Foreign direct investment, financial development and economic growth

in Asian developing countries

Supervisor: Christopher Gan

Associate Supervisor: Baiding Hu

1. Introduction

1.1 Rationale of the study

After experiencing an economic downturn in 2007 to 2009, followed by remarkable growth rate
during recent years, most economies of developing Asia exhibited a good record of economic
performance in 2015. Uzbekistan exhibited the highest growth rate of about 8%, followed by India
(7.6%), Cambodia (7.2%), Lao PDR (7%), and China (6.9%). In general, the average growth rate of
Asia is around 4%, which makes it one of the fastest growing regions in the World (2.4%), Euro Zone
area (1.7%), Sub-Saharan Africa (3.0%), Arab World (3%), and OECD members (2.0%) (World
Bank, 2016). There are many discussions and debates about this growth rate, such as government
spending, trade openness, education, and macroeconomic stability are the main reasons. Other
notable determinants of economic growth include the role of foreign direct investment and financial
development.

Several studies such as Tiwari and Mutascu (2011); Anwar and Nguyen (2010); Anwar and Sun
(2011); Shahbaz and Rahman (2010); Berthelemy and Demurger (2000) have shown that foreign
direct investment (FDI) is an essential factor to stimulate economic performance, especially in
developing countries. First, FDI transfers knowledge and technologies to recipient countries through
workforce training and organizational arrangements (Kotrajaras et al, 2011). As a result, it enables
firms to enhance their productivity which then contributes to the output of the country. This effect is
strongest when the country has high levels of human capital, developed financial markets, and low
level of corruption.

Secondly, through increasing investment, FDI plays a vital role in enriching capital accumulation (Li
and Liu, 2005). To be more specific, by increasing capital, FDI encourages firms to access global
input and new technologies; as a result it can augment output growth by using intermediate goods in
FDI related production.

Thirdly, Moudatsou and Kyrkilis (2011) using data in ASEAN and EU from 1970 to 2003 indicate
that FDI enhances the corporation’s competitiveness in their industries, which results in not only
diversifying products, but also qualifying to meet the demand of both domestic and global market –
an important step in economic growth. There is a vast consensus of positive impacts reported in the
literature, but negative results are also found by other studies. For instance, a country which has poor

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business environment, and low level of human capital, FDI might adversely affect the economic
performance (Ayanwale, 2007). Similarly, Gorg and Greenaway (2004) suggest that multinational
firms can inhibit the growth of local firms since the former benefit from economies of scale and
lower marginal costs.

On the other hand, while FDI is considered as a prominent factor in enhancing economic
performance, the role of financial development cannot be ignored. Financial sector, another proxy of
economic growth in developing countries (Anwar, and Nguyen, 2011), is measured by various
instruments, including banking credit sector to GDP, total liquid liabilities to GDP, credit to private
sector to GDP (Adeniyi et al, 2015), and size of the equity market (Suliman and Elian, 2014).
Among these instruments, the banking sector and stock market, are critical determinants promoting
growth (Rabiul, 2010; Levine and Zervos, 1998; Suliman and Elian, 2014).

Levine and Zervos (1996) argue that the stock market, measured by market capitalization and
liquidity, could minimize risk and increase the capital available to firms. In addition, stock market
development is also assessed by liquidity, which responds to well-functioning of the stock markets,
and a low transaction cost. Similarly, Cooray (2010) finds that the promotion of the stock market has
a positive impact on economic growth due to risk diversification and sharing, elimination of barriers
of capital flow. As a consequence, firms can enhance their investment and productivity, contributing
to growth. In addition, Demirgui-Kunt and Levine (1996) revealed that a country having a developed
stock market will also have strong financial intermediation, such as, investment firms, mutual funds,
brokerage houses, etc. Furthermore, the authors indicate that entrepreneurs can easily access capital
and use more financial services. Thus, the stock market associated with developed financial
intermediaries will have a strong link to long run growth. However, it is reported that the stock
market also decelerates economic performance, such as distortion of the financial system because of
weak regulations, and associated financial bubbles (Singh and Weiss, 1998). The authors illustrated
that the collapse of the speculative stock bubbles in Mexico resulted in instability of the economy and
GDP reduced by 7% in 1995.

There are two important channels that banks’ contribute to economic growth of a country (Lucchetti
et al, 2001). Firstly, banks reduce transaction costs and risks to firms, thus the capital accumulation is
improved enabling them to mobilize savings to finance, thereby enhancing investment. Secondly,
credit to private sector exerts a vital role on the demand of the firms. It enables firms to not only to be
self-financing but also leverage external resources for investment. As a result, purchasing power to
produce more products for firms will increase. Similarly, in a research of Malaysian banking system,
Vaithilingam et al. (2003) show banks take in deposits, and thereafter transform domestic savings to
credit to firms. Further, the banking system is also important to screen and monitor entrepreneurs so
that funds are used in the best way (Diamond, 1984). Banks can screen good borrowers at a low cost

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and monitor their behaviour during their loan period. Hence, fund flow to the most productivity firms
resulting in economic growth. However, the banking system can also cause harmful effects to
economic growth. For instance, the 1997 Asian financial crisis is a result of the banking system with
high capitalization but lack of competitive markets (Soedarmono et al, 2011). The authors point out
that in such cases, moral hazard will arise, which will create more risks and instability in banks and
the economy.

By and large, a nation’s growth does not only rely on the volume of FDI inflows, but also on efficient
financial markets (De Gregorio and Guidotti, 1995). Further studies also look at the link between FDI
- growth in the term of integration with recipient countries’ financial sector (Alfaro et al, 2004;
Hermes and Lensink, 2003). It is argued that the advantage of FDI might be lessened if domestic
financial system does not reach a threshold level (Suliman, and Elian, 2014). While FDI-growth
linkage is not substantial from a country to another, financial sector is taken into the consideration as
a component in contributing the gains to the linkage. Firstly, the deeper and wider the financial
institutions, the more strongly financial services boost growth (Errunza, 2001). Secondly, upgrading
financial system is one of the possibilities to attract more FDI inflows since investment will be more
effective which can boost productivity (Albuquerque, 2003). Thirdly, advanced financial sector helps
to eliminate asymmetric information which increases costs (Reisen and Soto, 2001). Meanwhile, the
financial sector also benefits from FDI by capturing overseas ventures, knowledge, and technological
diffusion, thus reflecting the nations’ ability to increase growth (Suliman and Elian, 2014).

Despite numerous studies concerning the nexus between FDI-Growth and Finance-Growth in one
country or a set of countries, there is little research that focuses on developing countries in Asia.
Among such studies are Choong (2012) in 95 developed and developing countries from 1983 to 2006
(GMM), Azman-Saini et al (2010) in 91 countries from 1975 to 2005 (threshold regression model),
Alfaro et al (2004) in both OECD and non OECD countries from 1975 to 1995 (OLS), Lee and Chang
(2009) in 37 countries from 1970 to 2002 (panel cointegration method), and Hermes and Lensink
(2003) in 67 countries from 1970 to 1975 (OLS). This study attempts to investigate the role of FDI
and financial development, and contend that a weak a financial system can restrict the positive effect
of potential FDI spillovers in economic performance in Asian developing countries.

1.2 Purpose of the study

This study aims to investigate whether FDI and financial development (measured by the banking
sector and stock market) influence economic performance in 23 Asian developing countries. The
study also tests whether the interactive relations between FDI and financial development affects
economic growth. As a result, we can argue that in conjunction with FDI, well developed financial
market exerts a vital influence in exploring advantage of FDI for a nation’s economy.

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1.3 Research objectives

1. To investigate whether there is causality between FDI and financial development in 23 Asian
developing countries.

2. To determine how the expansion of FDI fosters economic growth in 23 Asian developing
countries.

3. To determine whether financial development (measured by the banking sector and stock
market) has an impact on economic growth in 23 Asian developing countries. To answer this
objective, two sub-objectives will be examined:

3.1 To investigate how the expansion of the banking sector (measured by Domestic
credit to private sector and Commercial bank assets divided by commercial bank plus central
bank assets) improves growth rate of GDP of 23 Asian developing countries.

3.2 To investigate how the expansion of the stock market (measured by market
capitalization, stock market turnover, and stock market value traded) affects the growth rate of
GDP of 23 Asian developing countries.

4. To examine the interactive relations between FDI and financial development in the growth
rate of GDP of 23 Asian developing countries.

5. To identify which threshold level of financial development, and FDI will have a stronger
impact on the economic growth in 23 Asian developing countries.

1.4 Significance of the study

To the best of our knowledge, this is the first study to investigate the relationship between FDI,
financial development (measured by the banking sector and stock market sector) and economic
growth in Asian developing countries. While most previous research focuses on the role of FDI or
financial development separately, and several studies include FDI and financial institutions in the
economic growth nexus, but the financial sector were not assessed by two dimensions, including the
banking sector and market sector. This study attempts to examine the interaction of FDI and financial
development in economic performance of Asian developing countries.

2. Research Method

2.1 Research model

According to Otchere (2016), this study will test whether there is causality between the FDI and
Financial development based on the Granger Causality tests. If there is a bidirectional relationship
between them, then this stage also implies that FDI and FD should have potential endogeneity issue.
The equation is given as follows:

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 (1)

The null hypothesis is all coefficients equal to zero. If the null hypothesis is accepted, we can
conclude there is no causality. Otherwise, the process will continue with the homogeneous causality

test, and the null hypothesis is = . If the causality is heterogeneous (the null is rejected), then
there is at least one country having causality, or the structure of causality is not the same across
countries (Hood, 2008). In such case, two models have to be examined which will explain the
bidirectional nexus between them:

FDI = f(EGit, FDit , CONTROLSit ) (2)

FD = f(EGit, FDIit , CONTROLSit ) (3)

In the second stage, we will consider the role of FDI, financial development and their interactive term
in economic growth. According to Anwar and Nguyen (2011), and Das and Paul (2011), OLS seems
to be a weak model since the variables might be endogenous. The biased and inconsistent estimators
could exist in the OLS model. Therefore, GMM is suggested to address omitted variables biased, and
potential endogeneity problems. Similarly, recent studies use the GMM to test the economic
performance nexus (Choong, 2012; Anwar & Sun, 2011). This study will apply the GMM method to
investigate the impact of FDI and financial development on economic performance in 23 Asian
developing countries from 1996 to 2015. Apart from FDI and two channels of financial development,
including the banking sector and the stock market, the other determinants (control variables) such as
initial income, trading openness, inflation, government spending, exchange rate, human development,
population growth, nature resources, infrastructure, balance, gross domestic investment, learning by
doing, Asian financial crisis in 1997, global financial crisis in 2008, and six broad dimensions of
governance (measured by Worldwide Governance Indicators) are also taken into consideration.

The reduced form model is given as follows:

EGit = f (FDit , FDIit , FDit * FDIit , CONTROLSit ) (4)

Variable name Measurement Authors

Economic growth GDP per capital growth rate Law & Habibullahh, 2009; Cavenaile et al, 2014
(EG)
FDI + Foreign direct investment Kotrajaras et al, 2011; Li & Liu, 2005; Moudatsou
inflow over GDP; & Kyrkilis, 2011;
+ Foreign direct investment Otchere et al, 2016.
inflow over gross capital
formation.

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Financial development
(FD)
- The banking sector + Domestic credit to private Lee & Chang, 2009; Suliman & Elian, 2014;
sector by banks over GDP; Arestis et al, 2001; Beck et al, 2004.
(FD1)
+ Commercial bank assets Azman-Saini et al, 2010; Otchere et al, 2016.
divided by commercial bank
plus central bank assets.

- The stock market + Stock market capitalization Suliman, & Elian, 2014; Levine & Zervos, 1998.
sector (FD2) over GDP;
+ Stock market turnover over
Otchere et al, 2016.
GDP;
+ Stock market value traded
over GDP.

Interaction term
between FDI and FD
(FDI*FD)
Controlling variables
The initial income Log of initial level GDP per
capital
Government spending Government expenditure to
GDP
Trade openness Import plus export to GDP
Inflation Inflation, consumer prices
(annual %)
Exchange rate real exchange rate per USD
Human development Log of the initial level of the
secondary enrolment rate
Population growth Population growth rates
Nature resources The share of fuel and minerals
to total exports
Infrastructure Log of main phone lines per
1000 persons
Balance Current account balance to
GDP
Gross domestic Gross capital formation to GDP
investment
Learning by doing Annual manufacturing value
added to GDP
Dum 1997 Dummy for Asian financial
crisis in 1997
Dum 2008 Dummy for global financial
Alfaro et al, 2004; Choong & Lam, 2011; Adeniyi
et al, 2015.
Alfaro et al, 2004; Hermes and Lensink, 2003;
Azman-Saini et al, 2010.
Yanushevsky, 2013; Christie 2014.
Rajan & Zingales, 2003; Shahbaz, 2012.
Burdekin et al, 1994; Iqbal & Nawaz, 2009.
Kandil et al , 2007; Kamin & Roger, 2000.
Hermes and Lensink, 2003; Anwar, S and Sun, S.,
2011.
Alfaro et al, 2004; Azman-Saini et al, 2010.
Otchere et al, 2016.
Otchere et al, 2016.
Otchere et al, 2016
Alfaro et al, 2004; Otchere et al, 2016.
Anwar, S. and Nguyen, L.P., 2009
Anwar and Nguyen, 2009
Naude, 2009

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 crisis in 2008
Governance’s quality Six dimensions of governance
indicators between 1996 and 2015
Otchere et al, 2016; Kaufmann et al 2009.
- Voice and (Using the data from the Worldwide Governance
Accountability Indicators (WGI) research project. Can be
- Political Stability and downloaded from the website:
Absence of Violence http://info.worldbank.org/governance/wgi/
- Government index.aspx#doc)
Effectiveness
- Regulatory Quality
- Rule of Law
- Control of Corruption

The third stage will look at the presence of certain threshold level of financial system. In other words,
we will examine which threshold level of financial system and FDI will have the stronger effect on
economic growth. Following Azman-Saini et al (2010), we use equation (5) to examine threshold
level:

(5)

In this model, the FD plays as a threshold level (sample-splitting). The impact of FDI on economic

growth will be or based on whether the level of FD is smaller or larger than . There are two

other issues requiring some explanation. First, this study will estimate , and coefficient and ’s.

is the minimiser of sum of squared residuals, then and will be determined by the GMM
accordingly. Second, this study will test the significant of parameter (threshold level). Under the
null hypothesis of no threshold level ( ), via a model-based bootstrap of Hansen (2000), this purpose
will be examined.

2.2 Research data

This study will use the data collected from 23 Asian developing countries over the period from 1996
to 2015. The data will be sourced mainly from the websites of The World Bank, UK Data Services,
Asian Development Bank.

3. Time line and budget

3.1 Time line

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Research 2016 2017 2018 2019
activity
A S O N D J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J
Literature
review
Proposal
preparation
Proposal
presentation
Revised
literature
review
Revised
methodology
Data
collection
Data analysis
Results
interpretation
First draft
Second draft
Thesis
submission

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PHAM TIET HUY
3.2 Budget plan

No Cost Amount (NZ$)

1 Printing documents 1000

2 Editing expenses 500

3 Conference 4000

4 Thesis printing costs 500

Total 6000

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List of 23 Asian developing countries

Number Country Number Country

1 Bahrain 13 Oman
2 Bangladesh 14 Pakistan
3 China 15 Philippines
4 China HK 16 Qatar
5 India 17 Saudi Arabia
6 Iran 18 Sri Lanka
7 Jordan 19 Syria
8 Korea republic 20 Thailand
9 Kuwait 21 Turkey
10 Lebanon 22 United Arab Emirates
11 Malaysia 23 Vietnam
12 Myanmar

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