Substitutability Between FDI and Aid NOITS 9th Annual Workshop Substitutability Between FDI and Aid NOITS 9th Annual Workshop May 13 th 2006 Reykjavík Helga Kristjánsdóttir

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction The objective of this paper is to examine the substitution between aid flows and the flows of foreign direct investment (FDI) in some Heavily indebted poor countries. Use data running over 34 years from 1970 to I analyze this by means of simultaneous equation system, allowing me to determine the substitutability between foreign direct investment and aid.

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction Due to the small scale of flows, some model variables analyzed with an inverse hyperbolic sine function rather than a logarithmic function Findings indicate that as the HIPC countries income grows, there is a shift, so that aid and FDI flows substitute, rather than complement, one another

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction Studies: Majority of FDI between developed countries Markusen (2002) Between East and West Rather than North and South Incentives for FDI in developed countries different from those in developing countries

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction Determine to which degree foreign direct investment may substitute for foreign aid in the Heavily indebted poor countries (HIPC) receiving aid from the International Development Association (IDA) IDA role of supporting anti-poverty programs in the poorest developing countries with long-term, no interest loans

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction The research focus in on the substitutability between FDI and aid flows in the HIPC countries Determine the substitutability between FDI and aid in a sample of HIPC countries, and also to look specifically at one of the HIPC countries

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction The story to be considered: Whether the HIPC countries, depending on aid from IDA, are likely to become more attractive to multinationals after receiving IDA aid over a period of time With affective aid provision they could be expected to be shifted to a higher equilibrium after a period of time, with higher economic stability Should make these countries more attractive for foreign investors to enter into foreign direct investment

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Low-income economies (59) as presented by the World Bank (2006) AfghanistanHaitiPakistan BangladeshIndiaPapua New Guinea BeninKenyaRwanda BhutanKorea, Dem Rep.Sao Tome and Principe Burkina FasoKyrgyz RepublicSenegal BurundiLao PDRSierra Leone CambodiaLesothoSolomon Islands CameroonLiberiaSomalia Central African RepublicMadagascarSudan ChadMalawiTajikistan ComorosMaliTanzania Congo, Dem. Rep.MauritaniaTimor-Leste Congo, Rep.MoldovaTogo Cote d'IvoireMongoliaUganda EritreaMozambiqueUzbekistan EthiopiaMyanmarVietnam Gambia, TheNepalYemen, Rep. GhanaNicaraguaZambia GuineaNigerZimbabwe Guinea-BissauNigeria

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration IDA (67) supported countries as listed by the World Bank (2006A) AfghanistanGhanaNiger AlbaniaGuineaNigeria AngolaGuinea-BissauRwanda ArmeniaGuyanaSamoa BangladeshHaitiSao Tome and Principe BeninHondurasSenegal BhutanKenyaSierra Leone Burkina FasoKiribatiSolomon Islands BurundiKyrgyz RepublicSomalia CambodiaLao PDRSri Lanka CameroonLesothoSudan Cape VerdeLiberiaTajikistan Central African RepublicMadagascarTanzania ChadMalawiTimor-Leste ComorosMaldivesTogo Congo, Dem. Rep.MaliTonga Congo, Rep.MauritaniaUganda Cote d'IvoireMoldovaVanuatu DjiboutiMongoliaVietnam EritreaMozambiqueYemen, Rep. EthiopiaMyanmarZambia Gambia, TheNepal GeorgiaNicaragua

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction To capture the substitutability effects, use the simultaneous equations Determine to what extent FDI and aid are functions of each other, simultaneously Run regressions for aggregate group of the HIPC countries as well as individual HIPC countries

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction Choose certain HIPC countries as representatitves of the developing countries Choose Malawi, Mozambique and Ghana Can be expected to be green field rather than brownfield investments FDI less likely to be in the form of M&As Therefore apply aggregate FDI flow data

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction Has not really been looked into if FDI –Aid are substitutes Data hard to get and hard to handle IDA defined role of supporting anti-poverty programs in the poorest developing countries with long-term, no interest loans Foreign direct investment (FDI) Foreign ownership of controlling stock in a particular firm (generally 10% or more) Inward FDI is generally believed to be the type of investment with long-term commitment

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Introduction FDI needs not to be proxied by affiliate sales Brainard (1997) Markusen (2002) Ekholm et al. (2003) Based on aggregate data like in Kristjánsdóttir (2005)

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Literature Brainard (1997) Inward and outward FDI share proxies separately as share of affiliate sales in total export Slaughter (2000) FDI proxied by investment share (measured as majority-owned affiliates) in overall MNE investment Lane and Milesi-Ferretti (2003) The consideration is set on the composition of FDI and possible ways of correcting for M&As in the sample when estimating FDI

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Literature Literature on FDI in the developing countries often tends to consider the contribution of FDI to growth De Mello (1997), Balasubramanyam et al. (1996) and Borensztein et al. (1998) the latest finding that the host country of FDI needs to have a minimum threshold of human capital to experience a higher productivity of FDI. Some papers have looked at how FDI affects domestic firms in the local market, these would be like Aitken and Harrison (1999), and Aitken et al. (1997). Also, paper by Edwards (1990) looks at debt-equity swaps in the developing countries.

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Literature Dalgaard et al. (2004) provide some interesting insights on the how growth in impacted by aid flows, when considering some Burnside and Dollar papers when estimating the interaction of aid and growth GDP Population Fraction of land in tropic Budget surplus

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Data Data on aggregate FDI inflow from the World Bank (2006B) Data on Aid inflow from the International Development Association (IDA), listed by World Bank (2006B)

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Data IDA, Net financial flows as the disbursements of loans and credits less repayments of principal Foreign direct investment, net inflows Negative if high dividend payments Other explainatory variables Similar to Dalgaard et al. (2004) DP, Population, total, Land under cereal production (hectares), Current account balance, Crop production index ( = 100)

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Data Transformation The Inverse Hyperbolic Sine Function (IHS) IHS defined as sinh ⁻ ¹(x)= ln(x+(1+x^2)^0.5)

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Data Transformation The logarithm function and IHS

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Model Setup The simultaneous equation system looks as follows:

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration Conclusions Taken together, in the case of Ghana, FDI and aid are not found to support each other, that is they are found to be substitutes rather than complements When all the sample countries are included, FDI flows and aid flows are found to complement each other. These results can be found to support the hypothesis that when the HIPC countries experience a higher income per capita, as is the case for Ghana in comparison with Malawi and Mozambique, complementary effects diminish at the cost of supplementary effects, with FDI inflows increasingly substituting for aid flows

UNIVERSITY OF ICELAND Faculty of Economics and Business Administration