Microsoft Word - 8185-29584-1-SM-writer2-new-final Asian Journal of Finance & Accounting ISSN 1946-052X 2015, Vol. 7, No. 2 93 Foreign Direct Investments and Economic Growth: The Primary Drivers Peter Nderitu GITHAIGA School of Business and Economics, Department of Accounting and Finance Moi University, Eldoret, Kenya Tel: 254-722-350-383 E-mail: nderitugithaiga@mu.ac.ke Josiah Nyauncho School of Business and Economics, Department of Accounting and Finance Moi University, Eldoret, Kenya Charles Githinji KABIRU Finance Department, Moi University, Eldoret, Kenya Received: August 21, 2015 Accepted: Sep. 23, 2015 Published: December 1, 2015 doi:10.5296/ajfa.v7i2.8185 URL: http://dx.doi.org/10.5296/ajfa.v7i2.8185 Abstract In order to achieve the Global Millennium Development Goals (MDGs) there is need for enhanced global partnerships in areas such as trade, health, security, environmental sustainability, food security and education. Owing to these initiatives Foreign Direct Investments (FDIs), Official Foreign Development Assistance (ODAs) and other external capital flows are increasingly considered as drivers of economic growth for developing countries. By year 2000 FDIs flow to developing countries accounted for 19% of the total global FDI flow compared to 52% in 2010. Collectively FDI equates to 11% of global GDP and generates close to 80 million jobs globally. Global FDI totaled to US$ 1.2 trillion in 2010, US$ 1.4 trillion in 2011 and US$ 1.8 trillion in 2012. Similarly, the developing countries received half of the FDI and only invested a quarter of the FDI out flow. Studies show that FDIs contributes to economic growth by stimulating several macro-economic and demographic variables which are major agents of economic growth. This paper sought to explain the effect of FDI on the determinants of economic growth human capital Asian Journal of Finance & Accounting ISSN 1946-052X 2015, Vol. 7, No. 2 94 development, financial sector development and trade openness. A sample of 30 African countries was used for the study. The data used was retrieved from UNCTAD and World Bank online databases for the period between 1980 and 2012 and analyzed through a fixed effect regression model. The results of the study show that FDI had a positive impact on measures of financial sector development and trade openness. However the effect of FDI on human capital development was negative. The study recommends the need for favorable monetary policies that elicit more FDI for enhanced economic growth. The study also suggests increased global trade liberalization and integration to boost trade. Finally the study recommends that additional FDI flows should be directed towards human capital development. Keywords: FDI, Economic Growth, Human Capital Development, Financial Sector Development, Trade Openness JEL Classification: F23, F36, F43, O40 Asian Journal of Finance & Accounting ISSN 1946-052X 2015, Vol. 7, No. 2 95 1. Introduction The global urge to achieve the Millennium Development Goals (MDGs) by 2015 has led to enhanced and integrated transnational partnerships in trade, health, education and security. These partnerships are demonstrated by the increased flow of FDIs, Official Development Assistance (ODAs) and other foreign capital flows to developing countries. This is true for Africa which in the last five decades received a smaller portion of FDI inflows compared to developed countries (Asiedu, 2003). Today there is unprecedented increase in the volume of FDIs flowing to Africa. For instance in year 2000 FDIs received by developing countries was estimated at 19% of total global FDIs compared to 52% in 2010. FDIs accounts for 11% of global GDP and creates close to 80 million jobs globally (UNCTAD 2010). Global FDI totaled to US$ 1.2 trillion in 2010, US$ 1.4 2011 and US$ 1.8 in 2012 notably the developing countries received half of the FDI and invested only a quarter of the FDI out flow (UNCTAD 2012).It should also be noted that foreign direct investment have potentially desirable elements that affect the quality of growth which in the long run effect on poverty reduction, diffusion of technology, capital and managerial transfer and human capital accumulation. FDIs also absorb adverse shocks emanating from inefficiencies in the financial systems that adversely affect the poor population. Besides FDIs support corporate governance through the creation of sound institutional frameworks. Studies show that revenue generated from FDI support the development of safety nets for the underprivileged (Klein, Aaron and Hadji Michael, 2001). Owing to the importance of FDI on economic growth, studies are focusing on the determinants of FDI in developing countries identify supportive infrastructures, technical and managerial skills, macroeconomic stability and sound institutions as the key pull factors of FDI. With globalization interconnectivity ICT has been documented in empirical work (Addison and Heshmati, 2003). Other determinants include lower borrowing costs, economic reforms, and commitments to macro-economic discipline Dabla-Norris et al (2010). FDI and other foreign capital flows such as remittances remain significant external sources of finance for developing countries are face serious credit constraints. Another branch of studies concentrate on the impact of FDIs on the recipient countries economic growth (Alfaro and Chanda 2006,) and technological advancement through a spillover effect associated with transnational interaction. Important to note today is a growing relationship between China and African countries in areas such as trade and infrastructural development as noted by Judith (2006). 2. Theory and Hypothesis Development The impact of FDIs and other foreign capital flows on human capital development, technology transfer and economic growth (through the spillover effect) is extensively debated in literature. Theories in economics claim that an efficient financial sector, political stability and human capital development are the key drivers of a sound and sustainable economic growth. The effect of FDIs on economic growth can be analyzed as either direct or indirect. The direct effect is exhibited by infrastructural development, new businesses, job creation and portfolio investments. Indirectly, FDI leads to improved technical knowhow, transfer of managerial practices and concepts and technology spillovers. FDIs also contributes to capital accumulation through initiating domestic demand and consumption of goods and services Asian Journal of Finance & Accounting ISSN 1946-052X 2015, Vol. 7, No. 2 96 (Feenstra and Markusen, 1994). Studies by De Mello (1997 and 1999) show that FDIs contributes to new job opportunities, enhancement of technology transfer, and boosts overall economic growth in recipient countries. FDI are classified FDIs as either horizontal or vertical Beugelsdijk et al. (2008). The two types of FDIs have different impacts and these differences arise from the type of FDI and the characteristics of the receiving countries. These country characteristics include economic, political institutions and other factors which determine a country’s affinity for FDIs. For instance, developed countries enjoy solid institutional framework which make horizontal FDIs have a higher impact on economic growth than vertical FDIs. Vertical FDIs stimulate demand for labour. There is vast literature on the FDI – human capital – economic growth triangle. The impact of FDI solely depends on a country’s capacity to absorb the embodied technologies. This absorptive capacity depends on the level of human capital development. They estimate that 0.45 years of secondary school education is necessary to benefit from an infusion of foreign technology. The impact of FDIs on human capital development is explained by Lucas and Romer endogenous growth model. Endogenous Growth Model argue that endogenously accumulated human capital has a direct impact on productivity of labour since human capital development is specific to individuals thereby leaving innovation as a stock of knowledge as an exogenous factor. Human capital development is vital for long term growth owing to its direct input into scientific knowledge (Romer, 1990; Aghion and Howitt, 1992) or due to its positive externalities. Lucas (1988) notes that growth differentials among countries originate from transnational variations in human capital development. The key constituents of human capital development are education and health care. Foreign Direct Investment is classified based on the motive behind such foreign capital flows; natural resources FDIs (access to natural resources), market seeking FDIs (increase market share), efficiencies seeking FDIs (reduction of production cost) and Strategic Asset Seeking FDIs (technological transfers) USAID (2005). Notably FDIs and other foreign capital flows remain important sources of capital for developing and emerging economies thereby prompting academicians, development agencies and governments’ agencies to carry out numerous studies focusing on the key drivers of FDIs. Most of these studies are aimed at policy issues that create an enabling economic climate for FDIs to flourish and have a greater macro-economic impact. Some studies argue that real GDP, inflation and political stability as the primary determinants of FDI. Other determinants of FDI include; macro-economic conditions of the recipient country Blonigen (2005); push factor in the source country and pull factor in the recipient country (Fernandez–Arias, Eduordo, 1996); GDP and bi-directional causality, Chowdhury and Mavrotas( 2006) whose findings are premised on economic soundness as a precondition for external capital inflows and vice versa; Trade protection, exchange rates, taxes and institutions (Blonigen 2005); financial markets development (Alfaro et al, 2003); skilled labour (Waldkrich 2010); Superior plant and management expertise (Miyamoto 2003); financial sophistication (Adeniyi et al 2012). Several theories have attempted to explain the magnitude and direction of FDIs and other foreign capital transfers. Asian Journal of Finance & Accounting ISSN 1946-052X 2015, Vol. 7, No. 2 97 Production Cycle Theory (Vernon 1966) maintains that a production cycle has four stages: innovation, growth, maturity and decline. According to the theory, a product was created for developed and high income markets and as the market matures competition and imitation begins the product is standardized and this pushes the product to lower income markets in developing countries. Subsequently, FDI will flow alongside the product life cycle. Another theory is “The Theory of Exchange Rates on Imperfect Capital Markets” by Itagaki (1981) and Cushman (1985). This theory identifies exchange rate uncertainty as the determinant of FDI. Cushman found that an appreciation in real exchange rate spurred FDI made by US$ while an appreciation in foreign currency reduced American FDI (Denisia 2010). Based on the theory of exchange rates speculative behaviour on exchange rates therefore determines the magnitude and the direction of FDIs. The Internalization Theory by Buckley and Casson, (1976) modified by Hennart (1982) later revised by Casson, (1983) postulate that multinational corporations capitalize on their own internal capabilities accordingly will organize their internal processes in a manner that maximize specific foreign advantages in production and distribution. Multinational Corporation enjoys certain economies through direct foreign investment compared to other entry strategies to foreign markets. Hyme (1976) found that FDI is a firm-level strategy decision rather than a capital-market financial decision. “The Eclectic Paradigm” theory by Dunning (1988) merges both industrial economics and international trade to explain the existence, activities and strategies of MNEs. The Electric Paradigm theory identifies three sources of competitive advantage which prompts the establishment of MNCs; Ownership advantage, geographical advantage and internalization advantage. Lastly is the “Transaction Cost” theory developed by Coase (1937) that suggest that cost discovering relevant to prices and cost of certainty, if high enough in market place, justifies firms’ decisions to coordinate economic activities locally and globally. Since many studies have focused on the effect of FDI on economic growth; this study will shift its focus by looking at the effect of FDIs on the key determinants of economic growth. The concept of economic growth is multifaceted and it’s the output of the interaction of a number of variables. Some of the determinants of economic growth are; inflation, trade openness, and current account balance Tolo (2011); demography, education, economic openness, institutions and trade policy Bhalla (2012); rule of law and international, openness, human capital (Barro 2003); human capital and foreign direct investment and stock market liquidity (Salahuddin 2010); terms of trade, improvements on the quality of capital, and the presence of distortions; human and physical capital accumulation Chumacero and Fuentes (2003). The impact of FDI on economic growth is dependent on the casual relationship between remittances and the drivers of economic growth. This paper therefore sought to explain the effects of FDIs on the primary drivers of economic growth namely; Human Capital Development (HCD), Trade Openness (TO), and Financial Sector Development (FSD). These drivers are also considered as pull factors of FDIs and other foreign capital flows. For example on human capital development, a report by UNCTAD (1994:218) note MNCs’ “demand for highly trained graduates manifests itself in the form of financial support, particularly to business schools and science facilities, the provision of assistance and advice through membership of advisory boards, curriculum review committees, councils and senates” Asian Journal of Finance & Accounting ISSN 1946-052X 2015, Vol. 7, No. 2 98 The study had three hypotheses as shown below: H01 Foreign Direct Investment has a positive and statistically significant effect on Financial Sector Development H02 Foreign Direct Investment has a positive and statistically significant effect on Human Capital Development H03 Foreign Direct Investment has a positive and statistically significant effect on Trade Openness 2.2 Conceptual framework The diagram below illustrates the conceptual framework of the research. In the diagram Foreign Direct Investment is the independent variable while the three primary drivers of economic growth are considered as the dependent variables. Independent Variable Dependent Variable Figure 1. Conceptual framework 3. Research Methodology The study used a sample of 30 countries and their data for the period between 1980 and 2012(see the list of countries in Table 7). The data used was collected and stored by World Bank’s (World Development Indicator Database) (2014) and UNCTAD (2014). FDI was measured as a percentage of the recipient country GDP. This will help control for country size and population. Economic and monetary policies were indexed by the rate of inflation and exchange rates. Trade openness with be measured by the volume of exports as a percentage of GDP while the financial sector development was indexed by domestic credit to Private Sector as a percentage of GDP and bank deposit as a percentage of GDP. Human Capital Development (HCD) is measured by health component indexed by infant mortality rate. The study controlled for monetary policies, GDP per capita income (initial state) and other foreign capital flows and local investment. A country’s monetary policy attracts or discourages local and foreign investor. The attractiveness of monetary policies is measured Foreign Direct Investment (FDI) Drivers of Economic Growth • Human Capital Development (H1) • Trade openness (H2) • Financial sector development (H3) Control Variables • Rate of Inflation • Exchange Rate • GDP • Remittances Asian Journal of Finance & Accounting ISSN 1946-052X 2015, Vol. 7, No. 2 99 by exchange rates (EXCH) and the level of inflation (INF). The determinants of economic growth were influenced by government and private citizens’ investments. Gross capital formation (local investment denoted by LI) controls for the aggregate improvement in a country’s capital stock. Apart from FDI a country benefits from other external capital flows such as remittances and foreign aid which also have an impact on economic growth. The effect of these foreign capital inflows on the determinants of economic growth was controlled for by personal remittance received as a percentage of GDP (REM). The research model is shown below; DEGi = 0i+ 1FDIi + 2MPi + 3 i + 4LIi + 5REMi + i . Where; DEG represents drivers of economic growth (Financial Sector Development, Trade Openness and Human Capital Development). FDI represent Foreign Direct Investments (explanatory variable). MP represents monetary policy, GDP denote Gross Domestic Product, REM represents other foreign capital flows and LI local investment both (government and private investment). denotes an error term 4. Empirical analysis 4.1 Descriptive Statistics Table 1 shows the period averages and summary statistics for the research variables for the period 1980-2012. The mean FDI net inflows were estimated at 3.520% of the GDP of the receiving countries with a minimum value of -6.897 and maximum value of 35.24. Table 1 confirms a significant increment in FDI in the last decade up from 1.4% in 1980 to 3.2% in 2012. The average domestic credit to private sector was estimated at 36.5% of GDP. Credit to private sector double between 1980 and 2012 as shown by the average values of 2.6% in 1980 and 4.8% in 2012. The mean remittances received in the period were 5.38% of GDP. There was a slight improvement in these transfers of 0.6. What is worth noting is the fact that remittances are a larger component of the receiving countries GDP compared to GDP. The analysis further show that the combined effect of remittances and foreign direct investment is approximate 7.6% of GDP compared to an average local investment of 23.26% of GDP (approximately one-third of local investments)These figures suggest that foreign capital flows are important external sources of finance if well harnessed. The high exchange rate of 90.71% and inflation of 28.49% indicate ineffective monetary policies that discourage investment both local and foreign. The table further shows high infant mortality rate averaged at 45 deaths per 1000 of the population which is deterrence to human capital development. Asian Journal of Finance & Accounting ISSN 1946-052X 2015, Vol. 7, No. 2 100 Table 1. Summary Statistic of the Research Variable 4.2 Correlation Analysis The correlation matrix represented in table show that FDIs are positively correlated with other foreign capital flows, GDP, trade openness (export), investments and domestic credit to private sector investment. The positive link between FDIs and other foreign transfers could be due to similarities of push and pull factors. FDIs and local investments have a dual causality. The existing state of infrastructure attract foreign investors or still foreign investors and donors would be willing to invest on infrastructural development where locals are not willing to invest due to the huge capital outlays, lack of expertise or risks involved. The relationship between FDIs and bank credit is likely to be duo. Availability of credit locally attracts foreign investors; likewise foreign investor interested in lending or interesting in securities can help alleviate credit constraints affecting households. The relationship between FDI and exchange rates, inflation and human capital development is negative. Unfavorable monetary regime inhibits foreign investors. Foreign capital flows are on the other hand associated with the Dutch Disease. Table 2. Pairwise Correlation of the Research Variables REM 990 5.385063 11.88878 .0014116 106.4789 LI 990 23.26887 7.992249 3.377636 74.82202 INF 990 28.4905 395.1565 -11.16159 12338.66 EXCH 990 90.71891 215.3887 .0000245 1401.437 GDP 990 5328.565 9819.106 168.7364 67435.95 EXPORT 990 31.02137 16.61088 3.279997 100.949 HCD 990 45.17061 30.49665 1.7 133.5 CREDIT 990 36.57213 30.61217 1.542268 319.4609 DEPOSIT 990 27.18864 353.0369 -128.9158 11046.93 FDI 990 2.351571 3.520934 -6.897609 35.23495 Variable Obs Mean Std. Dev. Min Max REM 0.2304 -0.0226 -0.1113 0.1599 0.0732 -0.1726 -0.1145 -0.0201 0.4520 1.0000 LI 0.3083 -0.0153 0.2074 -0.1691 0.1661 0.0225 0.0291 -0.0248 1.0000 INF -0.0281 0.9972 -0.0313 0.0687 -0.0308 -0.0235 -0.0226 1.0000 EXCH -0.0862 -0.0159 0.1277 -0.1281 0.0382 0.0375 1.0000 GDP 0.1138 -0.0120 0.6043 -0.5503 -0.0676 1.0000 EXPORT 0.2837 -0.0245 0.2017 -0.3182 1.0000 HCD -0.1335 0.0553 -0.5388 1.0000 CREDIT 0.2362 -0.0088 1.0000 DEPOSIT -0.0229 1.0000 FDI 1.0000 FDI DEPOSIT CREDIT HCD EXPORT GDP EXCH INF LI REM Asian Journal of Finance & Accounting ISSN 1946-052X 2015, Vol. 7, No. 2 101 4.2 Results of Panel Regression The study predicts that 1% increase in FDI stimulates 1.4% growth in domestic credit to private sector and 0.4% expansion in bank deposits. However it’s only the link between FDI and domestic credit to private sector that was found as statistically significant as confirmed by t=8.39 and p=0.000 as shown in table 3. The regression results for FDI and bank deposits shown in table 5 with t=1.47 and p=0.141 illustrate that the effect of FDI on bank deposits is statistically insignificant. The study further established a significant and negative relationship between FDIs and human capital development (infant mortality rate) as reported by t= - 5.71 and p= 0.000 as shown in table 4. The beta coefficient suggests that 1% increase in FDI contributes to 0.87% deterioration in health care in the receiving country. The relationship between trade openness FDI was statistically significant and positive (t=3.8, p=0.000) illustrated in table 6.. One point improvement in FDI is accompanied by 0.35 point improvement in trade openness. It’s therefore logical to conclude that foreign capital flows be it official development assistance, portfolio investments or altruistic transfers such as personal remittances will open up a country’s economy. Table 3. Regression of FDI on Domestic Credit to private sector Table 4. Regression of FDI on Human Capital Development _cons 13.50807 6.13415 2.20 0.036 .9623242 26.05382 REM .1376739 .1419627 0.97 0.340 -.1526723 .4280202 LI .2572714 .1251571 2.06 0.049 .0012964 .5132464 INF -.0011974 .0003237 -3.70 0.001 -.0018594 -.0005355 EXCH .0191303 .0353532 0.54 0.593 -.0531751 .0914357 GDP .0021414 .0006562 3.26 0.003 .0007993 .0034835 FDI 1.37113 .7512414 1.83 0.078 -.1653311 2.907591 CREDIT Coef. Std. Err. t P>|t| [95% Conf. Interval] Robust _cons 56.8733 6.44161 8.83 0.000 43.69873 70.04787 REM -.4430031 .2837535 -1.56 0.129 -1.023344 .137338 LI -.1469277 .2457637 -0.60 0.555 -.6495709 .3557154 INF .0028719 .0003142 9.14 0.000 .0022292 .0035145 EXCH -.0289548 .0150678 -1.92 0.065 -.0597718 .0018622 GDP -.000244 .0001721 -1.42 0.167 -.000596 .0001079 FDI -.8730139 .3293321 -2.65 0.013 -1.546574 -.1994542 HCD Coef. Std. Err. t P>|t| [95% Conf. Interval] Robust Asian Journal of Finance & Accounting ISSN 1946-052X 2015, Vol. 7, No. 2 102 Table 5. Regression of FDI on Bank Deposits (Claims to Private Sector% GDP) Table 6: Regression of FDI on Trade openness 5. Conclusion and Recommendations The study concludes that FDIs stimulates financial sector development. FDIs enhance the availability of capital for investment purposes either through direct investments by the foreign investors or indirectly through investment vehicles such us investment banks, money markets or capital markets. The study also established that foreign direct investments boost trade openness. Trade openness could be as a result of market drive FDIs or spillover effect arising from cross border transactions. In the study FDI was found as having undesirable effect on health care replicating Peter and Nunnenkamp (2012) and Wilkinson (2000) who maintain that FDIs contributes to unequal societies that are described by relative deficiency and prolonged stress considered the main channels through which inequality ruins health. This observation is informed by the argument that FDIs are market driven unlike official development assistance and remittances. Many studies show that FDI have a positive effect on economic growth. This study sought to establish the direct impact of FDIs on the primary drivers of economic growth. The study therefore recommends the need for favourable monetary regimes that attracts foreign investments. Favorable monetary regime encompasses stable exchange rates, controlled inflation and interest rate regimes. Favorable monetary policies attract more foreign direct investments for development purposes. The study further recommends preferential trade agreements and market liberation as a way of encouraging international trade. Enhanced international trade facilitates the flow of factors of production including foreign capital. The study further recommends that foreign investors should consider investing directly into human capital development. _cons -13.01903 5.887971 -2.21 0.035 -25.06128 -.976776 REM .0055936 .0626753 0.09 0.929 -.1225917 .133779 LI .6107197 .2393492 2.55 0.016 .1211955 1.100244 INF .8914029 .000979 910.52 0.000 .8894006 .8934052 EXCH .0084561 .0171578 0.49 0.626 -.0266355 .0435477 GDP -.0002186 .0002034 -1.07 0.292 -.0006346 .0001975 FDI .4115461 .3733992 1.10 0.279 -.3521409 1.175233 DEPOSIT Coef. Std. Err. t P>|t| [95% Conf. Interval] Robust _cons 28.99464 5.422434 5.35 0.000 17.90452 40.08476 REM -.1613849 .1707604 -0.95 0.352 -.510629 .1878593 LI -.0291776 .2098073 -0.14 0.890 -.4582816 .3999264 INF -.0005887 .0001303 -4.52 0.000 -.0008552 -.0003223 EXCH .0240264 .0054303 4.42 0.000 .0129203 .0351325 GDP .0001116 .0000684 1.63 0.113 -.0000282 .0002514 FDI .3475294 .2111934 1.65 0.111 -.0844096 .7794684 EXPORT Coef. Std. Err. t P>|t| [95% Conf. 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