Title: Impact of Foreign Investment and Trade on Economic Growth

Author: Shiva S. Makki and Agapi Somwaru

Source: https://jgea.org/resources/download/2595.pdf

II. Abstract
Foreign direct investment (FDI) and trade are often seen as important catalysts for
economic growth in the developing countries. FDI is an important vehicle of technology
transfer from developed countries to developing countries. Furthermore, FDI stimulates
domestic investment and facilitates improvements in human capital and institutions in the
host countries. International trade is also known to be an instrument of economic growth.
Trade facilitates more efficient production of goods and services by shifting production to
countries that have comparative advantage in producing them. Our analysis, based on cross
sectional data of a sample of 66 developing counties over three decades, indicates that FDI
and trade contribute significantly towards advancing economic growth in developing
countries. We show that FDI interacts positively with trade and stimulates domestic
investment. Sound macroeconomic policies and institutional stability are necessary preconditions for FDI-driven growth to materialize. Our results imply that lowering inflation
rate, tax rates, and government consumption would promote economic growth in developing
countries.
III.
Regression model used:
g = a + b1 FDI + b2 TRD + b3 HC + b4 K + b5 G0 (1) + c1 FDI * TRD + c2 FDI* HC + c3
FDI* K + d1 IRT + d2 TX + d3 GC + e
Definition of variables:
g is the per capita GDP growth rate
FDI is the foreign direct investment
TRD is the trade (exports plus imports) of goods and services
HC is the stock of human capital
K is the domestic capital investment
G0 is the initial GDP (initial stock)
FDI*TRD is the interaction term between FDI and Trade
FDI*HC is the interaction term between FDI and Human Capital
FDI*K is the interaction term between FDI and Domestic Investments

IRT is the inflation rate

TX is tax on income, profits, and capital gains in the host country expressed as percentage of
current revenue
GC is government consumption
Source of Data
Data were obtained from the World Development Indicators database and it covers 66
countries from 1960 to 2000. However, the analysis was limited to 1971 to 2000 because of
the flow of FDI to most developing countries began in the 1970s. All variables represent the
average over the following decades: 1971-1980, 1981-1990, and 1991-2000.
Tabulated Parameter Estimates

Major Conclusion of the study

The study was able to show that FDI and trade positively contribute toward advancing
economic growth in developing countries. The results implied that investments in human
capital and domestic investments would positively benefit the countrys growth. FDI and
trade complement each other in advancing the growth in developing countries. This result is
consistent with the idea that flow of advanced technology brought along by FDI can increase
the growth rate of the host economy by interacting with that countrys trade. Also, sound

economic policies and institutional stability are needed for FDI-driven growth to happen. The
results also implied that by lowering tax rate, inflation and government consumption will
help in promoting the economic growth in developing countries.

IV.
A. What economic issue did you find interesting in this study?
The economic issue I found interesting in this study is how lowering the inflation rate, tax
rate and government consumption would help in promoting the countrys growth. If that
was easy, why doesnt the government do it? A lower inflation would mean that the hosts
country economic policies are stable. A lower tax rate will lower the burden of the people
so that they can invest more making it profitable. Decreasing the government
consumption would leave money for investments.
B.

General impressions on the econometric model used

Their econometric model was appropriate since it was derived from a production function
in which the level of a countrys growth depends on the FDI, trade, domestic investment,
human capital and initial gross domestic product per capita. The model was also based on
the endogenous growth theory where FDI contributes directly and indirectly in economic
growth.

Specification of the model

The regression 1.1 is the basic specification with explanatory variables of FDI, trade,
human capital, domestic investment and initial GDP. Regression 1.2 expanded 1.1 to
include the interaction of FDI with trade, human capital and domestic investments.
Regression 1.3 is the final specification which expanded 1.2 to include the policy
variables which are inflation rate, tax burden and government consumption. The
results showed that most coefficients have expected signs particularly in the
specification 1.3. Some signs change for some coefficients across specifications.

Significance of the B-coefficients

On Regression 1.1, the results showed that FDI is statistically significant and contribute
positively to economic growth. Trade and initial GDP per capita is positive but not statistically
significant. Human capital is statistically significant but at 90% confidence interval and positive.
Domestic investment is not statistically significant and it is negative.
On Regression 1.2, FDIs interaction with trade, capital, and domestic investment were added in
the regression model. FDI and trade were not statistically significant but they are positive.
Human capital is Human capital is positive and statistically significant but at 90% confidence
interval. Domestic investment and initial GDP per capita are negative and not statistically
significant. FDIs interaction with trade and domestic investment are positive and statistically

significant but FDIs interaction with domestic investment is only statistically significant at 90%
confidence interval. FDIs interaction with human capital, on the other hand, is negative and not
statistically significant.
On Regression 1.3 which is the final specification model, it revealed that FDI and trade
estimated coefficients were not statistically significant but they contribute positively to economic
growth. Human capital and domestic investment estimated coefficients were statistically
significant and positive. The initial GDP per capita was negative and not statistically significant.
The interaction of FDI among trade, human capital and domestic investment are positive but
only its interaction with trade was statistically significant. This implies that FDI and trade
complement each other in advancing the growth rate of income in developing countries. The
results also showed that the three policy variables, inflation rate, tax rate and government
consumption have negative and statistically significant coefficients which means lowering
inflation, tax rate and government consumption will encourage more investments that will help
in promoting the developing countries growth.

Goodness of the fit of the model

In regression 1.1, with coefficients FDI up to initial GDP per capita, the R 2 was
0.0698 or 6%. In regression 1.2 with coefficient FDI up to its interaction with trade,
human capital and domestic investment, the R2 was 0.1175 or 11.75%. The system R2
in the last regression was is 0.2560 or 25.60% which means the model is not good.
Even though the R2 was not high, R2 increased as more coefficients were added in the
model. The R2 is generally low but reasonable since the nature of the data used is
cross- sectional.

Sample size
The sample size is sufficient since they were able to examine the data of 66 countries
from 1971-2000 (30 years).

Source of data
The source of data was reliable since it was obtained from the World Development
Indicators database which is published by the World Bank and International Monetary
Fund. They were also able to gather data that cover the 66 countries for 40 years
(1960-2000). However, the analysis were limited to 1970-2000since the flow of FDI
to most developing countries began in the 1970s.
Other comments
Not all three equations were shown in the study. Only the final specification equation
was shown. The endogeneity problem was not also discussed thoroughly.

C. Were there any attempts of the author to check for regression problems present in the
model?
There was an endogeneity problem present in the model. Endogeneity can arise as a
result of measurement error, autoregression with autocorrelated errors and simultaneity and
omitted variables. In this study, the measurement error was present. The correlation between
FDI and growth rate could arise from an endogenous determination of FDI. That is, FDI,
itself, may be influenced by innovations in the stochastic process governing growth rates.

The endogeneity problem is addressed by using the instrumental variables. These variables,
while highly correlated with the original variables are uncorrelated with with measurement
error and the regression term. One of the major problem in using the instrumental variable
estimation method is the difficulty in identifying instruments that are highly correlated with
FDI (or trade) but not with the error term. The lagged values of FDI, lagged values of trade,
and log value of total GDP as instruments in a TSLS method.

The results of the TSLS model showed that the instrumental variable estimation yields
qualitatively similar results as those obtained by the SUR method. The estimated coefficients
on FDI and trade were still positive but statistically insignificant. The estimated coefficients
of human capital and investments are still positive and statistically significant. The
interactive term of FDI and trade is still positive and statistically significant. Also, the three
policy variables are still negative and statistically significant. This alternative estimation also
suggests that our results are robust.
Do you think this study can be replicated in other area of application?

Will this be a good thesis material? Why do you think so?

Yes, I think it can be replicated in other area of application. This will also make a good thesis
material. The topic is interesting and knowing the effects of the variables that were studied in
this journal will help in promoting the economic growth of the developing country. The
relationship of independent and dependent variable is in line with its economic theories. It
was shown how FDI and trade can affect the countrys growth and how the economic growth
of the country is affected by its macroeconomic and institutional stability.

References:

Makki, Shiva S. and Agapi Somwaru. "Impact of Foreign Direct Investment and Trade on
Economic Growth ." Journal of Economic Literature (n.d.).