Determinants of Foreign

Direct Investment in SAARC

Nations: An Econometric
Investigation
P Srinivasan*

The present study employs fixed effects and random effects models to
explore the determinants of Foreign Direct Investment (FDI) in selected
South Asian Association for Regional Cooperation (SAARC) countries
for the period 1970-2007. In order to choose an appropriate model among
the fixed effects and random effects estimator, the Hausman
specification test was conducted and its result supported the random
effects model regarding the determinants of FDI. The empirical results
reveal that the market size, GDP per capita, trade openness, infrastructure
facilities, inflation, degree of risk and uncertainty, and SAARC country
formation are the most significant factors in determining FDI in the
SAARC countries. Besides, the results show that other variables such as
human capital, degree of industrialization, real exchange rate, domestic
investment and terms of trade are insignificant, implying that these
factors do not play any significant role in attracting FDI in SAARC
countries. The findings indicate that the governments of the SAARC
countries should adopt incremental efforts to enhance economic growth,
enlarge GDP per capita, implement more successful open-door policies,
facilitate better infrastructural facilities and provide effective policy
framework on macroeconomic stability to successfully attract
appropriate FDI in the region.

Introduction
The significance of Foreign Direct Investment (FDI) inflows is well documented in literature
for both the developing and developed countries. Over the past two decades, there has
been an ongoing process of integration of the world economy and liberalization of
developing countries, which has led to a fierce competition for inward FDI in these countries.
The controls and restrictions over the entry and operations of foreign firms are now being

* Assistant Professor, Department of Economics, Christ University, Hosur Road, Bangalore 560029,
Karnataka, India. E-mail: srinivasan.palamalai@christuniversity.in

©262011 IUP. All Rights Reserved. The IUP Journal of Managerial Economics, Vol. IX, No. 3, 2011
replaced by liberalized policies that follow more open trade regimes to attract increased
FDI flows into the country. Accordingly, there has been a liberalized approach to FDI and
improving the FDI policy framework in south Asian countries since the 1990s. This has
led to enhancement of FDI inflows into these nations. Especially, the South Asian
Association for Regional Cooperation (SAARC) nations focus their investment incentives
exclusively on foreign firms. Over the past three decades, market reforms, trade
liberalization as well as more intense competition for FDI have led to reduced restrictions
on foreign investment and expanded scope for FDI in most sectors in the SAARC nations.
Since the early 1990s, the FDI inflows have been playing an increasingly prominent role in
the SAARC nations. The concurrent and growing trend of FDI flows and FDI-favoring
policies in the SAARC countries during the era of liberalization raise an important research
question—What explains the rise of SAARC FDI inflows? It would be necessary for foreign
firms and international investors to know the factors influencing the FDI in the SAARC
nations. In this context, the present study makes an attempt to examine the determinants of
FDI in the SAARC countries which have been experiencing a rapid surge in FDI inflows.
The remainder of the article is organized as follows: the next section provides an overview
of FDI inflows in SAARC countries. The following section presents a review of related
literature. The succeeding section describes the methodology and data used for empirical
analysis. And the last section offers empirical results, discussion and conclusion.

An Overview of FDI Inflows into SAARC Countries

During the past two decades, FDI has become increasingly important in the developing
world, with a growing number of developing countries succeeding in attracting substantial
and rising amounts of inward FDI. Like other developing world nations, the FDI inflows
into SAARC nations started picking up in the mid-1990s as a result of progressive market-
oriented reforms, trade liberalization and investment promotional policies.
Table 1 presents the FDI inflows into SAARC nations by host country. The table reveals
that India followed by Pakistan and Bangladesh attract larger FDI among the member
countries. The table shows a rising trend of absolute FDI inflows in the case of Sri Lanka.
Flows to the Maldives seem to be relatively stable since the mid-1990s. In 1997, there was
a big jump in FDI inflows into Sri Lanka as well as India and Bangladesh. This jump in Sri
Lanka and India is mainly due to the implementation of liberalized FDI policies under the
Indo-Sri Lanka Free Trade Agreement and a range of measures implemented to enhance
their attractiveness to potential foreign investors. These include provision of various taxes,
duties and other incentives, removal of restrictions on repatriation of profits, establishing
current account convertibility, reduction of the number of prohibited or restricted sectors,
relaxation of ownership restrictions, non-discrimination in favor of domestic investors,
fast-tracking of FDI approvals, guarantees against nationalization and expropriation, and
the setting in place of internationally acceptable dispute resolution mechanisms, besides
the FDI inflows into Bangladesh in the mid-1990s, largely as a result of progressive
liberalization of FDI policies in most of the sectors, and the adoption of generally more
outward-oriented policies. However, FDI flows into Nepal and Afghanistan have been

Determinants of Foreign Direct Investment in SAARC Nations: 27

An Econometric Investigation
volatile. For Bhutan, the FDI inflows relented significantly in the mid-1990s and early
2000s but rebounded and picked up in the following years. The increasing FDI flows into
SAARC nations are mainly due to their liberalized approach to FDI and changes in FDI
policy after 1990s, such as removal of the requirement of government approval for foreign
investment, permission for foreign equity participation of up to 100%, permission to negotiate
the terms and conditions of payment of royalty and technical fees suited to foreign investors
for transferring technology, liberalization of foreign exchange regime and permission for
remittances of principal and dividends from FDI, including an extensive set of fiscal
incentives and allowances to foreign investors. Besides, the objectives and policy initiatives
of SAARC related to economic, trade, financial and monetary areas of regional economic
integration with growing number of bilateral treaties for the avoidance of double taxation
(DTT), and multilateral investment agreements that have so far been made by member
countries contribute larger FDI inflows into the region.

Table 1: FDI Inflows into SAARC by the Host Country (in $ mn)
Year Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka
1990 NA 3.23 1.6 236.6 5.6 5.94 278.3 43.3
1996 0.69 231.6 1.4 2,525 9.31 19.16 439.3 133.0
1997 –1.46 575.2 –0.7 3,619 11.4 23.06 711 433.0
1998 –0.01 576.4 NA 2,633 11.5 12.02 506 150.0
1999 6.04 309.1 1.04 2,168 12.3 4.35 532 201.0
2000 0.17 578.7 0.0002 3,585 13.0 –0.48 309 172.9
2001 0.68 354.5 0.0002 5,472 11.7 20.8 383 171.7
2002 0.54 328.3 2.08 5,627 12.4 –5.95 823 196.5
2003 2.01 350.2 2.53 4,323 13.5 14.7 534 228.7
2004 0.62 460.4 3.46 5,771 14.6 –0.41 1,118 233.0
2005 3.61 692 9 6,676 9.49 2.44 2,201 272.0
2006 2.08 625 6.1 16,881 13.8 –6.55 4,273 480.0
2007 2.88 666 78 22,950 15.0 6 5,333 528.6
Note: NA denotes Not Available.
Source: UNCTAD FDI/TNC Database

Table 2 presents the FDI inflows as a percentage of GDP into SAARC member economies.
It shows that FDI as a percentage of GDP in SAARC economies were seen to be relatively
lower, and especially in the case of Afghanistan and Nepal, it remained less than 1% in the
1990s and 2000s. Similarly, the FDI openness to GDP in Bhutan seems to be less than 1%
until 2004, but rose to a peak level of 6.21% in 2007. Besides, the FDI as a percentage of GDP
for Bangladesh has been relatively stable, and in the case of India, Pakistan and Sri Lanka,
it shows a growing trend from the mid-1990s largely as a result of progressive liberalization
of FDI policies in most of the sectors in the region as well as the adoption of generally
outward looking policies in these nations.

28 The IUP Journal of Managerial Economics, Vol. IX, No. 3, 2011

 Table 2: FDI Inflows as a Percentage of GDP in SAARC Nations
Year Afghanistan Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka
1991 –0.008 0.004 0.252 0.025 2.659 0.068 0.439 0.725
1995 –0.002 0.223 0.016 0.580 1.812 0 0.604 0.486
2001 0.030 0.724 0 1.131 1.872 0.379 0.532 1.070
2002 0.011 0.632 0.385 1.116 1.935 –0.109 1.008 1.165
2003 0.042 0.611 0.402 0.729 1.949 0.246 0.546 1.229
2004 0.010 0.743 0.487 0.837 1.892 –0.006 0.989 1.144
2005 0.052 1.069 1.075 0.825 1.264 0.032 1.698 1.135
2006 0.026 0.916 0.661 1.868 1.529 –0.081 2.909 1.753
2007 0.029 0.856 6.219 2.018 1.438 0.060 3.187 1.736

Review of Literature
Extensive empirical literature on the determinants of inward FDI emphasizes three main
elements which guide the FDI decision process of foreign firms. Dunning (1973) had
synthesized these elements in the well-known eclectic paradigm or the Ownership-
Location-Internalization (OLI) explanation of FDI. For a foreign firm to invest successfully
abroad it must possess advantages which no other firm possesses (O); the country it wishes
to invest in should offer location advantage (L); and it must be capable of internalizing
operations (I). Internalization is synonymous with the exercise of control over operations
essential for the exploitation of ownership and location advantages. Based on this
paradigm, Dunning outlines four reasons—the search for resources, markets, efficiency
and strategic assets for a firm to invest abroad.
It is location advantages that form the core of much of the discussion on the determinants
of FDI in developing countries. Dunning’s (1973 and 1981) analysis provides a base for a
number of econometric studies designed to identify the main determinants of FDI. The
empirical studies carried out have focused on the determinants of FDI in either individual
country or cross country. The first group of studies includes Cheng and Kwan (2000),
Urata and Kawai (2000), Zhang (2001), Buckley et al. (2002), Sun et al. (2002),
Venkataramany (2003), Anjum and Nishat (2004), and Ho (2004). Studies in the second
group mainly concentrate on the developing or developed countries and include Root and
Ahmed (1979), Schneider and Frey (1985), Loree and Guisinger (1995), Campos and
Kinoshita (2003), Nonnemberg and Mendonça (2004), Nunnenkamp and Spatz (2004),
Asiedu (2006) and Agiomirgianakis et al. (2006). The empirical results of these studies
vary significantly, since both data sets and environment differ. However, the theoretical
debate and some common elements that exist in studies allow us to select a set of explanatory
variables that are widely used and found to be significant determinants of FDI.
Studies by Root and Ahmed (1979), Wheeler and Mody (1992), Wang and Swain (1995),
Cheng and Kwan (2000) and Pravakar (2006) find a positive and significant relationship
between market size and FDI. Similarly, studies by Schneider and Frey (1985),
Determinants of Foreign Direct Investment in SAARC Nations: 29
An Econometric Investigation
Lipsey (1999), Dasgupta and Rath (2000) and Durham (2004) find a positive impact of per
capita growth or growth prospect on FDI. Another important determinant of FDI inflows is
liberal trade regime of the host economy. There has been an extensive literature based on
the idea that trade openness generally positively influences the export-oriented FDI inflow
into an economy (Edwards, 1990; Gastanaga et al. 1998; and Asiedu, 2002). Further, studies
by Loree and Guisinger (1995), Cheng and Kwan (2000), Urata and Kawai (2000), Addison
and Hestmati (2003) and Elizabeth Asiedu (2006) find that good infrastructure, an educated
population, degree of industrialization and terms of trade are the major determinants of
FDI inflows. In this context, Pravakar (2006) finds that market size, labor force growth,
infrastructure index and trade openness are positive and have significant impact on FDI
in South Asian countries. He suggests that the South Asian countries need to maintain
growth momentum to improve market size, frame policies to make better use of their
abundant labor forces, improve infrastructure facilities and follow more open trade policies
for attracting more FDI.
In addition to this, several studies put forward inflation as a significant factor of
attracting FDI. Nonnemberg and Mendonça (2004) and Asiedu (2006) consider inflation
as a measure of economic instability. They suggest that foreign investors prefer to invest in
more stable economies that reflect a lesser degree of uncertainty. Hence, inflation is expected
to have negative impact on FDI. On the contrary, Addison and Heshmati (2003) argue that
higher inflation indicates higher price levels that lead to increased production activities of
the host economy and attract foreign firms to invest, resulting from increased expected
level of profitability, expected to have a positive impact on FDI. However, in a similar
study, he included variance of inflation to measure the level of economic stability to find
the negative impact on FDI inflows.
Moreover, the exchange rates also are a very important determinant of FDI inflow into
host countries. The effect of exchange rate movements on FDI flows is a fairly well-studied
topic, although the direction and magnitude of influence are far from certain. Froot and
Stein (1991) claimed that a depreciation of the host currency should increase FDI into the
host country, and conversely, an appreciation of the host currency should decrease FDI.
Similarly, Love and Hidalgo (2000) also acknowledge that the lagged variable of exchange
rate is positive, which indicates that a depreciation of the peso encourages US direct
investment in Mexico after some time. Contrary to Froot and Stein (1991), Campa (1993),
while analyzing foreign firms in the US, puts forth the hypothesis that an appreciation of
the host currency will in fact increase FDI into the host country, which suggests that an
appreciation of the host currency increases expectations of future profitability in terms of
the home currency. Therefore, the coefficient for exchange rate (EX) is ambiguous in many
studies.
Based on the above earlier literatures on the determinants of FDI, the selected explanatory
variables for the study include market size, Gross Domestic Product (GDP) per capita,
openness to trade, infrastructure, inflation, variance of inflation, domestic investment,

30 The IUP Journal of Managerial Economics, Vol. IX, No. 3, 2011

degree of industrialization, schooling, real exchange rate and terms of trade. The theoretical
discussions of these variables related to FDI are as follows:

Market Size
The size of the market, typically proxied by the level of GDP, appears to be an important
determinant of FDI inflows. The larger market size provides potential for local sales, greater
profitability of local sales to export sales and relatively diverse resources, which make
local sourcing more feasible. Thus, a larger market size provides more opportunities for
sales and also profits to foreign firms, and therefore attracts FDI (Addison and Heshmati,
2003; Ho, 2004; and Pravakar, 2006). So the expected impact of the size of the market on
FDI is positive.

GDP Per Capita

Along with market size, the prospect of growth, generally measured by GDP per capita,
also has a positive influence on FDI inflows. Countries that have high sustained growth
rates will yield high return on investment. Thus it attracts more FDI inflows than volatile
economies. So the expected impact of GDP per capita or growth prospect on FDI inflows is
positive (Lipsey, 1999; Durham, 2004; Agiomirgianakis et al., 2006; and Pravakar, 2006).

Openness to Trade
Openness is measured by the sum of exports plus imports as percentage of GDP and
measures the liberalized trade regime of the host economy that encourages more confidence
and foreign investment. The key hypothesis from various theories is that gains from FDI
are far higher in the export promotion regime than the import promotion regime. Trade
openness generally positively influences the export-oriented FDI inflow into an economy.
It is believed that a country with a greater degree of trade openness, which is more directed
towards the external market, would also be more open to foreign capital (Edwards, 1990;
Milner and Pentecost, 1996; Aseidu, 2002; Agiomirgianakis et al., 2006; and Pravakar,
2006).

Infrastructure
The availability of quality of infrastructure, particularly a well-developed network of roads,
airports, water supply, uninterrupted power supply, telephones and Internet access, is an
important determinant of FDI. It provides a better business environment to foreign firms to
secure more rate of return on investments. Therefore, countries with better infrastructure
attract more FDI inflows (Cheng and Kwan, 2000; Urata and Kawai, 2000; Romita, 2002;
Addison and Heshmati, 2003; Asiedu, 2006; and Pravakar, 2006). Hence, the expected
impact of infrastructure on FDI inflows is positive.

Inflation
Higher inflation indicates higher price levels that lead to increased production activities
of the host country and attract foreign firms to invest, resulting from increased expected
level of profitability. On the other hand, higher inflation leads to a fall in the value of

Determinants of Foreign Direct Investment in SAARC Nations: 31

An Econometric Investigation
money of the host economy, i.e., depreciation of currency takes place that attracts larger
FDI inflows, resulting from the increased relative wealth of foreign firms, and hence their
capacity to invest will increase through the reduced cost of capital. Consequently, the
depreciation of currency affects the foreign investors at the time of repatriation of their
profits. Therefore, the flow of FDI into the host country declines. Hence, the expected
relationship between the two is indeterminate (+/–).

Variance of Inflation
The variance of inflation was taken as a proxy for the level of economic stability, considering
that one of the classic symptoms of loss of fiscal or monetary control is unbridled inflation.
Generally, the foreign investors prefer to invest in more stable economies that reflect a
lesser degree of uncertainty. Hence, it is reasonable to expect that variance of inflation
would have a negative effect on FDI (Addison and Heshmati, 2003).

Domestic Investment
Theoretical arguments indicate whether domestic investment and FDI are considered to be
complementary or substitutes (Fry, 1992; and Bosworth and Collins, 1999). If the FDI
inflow does not crowd out domestic investments, then it is said to be complementary. On
the other hand, if the FDI inflow crowds out domestic investments, then it is said to be
substitutes. Therefore, if this indicator yielded a positive sign, then FDI and domestic
investment are considered to be complementary, while a negative sign implies FDI and
domestic investment are substitutes. Hence, the expected relationship between the two is
indeterminate (+/–).

Degree of Industrialization
The manufacturing share of GDP is a proxy for the host country’s degree of industrialization.
The higher the degree of industrialization, the higher the level of production potentiality of
the manufacturing sector that attracts larger FDI resulting from higher expected level of
profitability. Therefore, the degree of industrialization is expected to have a positive impact
on FDI inflows (Addison and Heshmati, 2003).

Schooling
The presence of workforce populations that are educated and trained to work in modern
business organizations has been recognized as an important determinant of FDI inflows.
The human capital variable is given as a gross secondary school enrolment ratio. The
higher level of education indicates the higher potential for an investment decision and
achievement of expected outcome. Therefore, this indicator is expected to be positively
correlated with FDI (Urata and Kwan, 2000; Rivlin, 2001; Addison and Heshmati, 2003;
and Agiomirgianakis et al., 2006).

Real Exchange Rate

The effect of exchange rate movements on FDI flows is a fairly well-studied topic, although
the direction and magnitude of influence are far from certain.Froot and Stein (1991) stated

32 The IUP Journal of Managerial Economics, Vol. IX, No. 3, 2011

that a depreciation of the host currency should increase foreign direct investment into the
host country, and conversely an appreciation of the host currency should decrease foreign
direct investment. On the other hand, Campa (1993) claimed that appreciation of the host
currency should increase foreign direct investment into the host country through increase
in expectations of future profitability in terms of the home currency. Therefore, the expected
relationship between the two is indeterminate (+/–).

Terms of Trade
The theoretical arguments indicate whether the FDI and trade are considered to be
complementary or substitutes. A substitutive relationship indicates that an increase in
FDI will decrease exports to foreign countries or vice versa. In contrast, a complementary
relationship indicates that FDI and exports move in the same direction. Therefore if this
indicator yielded a negative sign, then FDI is said to be substitutes to trade, while a positive
sign implies that FDI and trade are complementary. Hence the expected relationship between
the two is indeterminate (+/–).

SAARC Country Formation and Country-Specific Dummy Variable

Moreover, we included the dummy variable for the SAARC country formation in the model
that takes the value ‘0’ up to the year 1984 and ‘1’ from 1985 onwards. This will identify
the impact of the formation of SAARC on FDI flows in the selected member nations. If this
indicator yielded a positive sign, then it implies that the objectives and policy initiatives of
SAARC related to economic, trade, financial and monetary areas of regional economic
integration have a positive impact on FDI inflows. While a negative sign implies that this
indicator influenced negatively on FDI inflows.

Methodology and Data

The Fixed Effects (FE) model as well as the Random Effects (RE) model has been used to
explore the key determinants of FDI inflow into SAARC countries due to the fact that the
former takes into consideration the country-specific effect and the latter considers the time
effect.
The FEs model is defined as:

k
y it   i  X
k 1
itk  k   it i = 1, ..., N; t = 1, ..., T ...(1)

where yit represents the value of the dependent variable inward FDI in cross-section i
(number of countries), T is the length of time series (1970 to 2007), and k the number of
explanatory variables. The term i denotes unobserved country-specific effects which are
assumed to be fixed over time and different across country i. Xit and  represent the vectors
of explanatory variables and their parameters respectively. The subscript i indicates
individual countries, while t shows different time periods. it represents the vector of the

Determinants of Foreign Direct Investment in SAARC Nations: 33

An Econometric Investigation
error component which is assumed to be independently distributed across i and over t
with mean zero and variance 2. The i are estimated as coefficient dummy variables. This
is also referred to as the Least Squares with Dummy Variables (LSDV). In order to validate
the FEs specification, one could test the joint significance of these dummies, i.e.,
Ho: 1 = 2 = ..... n – 1 = 0, by performing F-test (Baltagi, 2003).
In the RE case, the model is defined as:

k
y it    X
k 1
itk  k  v it i = 1, .... N; t = 1, .... T ...(2)

where it = i + it and i are assumed to be independently distributed across i, with mean
zero and variance 2, and uncorrelated with Xit. The error term it is assumed to be
independently distributed across i and over t, with mean zero and variance 2. In the RE
model, the i are treated as random variables rather than fixed constants. Since i are
random, the errors now are it = i + it and the presence of i produces a correlation among
the errors of the same cross-section unit, though the errors from the different cross-section
units are independent. Therefore, the above model is to be estimated by the generalized
least squares method (Maddala, 2005).
Finally, a Hausman specification (1978) test is conducted in order to compare the two
categories of specifications1. It is proven that under the null hypothesis, the two estimates
the fixed and RE models could not differ significantly, since they are both consistent. So
the test is based on the difference. Under the null hypothesis, the Hausman statistic is
asymptotically distributed as chi-square with k degrees of freedom.
The general specification of the parameters of the model in the present case is as follows:

FDIit = a0 + a1GDPit + a2GPCit + a3OPENit + a4SCHit + a5INFRSit + a6INFit

+ a7VINFit + a8DINDit + a9EXRit + a10DIit + a11TOTit + a12SAARCit +Uit ...(3)
Definition, measurement and expected relationship of the selected variables of our
study are reported in Table 3. In the above specification, FDI is the net inflows of FDI into
country i (i = 1, 2, …., N) in period t (t = 1, 2, 3,…, T ). The right hand side variables in the
model include GDP as a proxy for market size; GPC is the GDP per capita, measures the
growth prospects; OPEN is the trade openness, as a proxy for liberal trade regime, measured
by the sum of export and import as percentage of GDP; SCH denotes schooling, acts as a
proxy for availability of skilled labor that measured by the secondary school enrollment
ratio; INFRS represents the availability of Infrastructure facilities (INFRS), measured by
telephone lines and cellular subscribers per 100 populations; INF is the inflation, measured
by producer price index; VINF is the variance of inflation, as a proxy for degree of risk and
1
H = ( GLS – F)’(v ( F)–v ( GLS))–1 ( GLS – F), where  GLS and  F are the estimates of the random effects and
fixed effects models, respectively. v(.) are the corresponding variance-covariance matrices of these
estimated coefficients (Maddala, 2005).

34 The IUP Journal of Managerial Economics, Vol. IX, No. 3, 2011

uncertainty; DIND is the degree of industrialization, measured by value added of
manufacturing industry as a percentage of GDP; EXR is the real exchange rate; DI is the
domestic investment, comprises the general government final consumption expenditure; a
indicates the parameters to be estimated; Uit is the stochastic disturbance term; and TOT is
the terms of trade, measured by the ratio of unit value of exports index to unit value of import
index. In addition, we included the dummy variable SAARC, which represents the formation
of SAARC.

Table 3: Variable Definition and Expected Relationship

Expected
Variable Definition Measurement Relationship
to FDI
FDI Foreign Direct Investment Net foreign direct investment inflows, –
Current prices, US$ mn
GDP Gross Domestic Product Current prices, US$ mn +
GPC GDP per capita Current prices, US$ mn +
OPEN Openness to trade Exports + Imports as a percent of GDP +
SCH Schooling Secondary school enrollment ratio +
INFRS Infrastructure Telephone lines and Cellular +
subscribers per 100 populations
INF Inflation Producer price index, base 2000 +

VINF Variance of inflation (Xi  X) 2

/n –

DIND Degree of industrialization Value added of manufacturing +

EXR Real exchange rate Exchange rate * domestic price +/–
level/foreign price level
DI Domestic investment Comprises general government +/–
final consumption expenditure
TOT Terms of trade Unit value of export index/Unit value +/–
of import index
SAARC Dummy variable for Dummy variable taking value 0 upto +/–
SAARC the year 1984 and 1 from 1985
country formation onwards

Empirical Results and Discussion

As for primary investigation, the correlation matrix results of the selected variables in the
study are presented in Table 4. The Table results reveal that most of the important
determinants of FDI inflows in the model have turned out to be in the expected direction.
Further, most of the variables are not found to be highly correlated; hence the collinearity
problem does not exist in the model. In order to capture the distribution of FDI across
countries and over the period considered, the estimates of Equation (3) were generated
with the following panel data linear regression models: (1) OLS (pooling); (2) FE model;

Determinants of Foreign Direct Investment in SAARC Nations: 35

An Econometric Investigation
 and (3) RE model. The
INFRS SAARC TREND estimation results of POLS, FE
and RE models are presented in
Table 5. In the Table, the first

1.000
column (Common Constant)
shows the estimation results of
regression Equation (3) from

1.000
0.671
pooled OLS method. As pointed
out earlier, the problem with

1.000
–0.06
–0.00
pooled OLS methodology is that
TOT

there is an unobservable FE
which captures country-
1.000
–0.04
0.869
0.812
EXR

specific heterogeneity. Such

unobservable FE is potentially
correlated with explanatory
1.000
0.799
–0.43
0.663
0.649
SCH

variables. If it is not controlled

for in the estimation, the
Table 4: Correlation Matrix

parameter estimates will be

DIND

1.000
0.804
0.595
–0.37
0.515
0.554

inconsistent due to omitted

variable bias. However, we
–0.066
–0.007

consider the estimation by OLS

1.000

–0.05
–0.31
0.161
0.129
DI

with pooled data only as a

reference (see also, Nonnemberg
VINF

1.000
0.305
0.529
0.642
0.853
–0.12
0.861
0.777

and Mendonça, 2004), which

allows us to check for the
existence of multi- colinearity in
1.000
0.965
0.285
0.597
0.757
0.915
–0.16
0.918
0.807
INF

the model by way of a Variance

Inflation Factor (VIF). The
literature points out that there is
OPEN

–0.613
1.000
0.488
0.450

0.612
0.646
0.717
0.022
0.530
0.445

indication of multicolinearity if
the VIF is greater than 5 (Judge
1.000
0.724
0.859
0.855
–0.09
0.601
0.629
0.855
0.039
0.841
0.726

et al., 1982). In Table 5, the mean

GPC

variance inflation factor from

pooled ordinary least squares
1.000
–0.06
–0.61
0.309
0.332
0.991
–0.10
–0.02
–0.02
–0.27
0.192
0.166
GDP

method is found to be 2.10 and it

implies that there is no
indication of multicolinearity
1.000
0.574
0.578
0.152
0.802
0.776
0.550
0.261
0.448
0.668
–0.11
0.729
0.645
FDI

problem in the model

considered.
Variables

Besides, the model selection

SAARC
INFRS
OPEN

DIND
VINF

based tests, viz., the F-test

GDP
GPC

EXR
SCH

TOT
FDI

INF

DI

(pooled OLS versus FE) and the

36 The IUP Journal of Managerial Economics, Vol. IX, No. 3, 2011

 Table 5: Determinants of FDI – Empirical Evidence from a Panel of SAARC Countries
Dependent Variable: FDI
Variables Common Constant Fixed Effects Random Effects
(POLS) (FE) (RE)
Intercept –12.05 4.3532 9.8721
(2.42)** (0.34) [1.16]
GDP 2.670 1.2916 0.9155
(1.98)** (2.91)* [5.20]*
GPC –1.236 5.4219 4.4968
(0.94) (2.72)* [2.78]*
OPEN 3.198 0.8293 0.0921
(3.94)* (3.42)* [2.31]**
SKILL –0.280 0.3744 1.9210
(0.31) (0.92) [0.67]
INFRS 0.721 0.1270 0.2179
(2.10)** (1.98)** [2.88]*
INF 2.937 2.314 2.471
(1.68)*** (2.08)** [2.01]**
VINF –0.545 –0.9593 –0.5062
(2.37)** (3.08)* [3.02]*
DIND –2.859*** 1.035 1.024
(1.74) (0.92) [0.99]
EXR 1.242 0.036 0.010
(1.34) (1.56) [0.41)
DI 0.372 0.035 0.024
(0.46) (1.29) [0.85]
TOT 0.187 0.32 0.04
(0.26) (0.57) [0.18]
SAARC 0.462 0.909 0.873
(2.53)** (3.56)* [3.03] *
Hausman test (p-Value) – 1.27
(0.991)
Wald 2 – – 83.41*
R -within
2
– 0.2415 0.2549
R -between
2
– 0.8273 0.8530
R -overall
2
0.7478 0.7192 0.7407
F-test – 5.31* –
Breusch and Pagan LM-test – – 34.01*
VIF 2.10 – –
Note: Parentheses ( ) and [ ] show the t-value and z-statistics, respectively. *, ** and *** denote the
significance at the 1%, 5% and 10% levels, respectively.

Determinants of Foreign Direct Investment in SAARC Nations: 37

An Econometric Investigation
Breusch-Pagan Lagrange Multiplier test (Pooled OLS versus RE), reveal that the F-test rejects
the null hypothesis (pooled OLS). So, FE model is preferred to pooled OLS model. Lagrange
Multiplier test rejects the null hypothesis (pooled OLS), so RE model is preferred to pooled
OLS model. These results show that there exists an unobserved heterogeneity effect.
In Table 5, the estimation results of the fixed-effects model and RE model are reported in
column two and three respectively. Now, our next concern here is the choice between FEs
and RE models. To select appropriate model for our empirical analysis, we conducted
Hausman specification test. The econometric theory suggests performing a Hausman (1978)
type test of no correlation between the µi and the regressors. The test gave 2 value of 1.27
which is distributed with 2 (5) under the null and it is not significant, suggesting that the
Generalized Least Squares (GLS) estimators of the RE method are the preferred ones. Besides,
the Wald 2 test for the RE model rejects the presence of heteroscedasticity in the estimated
regression. Since, Hausman specification test supports the RE model for the estimation of
Equation (3), our analysis of the determinants of FDI in SAARC countries is purely based
on supported model.
The findings from the RE model reveal that the GDP, as a proxy for market size, is found
to be positive and statistically significant at 1% level. This implies that the market size plays
a significant role in attracting more FDI flows into the SAARC nations. Besides, we found an
expected sign (positive) and statistically significant coefficient of GDP per capita on FDI
inflows. This shows that the degree of development, measured in terms of GDP per capita,
plays a decisive role in attracting and positioning FDI in the selected SAARC countries.
Moving to the next, openness to trade (OPEN), as a proxy for liberal trade regime, is
found to be positive and statistically significant at 5% level. This implies that more outward-
oriented trade regimes of SAARC countries attract larger inflows of FDI, suggesting that
other things being equal, investors are more likely to invest in these countries which have
been opened up to the outside world. Besides, the coefficient of infrastructure variable is
found to have a positive sign and statistically significant at 1% level, implying that the
infrastructure facilities facilitate more FDI flows into selected SAARC nations. This suggests
that improving stocks of infrastructural capital increase the attractiveness of the recipient
countries as a platform for multinational investment.
The inflation variable is found to be positive and statistically significant at 5% level,
indicating the higher price levels that lead to increased production activities of the SAARC
countries and attract foreign firms to invest due to increased expected level of profitability.
On the other hand, the higher inflation leads to a fall in the value of money, i.e., depreciation
of currency takes place that attracts larger FDI inflows into SAARC, resulting from the
increased relative wealth of foreign firms, and hence their capacity to invest will increase
through the reduced cost of capital.
Consistent with previous evidence of Addison and Heshmati (2003), Akinkugbe (2003),
Nunes et al. (2006), Kirkpatrick et al. (2006) and Sukar et al. (2007), we found a negative

38 The IUP Journal of Managerial Economics, Vol. IX, No. 3, 2011

relationship between variance of inflation and FDI flows. The result shows that the
coefficient of variance of inflation is statistically significant at 1% level, implying that the
higher the inflation, which is taken as a proxy for macroeconomic instability associated
with the SAARC economies, the more the FDI inflows deteriorate.
Moving to the introduction of SAARC, the dummy variable is found to be positive and
statistically significant at 1% level. This implies that the formation of SAARC has positively
influenced FDI inflows in selected member nations. The other variables such as human
capital, degree of industrialization, real exchange rate, domestic investment, and terms of
trade are found to be insignificant, implying that these factors do not play any significant
role in attracting FDI in SAARC countries. The findings indicate that the governments of
the SAARC countries should adopt incremental efforts to enhance economic growth,
enlarge GDP per capita, implement more successful open-door policies, facilitate better
infrastructural facilities and provide effective policy framework on macroeconomic stability
to successfully attract appropriate FDI in the region.

Conclusion
FDI is more than an external resource inflow and it can modernize industry and better
integrate the economy into international production. Keeping this in view, it may be stated
that FDI acts as a major stimulus to economic growth in developing countries including
the SAARC belt in particular. The SAARC nations have a tremendous potential for
absorbing greater flow of FDI in the days to come. Serious efforts are needed to attract
greater inflow of FDI in the country by taking several steps both on policy and
implementation fronts. In recognition of the important role of FDI in the accelerated economic
growth and development of the country, the present study employed FE and RE models to
explore the determinants of FDI in selected SAARC countries for the period 1970-2007.
The empirical results reveal that the market size, GDP per capita, trade openness,
infrastructure facilities, inflation, degree of risk and uncertainty, and SAARC country
formation are the most significant factors in determining FDI in the SAARC countries.
Besides, the results show that other variables such as human capital, degree of
industrialization, real exchange rate, domestic investment and terms of trade are
insignificant, implying that these factors do not play any significant role in attracting FDI
in SAARC countries. The findings indicate that the governments of the SAARC countries
should adopt incremental efforts to enhance economic growth, enlarge GDP per capita,
implement more successful open-door policies, facilitate better infrastructural facilities
and provide effective policy framework on macroeconomic stability to successfully attract
appropriate FDI in the region.

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42 The IUP Journal of Managerial Economics, Vol. IX, No. 3, 2011

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