Determinants of Foreign DirectInvestment in SAARC Countries Chapter 1 INTRODUCTION:Background of the Study: Foreign direct investment is an important source ofinsertion of foreign capital.
It refers as direct investment by a country orentity into another country by buying a company in a country or by intensifyingoperations of business in a country. Foreign direct investment is defined as along-term investment by a foreign investor in an enterprise resident in aneconomy other than that in which the foreign investor is based. It is generallyacknowledged that foreign direct investment produces economic benefits to therecipient countries by providing capital, foreign exchange, technology,competition and by enhancing access to foreign markets (Crespo and Fontoura,2007). There are various definitions of investment. It is a buying of an assetwith the intention of making profit from it in future. It can also define as aproduction of new capital goods, plants and equipment’s.
Investment is anacquired tool to produce and sell product. Real investment and financialinvestment are the two main types of investment. Real investment is an increaseof productive capacity of economy in the form of more stock of plants andequipment whereas financial investment is the investment made by investor thatdoes not increase the productivity of economy for instance purchase of bondsand stocks of existing companies. One of the major types of investment is aforeign private investment that is investment by the private entity in foreigncountry. There are two categories of foreign private investment these areforeign direct investment and foreign portfolio investment. Foreign portfolioinvestment is purchasing of inactive bonds, stocks and other financialinstruments that does not involve in the active management of these securitiesthat are issued by investors and foreign direct investment is transmitting information and other countrieseconomy. It is investment that comes from foreigncountries.
Foreign direct investment can be the outside FDI or can be inward FDI. OutwardFDI it is direct investment in abroad and inward FDI is direct investment thatcomes from abroad.This research study will beconduct to investigating the determinants of FDI in SAARC countriesi.
e. Bangladesh,India, Pakistan and Sari Lanka, investigating different factors that drive theFDI into these countries for the period of 1990 to 2014. Problem Statement: It has been recorded that in the SAARC countries FDI isminimum in the earlier stages but after the time period of 2005, increase inthe FDI for the SAARC countries is recorded (Awan et al: 2011). This researchtries to investigate the factors which motivate the foreign investors for theinvestment in the SAARC countries. Understanding the true factors that willaffect the FDI flows towards different SAARC countries is always a challenge.
This study investigates the factors that cause the FDI inflows and its positiveor negative impact on FDI. In order to increase the future amount on investmentin SAARC countries by foreign countries, we should explore measure like foreignexchange rate, inflation, market size, interest rate and trade openness. Theories and Theorization: From early 1980’s the policy makers’ start working onmarket based trade and industry reform policies. Through these policies, thegovernments gradually shifting their focus on trade and monetary incentives, toattract the foreign countries investors to invest in host countries. Theseincentives are tax allowances, credit facilities, and tariff cutback (Khan& Nawaz 2010). In the 1990s, thegovernments took further steps by relaxing the policy and opened different newopportunities for FDI like agriculture, telecommunications, energy andinsurance.
Unstable political environment and irregularity in policies are oneof the main reasons of the low level of FDI in SAARC countries as compared toother developing countries. However, the reform period of 90’s shows aremarkable progress for FDI inflows (Aqeel and Nishat, 2005). There aremany theoriesbased on foreign direct investment.
Some of the theories are based on imperfectcapital market other are based on non-economic factors. Following are the theorieson FDI.InternationalizationTheory, Heckscher and Ohlin Theory, Production Cycle Theory of Vernon, NewTrade Theory and Electic Paradigm.This should be discussing further Objective of Study: The Following are the objectivesof this study.
1. To investigate determinates of FDI that areresponsible for fall and rise of FDI in SAARC countries.2.
This studyhelp to reveal the importance of interest rate, exchange rate, CPI (inflation),trade openness and GDP besides of other determinants in attracting FDI.3. The basicidea behind the model proposed in this research is to give some stylized factsabout the pattern of FDI.4. This study help different economies to develop planfor the betterment of FDI in selected countries and that impact on worldwidetrade and as well as for the economics growth of selected countries in the near future. Organization of Study: The whole research is composed of four chapters, chapter(1) introduce the topic and then explain the objective and significance of thestudy chapter (2) review the literature and build up the hypothesis andarguments for the study, chapter (3) will be based on the analysis and estimatethe variables through regression models and the chapter (4) will conclude andsummaries’ the results.CHAPTER 2LITRATURE REVIEWThe level of FDI in a host country is influenced by a numerous factors.
Anumber of studies have identified the determinants of inbound FDI with respectto different countries. In the following discussion, a brief review of theliterature relevant to the variables of interest included in this study isgiven. The presence of a lot of vast literature on FDI provides arguments thatwith the rise in globalization increase the importance of FDI in economicgrowth and development Tintin (2013) but such investment slows high level ofdependency on the host country political and socio-economic condition.The available literature on FDI, may be divided into two broad groups, inone group researchers have studied the impact of FDI on economic growth, thathow FDI influence the growth of host country, second the determinants of FDIwere identified. Both of the groups are explained here.
Impact of FDI on Economic Growth: The impact of FDI on economic growth was studied by Liand Liu (2005) and found that the FDI plays a great role in enhancing theeconomic growth. They found positive and significant relationship of FDI andhuman capital. The same study was put forward by the De Meelo (1999) and foundthe positive relationship of FDI and economic growth both in developing anddeveloped countries.
The causality relationship of FDI and economic growth wasstudied by Javorcik (2004). with the inclusion of other variables like politicalstability, exchange rate and unemployment to study the impact on FDI.Borensztein et al.
(1998) conducted a research in 69 developing countries for the period of 20years and found that FDI is very important tool for the economic growth and forbringing technology in host country. They further elaborate that we areexpecting more FDI if the home country has more human capital available in thecountry. They also argue that economic growth is only possible when the hostcountry has the availability of advance technologies.Herman and Lensink (2003) concluded a research in LatinAmerica and Asia and found that financial development is very important for theFDI to have impact on economic growth of the receipt country. They tested 67financially developed countries in which they found that 37 well financialdeveloped countries have improved impact of FDI on economic growth. Ayanwaleand Adeolu (2007) conducted a research in Nigeria on FDI and economic growthfor the period of 1970-2002.
The data were collected from central bank ofNigeria, IMF and federal office of statistics using. Using OLS for theestimation of data, they found that FDI has positive impact on economic growthof Nigeria. They argue that the communication sector and oil sector have morepotential to grow the economy where as manufacturing sector has negative impacton economic growth because there is lack of skilled labor in Nigeria. Theyemphasized that the government needs to improve skill labor in order tocontribute in the economic growth of the country. Determinants of FDI: In the second group, the different determinants of FDIwere investigated. The initial research suggested the investor companies selectthe low cost, high labour force and developing countries were selected for theinvestment but after that the research of Mundell (1957) makes a struggle toexplain that different factors like trade barriers, rich and poor countries atcapital base and geographical distribution of investment suggest that the lowlevel countries at base of GDP, wage etc are not only the targeted countries.With time to time the researchers have identified different variables thatmotivate and influence the investors to invest in the host country.
Suchvariables are market size, economic stability, labour market, geographical andcultural indicators.The research of Alam and Shah (2013) identify the influencing role of market role, quality ofinfrastructure and labour cost on FDI by conducting a research in OECDcountries. A research study was conducted by Villeverate and Maza (2012) inSpanish economy for the period of 10 years. They use different variables intheir study but dramatically they found the negative relation of Market sizewith the FDI, which is one of the main positive influencing determinants of FDIin all most all countries. This study provides the argument that all thedeterminants do not show the same results in all countries and also for not allthe time.The Nigerian economy for the period of 1970 to 2009 was investigated byGabriel (2012) and found that for the economic development FDI is one of themost important catalysts. They concluded that FDI has not only a role ineconomic development but also has great impact on the technologicaldevelopment, transferring taste and infrastructural development.
It wasinvestigated that FDI has a great role in different countries and that’s whymost of the researchers study the determinants of FDI in different countriesand suggest that the determinants of FDI in all countries are not remain thesame. That is this research selects SAARC countries for the determinants of FDIForeign Direct Investment (FDI)Foreign direct investment is an important source of insertion of foreigncapital. It refers as direct investment by a country or entity into anothercountry by buying a company in a country or by intensifying operations ofbusiness in a country.Exchange Rate:Exchange rate is measured as determinant of FDI and different researchersgave their results. Researchers said that currency devaluation in a countryresults in decreasing the production cost in that country.
Because when it willbe measured in foreign currency it will result in increased inflow of FDI,which may cause foreign investors wealth to grow (Froot and Stein, 1998 &Klein and Rosenger, 1994).H1: Increasein Exchange Rate Increase FDI of the host country. CPI (Inflation):The economic stability is measured with inflation by Vijayakumar andSridharam (2010) and found that it seems to be insignificant determinant of FDIinflows in BRICS countries. While the other determinants used by them showsignificant relation like trade openness. When the inflation rate increases itresults in instability in the economy of the country. Supported by Nonnenburgand Mendonca (2004) that when inflation is taken as proxy for level of economicstability, than its sign on both policies of country will result inuncontrolled inflation.H2: Increasein Inflation decrease the FDI of the Host Country.Interest Rate:Bibi et al (2014) found negative relation between FDI and inflation byapplying Co-integraiton and DOLS (Dynamic Ordinary Least Square) times seriesdata for the period 1980 to 2011 that has been supported by New trade theorywhich state that companies who are the early entrant in the market becomes aleading companies due to the advantage of economies of scale.
As FDI inflows increasesmarket size also increase that leads to more industries in host countries whichresults in more production that help in achieving economies of scale.H3: Increasein Interest Rate increase the FDI of the Host Country. Trade Openness:Charkrabarati (2001) carried out research on thedeterminant of FDI and did sensitivity analysis of cross country regressions hefound trade openness is one of the determinants of FDI which is a measured asexports plus import. As due to globalization markets are expanding and moreinvestments are made in trading countries trade openness is very important.
H4: Increasein Trade Openness increase the FDI of Host Country. Market size (GDP):Artige and Nicolini (2006) explored market size that hasbeen measured by GDP is a fundamental determinant of FDI by carried outdescriptive research on “Evidence on the Determinants of Foreign DirectInvestment: The Case of European countries. Jordaan (2006) did research inuniversity of Pretoria on 16 developing countries over the period of 19 yearsand found that FDI is an investment made by foreign countries. It expandmarketplace increase the market size and boost the purchasing power of peoplefrom which firms can gain higher return and in turn increase profitabilityleads to economic development.H5: Increasein Market Size increase the FDI of the Host Country.CHAPTER 3: RESEARCHMETHODOLOGY Methodology: The study investigates the factors which affect FDIcrosswise four SAARC countries- Bangladesh, India, Pakistan and Sri Lanka.
Thetime period has been selected from 1990 to 2014. In the beginning of early1990’s the SARC countries has shown remarkable increase in FDI. The selectedvariables are Inflation rate (CPI), Gross Domestic Product (GDP), exchange rate(ER), foreign direct investment (FDI), interest rate (IR) and trade openness(TO). The time period, countries and variables were selected keeping in mindthe availability of data. Forselection of these variables one of the motives is that these variables werenot studied collectively, furthermore Variable Proxy Foreign Direct Investment Net Inflow to percent of GDP Inflation Consumer Price Index 2005=100 Gross Domestic Product GDP(current US $) Exchange Rate Real Effective Exchange Rate 2005=100 Interest Rate Real Interest Rate in Percentage Trade Openness Exports plus Imports to the percent of GDP Table 1 Variables and Proxies each variable has been studied by different researcher across differentcountries as the Puah et al (2007) studiedthe inflation in OECD countries, Gabriel (2012), Jha et al. (2013), Cuyvers et at.
(2011) and Alam and Shah (2013) selected the exchange rate is explanatoryvariable. The Cuyvers et al. (2011)and Jha et al. (2013) studiedinterest rate as explanatory variable. Trade openness was studied by theCuyvers et al.
(2011) and Jha et al. (2013) and Alam and Shah (2013).The data was collected from world developmentindicators of World Banks website and UNCTAD. Yearly based data was collectedfor the research period of 1990 to 2014