The Role of Financial Development in The

Review of Pacific Basin Financial Markets and Policies
Vol. 22, No. 2 (2019) 1950009 (32 pages)

°
c World Scientific Publishing Co.
and Center for Pacific Basin Business, Economics and Finance Research
DOI: 10.1142/S0219091519500097
by UNIVERSITY OF NEW ENGLAND on 10/23/19. Re-use and distribution is strictly not permitted, except for Open Access articles.
The Role of Financial Development in the

Relationship Between Foreign Direct Investment and
Economic Growth: A Nonlinear Approach
Rev. Pac. Basin Finan. Mark. Pol. 2019.22. Downloaded from www.worldscientific.com
Elya Nabila Abdul Bahri*

Faculty Economics and Administration
Universiti Malaya, Malaysia
elyanabila@gmail.com
Abu Hassan Shaari Md Nor

Faculty of Economics and Management
Universiti Kebangsaan Malaysia, Malaysia
ahassan@ukm.edu.my
Tamat Sarmidi
Faculty of Economics and Management
Universiti Kebangsaan Malaysia, Malaysia
tamat@ukm.edu.my
Nor Hakimah Haji Mohd Nor

Faculty of Management and Muamalah
Kolej Universiti Islam Antarabangsa Selangor, Malaysia
norhakimah@kuis.edu.my
Published 21 October 2019
Financial development is recognized as an absorptive capacity in the relationship

between foreign direct investment (FDI) and economic growth. Therefore, FDI
effect on economic growth is contingent with the level of financial development.
However, existing studies also show that financial development dampens economic
growth through the \too much finance harms economic growth" hypothesis. Hence,
there is a question of how far financial development should be developed to optimize
*Corresponding author.
1950009-1
Elya Nabila Abdul Bahri et al.
the benefits of FDI on economic growth. The novelty of this study is that it
reexamines the role of financial development in FDI-growth relationship by
including the interaction term between FDI and the nonlinearity of financial
development on economic growth in the period following the 2007–2008 Global
Financial Crisis. Interestingly, our results demonstrate that the nonlinear rela-
tionship of financial development on economic growth is a U-shaped curve by using

data from the 2009–2013 period, for 65 developing countries, which contrast the
findings from previous studies. The absorptive capacity effects work nonlinearly,
in that FDI accelerates growth after reaching a certain level of financial devel-
opment, and that the positive effect originates from a minimum level. The study
thus suggests that the level of financial development needs to be increased since it
serves as a form of absorptive capacity enabling the positive growth effects of FDI
in the recipient countries.
Keywords: Financial development; foreign direct investment; economic growth;

nonlinear; absorptive capacity.
1. Introduction
There is an ongoing debate about the impact of foreign direct investment
(FDI) on the economic growth of host countries, especially developing
countries. This debate takes on special importance in view of the composi-
tion and direction of changes in FDI and the liberalization of government
policies towards FDI in developing countries (Nair-Reichert and Weinhold,
2001). Attracting foreign investors is an important goal for policymakers,
especially in developing countries, where lack of capital is considered as one
of the key constraints to economic prosperity (Amendolagine et al., 2013).
Many developing countries are unable to capitalize on their abundant nat-
ural resources due to inadequacies in the workforce, physical capital and
technological know-how (Iamsiraroj and Ulubaşoğlu, 2015). Foreign in-
vestment in developing countries is therefore increasingly necessary to spur
these countries towards becoming developed countries with high rates of
economic development.
In recent years, policymakers, especially in developing countries, have
claimed that FDI is necessary to boost the growth of their economy. Several
studies have shown that FDI generates positive externalities in the form of
technology transfers, which contribute to economic development (see inter
alia Chakraborty and Nunnenkamp, 2008; Liu, 2008; Crespo and Fontoura,
2007; Carkovic and Levine, 2005; Sadik and Bolbol, 2001). On the other
hand, Aitken and Harrison (1999) have found empirically that FDI had a
negative impact on the productivity of domestically owned plants. Fur-
thermore, Konings (2001) found FDI to have negative effects on domestic
1950009-2
The Role of Financial Development
firms, and G€ org and Greenaway (2004) concluded that the effects of FDI on
economic growth were mostly negative. The mixed results in the existing
literature led to the curious issue as pointed by Iamsiraroj and Ulubaşoğlu
(2015) in their meta-analysis study which showed that fewer than half of the
studies conducted found positive and statistically significant effects of FDI

on economic growth; and nearly one-third reported negative effects of FDI
on economic growth. The incompatible results regarding the relationship
between FDI and economic growth may be due to other factors as an
absorptive capacity that would enable FDI to promote economic growth.
Recent empirical studies have highlighted the fact that financial devel-
opment is a key explanation for the inconclusive and ambiguous findings in
the FDI-economic growth nexus. Financial development in host countries
needs to be well-developed to serve as a vehicle for enabling FDI to accel-
erate economic growth (see inter alia Jayaraman et al., 2017; Nwosa and
Emma-Ebere, 2017; Adeniyi et al., 2015; Samad and Akhtaruzzaman, 2014;
Suliman and Elian, 2014; Azman-Saini et al., 2010). Financial development
is recognized as a form of absorptive capacity, as well as a precondition that
enables the positive growth effects of FDI to materialize. According to
Levine (2005), a growing evidence has shown that financial institutions and
financial markets can exert a strong influence on economic development.
Alfaro et al. (2009) provided evidence that financial markets act as a channel
in facilitating the positive growth effects of FDI to be realized. Their study
found that countries with well-developed financial markets gained signifi-
cantly from FDI through total factor productivity improvements. Both FDI
and financial development, as intertwined variables, were shown to be
important and complementary in promoting economic growth (Choong and
Lim, 2009; Jayaraman et al., 2017).
It is important to understand the effect of financial development on
economic growth in order to elucidate the role of finance in the FDI-
economic growth nexus. The importance of financial development is theoreti-
cally acknowledged through the functions and services it renders in the
process of economic growth (Hermes and Lensink, 2003; Levine, 2005).
Levine (2005) has highlighted five major functions of the financial system
that contribute to promoting economic growth: (1) it produces information
ex-ante on possible investments and allocates capital; (2) it monitors
investments and exerts corporate governance once financial assets have been
provided; (3) it facilitates trading, diversification, and management of risk;
(4) it mobilizes and pools savings; and, (5) it eases the exchange of goods and
services. This recommendation supported the \more finance, more growth"
1950009-3
proposition suggested earlier by Levine (2003). However, the selection of

financial indicators is crucial in measuring financial development. Common
measures employed are the domestic credit to private sector (DCPS), liquid
liabilities (LL) and private credit (PC). The DCPS is a proxy that provides
the financial resources to channel funds to the private sector, as well as

multinational companies, to generate economic activities for productive use.
It was used by Hassan et al. (2011) and Law and Singh (2014), among others,
to measure financial development. The LL of the financial system encompass
liabilities of banks, central banks, and other financial intermediaries that
reflect financial services (Demetriades and Hussein, 1996; Favara, 2003;

King and Levine, 1993a,1993b). Higher LL indicate more transactions in the
financial system that characterize high velocity in the financial cycle, which
may attract investors. Credit to the private sector as a proportion of the
gross domestic product (GDP) was most widely used as an alternative
measure of financial development (Arcand et al., 2015; Beck et al., 2000;
Demetriades and Hussein, 1996; Favara, 2003; King and Levine, 1993a).
This parameter indicates the ability of the financial system to channel funds
from depositors to investors and accounts for credit granted to the private
sector that enables the utilization of funds and their allocation to more
efficient and productive activities.
Recent studies have shown, however, that financial development can
enhance economic growth up to a threshold value, beyond which it can actually
harm economic growth (see Cecchetti and Kharroubi, 2012; Law and Singh,
2014; Arcand et al., 2015; Samargandi et al., 2015). The relationship between
financial development and economic growth was found to be nonlinear with
an inverted U-shape where financial development dampens economic
growth, due to the \vanishing effect" reaching beyond the threshold value
(Arcand et al., 2015). These findings contradict the ‘more finance, more
growth’ proposition and give the perception that financial development has
limited progress in being developed. Thus, our paper attempts to address the
issue of how much the level of financial development needs to be increased to
ensure that economic growth benefits from FDI. Are mixed findings in the
FDI-economic growth relationship contingent upon the nonlinearity of the
financial development-economic growth relationship as an absorptive
capacity? Further studies are necessary to elucidate this issue. Hence, this
study reexamines the consistency of the inverted U-shaped relationship
between financial development and economic growth based on the hypothesis
that ‘too much finance harms growth’ (Arcand et al., 2015; Law and Singh,
2014) for the period following the global financial crisis of 2007–2008.
1950009-4
In the aftermath of the global financial crisis, policy-makers scrutinized

the implications of financial liberalization on economic growth (Batuo and
Asongu, 2017). Several actions were taken by the World Bank, Interna-
tional Monetary Fund (IMF) and Bank of International Settlements (BIS)
to stabilize the financial conditions in developing countries. For example,

the World Bank released a report on global trade liquidity to address the
shortage of financial reserves in 2009 and presented the International
Finance Corporation’s multilateral financing program for the private
sector in developing countries in 2011. In addition, financial regulations
were tightened after the implementation of Basel III, which was associated
with the banking regulatory framework in 2011 and the global capital and
liquidity regulations in 2013. Taking these developments into account,
this study postulates that the significant improvement in financial insti-
tutions and economic growth following the global financial crisis might be
due to structural changes affected by the U-shaped nonlinearity in the
relationship between financial development and economic growth. The
impact of the absorptive capacity has worked nonlinearly with the boost in
FDI, so that economic growth has materialized beyond a threshold level of
financial development and the effects have originated from a minimum
level.
The aim of this paper is to examine the impact of FDI on economic
growth through the financial development in 65 developing countries from
2009 to 2013. The nonlinear impact of financial development on economic
growth was specifically considered. Our study contributes to the extant
literature in three ways: First, we look at the role of financial development
in the relationship between FDI and economic growth by focusing on the
interaction terms of FDI and the finance indicators in nonlinear properties
of financial development on economic growth. Second, the nonlinearity of
the relationship between financial development and economic growth in
the quadratic model is confirmed by using the Sasabuchi-Lind-Mehlum
test to investigate whether the relationship between financial development
and economic growth during the sample period was U-shaped or inverted
U-shaped. Accordingly, the consistency of the inverted U-shaped rela-
tionship as found in previous studies such as those of Law and Singh
(2014), Arcand et al. (2015) and Samargandi et al. (2015) is examined. The
nonlinear properties of financial development on economic growth are
considered in the interaction term between FDI and the finance indicators.
Third, data from the era following the global financial crisis of 2009–2013
are used to investigate the relevancy of the role of financial development in
1950009-5
the recent economies of the 65 developing countries. According to Alfaro

et al. (2004), developing countries have received more FDI since the 1980s
due to debt crises and the need for assistance in improving their econo-
mies. In addition, multinational enterprises realized an advantage from
their investments because of cheaper labor in developing countries that

can reduce production costs. Hence, the study of FDI in developing
countries is becoming ever more necessary because of its role in boosting
economic growth towards helping countries achieve a developed economy
status.
The data for the study were estimated using the dynamic panel data
analysis. This paper is organized as follows: Section 2 discusses the literature
on FDI and financial development as they are related to economic growth.
Section 3 presents the methodology used in the analysis. Section 4 discusses
the empirical findings. Finally, Section 5 presents the conclusions.
2. Literature Review
At the outset Markusen (1984) and Markusen and Venables (1998) stated
that horizontal FDI seeks markets and firms expand overseas to avoid trade
costs, leading to a substitutionary relationship with trade. From a theoret-
ical perspective, Aghion and Howitt (1992), who significantly contributed to
the new growth theory, highlighted the fact that innovations generated from
technological knowledge take the process a step ahead, in the form of new
goods, new markets, or new processes, towards sustaining a positive growth
rate of output per capita in the long run. Liu (2008) proposed that FDI
spillovers could decrease local firms’ short-term level of productivity but
could increase the long-term productivity growth rate. In the long run,
technology spillovers serve as a source of knowledge that can make pro-
ductivity growth rates sustainable, and they also become the ultimate engine
of economic growth.
The extensive literature surveyed indicated that an absorptive capacity
provided a key explanation for the ambiguous results in the FDI-economic
growth nexus. Financial development was identified as a crucial channel
which enabled the growth effects of FDI to be realized. Collectively, past
studies empirically discovered that a higher level of financial development
serves as a precondition for stimulating the positive growth effects of FDI.
The work by Hermes and Lensink (2003) demonstrated that the develop-
ment of banks and stock markets is an important prerequisite for the
materialization of the positive growth effects of FDI. The study used the
1950009-6
regressions of growth equation and a cross section of the data-set of the 67

less developed countries for the period 1970–1995. Later studies by Alfaro
et al. (2004), Azman-Saini et al. (2010), and Choong (2012) established
similar findings on the important role of financial development in the FDI-
economic growth nexus. Alfaro et al. (2004) employed cross-country data for
the period 1975–1995 for countries in the Organization for Economic
Development. Meanwhile, Azman-Saini et al. (2010) made cross-country
observations of 91 countries for the period 1975–2005. Other studies, such as
Lee and Chang (2009) and Ang (2009), also consistently established similar
finding on the positive link between the FDI and economic growth with prior
financial development as pre-condition.
A recent study by Iamsiraroj and Ulubaşoğlu (2015), based on utilization
of the global sample of 140 countries in the period from 1970 to 2009, con-
cluded that FDI positively affects economic growth. The purpose of their
study was to reach a final conclusion to overcome ambiguity from various
findings on the FDI-economic growth nexus by exploring 108 published
related studies. They also concluded that the relationship between FDI and
economic growth via financial development was more relevant for developing
countries than for developed ones. The appropriate absorptive capacity
indicators for positive growth identified were trade openness and financial
development.
Theoretically, financial development would serve as an effective pre-
condition in the FDI-economic growth nexus due to its major functions. The
role of financial development in the economy has been well acknowledged for
decades. The evidence became even more convincing after studies by Levine
and Zervos (1996) and Levine (1997), discovered that the level of financial
development served as a reliable predictor for future economic growth,
capital accumulation and technological change. The incorporation of finan-
cial development in the FDI-economic growth nexus led more interesting
findings, since empirical studies had shown that it played an important role
in the linkage. A previous study by Alfaro et al. (2004) revealed that an
increase in FDI led to higher growth rates in financially developed countries
than in their poorer counterparts. Alfaro et al. (2010) consistently estab-
lished the same findings regarding the positive link of FDI and economic
growth with the pre-condition that financial development had to have
reached a certain level. According to studies by Hermes and Lensink
(2003), Alfaro et al. (2004, 2010), and Durham (2004), the success of
technology spillovers required financial institutions that were functioning
well. A more developed financial system positively contributed to the process
1950009-7
of technology diffusion associated with FDI. Financial markets can reduce

the risks inherent in investments made by domestic firms seeking to imitate
the technologies of multinational companies.
The study by Choong and Lam (2011) revealed that FDI may either
increase or decrease the growth rate of the economy, depending on the level
of financial development. In other words, a certain level of financial devel-
opment is a significant prerequisite for FDI to exert positive effects on
economic growth. Choong and Lam (2011) employed the generalized method
of moments (GMM) estimation for a sample of 70 developed and developing
countries over the period of 1988–2002. In a subsequent study, Choong

(2012) provided similar evidence showing that the domestic financial system
was a significant precondition for FDI to have positive effects on growth. The
study also employed the GMM estimation method with a sample of 95
developed and developing countries from 1983 to 2006. The recent study by
Jayaraman et al. (2017) also found similar findings in the case of India, where
the effect of FDI on economic growth depended on a certain level of financial
sector development. The relationship between FDI, financial development,
and economic growth exists where all these three elements are cointegrated
(Pradhan, 2010; Lee and Chang, 2009). Based on the above findings as
discussed in the literature, this study formulates the following hypothesis to
examine whether higher financial development enhances the positive growth
effects of FDI.
H1: Higher financial development enhances a host country’s ability to

absorb the positive growth effects of FDI.
Even though recent studies have established that financial development

served as a precondition for the positive growth effects of FDI to be real-
ized, but the relationship between the variables including FDI and eco-
nomic growth, as based on the level of financial development, has not been
adequately addressed. Increased understanding of the channels employed
depends on knowing how FDI functions to affect economic growth posi-
tively (Lemi and Asefa, 2003). Studying the relationship between financial
developments and economic growth is important in understanding how
financial development serves as an absorptive capacity for FDI to accel-
erate economic growth. The level of financial development and the per-
formance of FDI in promoting economic growth may have different effects
due to the nonlinearity of financial development in its relationship with
economic growth.
1950009-8
Recent studies have established that the relationship between financial

development and economic growth was nonlinear of inverted U-shape
(see Cecchetti and Kharroubi, 2012; Law and Singh, 2014; Arcand et al.,
2015; Samargandi et al., 2015). Financial development had positive effects
on economic growth up to a certain point, beyond which it could dampen

economic growth. The proposition of more finance, more growth was thus
challenged by these findings, which used nonlinear models. In fact, a counter
proposal was accordingly suggested based on the hypothesis that \too much
finance harm growth". Besides, the study by Ibrahim (2007) claimed that
the fragility of financial development is associated with the episode of eco-

nomic crises. The consequence of nonlinearity of financial development and
economic growth exposed by these studies created some doubt on financial
development role of FDI in promoting economic growth. Does the financial
system to be developed have a limit? How can financial development assist
the FDI-economic growth nexus if the financial development exceeds its
threshold level? Based on the above discussion, this study reexamined the
nonlinear relationship between financial development and economic growth
in the aftermath of the global financial crisis and, accordingly, proposed the
following hypothesis:
H2: The relationship between financial development and economic growth is
nonlinear.
Although quite a number of extant studies have dealt with some aspects of
the FDI-financial development-economic growth issue, our study grew out
of the existing literature and has aimed at elucidating the nonlinear rela-
tionship between financial development and economic growth. According
to Azman-Saini et al. (2010), the positive impact of FDI on economic
growth \kicks in" only after financial market development surpasses a
threshold level. Azman-Saini et al. (2010), however, used cross-country
observations from 91 countries comprising developed and developing, and
used threshold regression without considering the endogeneity bias in the
estimation. Meanwhile, the nonlinearity in the FDI-financial development-
economic growth relationship studied by Iamsiraroj and Ulubaşoğlu (2015)
was shown in a mix of 140 developed and developing countries, in which
an the inverted U-shaped curve was discovered for the period from 1970
to 2009. Our study, however, anticipates the nonlinearity of financial
development in the aftermath of the global financial crisis as being U-shaped, as
well as U-shaped in FDI-financial development-economic growth relationship
1950009-9
through interaction with the quadratic model. Our study provides indication
on the nonlinear approach and, accordingly, proposes a hypothesis as follows:
H3: The nonlinearity of financial development and economic growth influ-
ences a host country’s ability to absorb the positive growth effects of FDI.
3. Methodology and Data

The baseline model used in this study was modified with reference to Levine
(2005) and Alfaro et al. (2004). The model is written in a dynamic panel data
form as
yit ¼ yit1 þ 1 FDIit þ 2 FINDEVit þ 0 Xit þ i þ "it ; ð1Þ
where y is the real gross domestic product (GDP) per capita, FDI is FDI
inflows as a percentage of GDP, FINDEV is financial development, and X is a
vector of control variables that affect y, comprising the consumer price index
(CPI), gross fixed capital formation (FCAPITAL), and human capital (HC).
The coefficient of denotes the dynamic effect, where the presence of the real
GDP per capita depends on itself in the previous year, and the coefficient
should be less than 1 due to the persistency of the variable and statistically
significant. The i is the country index ði ¼ 1; 2; . . . ; N Þ and t is the time index
ðt ¼ 1; 2; . . . ; T Þ, i denotes the unobserved country-specific effect term, and
"it denotes the error term ð"it ¼ 0Þ. The signs of 1 and 2 are expected to
positive. The group involved in financial development includes three proxies:
domestic credit to private sector (DCPS), liquid liabilities (LL), and private
credit to deposit money (PC). All proxies are tested by separate models. All
variables are in natural logarithm form, except for HC. In the baseline model,
we do not have control over the time effect, regarded as the time dummy, due
to our short sample duration (5 years), which did not include the span of the
economic crisis, and we therefore assumed the time effect to be homogeneous.
The extension to model specification is the FDI-financial development
interaction used to investigate the role of financial development in the FDI-
economic growth relationship. The impact of financial development on the
relationship between FDI and economic growth can be expressed as follows:
yit ¼ yit1 þ 1 FDIit þ 2 FINDEVit þ 3 ðFDI FINDEV Þit

þ 0 Xit þ i þ "it ; ð2Þ
where 3 is the coefficient for the interaction between FDI and financial
development, and it is expected to be positive and significant. The marginal
1950009-10
effect for the interaction term uses the first-order condition of y and FDI :
ð@y=@FDI Þ ¼ 1 þ ð 3 FINDEV Þ: ð3Þ
A positive and significant 3 in Eq. (2) confirms that financial develop-
ment plays a role as absorptive capacity on enhancing the FDI to promote
growth. Nevertheless, in analyzing the nonlinearity of the absorptive

capacity of financial development on economic growth, we adopt a standard
quadratic model. Equation (1) can thus be written as follows:
yit ¼ yit1 þ 1 FDIit þ 2 FINDEVit þ 2 FINDEV it2 þ 0 Xit þ i þ "it : ð4Þ
If the conjecture of Kuznets (1955) is correct, namely that the association

between financial development and economic growth has an inverted-U-shape,
and that the signs of the 2 and 2 coefficients are positive and negative,
respectively, and both are statistically significant, then the \too much finance"
or \finance curse" hypothesis is thus supported. Conversely, if the 2 and 2
coefficients are negative and positive, respectively, and both are statistically
significant, then the relationship between financial development and economic
growth is U-shaped, or anti-Kuznets, and the ‘finance curse’ hypothesis
(Arcand et al., 2015) is not supported, but it supported the ‘more finance, more
growth’ hypothesis by Levine (2003). Based on Eq. (4), the financial develop-
ment turning point (in natural logarithm) can be estimated as 2 =2 2 .
To examine the central objective of this study, financial development can
be a potential absorptive capacity with consideration of its nonlinear prop-
erties. Thus, we extend Eqs. (2) and (4) by incorporating a measure of
financial development and the financial development square interactively
with FDI as follows:
yit ¼ yit1 þ 1 FDIit þ 2 FINDEVit þ 2 FINDEV it2
þ 3 ðFDI FINDEV Þit þ 3 ðFDI FINDEV it2 Þit
þ 0 Xit þ i þ "it : ð5Þ
Based on Eq. (5) the \too much finance harms growth" hypothesis, or eco-
nomic Kuznets curve is supported when 2 þ ð 3 ln FINDEV Þ is positive,
2 þ ð 3 ln FINDEV Þ is negative, and both are statistically significant. In
Eq. (6), the FDI turning point through the first derivative of y and FDI
@y
¼ 1 þ ð3 ln FINDEV Þ þ ð 3 ln FINDEV 2 Þ ð6Þ
@FDI
is set to zero. From Eqs. (5) and (6), we surmise that financial development
has a significant influence on the shape of the economic Kuznets curve if both
3 and 3 are statistically significant.
1950009-11
This study uses macro panel data consisting of 65 selected developing

countries (as listed in Table 1) that covers a 5-year period from 2009 to 2013.
The countries were primarily selected based on the availability and reli-
ability of data collated over the period. The variables used are the real GDP
per capita to indicate economic development and the FDI inflows (per-
centage of the GDP) for investment. Meanwhile, the DCPS (percentage of
GDP), LL (percentage of GDP) and PC (percentage of GDP) are the proxies
for financial development, in accordance with Law and Singh (2014) and
Adeniyi et al. (2012). The control variables used the gross fixed capital
formation (GFCF) to indicate the domestic investment, the consumer price

index (CPI) to indicate the price of goods and services, and the average years
of schooling as a proxy for human capital (HC). The data were obtained from
the World Data Bank Indicators, United Nations Conference on Trade and
Development (UNCTAD) database, Financial Structure Dataset, and Barro
and Lee website. The summary of the statistics of the variables is shown in
Table 2. The highest median for financial indicators the LL at 41.59% of the
GDP. The median for the DCPS is 35.31% of the GDP and for the PC is
30.94% of the GDP.
Equations (1), (2), (4) and (5) were estimated by using the Generalized
Method-of-Moments (GMM) estimator, which allows for the lagged level
of economic growth. The GMM panel estimator was first proposed by
Table 1. The list of selected developing countries.
No. Country No. Country No. Country No. Country
1 Albania 18 Dominican Rep. 35 Mauritius 52 Senegal

2 Algeria 19 Ecuador 36 Mexico 53 Serbia
3 Armenia 20 Egypt 37 Moldova 54 Sierra Leone
4 Bangladesh 21 El Salvador 38 Mongolia 55 South Africa
5 Belize 22 Ghana 39 Morocco 56 Sri Lanka
6 Benin 23 Guatemala 40 Mozambique 57 Sudan
7 Bolivia 24 Guyana 41 Namibia 58 Tanzania
8 Botswana 25 Honduras 42 Nepal 59 Thailand
9 Brazil 26 India 43 Nicaragua 60 Togo
10 Burundi 27 Indonesia 44 Niger 61 Tunisia
11 Cambodia 28 Jordan 45 Pakistan 62 Turkey
12 Cameroon 29 Kazakhstan 46 Panama 63 Uganda
13 China 30 Kenya 47 Paraguay 64 Ukraine
14 Colombia 31 Lesotho 48 Peru 65 Vietnam
15 Congo, Dem. Rep. 32 Malawi 49 Philippines
16 Costa Rica 33 Malaysia 50 Romania
17 Cote d’Ivoire 34 Mali 51 Russia
1950009-12
Table 2. Summary statistics.
10 % 25% 50% 75% 90%

Mean Minimum Quantile Quantile Quantile Quantile Quantile Maximum
GDP 2,579.44 148.34 398.37 772.73 1,639.48 3,940.80 6,291.28 8,186.97

DCPS 43.11 4.64 13.51 23.86 35.31 50.23 81.48 146.00

LL 50.10 14.57 20.65 30.53 41.59 61.46 97.19 170.02
PC 35.46 6.13 13.94 21.27 30.94 46.45 71.35 120.80
FDI 4.63 0.09 0.93 1.98 3.32 6.02 8.58 27.16
FCAPITAL 23.48 12.35 16.42 19.40 23.11 26.97 31.48 45.16
CPI 107.44 97.38 103.14 103.98 106.11 109.36 114.60 139.24
HC 2.44 0.30 0.58 1.40 2.22 3.26 4.49 6.66
Holtz-Eakin et al. (1988), and it was subsequently extended by Arellano and

Bond (1991), Arellano and Bover (1995), and Blundell and Bond (1998).
There are at least two reasons for choosing this estimator. First, it control
for country-specific effects that cannot use country-specific dummies because
of the dynamic structure of the regression equation. Second, its controls over
the simultaneity bias are caused by the possibility that some of the
explanatory variables may be endogenous. This method uses a set of instru-
mental variables to solve the endogeneity problem of the regressors. There
are two types of GMM estimators (difference and system), and they can be
alternatively considered in their one-step and two-step versions. The set of
instruments of the difference-GMM estimator (diff-GMM) includes all of
available lags in the difference of the endogenous variables and the strictly
exogenous regressors (Arellano and Bond, 1991). The system-GMM esti-
mator (sys-GMM) includes not only the previously mentioned instruments
but also the lagged values of the dependent variable (Blundell and Bond,
1998). It helps solve the endogeneity problem arising from the potential
correlation between the independent variable and the error term in dynamic
panel data models (Topcu, 2013). It also allows one to deal with omitted
dynamics in static panel data models, owing to ignorance about the impact
of the lagged values of the dependent variable (Bond, 2002).
Arellano and Bond (1991) proposed transforming Equation (1) into first-
differences to eliminate country-specific effects as follows:
yi;t yi;t1 ¼ ðyi;t1 yi;t2 Þ þ 1 ðFDIi;t FDIi;t1 Þ
þ 2 ðFINDEVi;t FINDEVi;t1 Þ
þ 3 ðXi;t Xi;t1 Þ þ ð"i;t "i;t1 Þ: ð7Þ
To address the possible simultaneity bias of explanatory variables and
the correlation between ðyi;t1 yi;t2 Þ and ð"i;t "i;t1 Þ, Arellano and Bond
1950009-13
(1991) proposed that the lagged levels of the regressors are used as instru-
ments. This is valid under two assumptions; first, that the error term is
not serially correlated, and, second, that the lag of the explanatory variables
is weakly exogenous. This procedure is known as the diff-GMM estima-
tion. Following Arellano and Bond (1991) we set the following moment
conditions:
E½yi;ts ð"i;t "i;t1 Þ ¼ 0 for s 2; t ¼ 3; . . . ; T ; ð8Þ
E½FDIi;ts ð"i;t "i;t1 Þ ¼ 0 for s 2; t ¼ 3; . . . ; T ; ð9Þ
E½FINDEVi;ts ð"i;t "i;t1 Þ ¼ 0 for s 2; t ¼ 3; . . . ; T ; ð10Þ

E½Xi;ts ð"i;t "i;t1 Þ ¼ 0 for s 2; t ¼ 3; . . . ; T : ð11Þ
Although the difference estimator above is able to control for the country-
specific effects and simultaneity bias, it nevertheless has one major short-
coming. Alonso-Borrego and Arellano (1999) and Blundell and Bond (1998)
show that when the explanatory variables are persistent the lagged levels of
the variables become weak instruments. They show that weak instruments
may lead to biased parameter estimates in small samples and a larger var-
iance asymptotically. Previously, Blundell and Bond (1998) proposed an
alternative system estimator that combines the difference of Equation (7)
and the level of Eq. (1). Blundell and Bond (1998) show that this estimator is
able to reduce the biases and imprecision associated with the difference
estimator. Following Blundell and Bond (1998), the additional moment
conditions for the second part of the system (the regression in levels) are set
as follows:
E½ðyi;ts yi;ts1 Þ ði þ "i;t Þ ¼ 0 for s ¼ 1; ð12Þ
E½ðFDIi;ts FDIi;ts1 Þ ði þ "i;t Þ ¼ 0 for s ¼ 1; ð13Þ
E½ðFINDEVi;ts FINDEVi;ts1 Þ ði þ "i;t Þ ¼ 0 for s ¼ 1 ð14Þ
E½ðXi;ts Xi;ts1 Þ ði þ "i;t Þ ¼ 0 for s ¼ 1: ð15Þ
The consistency of the GMM estimator depends on two specification tests.
The first is Hansen’s (1982) J -test of over-identifying restrictions. Under the
null of joint validity of all instruments, the empirical moments have zero
expectation, so the J statistic is distributed as a Chi-square with degrees of
freedom equal to the degree of over-identification. The second test examines
the hypothesis of no second-order serial correlation in the error term of the
difference of Equation (6) (Arellano and Bond, 1991). Following Ibrahim
1950009-14
and Law (2014), one should reject the null of absence of the first-order serial
correlation (AR(1)) and not reject the absence of the second-order serial
correlation (AR(2)), because the GMM allows first-order serial correlation
between error term lag 1 but not lag 2.1 Failure to reject the null of the J -test
and the second-order serial correlation tests provides support for the
estimated model.
The GMM estimators are typically applied in one-step and two-step
variants (Arellano and Bond, 1991). The one-step estimators use weighting
matrices that are independent of estimated parameters, whereas the two-
step GMM estimator uses the so-called optimal weighting matrices, in which
the moment conditions are weighted by a consistent estimate of their
covariance matrix. This makes the two-step estimator asymptotically more
efficient than the one-step estimator. The use of the two-step estimator in
small samples is however has several problems in terms of the estimation and
diagnostics. These problems occur from the instruments’ proliferation. If the
number of instruments’ proliferation is more than the number of groups, the
estimation of the parameter is inaccurate. To overcome this problem, we use
the collapse of lag length technique proposed by Roodman (2009) to get
better results and achieve goodness of fit in the model. Therefore, we have
used the two-step system-GMM in this study.
To investigate the presence of an inverted U-shaped or U-shaped rela-
tionship between financial development and economic growth in Eq. (4), we
have conducted the U-test of Sasabuchi (1980), which was extended by Lind
and Mehlum (2010). In the quadratic case in Eq. (4), the composite null with
the joint hypothesis is tested as follows:
H0 : ð1 þ 2 2FINDEVmin 0Þ [ ð 1 þ 2 2FINDEVmax 0Þ; ð16Þ

H1 : ð1 þ 2 2FINDEVmin > 0Þ [ ð 1 þ 2 2FINDEVmax < 0Þ; ð17Þ
where FINDEVmin and FINDEVmax represent the minimum and maximum

values of financial development, respectively. If the null hypothesis is
rejected, this confirms the existence of an inverted U-shaped relationship.
In contrast, the presence of a U-shaped relationship (from Eq. (4)) indicates
that 1 þ 2 2FINDEVmin < 0 and 1 þ 2 2FINDEVmax > 0, whereas in
1
In accordance with Arellano and Bond (1991), post estimation specification test in
GMM would expect first order serial correlation, i.e., E½"i;t "i;t1 ¼ ½ð"i;t "i;t1 Þ
ð"i;t1 "i;t2 Þ ¼ E½" 2it1 ¼ 2" : But second order serial correlation would not expected,
i.e., E½"i;t "i;t2 ¼ ½ð"i;t "i;t1 Þð"i;t2 "i;t3 Þ ¼ 0. Thus, the presence of second order
serial correlation indicates a specification error.
1950009-15
the inverted U-shaped relationship, 1 þ 2 2FINDEVmin > 0 and 1 þ

2 2FINDEVmax < 0. Therefore, the presence of the U-shaped relationship
can be tested as follows:
H0 : ð 1 þ 2 2FINDEVmin 0Þ [ ð1 þ 2 2FINDEVmax 0Þ; ð18Þ
H1 : ð 1 þ 2 2FINDEVmin < 0Þ [ ð1 þ 2 2FINDEVmax > 0Þ: ð19Þ

Based on Eqs. (18) and (19), if the null hypothesis is rejected, the existence
of a U-shaped relationship between financial development and economic
growth is confirmed. Thus, the hypothesis of the U-test depends on the
quadratic model estimation from the system-GMM results in this study.
4. Results and Discussion

The estimated results for the model without interaction in Eq. (1) are
reported in Table 3. The results show that FDI is positive and significant in
Models 1a–1b, whereas financial development is positively significant for
economic growth only in Model 1b. However, this implies that the direct
effect of FDI in Model 1c and the effect of financial development on economic
growth in Models 1a and 1c are not in line with Keynesian theory. The effect
of FDI on economic growth is conditional with that of other factors such as
financial development (Choong and Lim, 2009; Alfaro, 2010; Choong and
Lam, 2011; Chong, 2012; Iamsiraroj and Ulubaşoğlu, 2015).
Therefore, we proceed with the discussion of the result estimation with
the interaction model in Eq. (2). The interaction model is used to investigate
Table 3. Two-step system-GMM estimation (linear model without interaction).
Model 1a: Domestic Model 1b: Model 1c:

Credit to Private Sector Liquid Liabilities Private Credit
GDP (1) 0.989*** 0.984*** 0.980***

CPI 0.008 0.001 0.003
FCAPITAL 0.036*** 0.014*** 0.007***
HC 0.014*** 0.008*** 0.013***
FDI 0.006** 0.005*** 0.003
FINDEV 0.003 0.008** 0.005
Constant 0.077 0.051 0.119
AR(1) (p-value) 0.002 0.003 0.002
AR(2) (p-value) 0.251 0.261 0.260
J -test (p-value) 0.323 0.231 0.137
No. of groups 65 65 65
No. of instruments 62 49 51
Notes: ***, ** and * denotes the significance level of 1%, 5% and 10%, respectively.
1950009-16
Table 4. Two-step system-GMM estimation (linear with interaction).
Model 2a: Domestic Model 2b: Liquid Model 2c:

Credit to Private Sector Liabilities Private Credit
GDP (1) 0.982*** 0.979*** 0.982***

CPI 0.014* 0.004 0.004

FCAPITAL 0.031*** 0.006* 0.008**
HC 0.006** 0.010*** 0.007***
FDI 0.016* 0.065*** 0.020***
FINDEV 0.001 0.013*** 0.003
FDI*FINDEV 0.007** 0.019*** 0.008***
Constant 0.112* 0.205** 0.147***
AR(1) (p-value) 0.004 0.001 0.002

AR(2) (p-value) 0.296 0.310 0.249
J-test (p-value) 0.554 0.235 0.258
the role of financial development in the FDI-economic growth relationship

and this is reported in Table 4. In the interaction specification, the rela-
tionship between FDI and economic growth is consistently negative and
significant for all models (Models 2a–2c). The negative impact of FDI is
consistent with studies by Li and Liu (2005) and Doytch and Uctum (2011).
Financial development is positive and significant for all proxies, however.
FDI interaction with the finance indicator produced a positive and signifi-
cant relationship for all models (Models 2a–2c). The interaction term be-
tween FDI and LL is the highest of the other three finance indicators. Our
findings are consistent with those of other studies that used linear and in-
teraction terms, such as those by Choong and Lim (2009), Choong and Lam
(2011), Choong (2012), and a more recent one by Jayaraman et al. (2017).
Our study therefore has established empirically that financial development
plays an important role in the FDI-economic growth linkage.
The marginal effect of FDI on economic growth depends on the level of
financial development, which can be expressed as follows:
@y
Model 2a: ¼ 0:016 þ 0:007DCPS; ð20Þ
@FDI
@y
Model 2b: ¼ 0:065 þ 0:019LL; ð21Þ
@FDI
@y
Model 2c: ¼ 0:020 þ 0:008PC : ð22Þ
@FDI
1950009-17
From the first-order derivative shown in Eqs. (20)–(22), the impact of FDI
on economic growth is contingent on the level of financial development. The
coefficients of the first-order derivation are obtained from the two-step
system-GMM estimation as shown in Table 4. From Eqs. (20)–(22), the
marginal effects based on the mean value in log form for the DCPS, LL and
PC are 0.009, 0.006, and 0.008, respectively. The results in Table 4 imply
that the effect of FDI inflows on economic growth increases monotonically
with financial development. Therefore, the higher the level of financial de-
velopment, the greater the effect of FDI in boosting economic growth. This
finding is consistent with findings of recent studies (see Jayaraman et al.,

2017; Nwosa and Emma-Ebere, 2017; Adeniyi et al., 2015; Samad and
Akhtaruzzaman, 2014; Suliman and Elian, 2014), which also discovered that
the effect of FDI inflows on economic growth depends on the level of financial
development from the host countries.
Although the result in Table 4 shows the role of financial development as
an absorptive capacity in the linkage between FDI and economic growth, the
nonlinear properties of the relationship between financial development and
economic growth cannot be ignored in the specification model. Before we
proceed further, it is important to examine the nonlinear relationship
between financial development and economic growth. The nonlinearity of
financial development and economic growth as shown in Table 5, is from the
specification in Eq. (4). The results from Table 5 show that there is U-shaped
nonlinear relationship between financial development and economic growth,
Table 5. Two-step system-GMM estimation (quadratic model without interaction).

GDP (1) 0.984*** 0.981*** 0.996***

CPI 0.017*** 0.020*** 0.014**
FCAPITAL 0.011*** 0.008*** 0.009***
HC 0.009*** 0.008*** 0.007***
FDI 0.008*** 0.011*** 0.009***
FINDEV 0.057*** 0.026*** 0.109***
FINDEV 2 0.010*** 0.006*** 0.015***
Constant 0.075** 0.037*** 0.129***
AR(1) (p-value) 0.002 0.002 0.002
AR(2) (p-value) 0.221 0.205 0.204
J -test (p-value) 0.203 0.245 0.167
1950009-18
where the sign of the 2 and 2 coefficients are negative and positive,
respectively, and both are significant for all Models 3a–3c. The estimation
obtained from the two-step system-GMM also passed the diagnostic test of
second-order correlation and over-identification of the J -test. In addition,
the number of instruments is fewer than the number of groups.

The nonlinearity of the U-shaped relationship between financial devel-
opment and economic growth has been confirmed by the U-test of Sasabuchi-
Lind-Mehlum (SLM), as shown in Table 6. Model 4a in the table shows that
the point estimate of the threshold value, using the DCPS, is 2.983 or 19.75%
of the GDP, with a corresponding 90% Fieller confidence interval [2.616,

3.194]. Meanwhile, the threshold point of the LL in Model 4b is 3.04 or
20.91% with a 90% Fieller confidence interval [3.222, 3.556], and the
threshold point of the PC is 2.567 or 13.03% in the range of the 90% Fieller
confidence interval [2.145, 2.891] in Model 4c. The threshold point for the LL
is higher compared with the rest of the financial indicators. The result thus
confirms that there are U-shaped relationships between financial development
and economic growth for all models. The slope of FINDEVmin is negative and
statistically significant, whereas FINDEVmax is positively significant for
all models. Hence, the results confirm the U-shaped relationship between
financial development and economic growth. The t-value of the SLM test of a
U-shaped relationship is significant at 1% level for all Models 4a–4c.
Our finding of a U-shaped relationship contrasted with findings of earlier
studies, which discovered an inverted U-shaped curve (Arcand et al., 2015;
Cecchetti and Kharroubi, 2012; Law and Singh, 2014; Samargandi et al., 2015).
Table 6. Sasabuchi–Lind–Mehlum test.

Extreme point 2.983 3.040 2.567

95% Fieller interval [2.616, 3.194] [3.222, 3.556] [2.145, 2.891]
Slope at FINDEVmin 8.854*** 55.498*** 11.472***
(3.312) (4.261) (4.908)
Slope at FINDEVmax 5.178*** 6.583*** 2.094***
(3.714) (4.339) (5.256)
Hypothesis test H0 : Inverted H0 : Inverted H0 : Inverted
U-shaped U-shaped U-shaped
H1 : U-shaped H1 : U-shaped H1 : U-shaped
SLM test for U-shaped 3.31*** 4.26*** 4.91***
(t-value)
p-value 0.000 0.000 0.000
1950009-19
Our results imply that the relationship between financial development and
economic growth is significantly negative, but that after it surpasses the
threshold point, the relationship becomes positive, leading to enhancement in
economic growth. The negative effect of financial development at the beginning
of the U-shaped curve is due to the influence of the vanishing effect where the
credit from households is not channeled to a productive use (Arcand et al.,
2015). In the aftermath of the global financial crisis in 2007–2008, financial
liberalization for stability and economic growth came under scrutiny (Batuo
and Asongu, 2017). Actions taken by policy makers of the World Bank, IMF
and BIS, such as financial regulations, were revised and tightened to help
improve the performance of the global financial system. For example, in
Basel III, a capital rules for the global regulatory framework was revised and
introduced in June of 2011 to increase the resilience of banks and banking
systems. In addition, the Basel Committee on Banking Supervision (BCBS)
released in Basel III monitoring tools for the liquidity coverage ratio and
liquidity risk, which aimed at strengthening global capital and liquidity
regulations.
Discussion of the above study suggests that the outlook for economic
growth is increased due to the strong legal environment driving the devel-
opment of financial intermediaries. Regulatory and legal aspects are dis-
cussed in this study because some financial regulations have been renewed
and implemented in developing countries due to the upsurge and recovery
measures following the global financial crisis. The linkages between financial
development and economic growth related to policies and legislation are also
supported by previous studies. La Porta et al. (1997) proved that countries
that protect investors achieved high value in the stock market compared
with countries that have no such protection. Levine (1999) demonstrated
that improvements in regulations and legislation enhanced intermediaries of
financial development, leading to economic growth in the long run. Levine
et al. (2000) found that countries with better creditworthiness, tight en-
forcement, and better accounting information tended to have more advanced
financial intermediaries. Additionally, Ergungor (2008) found that the
relationship between the financial sector (banking sector) and economic
growth was not linear in countries with an inflexible judiciary system. The
economy grew rapidly, however, as the banking-oriented financial system
increased.
Financial development generally improved in the aftermath of the global
financial crisis eliciting positive effect on economic growth once the threshold
point was exceeded, as was indicated in the U-shaped relationship shown in
1950009-20
our results. Hence, our study provides new findings for the literature on
financial development and economic growth; namely, that an absorptive
capacity affects work nonlinearly in that FDI enhances economic growth,
and that the effect arises from a minimum level after the threshold point of
financial development has been surpassed.

The results shown in Tables 5 and 6 indicate that, the nonlinear rela-
tionship between financial and economic growth merits further investigation
regarding its role as an absorptive capacity to the relationship between FDI
and economic growth. The U-shaped nonlinear relationship between finan-
cial development and economic growth remained in the more finance, more
growth hypothesis proposed by Levine (2003). The role of financial devel-
opment as a nonlinear, mediating variable in the FDI-economic growth
nexus is still unexplored in the extant literature and merits further inves-
tigation. Therefore, our findings have revealed ambiguity in the relationship
between these three variables, as highlighted by Iamsiraroj and Ulubaşoğlu
(2015).
The contribution of our study is the extension of modeling of nonlinearity
pertaining to the interaction effects of FDI with financial development. The
results of the specification in the quadratic model and the interaction term
from Eq. (5) are shown in Table 7. The coefficients estimated in Models 5a–5c
confirmed the presence of nonlinearity in the form of a U-shaped relationship
and interaction of FDI and financial development. The U-shaped association
between financial development and economic growth, where the signs of the
parameter 2 and 2 coefficients are positive and negative, respectively, and
both are statistically significant, supports the \more finance, more growth"
hypothesis. However, our result contrasted the findings of Iamsiraroj and
Ulubaşoğlu (2015), who found an inverted U-shaped relationship for the FDI-
financial development-economic growth nexus. The difference in our findings
can be attributed to two main reasons. First, the sample period of study in
Iamsiraroj and Ulubaşoğlu (2015) was 1970–1999, whereas our sample period
was more recent, spanning the years 2009–2013. The relationship between
FDI-financial development-economic growth may change due to changing
economic conditions, furthermore, our sample was collected after the global
financial crisis. Second, our study focused on developing countries, which are
likely to possess a necessary initial absorptive capacity, such as financial
development. As such, the interactions between FDI and financial devel-
opment, and between FDI and the financial development square were both
statistically significant. The absence of the second-order serial correlation
AR(2) consistently failed to reject the null hypothesis in Models 5a–5c.
1950009-21
Table 7. Two-step system-GMM estimation (nonlinear with interaction).
Model 5a: Domestic Model 5b: Liquid Model 5c: Private

Credit to Private Sector Liabilities Credit
GDP (1) 0.987*** 0.954*** 0.990***

CPI 0.008 0.019* 0.006

FCAPITAL 0.009*** 0.005 0.002
HC 0.005* 0.024*** 0.008*
FDI 0.066*** 0.283*** 0.179***
FINDEV 0.191*** 0.093*** 0.354***
FINDEV 2 0.028*** 0.017*** 0.054***
FDI*FINDEV 0.042*** 0.155*** 0.121***
FDI*FINDEV 2 0.005*** 0.020*** 0.019***

Constant 0.434*** 0.504*** 0.657***
AR(1) (p-value) 0.001 0.001 0.002
AR(2) (p-value) 0.232 0.348 0.305
J -test (p-value) 0.476 0.130 0.199
Threshold value 2.093 (8.11%) 2.945 (19.00%) 2.337 (10.35%)
Failure to reject the null hypothesis in the J -test in Table 7 would imply that
the instruments were valid and that Models 5a–5c were correctly specified.
The nonlinear relationship and the interaction term in the model need to
be incorporated to get the benefit from FDI in promoting economic growth
once financial development has reached the threshold value through the
first-order derivation and is set to zero as follows:
@y
Model 5a: ¼ 0:066 þ 0:042DCPS þ ð0:005DCPS 2 Þ ¼ 0; ð23Þ
@FDI
@y
Model 5b: ¼ 0:283 þ 0:155LL þ ð0:020LL 2 Þ ¼ 0; ð24Þ
@FDI
@y
Model 5c: ¼ 0:179 þ 0:121PC þ ð0:019PC 2 Þ ¼ 0: ð25Þ
@FDI
The coefficients in Eqs. (23)–(23) were estimated from the results in Table 7.
From these equations, we obtained the threshold values in logarithm form of
2.09, 2.94, and 2.34, respectively, for DCPS, LL, and PC. The coefficients
in the first-order derivation were estimated from the two-step system-GMM,
as shown in Table 7. The exponential value of the natural logarithm
emphasized the actual percentage that would be the precondition level of
financial development for FDI to enhance economic growth. For better results,
1950009-22
considering the nonlinearity of financial development on economic growth,

Models 5a–5c suggested a well-specification model that can best fit the FDI-
growth relationship. The results showed that FDI can stimulate economic
growth in developing countries via the financial development. Once the
threshold levels of DCPS (8.11% of GDP), LL (19.00% of GDP) and PC

(10.35% of GDP), or at least the 10th percentile (see Table 2) were exceeded,
the complementary relationship between FDI and financial development began
to accelerate economic growth.
The effect of FDI on economic growth contingent on financial develop-
ment is also illustrated in Fig. 1. The solid line in the figure confirms the
U-shaped effect of FDI being reliant on the level of financial development,
and the shaded area portrays the confidence intervals of this effect. Within
the range of the confidence intervals in the shaded area, FDI has a positive
and statistically significant effect on growth after the DCPS value has
surpassed 2.093 (see Fig. 1(a)), whereas the LL and PC exceed 2.945 (Fig. 1(b))
and 2.337 (Fig. 1(c)), respectively.
The U-shaped relationship of financial development on economic growth
is associated with the mix of negative and positive effects in the relationship
between FDI and economic growth as found in previous studies as expressed
by Nor et al. (2013) and Iamsiraroj and Ulubaşoğlu (2015). The findings of
our study reveal the cause of the clutter in the relationship between these
three variables. The weakness in FDI effectiveness at lower levels of financial
development can be due to the inefficiency of monetary policy. In addition,
investors have yet to obtain sufficient business outcomes. The negative effect
of FDI on economic growth below the threshold level was also associated
with investor sentiment and psychological pitfalls during the global financial
crisis, which led to a strong tendency on the part of investors to avoid past
unfavorable outcomes, as highlighted by Chang et al. (2017). The effec-
tiveness of financial development benefits the relationship between FDI and
economic growth, this may have occurred due to the transition period from
crisis to remedy after the global financial crisis, where residual proactive
actions were taken by the IMF, World Bank and BIS, as discussed earlier.
As a result of the recovery from financial and economic crises, especially in
developing countries, the strength of the financial position also affected the
positive impact of FDI on economic growth. In addition, financial investor
sentiment was exogenous to economic fundamentals (Du and Zhao, 2017).
Investors were reassured about investing in developing countries during the
economic recovery phase. By addressing the importance of financial devel-
opment as an absorbent capacity in the relationship between FDI and
1950009-23
(a) Domestic credit to private sector (% of GDP)
(b) Liquid liabilities (% of GDP)
(c) Private credit to deposit money (% of GDP)
Fig. 1. The effect of FDI on economic growth contingent on financial development

(in log form).
1950009-24
economic growth, its increase was able to enhance the positive impact of FDI
on economic growth after the threshold of financial development was
exceeded. A stable financial position after the global financial crisis has
restored investor confidence in considering at resource-seeking and helping
brown-field investments in businesses that are up and running and rely on

financial assistance.
An argument by Choong and Lim (2009) that is associated with the
U-shaped curve in the FDI-financial development-economic growth nexus in
this study contends that limitations in the domestic financial sector in
providing financial assistance to domestic firms and foreign firms create a

crowd-out effect. For banking institutions seeking to maximize profits,
financial provisions are limited to potential firms with highly developed
technology, especially multinational companies. If there is a positive spill-
over effect and the transfer of technology ensuing from high foreign invest-
ments which exceeds the crowd-out effect, the host country can still elicit a
positive impact on economic growth. The opposite would occur if the neg-
ative impact of the crowd-out effect were greater than the positive spillover
effects of FDI, leading to a low impact of foreign investments and a negative
effect on economic growth following oppression in the banking sector
(Choong and Lim, 2009).
A negative effect of FDI on economic growth occurred in the low level of
financial development in the host country. Limitations in the domestic
financial sector may reduce a domestic firm’s ability to purchase new tech-
nology because of the costs of introducing new technology fueled by FDI, it
may be too expensive and risky for a domestic firm to undertake this effort,
in addition to offering attractive salaries for skilled labourers from multi-
national companies. The two consequences of a low level of financial devel-
opment in a host country may reduce the efficiency of domestic firms in
competing with FDI, the presence of multinational enterprises may imply
significant losses in their market shares, forcing them to operate on a less
efficient scale, with a consequent increase in their average costs (Aitken and
Harrison, 1999; Harrison, 1994). Three situations aforementioned such as
the demonstration by multinational enterprises, labour mobility and com-
petition are related to three channels of the technological diffusion from FDI
(Crespo and Fontoura, 2007). The risk faced by domestic firms in the low
level of the domestic financial sector may be an initial detriment to economic
growth associated with an increase in FDI inflows into the host country.
Our study shows that the positive effect of FDI on economic growth
begins only after financial development exceeds a threshold level. This is
1950009-25
commensurate with the findings by Azman-Saini et al. (2010). The positive

effect of FDI on economic growth at a high level of financial development in a
host country corresponds to the ideas of competition. The ideas by
Schumpeter (1912) have been viewed by other studies as competition and its
effect on valuation such as Aleksanyan and Karim (2013), Chang and Chen
(2012), Chen et al. (2012), Hu and Lee (2013), I and Chuang (2010) and
Lin and Chang (2012). A high level of financial development in a host
country enables both multinational enterprises and domestic firms to cover
the costs of producing innovative products by investing in research
and development activities, developing human capital, and buying high-

end technology to compete in a market that stimulates economic growth.
In addition, high financial development can provide financial assistance
to the domestic banking sector to be able to protect multinational enter-
prises from foreign exchange exposure through hedging to protect the cost
of transactions in production. Hence, financial development serves as a
vehicle to accelerate economic growth from the positive spillover effect
of FDI.
5. Conclusion
This study examines the impact of FDI on economic growth through
financial development in 65 selected developing countries. The study uses
the two-step system-GMM estimation in a dynamic panel data framework.
The use of panel data is appropriate in this study because we can increase
the data points and the degree of freedom. The results demonstrated
that FDI inflow has a negatively significant relationship with economic
growth in the estimation of the model with interaction. However, FDI has
a positively significant effect on economic growth if it interacts with
financial development. The stronger the level of financial development,
the more FDI can promote economic growth. We can conclude that FDI
can accelerate economic growth, depending on the level of financial
development as an absorptive capacity. All countries should therefore
foster higher financial development in order to enable FDI to increase
economic growth.
The novelty of our study is in proving the nonlinearity of financial
development in the relationship between FDI and economic growth by using
data from the era after the global financial crisis. The nonlinear impact of
financial development on economic growth is U-shaped or an anti-Kuznets
curve, a finding that supports the \more finance, more growth" proposition
1950009-26
but contradicts the proposition of \too much finance harms economic

growth". By considering a U-shaped nonlinearity of financial development
on economic growth, the FDI effect on economic growth is negatively sig-
nificant, but it is subsequently boosted once financial development goes
beyond the threshold point. The FDI effect originates at a minimum level of
7.87% of GDP for the DCPS, 11.72% of GDP for the LL and 8.64% for the
PC. Our findings present new evidence about recent developments in
the economy, in contrast to those of previous finding by Iamsiraroj and
Ulubaşoğlu (2015).
Based on these findings, our study contributes to the study of the

FDI-financial development-economic growth relationship in two ways.
First, the relationship between FDI and economic growth depends on
financial development in a nonlinear approach of a U-shaped curve, as
shown in Fig. 1 and Models 5a–5c in Table 7. This would suggest well-
specification model that can best fit the relationship between FDI-financial
development-economic growth. Second, this study showed that the rela-
tionship between financial development and economic growth has been
U-shaped in the period following the global financial crisis, based on panel
data from the years 2009–2013, in contrast with previous findings that
relied on data from before the crisis. In consequence, the theory that too
much finance harms growth in recent economies (which was proposed
by Arcand et al., 2015; Law and Singh, 2014) may lead to the absence of
well-developed financial systems that limit potential positive externalities
of FDI to promote economic growth. As an alternative, our findings sug-
gest that the level of finance needs to be increased, but appropriate con-
trols and monitors should be put into place to avoid a future recurrence of
a financial crisis. These findings can be considered a contribution to new
empirical evidence in the FDI-financial development-economic growth
literature.
Acknowledgements
This paper benefited from comments and opinions of participants of an Asian
Academy Conference 2017 (AMC 2017), at Penang, Malaysia on 6–8
October 2017. The authors would like to thank the anonymous referees and
the editor of this journal for their insightful comments on an earlier draft. All
remaining errors are solely attributed to the authors. This research was
supported financially by the Ministry of Higher Education, Malaysia
through the International Islamic University College Selangor under the
1950009-27
Fundamental Research Grant Scheme (FRGS) grant: FRGS/2/2014/SS05/

KUIS/03/1.
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Review of Paciﬁc Basin Financial Markets and Policies

Vol. 22, No. 2 (2019) 1950009 (32 pages)

The Role of Financial Development in the

Elya Nabila Abdul Bahri*

Abu Hassan Shaari Md Nor

Nor Hakimah Haji Mohd Nor

Published 21 October 2019

Financial development is recognized as an absorptive capacity in the relationship

tionship of ﬁnancial development on economic growth is a U-shaped curve by using

Keywords: Financial development; foreign direct investment; economic growth;

studies conducted found positive and statistically signiﬁcant eﬀects of FDI

proposition suggested earlier by Levine (2003). However, the selection of

the ﬁnancial resources to channel funds to the private sector, as well as

reﬂect ﬁnancial services (Demetriades and Hussein, 1996; Favara, 2003;

In the aftermath of the global ﬁnancial crisis, policy-makers scrutinized

to stabilize the ﬁnancial conditions in developing countries. For example,

the recent economies of the 65 developing countries. According to Alfaro

their investments because of cheaper labor in developing countries that

regressions of growth equation and a cross section of the data-set of the 67

of technology diﬀusion associated with FDI. Financial markets can reduce

countries over the period of 1988–2002. In a subsequent study, Choong

H1: Higher ﬁnancial development enhances a host country’s ability to

Even though recent studies have established that ﬁnancial development

Recent studies have established that the relationship between ﬁnancial

on economic growth up to a certain point, beyond which it could dampen

the fragility of ﬁnancial development is associated with the episode of eco-

3. Methodology and Data

yit ¼ yit1 þ 1 FDIit þ 2 FINDEVit þ 3 ðFDI FINDEV Þit

growth. Nevertheless, in analyzing the nonlinearity of the absorptive

If the conjecture of Kuznets (1955) is correct, namely that the association

This study uses macro panel data consisting of 65 selected developing

formation (GFCF) to indicate the domestic investment, the consumer price

Table 1. The list of selected developing countries.

No. Country No. Country No. Country No. Country

1 Albania 18 Dominican Rep. 35 Mauritius 52 Senegal

Table 2. Summary statistics.

10 % 25% 50% 75% 90%

GDP 2,579.44 148.34 398.37 772.73 1,639.48 3,940.80 6,291.28 8,186.97

DCPS 43.11 4.64 13.51 23.86 35.31 50.23 81.48 146.00

Holtz-Eakin et al. (1988), and it was subsequently extended by Arellano and

E½FINDEVi;ts ð"i;t "i;t1 Þ ¼ 0 for s  2; t ¼ 3; . . . ; T ; ð10Þ

H0 : ð1 þ 2 2FINDEVmin  0Þ [ ð 1 þ 2 2FINDEVmax  0Þ; ð16Þ

where FINDEVmin and FINDEVmax represent the minimum and maximum

the inverted U-shaped relationship, 1 þ 2 2FINDEVmin > 0 and 1 þ

H1 : ð 1 þ 2 2FINDEVmin < 0Þ [ ð1 þ 2 2FINDEVmax > 0Þ: ð19Þ

quadratic model estimation from the system-GMM results in this study.

4. Results and Discussion

Table 3. Two-step system-GMM estimation (linear model without interaction).

Model 1a: Domestic Model 1b: Model 1c:

GDP (1) 0.989*** 0.984*** 0.980***

Table 4. Two-step system-GMM estimation (linear with interaction).

Model 2a: Domestic Model 2b: Liquid Model 2c:

GDP (1) 0.982*** 0.979*** 0.982***

CPI 0.014* 0.004 0.004

AR(1) (p-value) 0.004 0.001 0.002

the role of ﬁnancial development in the FDI-economic growth relationship

ﬁnding is consistent with ﬁndings of recent studies (see Jayaraman et al.,

Table 5. Two-step system-GMM estimation (quadratic model without interaction).

Model 3a: Domestic Model 3b: Model 3c:

GDP (1) 0.984*** 0.981*** 0.996***

the number of instruments is fewer than the number of groups.

of the GDP, with a corresponding 90% Fieller conﬁdence interval [2.616,

Table 6. Sasabuchi–Lind–Mehlum test.

E½FINDEVi;ts ð"i;t "i;t1 Þ ¼ 0 for s 2; t ¼ 3; . . . ; T ; ð10Þ

H0 : ð1 þ 2 2FINDEVmin 0Þ [ ð 1 þ 2 2FINDEVmax 0Þ; ð16Þ

GDP (1) 0.989* 0.984* 0.980***

GDP (1) 0.982* 0.979* 0.982***

GDP (1) 0.984* 0.981* 0.996***

GDP (1) 0.987* 0.954* 0.990***

FDIFINDEV 2 0.005 0.020* 0.019***