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Determinants of Foreign Direct Investment in Sri Lanka

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DOI: 10.1177/1391561415598458

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Research Article

Determinants of Foreign South Asia Economic Journal

16(2) 233–256
Direct Investment in ©2015 Research and Information
System for Developing Countries &
Sri Lanka Institute of Policy Studies of Sri Lanka
SAGE Publications
sagepub.in/home.nav
DOI: 10.1177/1391561415598458
http://sae.sagepub.com

K. Ravinthirakumaran1
E.A. Selvanathan2
S. Selvanathan3
T. Singh4

Abstract
Foreign direct investment (FDI) can play a significant role in achieving rapid eco-
nomic growth in developing countries such as Sri Lanka. Even after the 30-year-
long war that ended in 2009, the economy is still struggling to convince domestic
and foreign investors that Sri Lanka is ‘ready for business’. In the light of this situ-
ation, identifying the factors that could influence FDI inflows into Sri Lanka is crucial
to design policies aimed at attracting more FDI. This article empirically investigates
the determinants of FDI inflows into Sri Lanka using annual data for the period
1978–2013 and applying the latest econometric techniques in time series analysis.
As expected, market size, trade openness and infrastructure level have a positive
impact, while wage and political instability have a negative impact on FDI. From
a policy point of view, the results suggest that, to attract FDI inflows, Sri Lanka
should develop and introduce policies that would improve the level of market size,
trade openness, infrastructure and political stability but reduce the cost of labour.

JEL: F21, C32, O53

Keywords
FDI, cointegration, bounds test, economic growth

1
Research Scholar, Economics and Business Statistics Discipline, Griffith Business School, Griffith
University, Australia.
2
Professor, Economics and Business Statistics Discipline, Griffith Business School, Griffith University,
Australia.
3
Professor, Economics and Business Statistics Discipline, Griffith Business School, Griffith University,
Australia.
4
Senior Lecturer, Economics and Business Statistics Discipline, Griffith Business School, Griffith
University, Australia.

Corresponding author:
S. Selvanathan, Economics and Business Statistics Discipline, Griffith Business School, Griffith University,
Queensland, Australia.
Email: s.selvanathan@griffith.edu.au

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234 South Asia Economic Journal 16(2)

Introduction
Foreign direct investment (FDI) can play a significant role in achieving rapid
economic growth in developing countries such as Sri Lanka by bridging the gap
between domestic savings and investment, and bringing the latest technology and
management know-how from the developed countries. Hence, it can easily be
understood why many developing countries seek new ways to attract FDI inflows.
Some developing countries have been successful in attracting FDI while others
have not. The reason for this lies in how a country handles the factors that determine
FDI inflows. Identifying the factors that determine FDI inflows into a country is a
complex problem. A growing body of literature provides theoretical and empirical
evidence about the factors that determine FDI inflows into a host country.
Some of the important determinants that could affect FDI inflows are the
micro-level variables, including ownership advantages, cost reduction and econo-
mies of scale and others are macro-level variables, such as, barriers to entry, avail-
ability of resources, political stability, country risk and market size (Dunning &
Lundan, 2008; Faeth, 2009). Dunning’s eclectic paradigm or the ownership, loca-
tion and internalization (OLI) model (1977, 1981) proclaims that the returns on
foreign investment as a basic motive for FDI can be explained by three groups of
factors: the ownership advantage of the firm (O), location factors (L) and the
internalization of transaction costs (I). It has remained the dominant analytical
framework for accommodating a variety of operationally testable economic theo-
ries of the determinants of FDI (Dunning, 2000).
Sri Lanka is one of the developing countries that badly needs FDI as its capac-
ity to allocate its own funds for development is very low due to its lower level of
domestic savings, which was only 21 per cent of gross domestic product (GDP) in
2014 (Ministry of Finance, 2014). The investment favourable policies adopted by
the successive governments over the past three decades did result in FDI inflows
into Sri Lanka. However, the growth of FDI inflows into Sri Lanka has performed
below the government’s post-war expectations. Despite the rapid growth of infra-
structure, sound macroeconomic conditions, favourable investment climate and
huge government support for FDI inflows, Sri Lanka has still failed to attract a
significant amount of FDI inflows compared to its South Asian neighbours. For
example, Sri Lanka had set a target to attract US$ 2 billion FDI in 2013 (US
Department of State Report, 2014), but managed to receive only US$ 0.916 billion.
Why is Sri Lanka lagging behind in attracting FDI? What are the factors that
influence FDI inflows into Sri Lanka? This article aims to find answers to these
questions by using historical (time series) data on FDI inflows and a number of
other relevant explanatory variables.
Although a number of studies have been published on FDI in Sri Lanka, to the
best of our knowledge, only two studies (Albert & Stuart, 2008; Jayasekara, 2014)
have studied the determinants of FDI. In the first study, applying the vector auto
regressive (VAR) method, Albert and Stuart have concluded that among the vari-
ables, the study considered (real GDP, trade, wage rate, exchange rate and interest
rate) for the period 1950–2004, wage rate is the most important determinant of
FDI. In the second study, by using fully modified ordinary least squares (FM-OLS)

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Ravinthirakumaran et al. 235

technique and data for the period 1975–2012, Jayasekara has found that GDP
growth, rate of inflation, infrastructure quality, lending interest rate, labour force,
exchange rate and corporate income tax are significant determinants of FDI.
Our contribution differs from the above two studies in the following ways.
Albert and Stuart (2008) used the data prior to the post-war period, while our
study uses the data up to 2013. While Jayasekara (2014) used more recent data,
the use of the autoregressive distributed lag (ARDL) bounds test method in our
estimation captures the short- and long-run effects of the determinants of FDI and
is more appropriate. We believe that analyzing the short- and long-run impact of
the FDI determinants is more beneficial for policy makers to design policies at
different time horizons.
The remainder of the article is organized as follows: The section ‘Evolution of
the FDI Policies in Sri Lanka’ discusses the evolution of FDI policies in Sri Lanka
as a background for the study. The section ‘A Brief Review of the Literature’
presents a review of selected published studies on the topic. The section
‘Preliminary Data Analysis’ presents a preliminary analysis of the data. The sec-
tion ‘Model Specification and Estimation Results’ discusses the methodology and
the estimation results. Finally, the section ‘Conclusions and Policy Implications’
provides the concluding comments and policy implications.

Evolution of the FDI Policies in Sri Lanka

Since independence in 1948, there were two distinctive phases of government
policy towards private investment in Sri Lanka. The first phase was from 1948 to
1977 when the public sector was the dominant entity and controlled the country’s
resources. During this phase, mixed policies were pursued. For example, during
the late 1960s, there was a partial liberalization that generated better conditions
for the private sector. The period 1971–1977 saw a reversal of intensified govern-
ment intervention and several policy measures that had adverse impact on private
sector investment (UNCTAD, 2004).
The second distinctive phase was that Sri Lanka launched its economic liber-
alization reforms in 1977, becoming the first country in the South Asian region to
do so. These reforms replaced the quantitative restrictions on imports with tariffs
and revised the tariff structure to achieve greater uniformity. Such reforms resulted
in reducing restrictions together with new incentives for export-oriented foreign
investment under an attractive Free Trade Zone (FTZ) scheme. Reforms on finan-
cial institutions led to the adjustment of the interest rates to levels above the rate
of inflation, opening the banking sector to foreign banks and freeing the credit
markets to determine interest rates. Furthermore, reforms were introduced to limit
the public sector participation in the economy, and a programme for the privati-
zation of public enterprises, exchange rate realignment and incentives for non-
traditional exports was also implemented (Athukorala, 2005).
There have been two significant developments in the investment environment
since the liberalization phase began in 1977. The introduction of export process-
ing zones (EPZs) has been important in terms of the attraction of export-oriented

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236 South Asia Economic Journal 16(2)

foreign firms. An enabling regime for EPZs was set up in 1978 as part of the crea-
tion of the Greater Colombo Economic Commission (GCEC). EPZs contribute a
significant share to Sri Lanka’s industrial export earnings. Another notable change
was the adoption of an ambitious privatization programme. Privatization was
announced as a state policy in 1987 with the objective of reducing the burden on
the budget created by the operations of the state-owned enterprises (SOEs) and
improving the efficiency and profitability of these enterprises. In 1992, the most
important building block of Sri Lanka’s FDI policies was the establishment of the
Board of Investment (BOI). With the aim of improving Sri Lanka’s effectiveness
in attracting FDI, the BOI was bestowed with wide powers of tax relief and admin-
istrative discretion in all matters relating to FDI. The BOI provides “one-stop-
shop” (many organizations in one) service for foreign investors, with duties
including approving projects, granting incentives, arranging utility services and
facilitating import and export clearances.
Sri Lanka’s foreign investment regime has been significantly liberalized. Total
foreign ownership is permitted in most industries and in a number of service sec-
tor activities including banking, insurance, finance, construction, mass transporta-
tion, telecommunications and information technology and petroleum distribution.
There is no restriction on the repatriation of profits/dividends of foreign compa-
nies. The remittance of management fees, royalties and licensing fees are also
permitted for companies with majority foreign investment approved under Section
17 of the Board of Investment (BOI) Act. Stock market investments can be remit-
ted without prior approval from the Central Bank. Investment returns can be
remitted in any convertible currency at the market rate, while foreign investors
may invest in foreign-currency-denominated bonds. National treatment is offered
to all foreign investors.
The BOI promotes the following sectors as priority sectors for FDI: tourism
and leisure, infrastructure, knowledge services, utilities, apparel, export manufac-
turing, export services, agriculture and education. However, FDI is not permitted
in the following businesses: non-bank money lending, pawn-brokering, retail
trade with a capital investment of less than US$1 million and coastal fishing. The
BOI maintains a number of EPZs (Katunayake, Biyagama, Koggala, Mirigama,
Wathupitiwala, Malwatta, Seethawaka and Horana) that feature business-friendly
regulations and improved infrastructure for foreign investors (BOI, 2014).
Sri  Lanka seems to have a relatively well-designed (FDI) promotion strategy
since the end of the civil war in 2009. Despite the fact that Sri Lanka’s FDI regime
has been liberalized more quickly than most of its competitors, Sri Lanka is still
facing a number of impediments, where policy instruments need to take effect.

A Brief Review of the Literature

There is a growing body of research that provides empirical evidence with regard
to the factors determining FDI inflows across different countries and regions.
Table 1 presents a summary of a selected number of studies that have examined
the factors affecting FDI inflows by presenting the country studied, data period,

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 Table 1. Determinants of FDI: A Summary Review

Publication
(Author(s), Year) Countries Period Methodology Determinants of FDI
Albert and Stuart Sri Lanka 1950–2004 VAR • GDP
(2008) • Trade Openness
• Exchange rate
• Labour cost
• Interest rate
Ali and Guo China 2004 Descriptive Analysis • GDP
(2005) • Labour cost
• Government incentive policies
• Return on capital
• Global integration
Ang (2008) Malaysia 1960–2005 2SLS • GDP
• Trade openness
• Infrastructure
• Financial development
Asiedu (2002) 71 developing countries 1988–1990 Panel regression • Trade openness
(SSA-Sub-Saharan Africa and 1991–1993 • Infrastructure

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non SSA) 1994–1997 • Return on capital
Bhavan et al Pakistan, India, Bangladesh, Panel data GMM • Trade openness
(2011) Sri Lanka 1995–2008 • Infrastructure
• Distance
• Human development
• Population
(Table 1 Continued)
 (Table 1 Continued)
Publication
(Author(s), Year) Countries Period Methodology Determinants of FDI
Billington (1999) 7 industrialized countries and 7 Countries – Pooled regression • GDP
11 UK regions 1986–1993; • GDP growth
11 Regions– • Labour cost
1984, 1986, • Interest rates
1990–1994 • Unemployment
• Host country imports
• Corporate tax
• Population density
Boateng et al Norway 1986–2009 FM-OLS • GDP
(2015) • Trade openness
• Exchange rate
• Interest rate
• Rate of inflation
• Money supply
• Unemployment
Casi and Resmin 25 European countries 2005–2007 OLS and spatial error • GDP
(2010) model • GDP growth

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• Labour cost
Cevis and 17 developing countries and 1989(1)–2006(4) GLS • Trade openness
Camurdan (2007) transition economies • GDP growth
• Interest rate
• Rate of inflation
 Demirhan and 38 developing countries 2000–2004 OLS • GDP per capita
Masca (2008) • Trade openness
• Infrastructure
• Rate of inflation
• Tax rate
Hara and Japan 1980–2001 OLS • GDP
Razafimahefa • Volatility exchange rates
(2005) • Land price
• Deregulation
Jayasekara (2014) Sri Lanka 1975–2012 FM-OLS • GDP growth
• Rate of inflation
• Infrastructure quality
• Interest rate (lending)
• Labour force
• Exchange rate
• Income tax rate
Janicki and European Union and 8 1997 WLS • GDP
Wunnava (2004) Central and East European • Trade openness
countries (CEEC) • Labour cost
• Risk
Khan and Nawaz Pakistan 1970–2004 OLS • GDP growth

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(2010) • Exchange rate
• Whole sale price index
• Tariff rate
• Exports
 (Table 1 Continued)
Publication
(Author(s), Year) Countries Period Methodology Determinants of FDI
Koojaroenprasit Australia 1986–2011 OLS • GDP
(2013) • Exchange rate
• Interest rate
• Custom duty
Mold (2003) US and developed European 1978–1995 Panel regression • GDP
countries • Labour costs
• Exchange rate variability
Piteli E (2010) 17 developed OECD 1972–2000 Panel regression • Total factor productivity
countries
Ramasamy and OECD countries 1980–2003 GMM • GDP
Yeung (2010) • GDP growth
• Trade openness
• Infrastructure
• Labour cost
• Interest rate
• Education
• Risk

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• Lagged FDI
Sader (1995) 36 developing countries 1988–1993 OLS • Trade
• Domestic investment
• Government consumption
 Sahoo (2006) 5 South Asian countries 1975–2003 Panel regression • GDP
(India, Pakistan, Bangladesh, • Trade openness
Sri Lanka and Nepal • Infrastructure
• Labour force growth
Severiano A Portugal 1980–2009 OLS • GDP per capita
(2011) • Trade openness
• Exchange rate
• Minimum wage
Singhania and India 1991–2008 ARIMA • GDP
Gupta (2011) • Rate of inflation
• Scientific research
Vogiatzoglou South and East Asia (9 host- 1994–2003 Panel gravity model • Bilateral trade
(2007) countries from South and • vertical specialization
East Asia and 10 major home
or investing countries)
Source: Information collated from publications listed in the first column of the table.

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242 South Asia Economic Journal 16(2)

methodology used and the findings in terms of the determinants of FDI. In the
following section, we consider the possible explanatory variables and their prox-
ies and discuss their direction of effect on FDI inflows.
Market size and growth potential are significant determinants for FDI inflows. In
most empirical studies, GDP or GDP per capita (GDPPC) is used as a proxy to
measure the market size of an economy, and GDP growth rate is used as a proxy for
the growth of market potential. Market size and growth potential are found to have
a positive influence on FDI inflows (Albert & Stuart, 2008; Ali & Guo, 2005; Ang,
2008; Billington, 1999; Boateng et al., 2015; Casi & Resmin, 2010; Cevis &
Camurdan, 2007; Demirhan & Masca, 2008; Hara & Razafimahefa, 2005; Janicki
& Wunnava, 2004; Jayasekara, 2014; Khan & Nawaz, 2010; Koojaroenprasit, 2013;
Mold, 2003; Ramasamy & Yeung, 2010; Sahoo, 2006; Singhania & Gupta, 2011).
Trade openness is a significant determinant of FDI inflows. A number of
researchers have used the ratio of total trade (imports plus exports) to GDP to
measure the trade openness. Trade openness is found to have a positive influence
on FDI inflows (Albert & Stuart, 2008; Ang, 2008; Asiedu, 2002; Bhavan, Xu &
Zhong, 2011; Boateng et al., 2015; Cevis & Camurdan, 2007; Demirhan & Masca,
2008; Janicki & Wunnava, 2004; Jayasekara, 2014; Ramasamy & Yeung, 2010;
Sahoo, 2006; Severiano, 2012).
Infrastructure is an important determinant of FDI inflows. In order to measure
the infrastructure level, while many researchers used telephone lines, some
researchers used road mileage, electricity consumption and infrastructure index.
Most studies have found good infrastructure to promote FDI inflows (Ang, 2008;
Asiedu, 2002; Bhavan et al., 2011; Demirhan & Masca, 2008; Jayasekara, 2014;
Ramasamy & Yeung, 2010; Sahoo, 2006).
Exchange rate strength influences FDI inflows. An appreciation of the domes-
tic currency is supposed to reduce the FDI inflows. Ang (2008), Jayasekara (2014),
Khan & Nawaz (2010), Koojaroenprasit (2013), and Severiano (2012) have found
a negative relationship between exchange rate and FDI. In contrast, Boateng et al.
(2015) have found a positive relationship between them.
Cheap labour cost is usually considered as an important factor that attracts
FDI inflows. Lower labour cost reduces the cost of production, ceteris paribus.
Albert & Stuart (2008), Ali & Guo (2005), Casi & Resmin (2010) and Janicki &
Wunnava (2004) have found a negative relationship between labour cost and
FDI inflows.
Interest rate is another significant determinant of FDI inflows. Low interest
rate provides a cost advantage for investors. Some of the surveyed studies have
found a negative relationship between interest rates and FDI inflows (Boateng
et  al., 2015; Koojaroenprasit, 2013; Ramasamy & Yeung, 2010). On the other
hand, some other studies found that higher interest rates in the host country make
foreign investments more attractive as they lead to profitable investments, and
hence a positive relationship between interest rate and FDI inflows is also reason-
able (Billington, 1999; Cevis & Camurdan, 2007; Jayasekara, 2014). Thus, the
impact of interest on FDI inflows is inconclusive.
Rate of inflation reflects the economic stability of an economy. Usually, a high
rate of inflation (economic instability) reduces the return on investment. Therefore,

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Ravinthirakumaran et al. 243

45 41
Percentage of studies

40
35
30
25 21
20
15 11
10 7 7 7 5
5
0
GDP growth Trade Infra- Exchange Wage Interest Rate of
openness structure rate rate Inflation

Figure 1. Major determinants of FDI

Source: Based on the reviewed publications in Table 1.

the rate of inflation has a negative impact on FDI inflows (Boateng et al., 2015;
Cevis & Camurdan, 2007; Demirhan & Masca, 2008; Singhania & Gupta, 2011).
In contrast, Jayasekara (2014) has found a positive relationship between the rate
of inflation and FDI inflows.
Political instability increases uncertainty about the cost and profitability of
investment. A number of studies have found that political instability has a nega-
tive impact on FDI inflows. (Azzimonti & Sarte, 2007; Minhas & Ahsan, 2015).
In summary, wage, exchange rate, rate of inflation and political instability have
a negative impact on FDI inflows, while GDP and GDP growth rate, infrastructure
and trade openness have a positive impact on FDI inflows. The impact of interest
rate on FDI inflows is inconclusive.
To summarize the results of these studies, the major factors affecting the FDI
inflows are identified and their frequency distribution is presented in Figure 1. As
can be seen, GDP/GDP growth rate, trade openness, infrastructure, exchange rate,
wage, interest rate and rate of inflation are the dominant determinants identified
by the majority of the studies.

Preliminary Data Analysis

This section presents the sources of data used in the study and conducts a prelimi-
nary analysis of the data. In the following section, we use time series analysis to
analyze formally the relationship between FDI and its determinants.
Figure 2 presents the FDI inflows and FDI inflows as a percentage of GDP to
Sri Lanka during the period 1970–2013. As can be seen, before the implementa-
tion of inward-oriented policies in 1977, FDI inflows were negligibly small. FDI
inflows began to increase with the establishment of the GCEC and the EFZ in
1978. For example, FDI inflows have increased from US$ 47 million in 1979 to
US$ 64 million in 1982. However, the impressive upward trend in FDI inflows
was disrupted by the escalation of ethnic problems into a civil war in 1983. Major

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244 South Asia Economic Journal 16(2)

1000 3.0
900

FDI inflows (% of GDP)

FDI inflows (US$m)

800 2.5
700 2.0
600
500 1.5
400
300 1.0
200 0.5
100
0 0.0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
FDI net inflows ( US$m) FDI net inflows (% of GDP)

Figure 2. FDI Inflows in Sri Lanka, 1970–2013

Source: Data are from Worldbank, 2014.

ethnic riots in the capital city and elsewhere took place in July 1983, and the onset
of the civil war between the government of Sri Lanka and the Liberation Tigers of
Tamil Eelam (LTTE) from that year made the investment climate less attractive
to foreign investors. Since 1983, the FDI inflows have declined during periods
of hostilities and increased during periods of peace negotiations between the
Sri Lankan government and the LTTE. In the final stages of the war, during 2008–
2009, FDI inflows declined sharply from US$ 752 million to US$ 404 million
and, since then, have increased to US$ 916 million in 2013. The line graph in
Figure 2 shows that the FDI inflows as a percentage of GDP remained very low
(less than one) until 1977. Since then, movements in FDI inflows as a percentage
of GDP have been consistent with that of the FDI.

The Data
For our analysis, we use the annual time series data for the period 1978–2013 on
FDI, GDPPC, trade openness, infrastructure, exchange rate, wage, interest rate,
rate of inflation and political stability. These data are collected from various issues
of World Development Indicators (World Bank, 2014), Annual Reports and
Economic and Social Statistics Reports of the Central Bank of Sri Lanka and the
Sri Lankan Election Commission reports.
FDI net inflows are measured in US$. We use GDPPC (constant 2005 US$)
and GDP growth as proxies for market size and growth of market size: trade
openness (TOPEN) (i.e., TOPEN = [(exports + imports)/GDP)] as a proxy for
‘openness’ of the country. An ‘infrastructure index’ is used as a proxy to meas-
ure the level of infrastructure. We have constructed this weighted index based
on three variables, namely number of telephone lines (per 100 people), road
mileage (national highway roads) and electricity production (kWh) (Li, 2004;

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Ravinthirakumaran et al. 245

Ramasamy & Yeung, 2010), where the weights are the share of these variables on
the GDP. We use the average official US$ per Sri Lankan rupees exchange rate;
the wage rate index (real wage rate index for all workers) as a proxy for labour
cost; interest rate (real lending interest rate) as a proxy for cost of capital; the rate
of inflation (GDP deflator, annual percentage) as a proxy for the level of macroeco-
nomic instability; and a dummy variable (political in stability, POLINS), taking a
value 1 for the change of government years and 0 otherwise, as a proxy for political
instability (Alesina et al., 1996; Benhabib & Spiegel, 1997; Mauro, 1995).
The expected signs of the determinants on FDI are as follows: GDPPC, trade
openness, GDP growth and infrastructure are expected to have a positive impact
on FDI while exchange rate, wage, rate of inflation and political instability are
expected to have a negative effect. The interest rate could have either positive or
negative effects on FDI. These expected signs are also supported by the literature
review presented in the section ‘A Brief Review of the Literature’. A larger size of
GDPPC results in more FDI inflows due to the benefits of economies of scale.
Trade openness is often interpreted as a measure of trade restrictions. As less trade
restriction encourages export, the presence of high openness (less trade restric-
tion) will increase FDI inflows. Economic growth could attract more FDI as it
provides market potential. The well-developed infrastructure raises the productiv-
ity of investments and therefore stimulates FDI inflows. An appreciation of the
domestic currency reduces FDI, since it increases the cost of capital investment.
Higher labour cost discourages FDI because it makes production in an economy
more costly. If the rate of interest in the host nation is low (relative to world inter-
est rates), foreign multinational enterprises (MNEs) will invest more in the host
country. As a high rate of inflation would reduce the return on investment, FDI
inflows will be discouraged. Political instability causes an uncertain political
environment, raising risks and reducing FDI.
As a preliminary investigation, in Figure 3, we present scatter plots of FDI
inflows against each of the possible determinants; (i) GDPPC, (ii) trade openness
(OPEN), (iii) infrastructure (INFRA), (iv) wage (WAGE), (v) rate of inflation
(INF), (vi) interest rate (INT), (vii) exchange rate (EXCH) and (viii) GDP growth
(GRO). As can be seen, as expected, we observe a positive relationship between
FDI and GDPPC, trade openness, infrastructure, interest rate and GDP growth,
and a negative relationship between FDI and exchange rate and rate of inflation.

Model Specification and Estimation Results

To investigate the relationship between FDI and its possible explanatory varia-
bles, we consider FDI as a linear function of the following variables: GDPPC,
OPEN, INFRA, WAGE, INF and POLINS. Since exchange rate and interest rate
are highly correlated with the remaining independent variables, we exclude these
two variables from the model to avoid the multicollinearity problem (Sun, Tong
& Yu, 2002). (For example, Corr(INT, INF) = –0.76, Corr(EXCH,GDPPC) =
–0.93, Corr(EXCH,OPEN) = –0.85, Corr(EXCH,INFRA) = –0.96.) All variables,

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 21 21

20 20

19 19

Ln(FDI)

Ln(FDI)
18 18

17 17 y = 6.2138x + 21.869
y = 2.5401x + 1.3575
16 16
6.0 6.5 7.0 7.5 8.0 0.8 0.7 0.6 0.5 0.4 0.3 0.2
Ln(GDPPC) Ln(Openness)
21 21

20 20

19 19

18 18

Ln(FDI)
Ln(FDI)
17 y = 8.2104x -57.411 17 y = -3.7885x + 29.378
16 16

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9 9.1 9.2 9.3 9.4 9.5 2.5 2.6 2.7 2.8 2.9 3.0
Ln(Infrastructure) Ln(Wage)

21 21

20 20

19 19
18

Ln(FDI)
Ln(FDI)

18
17 17
y = -0.0651x + 19.447 y = 0.0351x + 18.555
16 16
0 3 6 9 12 15 18 21 6 3 0 3 6 9 12
Rate of inflation Interest rate
 19 19

18 18

Ln(F
Ln(F
17 y = 8.2104x -57.411 17 y = -3.7885x + 29.378
16 16
9 9.1 9.2 9.3 9.4 9.5 2.5 2.6 2.7 2.8 2.9 3.0
Ln(Infrastructure) Ln(Wage)

21 21

20 20

19 19
18

Ln(FDI)
Ln(FDI)
18
17 17
y = -0.0651x + 19.447 y = 0.0351x + 18.555
16 16
0 3 6 9 12 15 18 21 6 3 0 3 6 9 12
Rate of inflation Interest rate
21 21

20 20

19
19

Ln(FDI)
18

Ln(FDI)
18
y = -1.5391x + 12.606 17
17 y = 0.2538x + 17.441
16

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5 4.5 4 3.5 3 2.5
Ln(Exchange rate) 2 0 2 4 6 8
GDP Growth rate

Figure 3. FDI inflows vs GDP per capita, Trade Openness, Infrastructure, Wage, Rate of Inflation, Interest Rate, Exchange rate and GDP
Growth rate, 1978–2012
Source: Original data for all variables are from Worldbank, 2014.
248 South Asia Economic Journal 16(2)

except rate of inflation, are in natural logarithm. The estimating equation takes
the form,

LFDI  l0  l1LGDPPC  l2 LOPEN  l3 LINFRA  l4 LWAGE  l5 INF

 l6 POLINS  e, (1)

where LA refers to the logarithm of variable A.

Unit Root Test

We first formally test the stationarity of the six time series variables in model (1)
and determine their order of integration, using the augmented Dickey–Fuller
(Dickey & Fuller, 1979) test. The results of the unit root tests are reported in
Table 2. As can be seen, the rate of inflation is integrated of order zero, I(0), and
all other variables are integrated of order one, I(1).

Bounds Test for Cointegration

When we have a linear relationship involving a group of time series variables in
which some are stationary, I(0), and other non-stationary but I(1), then it is recom-
mended the use of ARDL bounds test to confirm whether a long-run relationship
exists between the model variables. In model (1), the variable inflation is I(0) and
others are I(1), bounds test approach for cointegration based on an ARDL frame-
work would be suitable for our analysis. The bounds test approach was originally
introduced by Pesaran & Shin (1999) and further extended by Pesaran, Shin &
Smith (2001). The attraction of this approach is that it involves a single equation
estimation which allows for the possibility of different variables with different lag
lengths as they entered the model. In addition, once the appropriate lag lengths for
each variable are determined, the relationship can be estimated by OLS, and hence
it is easy to implement and the results can be easily interpreted.

Table 2. Augmented Dickey-Fuller Unit Root Test Results

Level Form First Difference form Order of

Variables Test Statistic p-value Test Statistic p-value Integration
LFDI 0.73 0.82 –5.69* 0.00 I(1)
LGDPPC 1.33 0.99 –3.57* 0.01 I(1)
LOPEN –1.58 0.48 –6.04* 0.00 I(1)
LINFRA –2.45 0.34 –3.30* 0.02 I(1)
LWAGE –1.37 0.58 –5.76* 0.00 I(1)
INF –4.02* 0.00 I(0)
Note: The p-values are for the null hypothesis Ho: The series has a unit root. * denotes p-value
< 0.05 and Ho is rejected at the 5% level.

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Ravinthirakumaran et al. 249

The unrestricted error correction model (ECM) for the ARDL bounds test can
be written as:

DLFDIt  b 0  b1LFDIt1  b 2 LGDPPCt1  b3 LOPEN t1  b 4 LINFRA t1

j
 b5 LWAGE t1  b 6 INFt1  b 7 POLINSt1   a1i DL
LFDIti
i1
k l m
  a2i DLGDPPCti   a3i DLOPEN ti   a4i DLINFRA ti
i0 i0 i0
n p q
  a5i DLWAGE ti   a6i DINFti   a7 i DPOLINSti  et (2)
i0 i0 i0

where D is the first-difference operator, LA is the logarithm of variable A and et is

the white-noise disturbance term. The coefficients bi (i =1, 2,…, 7) measure the
long-run effects of the variables, whereas coefficients ari (r = 1, 2,…, 7) measure the
short-run dynamics of the model. The structural lags j, k, l, m, n, p and q are deter-
mined by using the minimum Akaike Information Criterion (AIC).
The ARDL approach to cointegration involves three steps for estimating the
long-run relationship (Pesaran & Pesaran, 1997; Pesaran et al., 2001). The first
step in the ARDL bounds testing approach is to estimate Equation (2) by OLS in
order to test for the existence of a long-run relationship among the variables by
conducting an F-test for the joint significance of the coefficients, bi’s (i = 1,
2,…, 7). The null and the alternative hypotheses are:

H 0 : b1  b 2  b3  b 4  b5  b6  b 7  0 no cointegration or no long-run relatio

onship 
H1 : At least one bi  0, i  1, 2,  , 7 cointegration or long-run relationship exists 

The F-test statistic has a non-standard distribution which depends upon (i) whether
variables included in the ARDLs model are I(0) or I(1); (ii) the number of
regressors; (iii) whether the ARDL model contains an intercept and/or a trend;
and (iv) the sample size. Thus, the computed F-statistic is compared with two
asymptotic critical values tabulated in Table C1 (iii) of Pesaran et al. (2001). This
table provides the critical value bounds for all three classifications of the regres-
sors: purely I(1), purely I(0) or mutually cointegrated. According to Pesaran et al.
(2001), the lower bound critical values are obtained assuming that the explanatory
variables are I(0), while the upper bound critical values are obtained assuming
that the explanatory variables are I(1). Therefore, if the computed F-statistic is
greater than the upper critical bounds, the null hypothesis should be rejected and
we conclude that there is a long-run relationship among the selected variables. If
the calculated F-statistic is below the lower critical bounds, the null hypothesis
cannot be rejected and there is no long-run relationship among them. On the other
hand, if the computed F-statistic falls within the critical value bounds, the test is
inconclusive.
An ARDL (2, 0, 2, 2, 0, 0, 0) model is selected based on the AIC. Table 3
presents the results. The calculated value of the F-statistic to test the above null
hypothesis is 6.10, which is greater than the upper critical bound value of 3.61 at

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250 South Asia Economic Journal 16(2)

Table 3. ARDL (2,0,2,2,0,0,0) Estimation Results

Regressor Parameter Estimate Standard Error t-Ratio p-Value

DLFDI(–1) a11 0.267 0.161 1.661 0.112
DLFDI(–2) a12 –0.185 0.103 –1.793 0.088
DLGDPPC a20 1.141 0.476 2.399 0.026
DLOPEN a30 1.843 1.893 0.974 0.342
DLOPEN(–1) a31 –5.838 2.065 –2.828 0.010
DLOPEN(–2) a32 2.548 1.970 1.294 0.211
DLINFRA a40 4.008 3.055 1.312 0.204
DLINFRA(–1) a41 –1.717 4.124 –0.416 0.682
DLINFRA(–2) a42 6.861 3.787 1.812 0.085
DLWAGE a50 –3.459 1.277 –2.710 0.013
DINF a60 –0.008 0.016 –0.503 0.620
POLINS a70 –0.454 0.162 –2.808 0.011
C –40.796 14.329 –2.847 0.011
R 2 = 0.90 S.E of Regression = 0.364
ATC = –18.23 Computed F-statistic = 6.102
SBC = –27.95
Note: The lower and upper bounds of the critical values at the 1, 5 and 10 percent significance levels
are [3.15, 4.43], [2.45, 3.61] and [2.12, 3.23], respectively (Pesaran et al, 2001, Table C1 (iii)).

the 5 per cent level of significance. Therefore, we conclude that cointegration

exists. That is, there is a long-run relationship between FDI and other variables
considered in model (1).
A point worth noting is that our sample consists of 36 observations. However,
the critical values available in Pesaran et al. (2001) are asymptotic and valid for
larger sample sizes. As our study has only 36 observations, as a check, we also use
the finite-sample critical values available in Narayan (2005) for T = 36 to see
whether our conclusions remain the same. The lower and upper bound critical
values from Narayan (2005), Table: Case III, are [4.01, 5.79] at the 1 per cent
level, [2.86, 4.32] at the 5 per cent level and [2.38, 3.67] at the 10 per cent level
of significance. Since the calculated value of the test statistic is 6.10, which is
greater than any of the upper bound values, the null hypothesis of no cointegration
is rejected in favour of the alternative at the 1 per cent level, we can conclude that
the variables are cointegrated. Therefore, there exists a long-run relationship
between FDI and the six selected variables in the model.
Since cointegration between the model variables is established, the next step is
to estimate the conditional ARDL long-run model for LFDI = ln(FDI) in the
form of Equation (1). The estimated long-run coefficients of the model are given
in Table 4. As can be seen, in the long run, GDPPC contributes positively to FDI
inflows and is statistically significant at the 1 per cent level, confirming the

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Ravinthirakumaran et al. 251

Table 4. Estimated Long-run Coefficients of the ARDL Model

Regressor Parameter Estimate Standard Error t-Ratio p-Value

LGDPPC l1 1.613 0.347 4.644 0.000
LOPEN l2 4.465 1.278 3.493 0.003
LINFRA l3 6.596 1.813 3.638 0.002
LWAGE l4 –2.763 0.981 –2.816 0.010
INF l5 –0.022 0.026 –0.824 0.419
POLINS l6 –1.355 0.292 –4.639 0.000
C l0 –46.960 14.494 –3.239 0.004

argument of motivation of the market-seeking FDI. An increase in market size

increases the prospects for higher demand within the economy. Specifically, a 1
per cent increase in GDPPC would generate a 1.61 per cent increase in FDI
inflows, provided all other things being equal. This result is in line with the results
reported in previous studies, such as, Albert & Stuart (2008), Ali & Guo (2005),
Ang (2008), Billington (1999), Boateng et al. (2015), Casi & Resmin (2010),
Hara & Razafimahefa (2005), Mold (2003), Janicki & Wunnava (2004), Khan &
Nawaz (2010) Koojaroenprasit (2013), Ramasamy & Yeung (2010), Sahoo (2006)
and Singhania & Gupta (2011).
The coefficient of trade openness is positive and significant at the 5 per cent
level. A 1 per cent increase in openness would create a 4.47 per cent increase in
FDI inflows, all things being considered equal. This supports the argument that
the extent to which a country allows free movement of goods and services would
determine the level of FDI inflows. This result is in line with the results reported
in Ang (2008), Albert & Stuart (2008), Asiedu (2002), Bhavan et al. (2011),
Boateng et al. (2015), Cevis & Camurdan (2007), Demirhan & Masca (2008),
Janicki & Wunnava (2004), Jayasekara (2014), Ramasamy & Yeung (2010),
Sahoo (2006) and Severiano (2011). However, this result contradicts with the
study of Koojaroenprasit (2013) that found a negative relationship.
The estimated coefficient for the infrastructure variable is positive and statis-
tically significant at the 5 per cent level. A 1 per cent increase in infrastructure
leads to 6.60 per cent increase in FDI inflows, ceteris paribus. This reveals that
improvements in infrastructure facility attract FDI inflows to Sri Lanka. A simi-
lar finding is reported in Ang (2008), Asiedu (2002), Bhavan et al. (2011),
Demirhan & Masca (2008), Jayasekara (2014), Ramasamy & Yeung (2010) and
Sahoo (2006).
Wage rate coefficient is significant at 5 per cent level and has a negative impact
on FDI inflows. A 1 per cent increase wage rate would cause a 2.76 per cent
decrease in FDI inflows, which confirms that FDI is highly negatively influenced
by labour cost as it represents a large percentage of the production cost. Hence,
higher wage rate reduces FDI inflows into Sri Lanka. Our results, in relation to
labour cost, are also supported by the findings: Janicki and Wunnava (2004), Ali
and Guo (2005), Casi and Resmin (2010) and Albert and Stuart (2008).

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252 South Asia Economic Journal 16(2)

The coefficient of political instability has a negative impact on FDI, as expected,

and it is significant at 1 per cent level, suggesting that a change in government
leads to political instability which reduces FDI inflows. Our finding in relation to
political instability is in line with the results reported in Azzimonti & Sarte (2007)
and Minhas & Ahsan (2015).
In the third and final step, we obtain the short-run dynamic parameters by esti-
mating an ECM as follows:
j k l
DLFDIt  a0   a1i DLFDIti   a2i DLGDPPCti   a3i DLOPEN ti
i1 i0 i0
m n p
  a4i DLINFRAti   a5i DLWAGE ti   a6i DINFti
i0 i0 i0
q
  a7 i DPOLINSti  jECM t1  et (3)
i0

where, aij (i = 1, 2,…,7) are the short-run dynamic coefficients, j is the speed of
the adjustment parameter and ECM is the error correction term that is derived
from the estimated Equation (1) in the following form,

ECM t1  LFDIt1  h0  h1LGDPPCt1  h2 LOPENt1  h3 LLINFRAt1

 h4 LWAGE t1  h5 INFt1  h6 POLINSt1 (4)

where hi (i = 1, 2,…, 7) are the estimated parameters. The results of short-run

dynamic coefficients associated with the long-run relationships obtained from
the ARDL–ECM Equation (3) are presented in Table 5. The optimal lag length
for the selected error correction representation of the ARDL model is deter-
mined by using the AIC.
Beginning with the long-run results, the coefficient of the error correction term
is highly significant with the expected negative sign, which confirms the result of

Table 5. Estimates of the Error Correction Representation

Regressor Parameter Coefficient Standard Error t-Ratio p-Value

DLFDI(–1) a11 0.185 0.103 1.793 0.087
DLGDPPC a20 1.141 0.476 2.399 0.025
DLOPEN a30 1.843 1.893 0.974 0.341
DLOPEN(–1) a31 –2.548 1.970 –1.294 0.209
DLINFRA a40 4.008 3.055 1.312 0.203
DLINFRA(–1) a41 –6.861 3.787 –1.812 0.084
DLWAGE a50 –3.459 1.277 –2.710 0.013
DINF a60 –0.008 0.016 –0.503 0.620
DPOLINS a70 –0.454 0.162 –2.808 0.011
ECM(–1) j –0.918 0.190 –4.834 0.000

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Ravinthirakumaran et al. 253

Table 6. Diagnostics checks: Model Assumptions

Test F-Statistic p-value

Serial correlationa 0.186 0.671
Model specification b
0.326 0.574
Normalityc 2.577 0.939
Heteroscedasticity d
0.115 0.736
Note: a
Lagrange multiplier (LM) test of residual serial correlation; b
Ramsey’s RESET test;
c
 Jarque-Bera test; d: LM test for heteroscedasticity.

the bounds test for cointegration. Once shocked, the larger the error correction
coefficient, the faster will be the return to equilibrium (Pesaran & Pesaran, 2009).
The coefficient of the error correction term is –0.92, which suggests a fast adjust-
ment process. Approximately, 92 per cent of the disequilibrium of the previous
year’s shock adjusts back to the long-run equilibrium in the current year.

Diagnostic Tests
Diagnostic tests for serial correlation, functional form, normality and heteroscedas-
ticity of the models were conducted, and the results are presented in Table 6. As can
be seen, the model has the desired econometric properties, in that it has a correct
functional form and residuals are serially uncorrelated, normally distributed and
homoscedastic. Therefore, the results are valid for meaningful interpretation.

Stability Tests
The cumulative sum (CUSUM) of recursive residuals and the CUSUM of square
(CUSUMSQ) tests are applied to assess the parameter stability (Pesaran &
Pesaran, 1997). The cumulative sum test identifies systematic changes in the
regression coefficients, while the cumulative sum of squares test detects sudden
changes from the constancy of the regression coefficients. Figure 4 plots the
results for CUSUM and CUSUMSQ tests. The results indicate the absence of any
instability of the coefficients because the plots of the CUSUM and CUSUMSQ
statistics fall inside the critical bands of the 5 per cent confidence intervals of
parameter stability. Therefore, there exists stability in the coefficients over the
sample period for Sri Lanka.

Conclusions and Policy Implications

The objective of this study was to develop an empirical framework to identify
the determinants of FDI inflows in Sri Lanka by using time series data for the
period 1978–2013. Based on the review of previous research, we identified six

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254 South Asia Economic Journal 16(2)

Plot of Cumulative Sum of Plot of Cumulative Sum of Squares of

Recursive Residuals Recursive Residuals
20 1.4
1.2
10 1.0
0.8
0.6
0 0.4
0.2
-10 0.0
-0.2
-20 -0.4
1980 1988 1996 2004 2012 1980 1988 1996 2004 2012
CUSUM and CUSUMSQ tests The straight lines represent critical
for Parameter Stability bounds at 5% significance level

Figure 4. CUSUM and CUSUMSQ tests for Parameter Stability

important determinants that generally determine FDI inflows. These are market
size, trade openness, infrastructure, labour cost, macroeconomic stability and
political instability.
Empirical analysis on the Sri Lankan data reveals that the market size has a posi-
tive effect on FDI and is statistically significant. As higher GDPPC leads to larger
market size, maintaining the momentum in GDPPC is necessary for Sri Lanka to
attract FDI inflows. Trade openness also positively influences FDI inflows into
Sri Lanka and is statistically significant. This implies that greater trade liberaliza-
tion policies increase FDI inflows into Sri Lanka. Infrastructure has a positive
effect on FDI and is statistically significant. This suggests that improved infrastruc-
ture is essential for Sri Lanka to attract more FDI into the country. Labour cost in
Sri Lanka negatively impacts on FDI and is statistically significant, implying that a
low wage rate is crucial for Sri Lanka to increase its FDI inflows. This finding also
suggests that cheap labour-led FDI hypothesis is supported by the Sri Lankan data.
Political instability has a negative impact on FDI and is statistically significant; this
reveals that higher political instability is associated with lower FDI inflows.
Therefore, Sri Lankan government has to mitigate the political instability.
Finally, it can also be concluded that there is a long-run equilibrium between
FDI and the six explanatory variables considered in this study. The major deter-
minants of FDI in Sri Lanka are market size, trade openness, infrastructure labour
cost and political instability. Thus, the recommendation, from this study, is that
for future FDI policy planning and implementation; the Sri Lankan government
has to consider developing policies to improve the market size, trade openness,
infrastructure, political stability and to maintain cheap labour cost. This will
enhance the FDI inflows into Sri Lanka.

Acknowledgements
The authors would like to thank two anonymous referees and the editor of this journal for
their constructive comments on an earlier version of this article. Views expressed by the
authors are personal. Usual disclaimers apply.

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Ravinthirakumaran et al. 255

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