export and labor growth are significant at the five percent level (* over the variables). From the estimated coefficients, we constructed the sources of economic growth decomposition in Table 2. The outcome indicates that FDI stock contributes more to GDP growth (23.28%) than domestic capital (19.68%) while labor 26.05% and MFP 28.22% contribute the most. This result illustrates that the FDI as compared to domestic capital has a significant influence on GDP growth in the U.S. economy and constitutes crucial factor determining economic growth. The average growth rates based on values of individual factors show that FDI growth rate (9.64%) was much higher than the growth rate of domestic capital in the U.S. economy (2.66%) in comparison with export (3.46%) and labor (1.25%).

108 FDI CONTRIBUTES TO OUTPUT GROWTH IN THE U.S. ECONOMY Table 2 Sources of Economic Growth in U.S. Economy (1981-2007) Growth rate a (%) Share (%) Average growth rate b (%) Factors of production Domestic capital 0.42 19.68 2.66 Labor 0.56 26.05 1.25 Productivity change Export 0.06 2.77 3.46 FDI 0.50 23.28 9.64 MFP 0.61 28.22 1.01 Total (GDP) 2.15 100 Notes. a The numbers of this column is obtained by multiplying the estimated elasticity s by the average rate of growth of the factors concerned; b Average values of various variables (mean values). Conclusions This study tested the hypothesis that the FDI contributes extensively to GDP growth in the U.S. economy and constitutes a crucial factor determining economic growth. It is important for the U.S. economy to continue to attract foreign investment. This calls on the U.S. policy makers to formulate policies that are conducive to increasing the amount of foreign direct investment in this country. The key factor that sustained the economic expansion during the 1980s and the second part of 1990s was the ability of the U.S. to attract capital inflows from abroad. The economic expansion in the U.S. in 1990s has been sustained by the willingness of foreign investors to provide capital. The regression analyses indicate that the FDI stock in the U.S. economy shows relatively higher rate of growth in comparison with domestic capital (9.6% versus 2.7%) and contributes 23.28% to the GDP growth in comparison with domestic capital contributing 19.68%. This results point out that the FDI as compared to domestic capital has a significant influence on GDP growth in the U.S. economy and constitutes crucial factor determining economic growth. The future research will be related to the determinants of FDI in the U.S. economy and will analyze location and industry specific determinants of FDI in the U.S. economy. References Asheghian, P. (2004). Determinants of economic growth in the United States: The role of foreign direct investment. The International Trade Journal, 18(1), 63-83. Brock, G. (2005). Growth in Russia during the 1990s: What role did FDI play? Post-Communist Economies, 17(3), 319-329. Cernat, L., & Vranceanu, R. (2002). Globalization and development: New evidence from Central and Eastern Europe. Comparative Economic Studies, 44(4), 119-136. Chowdhury, A., & Mavrotas, G. (2006). FDI and growth: What causes what? The World Economy, 29(1), 9. De la Dehesa, G. (2006). Winners and losers in globalization. Malden, MA: Blackwell Publishing. Ford, T. C. (2002). Essays on foreign direct investment and growth in the United States. Retrieved from ProQuest Digital Dissertations database. (AAT 3070973). Goss, E., Wingender Jr., J. R., & Torau, M. (2007). The contribution of foreign capital to U.S. productivity growth. Quarterly Review of Economics and Finance, 47(3), 383. Hansen, H., & Rand, J. (2006). On the casual links between FDI and growth in developing countries. The World Economy, 29(1), 21. Hendriks, M. (1990 July). International factors affecting the U.S. business cycle. Business Economics, 25(3). International Monetary Fund. (1993). The balance of payments manual BPM5 (5th ed.). Retrieved from http://www.unctad.org/ Templates/Page.asp?intItemID=3146&lang=1

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