An empirical investigation of foreign direct investment and economic growth in SAARC nations
| Pages | 232-248 |
| DOI | https://doi.org/10.1108/15587891111152366 |
| Published date | 26 July 2011 |
| Date | 26 July 2011 |
| Author | Palamalai Srinivasan,M. Kalaivani,P. Ibrahim |
| Subject Matter | Strategy |
An empirical investigation of foreign direct
investment and economic growth in
SAARC nations
Palamalai Srinivasan, M. Kalaivani and P. Ibrahim
Abstract
Purpose – This paper aims to investigate the causal nexus between foreign direct investment (FDI) and
economic growth in SAARC countries.
Design/methodology/approach – Johansen’s cointegration test was employed to examine the
long-run relationship between foreign direct investment and economic growth in SAARC countries.
Besides, the vector error correction model (VECM) was employed to examine the causal nexus between
foreign direct investment and economic growth in SAARC countries for the years 1970-2007. Finally,the
impulse response function (IRF) has been employed to investigate the time paths of log of foreign direct
investment (LFDI) in response to one-unit shock to the log of gross domestic product (LGDP) and vice
versa.
Findings – The Johansen cointegration result establishes a long-run relationship between foreign direct
investment and gross domestic product (GDP) for the sample of SAARC nations, namely, Bangladesh,
India, Maldives, Nepal, Pakistan and Sri Lanka. The empirical results of the vectorerror correction model
exhibit a long-run bidirectional causal link between GDP and FDI for the selected SAARC nations except
India. The test results show that there is a one-way long-run causal link from GDP to FDI for India.
Research limitations/implications – This paper employed annual data to examine the causal nexus
between FDI and economic growth. Therefore, researchers are encouraged to test the FDI-growth
relationship further by using quarterly data.
Practical implications – The SAARC nations should adopt effective policy measures that would
substantially enlarge and diversify their economic base, improve local skills and build up a stock of
human capital recourses capabilities, enhance economic stability and liberalise their market in order to
attract as well as benefit from long-term FDI inflows.
Originality/value – This paper would be immensely helpful to the policy makers of SAARC countries to
plan their FDI policies in a way that would enhance growth and development of their respective
economies.
Keywords Foreign direct investment, Economic growth, Time series analysis
Paper type Research paper
I. Introduction
Foreign direct investment (FDI) is an investment involving a long-term relationship and
reflecting a lasting interest and control by a resident entity in one economy (foreign direct
investor or parent enterprise) in an enterprise resident in an economy other than that of the
foreign direct investor (FDI enterprise or affiliate enterprise or foreign affiliate). Foreign direct
investment implies that the investor exerts a significant degree of influence on the
management of the enterprise resident in the other economy. Such investment involves both
the initial transaction between the two entities and all subsequent transactions between them
and among foreign affiliates; both incorporated and unincorporated. FDI may be undertaken
by individuals as well as business entities (UNCTAD, 2000). Foreign directinvestment (FDI)
is widely viewed as an important catalyst for the economic transformation of the transition
economies. The most widespread belief among researchers and policy makers is that FDI
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VOL. 5 NO. 2 2011, pp. 232-248, QEmerald Group Publishing Limited, ISSN 1558-7894 DOI 10.1108/15587891111152366
Palamalai Srinivasan is
based at Christ University,
Bangalore, Karnataka,
India. M. Kalaivani is based
at Periyar University, Tamil
Nadu, India. P. Ibrahim is
based in the Department of
Economics at Pondicherry
University, Puducherry,
Pondicherry , India.
boosts growth through different channels. It increases the capital stock and employment,
stimulates technological change through technological diffusion and generates
technological spillovers for local firms. As it eases the transfer of technology, foreign
investment is expected to increase and improve the existing stock of knowledge in the
recipient economy through labour training, skill acquisition and diffusion. It contributes to
introduction of new management practices and more efficient organisation of the production
processes, which in turn would improve productivity of host countries and stimulate
economic growth. The advent of endogenous growth models (Romer, 1986, 1987; Lucas,
1988, 1990; Mankiw et al., 1992) considered FDI contributes significantly to human capital
such as managerial skills and research and development (R&D). multinational corporations
(MNCs) can have a positive impact on human capital in host countries through the training
courses they provide to their subsidiaries’ local workers. The training courses influence most
levels of employees from those with simple skills to those who possess advanced technical
and managerial skills. Research and development activities financed by MNCs also
contribute to human capital in host countries and thus enable these economies to grow in the
long term (Blomstrom and Kokko, 1998; Balasubramanyam et al., 1996). By and large, there
is a direct relationship between inward foreign direct investment in relation to their size and
economic development of a country. One of the strongest statements in that connection was
made by Romer (1993) who suggested that for a developing country that wishes to gain on
the developed countries, or at least keep up with their growth ‘‘ . . . one of the most important
and easily implemented policies to give foreign firms an incentive to close the idea gap, to let
them make a profit from doing so . .. The government of a poor country can therefore help its
residents by creating an economic environment that offers an adequate reward to
multinational corporations when they bring ideas from the rest of the world and put them to
use with domestic resources’’.
Besides, the FDI can exert a negative impact on economic growth of the recipient countries.
The dependency school theory argues that foreign investment from developed countries is
harmful to the long-term economic growth of developing nations. It asserts that First World
nations became wealthy by extracting labour and other resources from the Third World
nations. It also argued that developing countries are inadequately compensated for their
natural resources and are thereby sentenced to conditions of continuing poverty.This kind of
capitalism based on the global division of labour causes distortion, hinders growth, and
increases income inequality in developing countries (Stoneman, 1975; Bornschier, 1980;
O’Hearn, 1990). Further, the neo-classical growth models of Solow (1956) typically ascribe
negligible long-run growth effects for FDI inflows and, with its usual assumption of
diminishing returns to physical capital, these inflows can only have short-run impacts on the
level of income, leaving long-run growth unchanged. Moreover, FDI flows may have a
negative effect on the growth prospects of a country if they give rise to substantial reverse
flows in the form of remittances of profits and dividends and/or if the MNCs obtain substantial
tax or other concessions from the host country. These negative effects would be further
compounded if the expected positive spillover effects from the transfer of technology are
minimized or eliminated altogether because the technology transferred is inappropriate for
the host country’s factor proportions (e.g. too capital intensive); or,when this is not the case,
as a result of overly restrictive intellectual property rights and/or prohibitive royalty payments
and leasing fees charged by the MNCs for the use of the ‘‘intangibles’’ (see Ramirez, 2000;
Ram and Zhang, 2002).
II. Review of literature
From the above theoretical arguments, it appears that the debate of whether FDI inflows are
growth-enhancing or growth-retarding in the emerging economies remains largely an
empirical question. Considerable volume of research has been conducted on the subject,
but still there exist conflicting evidences in the literature regarding the FDI-growth
relationship. Early studies on FDI, such as Singer (1950), Prebisch (1968), Griffin (1970) and
Weisskopf (1972) supported the traditional view that the target countries of FDI receive very
few benefits because most benefits are transferred to the multinational company’s country.
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