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					          Foreign Direct Investment and Economic Growth in Asia




                                    Dharmendra Dhakal
                            Department of Economics and Finance
                                 Tennessee State University
                                Nashville, TN 37203, U.S.A
                                 Telephone: (615) 963-7345
                                E-mail: ddhakal@tnstate.edu


                                        Saif Rahman
                                 Department of Economics
                                 Ohio Wesleyan University
                                Delaware, OH 43015. U.S.A
                                 Telephone: (740) 368-3549
                                E-mail: msrahman@owu.edu
                                           and
                                   Kamal P. Upadhyaya *
                               Department of Economics and Finance
                                  University of New Haven
                                   300 Boston Post Road
                               West Haven, CT 06516, U.S.A
                                 Telephone: (203) 932-7487
                             E-mail: Kupadhyaya@newhaven.edu


*
    Corresponding authors
                                        Abstract

The literature on foreign direct investment (FDI) and economic growth generally
points to a positive FDI-growth relationship. However, very few studies offer direct
tests of causality between the two variables. In theory, economic growth may induce
FDI inflow, and FDI may also stimulate economic growth. This paper adds to the
literature by analyzing the existence and nature of these causal relationships. The
present analysis focuses on South and Southeast Asia, where growth of FDI has been
the most pronounced. Using Granger causality tests, the paper finds substantial
variation in the FDI-growth relationship across countries. Further analyses, based on
regression techniques, reveal that FDI-to-growth causality is strengthened by the
presence of greater trade openness, more limited rule of law, lower receipts of aid, and
lower income level of the host country. Growth-to-FDI causality, on the other hand, is
reinforced by greater political rights and more limited rule of law.


Keywords: Foreign direct investment; economic growth; Granger causality

JEL Classification: F21, O17, O19




                                           2
         Foreign Direct Investment and Economic Growth in Asia

I. INTRODUCTION

   Over the past two decades, many countries around the world have experienced

substantial growth in their economies, with even faster growth in international

transactions, especially in the form of foreign direct investment (FDI). The share of net

FDI in world GDP has grown five-fold through the eighties and the nineties, making the

causes and consequences of FDI and economic growth a subject of ever-growing interest.

This paper attempts to make a contribution in this context, by analyzing the existence and

nature of causalities, if any, between FDI and economic growth. It uses as its focal point

the South and Southeast Asian region, where growth of economic activities and FDI has

been one of the most pronounced.

   The literature on FDI and economic growth generally points to a positive relationship

between the two variables, and offers several, standard explanations for it. In principle,

economic growth may induce FDI inflow when FDI is seeking consumer markets, or

when growth leads to greater economies of scale and, hence, increased cost efficiency.

On the other hand, FDI may affect economic growth, through its impact on capital stock,

technology transfer, skill acquisition, or market competition. FDI and growth may also

exhibit a negative relationship, particularly if the inflow of FDI leads to increased

monopolization of local industries, thus compromising efficiency and growth dynamics.

Empirically, the positive effect of economic growth on FDI and also the positive and

negative effects of FDI on economic growth have been identified in the literature.

However, very few studies attempt to directly test for causality between FDI and growth.

Two studies that do so include Basu, Chakraborty and Reagle (2003), and Trevino and


                                              1
Upadhyaya (2003). Both find that FDI-to-growth causality is more likely to exist in more

open economies. In addition, an earlier study by Ericsson and Irandoust (2000) explores

the causal relationship between FDI and total factor productivity growth in Norway and

Sweden, and finds the two to be causally related in the long run.

   This paper extends the line of work mentioned above, and provides a direct test of

causality between FDI and economic growth in one of the most dynamic regions of the

world: South and Southeast Asia. Using Granger causality tests, the analysis reveals

substantial variation in the FDI-growth causal relationship across countries, implying that

generalization of any causality between the two variables can be problematic. To better

understand the cross-country variation, the paper extends the analysis using regression

techniques, and identifies institutional variables that affect the FDI-growth relationship.

The importance of institutions to economic dynamics is now well recognized, and given

the widespread but varying institutional reforms across countries through the eighties and

the nineties, the inclusion of institutional factors is indispensable for the analysis at hand.

To identify their relevance to the FDI-growth relationship, separate from their direct

effects on FDI or growth alone, the analysis focuses on interaction effects involving the

explanatory variables. The results show that FDI-to-growth causality is reinforced by

greater trade openness, more limited rule of law, lower receipts of bilateral aid, and lower

income level in the host country. Growth-to-FDI causality, on the other hand, is

reinforced by greater political rights and more limited rule of law.

   The remainder of the paper is structured as follows. Section II discusses the

background literature on the determinants of and relationship between FDI and economic

growth. It also describes the sample used in the present analysis. Section III carries out




                                               2
the Granger causality tests and establishes the cross-country variation in FDI-growth

causality. Section IV extends the analysis using regression techniques and identifies the

economic and institutional factors that help to explain the cross-country variation in the

FDI-growth causal relationship. Finally, Section V concludes. Relevant tables, with

descriptive statistics and results of the analyses, are presented in the appendix.

II. FOREIGN DIRECT INVESTMENT AND ECONOMIC GROWTH

   Standard economic theory points to a direct, causal relationship between economic

growth and FDI that can run in either direction. On the one hand, FDI flows can be

induced by host country economic growth if the host country offers a sizeable consumer

market, in which case FDI serves as a substitute for commodity trade, or if growth leads

to greater economies of scale and cost efficiency in the host country. On the other hand,

FDI itself may contribute to host country economic growth, by augmenting the country‘s

capital stock, introducing complementary inputs, inducing technology transfer and skill

acquisition, or increasing competition in the local industry. Of course, FDI may also

inhibit competition and thus hamper growth, especially if the host country government

affords extra protection to foreign investors in the process of attracting their capital.

   Empirically, the positive effect of host country economic growth on FDI inflow has

been confirmed by various studies (see Veugelers, 1991; Barrell and Pain, 1996; Grosse

and Trevino, 1996; Taylor and Sarno, 1999; Trevino et al., 2002). The effects of FDI on

subsequent economic growth has been shown to be both positive (Dunning, 1993;

Borensztein et al., 1998; De Mello, 1999; Ericsson and Irandoust, 2000; Trevino and

Upadhyaya, 2003) and negative (Moran, 1998). Generally, the positive growth effects of

FDI have been more likely when FDI is drawn into competitive markets, whereas




                                               3
negative effects on growth have been more likely when FDI is drawn into heavily

protected industries (Encarnation and Wells, 1986). Overall, though, FDI turns out to be

associated with greater domestic investment, not smaller. Moreover, this positive

association between FDI and domestic investment tends to be greater than that between

foreign portfolio investment and domestic investment (Bosworth and Collins, 1999).

   Basu, Chakraborty and Reagle (2003) study a panel of 23 developing countries from

Asia, Africa, Europe and Latin America, and find the causal relationship between GDP

growth and FDI to run both ways in more open economies, and in only one direction—

from GDP growth to FDI—in more closed economies. Trevino and Upadhyaya (2003)

find a comparable result, based on their study of five developing countries in Asia, that

the positive impact of FDI on economic growth is greater in more open economies.

Whether other factors, especially institutional ones that directly affect FDI or economic

growth, also influence FDI-growth relationship remains an open question.

   Generally speaking, FDI decisions depend on a variety of characteristics of the host

economy, in addition to its market size. These include the general wage level, level of

education, institutional environment, tax laws, and overall macroeconomic and political

environment. The impact of host country wage level or education level on FDI depends

on the skill intensity of the particular production process in question and, hence, may

vary from case to case. The impact of institutional quality, physical infrastructure, import

tariffs, macroeconomic stability, and political stability on FDI inflow is usually positive

(see Wei, 1997; Mallampally and Sauvant, 1999; Trevino et al., 2002; Biswas, 2002),

whereas that of corporate taxes tends to be negative (see Wei, 1997; Gastanaga et al.,

1998; Hsiao, 2001). Turning to economic growth, the standard determinants include the




                                              4
rate of capital accumulation and variables that raise total factor productivity, such as

education level, institutional quality, macroeconomic stability, political environment,

and, potentially, trade openness. In studying the direct, causal relationship between FDI

and economic growth in this paper, we explore the relevance of some of these economic

and political economy variables just mentioned.

   Our study covers the FDI-growth relationship in nine countries: Bangladesh, India,

Korea, Malaysia, Pakistan, the Philippines, Singapore, Sri Lanka and Thailand. The

choice of this sample was driven by our attempt to include an economically diverse set of

countries in a region that has been characterized by relatively high rates of economic

growth and FDI over the past two decades. Collectively, the sample countries have

featured higher rates of foreign investments, foreign aid, and commodity trade relative to

their GDP than has the rest of world. They also experienced significantly greater growth

rates in GDP, foreign investments, and commodity trade, compared to the rest of the

world. Table 1 presents some of the key statistics with respect to resource flows and

commodity trade in the sample countries vis-à-vis the world economy. Table 2 presents

some data on cumulative growth rates of these flows.




                                              5
TABLE 1. RESOURCE FLOWS AND COMMODITY TRADE: 1980–2001 AVERAGE

Country / Group                             FDI        FPI        Aid               Trade
                                    (% of GDP) (% of GDP) (% of GDP)          (% of GDP)
Bangladesh                                0.105      0.001      5.100             26.366
India                                     0.255      0.380      0.669             20.081
Korea, Rep.                               0.552      0.998      0.026             68.461
Malaysia                                  4.316      1.378      0.387           152.059
Pakistan                                  0.606      0.362      2.490             35.495
Philippines                               1.230      0.928      1.623             69.850
Singapore                                10.038        n.a.     0.077           329.231
Sri Lanka                                 0.991      0.383      6.380             73.264
Thailand                                  1.898      0.734      0.801             75.885

Sample Countries                          2.232         0.688         1.950        82.037
Low & Middle Income Countries             1.437         0.230         1.121        42.199
High Income Countries                     1.118           n.a.        0.015        40.478
World                                     1.180           n.a.        0.244        41.514

Sources: World Development Indicators, Global Development Finance, and authors‘
calculations.
Notes: FDI refers to net inflows of foreign direct investment; FPI refers to foreign
portfolio investment. Aid measures the sum of official development assistance (ODA) and
net official aid flows.




                                          6
              TABLE 2. CUMULATIVE GROWTH RATES: 1980–2001

Country / Group          GDP      FDI     FDI     Aid      Aid Exports Imports   Trade
                                       (%GDP)          (%GDP)                  (%GDP)
Bangladesh                 155    2472    898       -8     -64    482     164      34
India                      144    3143   1218      -19     -67    419     302      83
Korea, Rep.                525   12225   1936     -172    -111    699     530      13
Malaysia                   231     129     -29     -48     -84    659     480     101
Pakistan                   116     419    140       15     -48    211      71       0
Philippines                111    4298   2370       84     -13    391     285     105
Singapore                  539     474      -9     -98    -100    n.a.    n.a.    n.a.
Sri Lanka                  262     234      -7     -26     -80    354     240       5
Thailand                   245    1896    477       59     -55    832     566     128

Sample Mean                259    2810     777     -24      -69      506      330       59
Low & Middle Income         99     972     297      90       -4      156      150       64
High Income                201    2087     500     -15      -72      242      241       16
World                      180    1783     442      85      -34      227      224       32

Source: Authors‘ calculations.
Notes: Growth rates reflect cumulative growth from 1980-82 average (in current dollars) to
1999-2001 average.




                                           7
   Evidently, not all countries in the sample have been highly open to foreign

investments or trade, and not all countries have experienced similar growth in GDP or in

international transactions. In terms of GDP growth, Bangladesh, India, Pakistan, and the

Philippines outperformed other low and middle-income countries collectively, but they

lagged behind the world average. As for FDI, Bangladesh, India, Pakistan, Sri Lanka,

and Korea tended to attract less investments compared with other countries. However,

over the years Bangladesh, India and Korea outpaced most other countries in terms of

FDI growth. As for trade, one finds lower-than-average openness (defined as the ratio of

total trade to GDP) in Bangladesh, India and Pakistan, with Pakistan also lagging behind

the rest of the world in terms of growth in trade.

   A casual look at the data does not reveal any clearly discernible pattern involving

GDP growth and FDI. However, it seems consistent with a positive correlation between

the two variables. As already discussed, causality, if any, can run in either direction, and

other variables may also complicate these direct, causal relationships. We now turn to

the empirical examination of these relationships for our sample countries.

III. GRANGER CAUSALITY

   In order to test for direct causality between FDI and economic growth, we perform a

Granger causality test using equations (1) and (2):

                       k                k
        GDPt     i GDPt i    i  FDIt i   t                     (1)
                      i 1             i 1


                       k                k
        FDI t       i GDPt i   i  FDIt i  t                    (2)
                      i 1             i 1


where GDPt and FDI t are stationary time series sequences,  and  are the respective

intercepts,  t and  t are white noise error terms, and k is the maximum lag length used



                                                8
in each time series. The optimum lag length is identified using Hsiao‘s (1981) sequential

procedure, which is based on Granger‘s definition of causality and Akaike‘s (1969, 1970)

                                                                   k
minimum final prediction error criterion. If in equation (1)   i is significantly different
                                                                  i 1


                                                                                 k
from zero, then we conclude that FDI Granger causes GDP. Separately, if  i in
                                                                               i 1


equation (2) is significantly different from zero, then we conclude that GDP Granger

causes FDI. Granger causality in both directions is, of course, a possibility.

   Since macroeconomic time-series data are usually non-stationary (Nelson and

Plosser, 1982) and thus conducive to spurious regression, we test for stationarity of the

data series before proceeding with the Granger causality test. We employ two separate

methods for the stationarity test. First, we conduct an augmented Dickey-Fuller test

(Nelson and Plosser, 1982) by carrying out a unit root test based on the structure in (3):

                                            n
        X t        t   i  X t i   i X t i   t               (3)
                                           i 1


where X is the variable under consideration,  is the first difference operator, t captures

any time trend,  t is a random error, and n is the maximum lag length. The optimal lag

length is identified so as to ensure that the error term is white noise. If we cannot reject

the null hypothesis   0 , then we conclude that the series under consideration has a unit

root and is therefore non-stationary. Second, in addition to the Dickey-Fuller test, we

perform the Phillips-Perron test (Phillips, 1987; Phillips-Perron, 1988), using a non-

parametric correction to deal with any correlation in error terms.

   The results of the stationarity tests are reported in Table 3. The unit root tests on the

levels of each variable reveal the corresponding series to be non-stationary for all



                                                    9
countries. Analogous tests on the first-difference measures of the variables, however,

reveal both series to be integrated in the first order and, hence, stationary at the first-

difference level. We therefore proceed with the Granger causality tests with equations

(1) and (2) using first-differences of the respective series.

    According to the test results, reported in Table 4, the existence and direction of

causalities between GDP growth and FDI have varied significantly across the countries in

our sample. In Bangladesh and Malaysia, no direct causal relationship between the two

variables seems to have existed during the given period. In South Korea, Singapore, Sri

Lanka, and Thailand, causality ran from growth to FDI, but not in the reverse direction.

In Pakistan, causality ran from FDI to growth, and not from growth to FDI. In India and

the Philippines, causality ran both from growth to FDI and from FDI to growth.

    It is thus evident that despite the above-average growth rates in both GDP and FDI in

the sample region, we cannot generalize any FDI-growth causal relationship for the

region. Growth seems to induce FDI in several, but not all, cases. Likewise, FDI seems

to induce growth in some, but not all, cases. Overall, the results indicate the presence of

some FDI-growth causality in seven of the nine countries, with the variation in the nature

of this relationship pointing to possible influence of other, institutional factors. We

explore these possibilities in the next section.




                                               10
                                  TABLE 3. UNIT ROOT TEST

                                    Augmented Dicky Fuller                        Philip-Perron
                                Level        First Diff.               Level             First Diff.
Bangladesh       FDI            -2.608       -3.572***                 -2.626            -4.595*
                 GDP            -1.069       -3.479***                 -0.544            -5.670*
India            FDI            -2.512       -3.330***                 -2.106            -3.295***
                 GDP            -2.988       -3.759**                  -2.539            -4.000**
Korea, Rep.      FDI            -2.892       -3.805**                  -2.777            -5.393*
                 GDP            -1.408       -3.877**                  -2.539            -4.648*
Malaysia         FDI            -1.835       -3.937**                  -2.768            -5.894*
                 GDP            -1.877       -3.344**                  -1.800            -4.515*
Pakistan         FDI            -2.691       -4.506*                   -3.019            -3.603**
                 GDP            -0.996       -4.261**                  -0.601            -7.650*
Philippines      FDI            -1.723       -3.998**                  -3.046            -6.831*
                 GDP            --2.912      -4.126**                  -1.871            -3.937**
Singapore        FDI            -2.434       -3.942**                  -2.615            -5.764*
                 GDP            -1.979       -3.736**                  -1.457            -3.920**
Sri Lanka        FDI            -2.255       -4.618*                   -2.698            -8.603*
                 GDP            -1.955       -3.051                    -2.076            -4.334**
Thailand         FDI            -1.591       -3.259***                 -1.709            -4.051**
                 GDP            -1.707       -3.770**                  -0.947            -3.753**

                   TABLE 4. GRANGER CAUSALITY TEST RESULT
                  FDI  GDP GDP  FDI      F statistic.  P value
Bangladesh            No                     0.1345       0.967
                                 No           0.619       0.657
India                 Yes                   2.497  ****
                                                          0.119
                                Yes         2.593****     0.117
Korea, Rep.           No                      0.233       0.915
                                Yes         2.477***      0.089
Malaysia              No                      1.512       0.245
                                 No           1.777       0.187
Pakistan              Yes                    3.953  **
                                                          0.039
                                 No           0.624       0.611
Philippines           Yes                   7.111***      0.069
                                Yes         4.437  ***
                                                          0.085
Singapore             No                      0.413       0.855
                                Yes         2.409  ***
                                                          0.098
Sri Lanka             No                      0.713       0.559
                                Yes         3.001  ***
                                                          0.060
Thailand              No                      0.024       0.976
                                Yes         2.814  ***
                                                          0.079
           *
            denotes significance at 99% confidence level; ** denotes significance at 95% confidence level
           ***
               denotes significance at 90% confidence level; **** denotes significance at 85% confidence
           level




                                                   11
IV. INSTITUTIONAL FACTORS AFFECTING THE FDI-GROWTH

   RELATIONSHIP

   Most studies investigating the causes of FDI or economic growth concentrate on

identifying factors that directly affect the variable under consideration. In this sense, the

analysis in the preceding section, which tests for a direct, causal relationship between

FDI and growth, is similar to existing studies. The key finding from the causality tests

here that is of particular significance is the cross-country variation in FDI-growth

causality. Some of this variation is likely due to cross-country differences in the

predominant type of FDI inflow, that is, the investor‘s motivation behind FDI, such as

access to host country consumer markets versus locating low-cost production areas.

Additional variation in the FDI-growth causal relationship likely arises from cross-

country differences in economic and institutional structures. Very few studies have

explored these host country influences. Examples include Basu et al. (2003) and Trevino

and Upadhyaya (2003), both of which find that the degree of trade openness of the host

country affects the extent to which growth and FDI affect each other. We extend this line

of work by considering a broader set of economic and institutional factors, and attempt to

better understand the variation in FDI-growth causalities observed within our sample.

   In Table 5, we divide our sample countries into four sub-groups, based on the

existence of causal relationships between FDI and growth as established in Section III,

and present a set of economic and institutional data for each sub-group. A glance at these

data, though cursory, is somewhat revealing. A causal link from FDI to economic growth

seems more likely to exist in countries that receive less FDI, are less open, have more




                                             12
limited transparency and rule of law, receive greater amounts of aid from the U.S., and

have lower income per capita. On the other hand, growth-to-FDI causality is more likely

in countries that have greater political rights and receive smaller amounts of bilateral aid

overall. Of course, this cursory glance misses valuable information contained in the

time-series variation within the panel data, and is therefore only suggestive. In order to

draw more accurate inferences from the given data, we use basic regression techniques

and look at the interaction effects associated with the FDI-growth relationship.

 TABLE 5. FDI, GDP, AND INSTITUTIONAL VARIABLES: GROUP AVERAGES

FDI  GDP                          0                  0               1                1
GDP  FDI                          0                  1               0                1
                                                   Korea,
Countries in Group              Bangladesh,      Singapore,      Pakistan           India,
                                 Malaysia        Sri Lanka,                      Philippines
                                                  Thailand
FDI (% of GDP)                      2.33            3.24            0.44             0.45
Growth in GDP-PC (%)                6.32            8.64            5.76             4.54
Open (% of Years)                   0.50            0.87            0.00             0.20
Corruption                          2.52            3.58            1.67             2.10
Rule of Law                         2.61            3.20            1.70             1.93
Political Rights Index              3.77            3.48            4.93             2.97
Bilateral Aid (% of GDP)            0.42            0.35            0.35             0.37
ODA-USA (mil 1985$)                  66              13              102              95
GDP-PC (PPP$)                       2391            5073            1133            2064
Sources: Alesina and Dollar (2000), World Bank (2003), and authors‘ calculations.
Notes: ‗0‘ for FDI  GDP or GDP  FDI denotes the absence of the corresponding
granger causality.
         ‗1‘ for FDI  GDP or GDP  FDI denotes the presence of the corresponding
granger causality.
           GDP-PC refers to per capita GDP, measured at purchasing power parity exchange
rates.
          Political rights index is based on Freedom House reports, with lower values
reflecting more freedom.


   Since FDI typically involves longer-term considerations, we divide the time-series

data from 1980 through 1999 into sub-periods of five years each, and regress the


                                             13
dependent variable on lagged independent variables. The explanatory variables in the

growth model include FDI, trade openness, rule of law, political rights, overall bilateral

aid, bilateral aid from the U.S., and per capital GDP. Additional terms include quadratic

terms for FDI and per capita GDP, and interaction terms involving FDI. The FDI model

includes as explanatory variables per capita GDP growth, trade openness, rule of law,

political rights, overall bilateral aid, and bilateral aid from the U.S. Additional terms

include the interaction effects involving economic growth. The results from the growth

model are presented in Table 6, and those from the FDI model are presented in Table 7.

   For the sample as a whole, the effect of FDI on subsequent economic growth is not

statistically significant (Table 6), whereas the effect of growth on subsequent FDI inflow

is positive and significant (Table 7). It is worth noting, though, that inclusion of country

dummies in the growth model (not reported in the paper) reveals the growth effect of FDI

to be positive, diminishing, and statistically significant. More central to our analysis here

are the interaction effects in the two models. In this context, the growth model reveals

that the effect of FDI on economic growth is more positive in countries characterized by

greater trade openness, more limited rule of law, lower receipts of bilateral aid, and

lower income level. The positive effect of openness on FDI-to-growth causality is

consistent with the findings by Basu et al. (2003) and Trevino and Upadhyaya (2003),

and likely reflects the importance of an open, competitive economic environment

required for productive investment. The negative interaction effect of the rule of law, in

our interpretation, is suggestive of a beneficial role of FDI within an institutional

environment that otherwise constrains the efficiency of investments.




                                             14
TABLE 6. ESTIMATING PER CAPITA GDP GROWTH: FDI AND INTERACTION
                            EFFECTS

 Dependent variable                              GDP-PC Growth
 R-Squared (%)                                       93.0
 Adjusted R-Squared (%)                              78.9
 Constant                                         1131.5****
                                                   (292.5)
 Trade Openness t-1                                  0.1167
                                                     (0.1205)
 Rule of Law t-1                                      4.654***
                                                     (1.749)
 Political Rights (PR) Index t-1                      1.2038
                                                     (0.8593)
 Bilateral Aid t-1                                   13.197**
                                                     (6.503)
 U.S. Aid t-1                                        0.03565*
                                                     (0.02158)
 GDP-PC t-1                                           0.004333
                                                     (0.002920)
 (GDP-PC t-1)2                                       0.44 E-06*
                                                     (0.25 E-06)

 FDI t-1                                               9.738
                                                      (9.353)
 (FDI t-1)2                                           0.7423
                                                      (0.6978)
 Trade Openness t-1  FDI t-1                          0.14579***
                                                      (0.06380)
 Rule of Law t-1  FDI t-1                            3.151**
                                                      (1.684)
 PR Index t-1  FDI t-1                               0.886
                                                      (1.348)
 Bilateral Aid t-1  FDI t-1                         13.505**
                                                      (6.147)
 U.S. Aid t-1  FDI t-1                                0.01807
                                                      (0.02994)
 GDP-PC t-1  FDI t-1                                 0.0018319***
                                                      (0.0007693)

 Year                                                   0.5738****
                                                        (0.1469)
 Notes:      Standard errors are in parentheses below the estimates.
        ****
             denotes significance at 99% confidence level, ***denotes significance at 95%
        confidence level, **denotes significance at 90% confidence level, and *denotes
        significance at 85% confidence level


                                          15
TABLE 7. ESTIMATING FDI: PER CAPITA GDP GROWTH AND INTERACTION
                              EFFECTS

 Dependent variable                                    FDI
 R-Squared (%)                                        93.5
 Adjusted R-Squared (%)                               85.8
 Constant                                         – 354.9***
                                                   (135.6)
 Trade Openness t-1                                    0.04079
                                                      (0.05447)
 Rule of Law t-1                                       2.863**
                                                      (1.472)
 Political Rights (PR) Index t-1                       1.960*
                                                      (1.162)
 Bilateral Aid t-1                                   – 8.596
                                                      (8.850)
 U.S. Aid t-1                                          0.04373
                                                      (0.03266)

 GDP-PC Growth t-1                                     1.5981**
                                                      (0.8786)
 Trade Openness t-1  GDP-PC Growth t-1              – 0.000246
                                                      (0.006869)
 Rule of Law t-1  GDP-PC Growth t-1                  0.3041*
                                                      (0.1898)
 PR Index t-1  GDP-PC Growth t-1                     0.2712*
                                                      (0.1671)
 Bilateral Aid t-1  GDP-PC Growth t-1                 1.336
                                                      (1.271)
 U.S. Aid t-1  GDP-PC Growth t-1                     0.005635
                                                      (0.004698)
 GDP-PC t-1  GDP-PC Growth t-1                       0.3003 E-04
                                                      (0.2286 E-04)

 Year                                                    0.17151***
                                                        (0.06619)
 Notes:      Standard errors are in parentheses below the estimates.
        ****
             denotes significance at 99% confidence level,***denotes significance at 95%
        confidence level, **denotes significance at 90% confidence level, and
        *
         denotes significance at 85% confidence level




                                          16
It is plausible that due to structural reasons foreign investment has a greater degree of

immunity to domestic corruption and institutional weaknesses than does domestic

investment, and consequently the marginal productivity of foreign capital is relatively

higher in an environment with weaker legal infrastructure. In this sense, FDI and

domestic rule of law exhibit some substitutability in generating domestic economic

growth. Finally, note that the negative interaction effects associated with bilateral aid

receipts and income level are consistent with diminishing returns to resources.

   Turning to the FDI model, the positive and significant effect of economic growth on

subsequent FDI inflow is found to be greater in the presence of greater political rights

(lower PR index) and more limited rule of law in the host country. Note, however, that

the direct effect of political rights on FDI inflows is negative, and that of domestic rule of

law is positive. This suggests that in the sample region FDI as a whole has been more

likely in the presence of more authoritarian regimes, perhaps reflecting greater stability,

whereas market-seeking FDI, which is induced by growth, prefers political competition

in the host country. Similarly, well-functioning institutions and legal systems attract FDI

overall, but in the presence of institutional weakness, the pull effect of economic growth

on FDI inflow tends to be greater. Weak institutions and economic growth thus exhibit

some substitutability in inducing FDI, and it may be that institutional weakness is more

harmful to domestic investment than it is to foreign investment and, consequently, growth

induces greater FDI when domestic institutions are weak.

V. CONCLUSION

   We analyze in this paper the causal relationship between economic growth and

increased FDI in nine Asian countries. Using Granger causality test, we find evidence of




                                             17
FDI-to-growth causality in three of the nine countries, and growth-to-FDI causality in six

countries. Two of the countries showed causality in both directions, while two showed

no causality at all. This variation in the FDI-growth relationship indicates that causality

between the two variables cannot be generalized and must be considered more carefully.

   We extend our investigation of FDI-growth causality using regression techniques, and

identify institutional variables that may help to explain the cross-country variation. The

results show that FDI-to-growth causality is reinforced by greater trade openness, more

limited rule of law, lower receipts of bilateral aid, and lower income level in the host

country. Growth-to-FDI causality, on the other hand, is reinforced by greater political

rights and more limited rule of law.

   Our findings are revealing of the substantial cross-country variation in FDI-growth

causality as well as some of the economic and institutional causes of such variation.

Given the rapid growth of both FDI and GDP around the world, and specifically in South

and Southeast Asia, these findings should be of significant interest to both scholars and

policymakers in the arena of international development. Of course, the present findings

are region-specific, and further work is needed to establish whether we may generalize

the results for the global economy.




                                             18
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Description: Rapid population growth has long been recognized as one of most binding constraints to alleviating poverty in Bangladesh. It took six decades for the population to almost double from 29 million in 1901 to 53 million in 1961. But it required only 26 years to double again to 106 million by 1987, as a result of high fertility and falling mortality rates.