Professional Documents
Culture Documents
B Seetanah
School Public Policy & Management
University of Technology, Mauritius
Pointes-Aux-Sables Reduit
Mauritius
Email: b.seetanah@utm.intnet.mu
A J Khadaroo
Department of Economics & Statistics
University of Mauritius
Mauritius
Email: j.khadaroo@uom.ac.mu
Abstract
The paper investigates the impact of foreign direct investment (FDI) on economic growth
for a panel of 39 Sub-Saharan African countries for the period 19802000. An extended
Cobb Douglas production function is used whereby investment is disaggregated into its
different types namely domestic private, foreign direct and public investment for more
insights comparative analysis. Taking into account the possible existence of endogeneity
in FDI modeling, the study employs both static and dynamic panel data estimates. Results
from the analysis suggest that FDI is an important element in explaining economic
performance of Sub Saharan African countries, though to a lesser extent as compared to
the other types of capital. Moreover the study confirms the presence of important
endogeneity in FDI-growth relationship as FDI is not only seen to lead growth but to
follow growth as well.
Key Words: Foreign Direct Investment, Economic Growth Dynamic Panel Data, SSA
JEL classification: C22, F21
1. INTRODUCTION
There is a general theoretical consensus among development economists that foreign
direct investment (FDI) inflows is likely to play a critical role in explaining growth of
recipient countries (De Mello, 1997, 1999; Buckley et al., 2002; Akinlo, 2004 provide
detailed literature survey). FDI inflows in fact represent additional resources a country
needs to improve its economic performance and provides both physical capital and
employment possibilities that may not be available in the host market. As De Gregorio
(1992) argued by increasing capital stock, FDI can increase countrys output and
productivity through a more efficient use of existing resources and by absorbing
unemployed resources. However, the economic impact of FDI remains more contentious
in empirical than in theoretical studies. While many studies observe positive impacts of
FDI on economic growth, others also reported a negative relationship and among the
main reasons for this controversy remain data insufficiency and methodological flaws.
Earlier cross country studies failed to take into account continuously evolving countryspecific differences in technology, production and socioeconomic factors and it is only
recently that empirical studies have made use of panel data to correct the above ( see
Bende-Nabende & Ford, 1998; Nair-Reichert & Weinhold, 2001; Bende-Nabende et al,
2003; Choe, 2003). Another often ignored fact when analysing the hypothesis has been
the endogeneity issue. In effect, FDI may have a positive impact on economic growth
leading to an enlarged market size, which in turn attracts further FDI as well. This is
referred to as the market size hypothesis, that is markets with rapid economic growths
tend to give multinational firms more opportunities to generate greater sales and profits
and thus become more attractive to their investments. Given the possible interdependency
of these two variables, there is a need for a proper test of endogeneity. Moreover a very
scarce amount of work has been devoted on the relationship between FDI and growth in
developing countries, particularly for African economies.
This research thus attempts to complement the few empirical works have undertaken on
the FDI-growth hypothesis in the case of Africa. For aims at investigating the empirical
link between FDI inflows and economic performance for a panel of 39 Sub Saharan
African countries, selected as per data availability, for the period 1980-2000 using panel
data regression techniques. The study further allows for dynamics and endogeneity issues
by using dynamic panel data estimates, namely the Generalised Methods of Moments
(GMM) method. Such empirical evidences from Sub-Saharan African countries are
believed to add to the growing literature in the debate.
The paper is organised as follows, section 2 reviews the literature review, section 3
discusses the empirical approach, the data used and also analyses the econometric results.
The last section concludes the study.
2. LITERATURE REVIEW
Foreign direct investment has been proved in the literature to be an important promoter of
growth in its own right1. In effect, foreign direct investment is argued to increase the
level of domestic capital formation. This also implies producing on large scale which in
The vast literature of the effect of foreign direct investment on growth has been surveyed many times. See
Akinlo (2004), Buckley et al., (2002); De Mello (1997, 1999) and Borensztein et al (1998) for recent
surveys of the literature on FDI.
turn results in benefits of economies of scale and specialisation and also increasing export
and employment opportunities. These are likely to result in positive economic impacts.
Balasubramanyam, Salisu, and Sapsford (1996) and De Mello (1999) interestingly sumarised FDI as
being a composite bundle of capital stock, know-how, and technology, and can augment the existing stock
of knowledge in the recipient economy through labor training, skill acquisition and diffusion, and the
introduction of alternative management practices and organizational arrangement.
3
In this context, a recent econometric analysis by Barrell and Pain (1997) found that foreign direct
investments impact on technological change accounted for 30% of labour productivity growth in the UK
manufacturing sector between 1985 and 1995.
markets as well. It should be noted that the foreign capital inflows, by themselves, can
lead to an increase in domestic credit supply (Jansen, 1995).
FDI also beneficially affect the productive efficiency of domestic enterprises. Local firms
have an opportunity to improve their efficiency by learning and interacting with foreign
firms. FDI can also raise the quality of domestic human capital and improve the knowhow and managerial skills of local firms (the learning by watching effect). Moreover FDI
stimulates the development and propagation of technological skills through multinational
corporations internal transfers and through linkages and spillovers among firms
(Borensztein et al, 1998). Finally FDI also helps to increase local market competition,
create modern job opportunities and increase market access of the developed world
(Noorbakhsh, Paloni, Youssef, 2001) all of which should ultimately contribute to
economic growth in recipient countries.
Hermes and Lensink (2000) interestingly summarised different channels through which
positive externalities associated with FDI can occur namely: i) competition channel
where increased competition is likely lead to increased productivity, efficiency and
investment in human and/or physical capital. Increased competition may lead to changes
in the industrial structure towards more competitiveness and more export-oriented
activities; ii) training channel through increased training of labour and management; iii)
linkages channel whereby foreign investment is often accompanied by technology
transfer; such transfers may take place through transactions with foreign firms and iv)
domestic firms imitate the more advanced technologies used by foreign firms commonly
termed as the demonstration channel
However, FDI may have negative effects on the growth prospects of the recipient
economy if they give rise to a substantial reverse flows in the form of remittances of
profits, and dividends and/or if the transnational corporations (TNCs) obtain substantial
or other concessions from the host country. FDI may not lead to growth rate because
MNCs tend to operate in imperfectly competitive sectors (with high barriers to entry or a
high degree of concentration). As a result, FDI may crowd out domestic savings and
investment. Moreover, FDI may have a negative impact on the external balance because
profit repatriation will tend to affect the capital account negatively. It is also at times
associated with enclave investment, sweatshop employment, income inequality and high
external dependency (Details of negative effects can be found in Ramirez, 2000).
While the literature largely discussed the importance of FDI to growth, one should also
realise that economic growth could be an important factor in attracting FDI flows as well.
The importance of economic growth to attracting FDI is closely linked to the fact that
FDI tends to be an important component of investing firms strategic decisions. In fact
Brewer (1993) suggests three hypotheses in explaining strategic FDI projects namely,
efficiency seeking hypothesis, resource seeking hypothesis and market seeking or
market size hypothesis. The importance of economic growth in determining FDI flows
can be explained by the market size hypothesis. As Pfefferman and Madarassy (1992)
stated market size is one of the most important considerations in making investment
location decisions for three reasons: larger potential for local sales, the greater
profitability of local sales than export sales and the relatively diverse resources which
make local sourcing more feasible. In other words, the market size hypothesis predicts
that markets with large populations and/or rapid economic growths (as measured by real
GDP per capita or its growth) tend to give multinational firms more opportunities to
generate greater sales and profits and thus become more attractive to their investments.
Empirical studies by Schneider & Frey (1985), Bajo- Rubio & Rivero (1994) and Wang
& Swain (1995) all support this hypothesis.
Empirical studies
In this part we review the recent empirical evidences4 on the FDI-growth hypothesis and
we focus on cross country analysis mainly. Among the recent popular and influential
work features Borensztein et al., (1998) who tested the effect of FDI on economic growth
in a framework of cross-country regressions for 69 developing countries over the last
decade. Their results suggest that FDI was in fact an important vehicle for the transfer of
technology, contributing to growth in larger measure than domestic investment.
Moreover, the authors also found that there was a strong complementary effect between
FDI and human capital, that is, the contribution of FDI to economic growth was enhanced
by its interaction with the level of human capital in the host country. Earlier works by De
Gregorio (1992) for a panel of 12 Latin American countries and Blomstrom et al. (1996)
for less developed countries also found a strong effect of FDI on economic growth.
Similarly, Campos and Kinoshita (2002) investigated the effects of FDI on 25 transitional
economies of the former Soviet Bloc. Their results concurred with those of Borensztein et
al (1998), indicating that FDI is a significant factor in economic growth. Nyatepe-Coo
(1998) also assessed the contributions of FDI to economic growth in selected countries in
Southeast Asia, Latin America and Sub-Saharan Africa covering the period 1963-1992
following the work of Borensztein et al., (1998). The author reported that FDI did
promote economic growth in the majority of the 12 countries examined.
De Mello (1999) attempted to find support for an FDI-led growth hypothesis with time
series analysis and panel data estimation for a sample of 32 OECD and non-OECD
countries covering the period 1970-1990. His work estimated the impact of FDI on
capital accumulation, output, and TFP growth in the recipient economy. The author
reported that FDI had a positive impact on output growth and also that there was a
dominant complementarity effect between FDI and domestic investment.
Wang (2002) used data from 12 Asian economies over the period of 1987-1997 and
found that total FDI inflows significantly affect economic growth. Disaggregating the
types of flows entering these economies, she found that only FDI in the manufacturing
sector has a significant and positive impact on economic growth and attributes this
positive contribution to FDIs spillover effects.
Li and Liu (2005) also recently investigated the hypothesis in both developed and
developing countries using a large cross-country sample for the period 197099 and
accounted for the endogeneity issue. FDI and economic growth were reported to become
significantly complementary to each other and form an increasingly endogenous
relationship only from the mid-1980s. Li and Liu found that there was a strong
complementary connection between FDI and economic growth in both developed and
developing countries. They furthermore reported that FDI not only directly promoted
economic growth by itself but also indirectly did so via human capital. The authors also
confirmed that inward FDI tends to be attracted to any host country with a large market
size.
It is only lately that some studies attempted to test for the direction of causation in FDI
modeling. For instance using data on 80 countries for the period 197195, Choe (2003)
detected two-way causation between FDI and growth, but the effects were more apparent
from growth to FDI. Bende-Nabende, Ford, Sen and Slater (2000) found evidence from
the Asia-Pacific Economic Cooperation region that FDI positively affects output directly
and indirectly (through spillover effects) while studying the long-run dynamics of FDI
and its spillovers to output by using cointegration and VAR techniques. They also found
that less advanced countries output responded more to FDI, human capital, capital
formation, international trade, and new technology than that of advanced countries.
However it should be pointed out that some studies could not also establish positive
relationship between FDI and growth. For instance Carkovic and Levine (2002) uses a
mix of countries and analyzed a data sample of 72 countries, ranging from the United
States to Rwanda, that includes aggregate FDI flows to each of the countries. The results
of their analyses indicate that the exogenous component of FDI has no effect on growth.
Durham (2004) also failed to identify a positive relationship between FDI and economic
growth, but instead suggests that the effects of FDI are contingent on the absorptive
capability of host countries. This is confirmed by Xu (2000) who investigated US
multinational enterprises as a channel of international technology diffusion in 40
countries from 1966 to 1994. Using data from 10 East Asian economies, Kholdy (1995)
carries out Granger causality tests but does not find causation between FDI and
productivity.
10
We follow recent studies in the field (see Nyatepe-Coo, 1998; De Bende-Nabende and
Ford, 1998; Mello, 1999; Bende-Nabende et al., 2002, 2003 and Li and Liu, 2005 among
others) by specifying an extended Cobb-Douglas production function (equation 1) to
represent the production technology of an economy. Investment is decomposed in three
types namely, domestic private investment, foreign direct investment and also
government investment. Such disaggregation allows us to fully investigate the role of
FDI in economic development and permits useful comparative insights among the
different types of investment as well.
(1)
The Cobb-Douglas function is both homothetic and strongly separable and i represents
the countries and t the time dimension.
Y denotes the economys output, A the shift in the production function attributed to
technical progress, which is assumed to be risk neutral, K the domestic private
investment, FDI is the foreign direct investment, G is the public investment and L is
labour.
The different investment types of each respective country, that is the domestic private
investment (K), the foreign direct investment (FDI) and the public investment (G) (note
11
that aggregating all these generates each countrys total investment) are measured as the
ratio of the amount of each investment type to the GDP of the country. The main sources
of data are from the International Monetary Funds International Financial Statistics (IFS)
(various issues), World Development Indicators (various issues), from African
Development Bank, Selected Statistics on African Countries (2000) and the World
Investment Directory published by the United Nations.
The proxy used for Labour (L) is the employment level of the countries in the sample.
The data were available from the (IFS), World development indicators (various issues)
and from various country Central Statistics Websites. Extrapolation was kept to a
minimum.
The dependent variable output was proxied by the real Gross Domestic Product at
constant price (Y) and was generated from the Summers and Heston (version 6.0). The
data set used covers 39 Sub Saharan African countries5 (as per data availability) over the
period 19802000.
Countries in the sample includes the following country:Angola, Benin, Botswana, Burkina Faso, Burundi,
Ethopia, Gabon, Gambia, Ghana, Guinea, Guinea Bissau, Kenya, Lesotho, Madagascar, Malawi, Mali,
Mauritania, Mauritius, Mozambique, Namibia, Niger, Nigeria, Rwanda, SaoTome, Senegal, Seychelles,
Sierra Leone, S Africa, Tanzania, Togo, Uganda, Zambia and Zimbabwe.
12
y t = t + 1k t + 2 fdit + 3 g t + 4 lt + t
(2)
where the coefficients 1, 2, 3 and 4 are the output elasticities of the factor inputs and
is the error term
A central issue before making the appropriate specification, often ignored by past
researchers, is to test if the variables are stationary or not. We thus carry out panel unit
root tests on the dependent and independent variables. We follow the approach of Im,
Pesaran, and Shin (IPS) (1995), who developed a panel unit root test for the joint null
hypothesis that every time series in the panel is non stationary. This approach is based on
the average of individual series ADF test and has a standard normal distribution once
adjusted in a particular manner. Assuming that the cross-sections are independent, IPS
propose to use the following standardized t-bar statistic .The IPS panel unit root test
NT
1
N
E [tiT (pi,0)]
i =1
1 N
Var[tiT ( pi ,0) ]
N i=1
N is the number of panels, t NT is the average of the ADF test for each series across the
panel. The values for E[tiT(pi,0)] and Var[tit(pi,0)] are obtained from the Monte Carlo
13
Results of this test applied on our time series in level suggests that we reject a unit root in
favor of stationarity (the results were also confirmed by the Fisher-ADF and Fisher-PP
panel unit root tests) at the 5 percent significance level and it is deemed safe to continue
with the panel data estimates of the above econometric specification (equation 2).
We performed cross section (averaged over the sample period 1980-2000) and pooled
OLS analysis of our hypothesis for some preliminary results. Standard errors of the OLS
regression were corrected by the White procedure. White (1980) proposed the
heteroskedasticity-robust variance matrix estimator to adjust the standard errors of a
regression in the presence of heteroskedasticity. The results are reported in table 1
(column 2 and 3). The positive and significant coefficient of fdi from the cross section
analysis suggests that FDI has been an ingredient of economic growth of African
economies over the period of study, although to a lesser extent as the other types of
investment. The results are consolidated when using Pooled OLS estimates. The
limitations of using a single-equation OLS cross sectional regression model and pooled
OLS are known (see Kennedy 2003). To overcome these short comings, panel data
techniques are advised. The paper still reports, for comparative purposes and to get a
broad overview the above estimates.
14
We employ both static and dynamic (Generalised Methods of Moments) panel data
techniques to analyse the role of FDI in the economic growth of our sample of country. In
fact use of panel data allows not only to control for unobserved cross country
heterogeneity but also to investigate dynamic relations. To test whether to use a random
effect or a fixed effect estimation approach, the Hausman test has been used. In fact the
Hausman test tests the null hypothesis that the coefficients estimated by the efficient
random effects estimator are the same as the ones estimated by the consistent random
effects estimator. The specification test was performed and recommended the use of
random effects model and table 1 (column 4) reports the relevant estimates.
Table 1: Panel data estimates : Random effects (39 countries x 21 years (1980-2000))
Dependent variable y = (log of Y).
Variable
Cross Section
Pooled OLS
RE robust
Estimates
estimates
estimates/RE
9.44
11.25
11.25
(8.23)
(3.52)***
(3.99)***
0.2
0.33
0.34
(1.79)*
(5.93)***
(5.81)***
0.06
0.09
0.11
(1.67)*
(3.20)***
(3.72)***
0.1
0.19
0.18
(0.57)
(3.75)***
(3.65)***
0.12
0.18
0.18
(1.77)*
(10.12)
(10.13)***
(average 19802000)
Constant
k
fdi
g
l
15
R2
0.40
0.40
0.35
39
819
819
Number of
observations
Hausman Test
Prob>Chi2=0.503
Random effects estimates suggests that FDI to Sub Saharan African countries has been an
important element in explaining growth performance, although as earlier seen, to a lower
extent as compared to the other types of capital, namely domestic private and public
capital. This positive contribution is in line with the theoretical underpinnings discussed
earlier. The effect of FDI in these economies is also reported to be relatively less as
compared to other studies, for instance De Gregorio (1992) for Latin American countries,
Borensztein et al., (1998) for a panel countries, Wang (2002) for the Asian economies
case and Campos and Kinoshita (2002) for transitional economies. This may be explained
by the fact that African countries have been among the lowest beneficiaries of FDI.
Foreign direct investment flows to Africa have registered a steady decline during the
years. During the period of study, most FDI flows to developing countries were directed
towards the South, East and South-Eastern Asia followed by Latin America with Africa
accounting for 4-5% of total FDI flow to developing world. According to the WIR (2001)
African share of FDI in the world fell below 1 percent in 2000. Sub-Saharan Africa also
registered the same trend.
16
Sub Saharan African countries have thus been depending mainly on domestic private
investment and public investment as well. Despite the relatively lower flow of FDI in
these economies, explaining probably its small effect, such type of investment is still seen
from the study to play a non negligible role in economic growth. It is believed that higher
level of FDI in these economies would be accompanied with higher growth rates.
As discussed before FDI may have a positive impact on economic growth leading to an
enlarged market size, which in turn attracts further FDI. This is referred to as the market
size hypothesis, that is markets with rapid economic growths tend to give multinational
firms more opportunities to generate greater sales and profits and thus become more
attractive to their investments.
The incorporation of dynamics into our model necessitates our econometric equation to
be rewritten as an AR (1) model in the following.
y it y it 1 = t + y it 1 + x it + it
(3)
where the LHS is the log difference in tourist arrivals over a period; yit = the log of real
GDP; xit= the vector of explanatory variables, that is x = [k, fdi, g, l] and t = the period
specific intercept terms to capture changes common to all sectors; it = the time variant
idiosyncratic error term.
17
(4)
y it = t + ( + 1) y it 1 + x it + it
(5)
A problem of endogeneity might exist if yt-1 is endogeneous to the error terms through uit1,
overcome this problem of endogeneity, an instrumental variable need to be used for yit-1.
Two approaches, namely Instrumental Variable (IV, Anderson and Hsiao 1982) and two
GMM estimators (Arellano and Bonds 1991), first and second step respectively, can be
used in this regard. We used the latter technique, as the IV approach leads to consistent
but not necessary efficient estimates of the parameters (see Baltagi 1995). Moreover, the
first step GMM estimator will be used since it has been shown to result in more reliable
inferences. The asymptotic standards errors from the two step GMM estimator have been
found to have a downward bias (Blundell and Bond 1998).
The results from estimating equation (5), extended with some lagged terms, using the
Arellano-Bond (1991) first step GMM estimator are contained in table 3 (in Appendix).
The various estimated equations passes all diagnosis test related to Sargan Test of Overidentifying restrictions and the Arellano-Bond test of 1st order and 2nd autocorrelation.
18
GMM estimates
Constant
0.005
(2.49)**
yt-1
0.36
(7.53)***
0.16
(3.95)***
fdi
0 05
(3.16)***
0.11
(2.60)**
0.13
(10.96)***
Diagnosis tests
Sargan Test of
Overidentifying restrictions
prob>chi2=0.18
prob>chi2=0.28
nd
Arellano-Bond test of 2
order autocorrelation
prob>chi2= 0.37
The results from the dynamic panel analysis validate the hypothesis that FDI is growth
conducive in our sample of countries even in the short run. Interestingly the positive and
19
significant coefficient of yt-1 from the table suggests that lagged income of the country
contributes positively towards the current level of y confirming the existence of
dynamism and endogeineity in the modeling framework. This is consistent with recent
works from Bende-Nabende, Ford, Sen and Slater (2000) and Choe (2003) and Li and
Liu (2005). In fact the value of the coefficient of the lagged FDI is 0.36 implying a
coefficient of partial adjustment of 0.64. This means that y in one year is 64 percent of
the difference between the optimal and the current level of y. The other explanatory
variables are also confirmed to be important ingredients in explaining growth pattern in
these countries.
4. CONCLUSIONS.
The paper investigated the relationship between FDI and the economic performance for
the case of 39 African countries over the period 1980-2000. Capital stock, as proxied by
investment ratios, has been disaggregated into its different components namely domestic
private, FDI and public investment as well in an attempt to disentangle the effect of FDI
and for comparative insights. Results from the static random effects estimates shows that
FDI has a positive and significant effect on the level of economic growth and is thus
consistent with the literature, particularly with respect to developing countries. The
contribution of foreign direct investment is however observed to be relatively less as
compared to the other type of investment. Moreover it is also on the lower side as
compared to previous studies on non African economies and this might be explained by
the fact African countries have been among the lowest beneficiaries of FDI. The positive
20
link is also confirmed when using GMM panel estimates which moreover suggested the
presence of dynamic in the system. Thus FDI does not only precede growth and output
level of the country but also followed growth. The above results highlight the economic
importance of FDI and provide new evidences for the case of African economies.
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