1 Do Host Country Factors Affect The Impact Of Foreign Direct Investment On Economic Growth? Edna Solomon 27 November, 2006 ESDS International Annual Conference 2006

2 Objective What is the impact of FDI on Economic Growth? Do three host country factors: the level of human capital, the level of financial development and the level of institutional quality affect the impact of FDI on Economic Growth?

3 Outline Introduction Model Data Results Conclusion

4 Motivation : Volume of FDI Inflows Graph indicates a massive increase in FDI in the last decade alone. Source: Data from IMF ’ s BOPS(2005) from the ESDS International Databank.

5 Literature Review (FDI & Growth)

6 Literature Review (FDI, HCFs & Growth)

7 My Contribution Most studies focus on the interaction between FDI and one HCF. But I shall investigate the impact of human capital, financial development & quality of institutions simultaneously on the FDI/growth relationship.. Use of System GMM method of estimation.

8 Model-Theoretical The model that I used was adopted from Borenstein et. al. (1998) Use of an EGM with TP driver of growth Mechanism: Increase in variety of capital goods (N) TP growth Y t =AH t  k t 1- There exists N varieties of k t N= n + n 

9 Model-Empirical g=c 0 +c 1 FDI+c 2 FDIH+c 3 H+c 4 Y 0 +c 5 A. Where g=growth rate of gdp per capita for each decade ; FDI=FDI as a ratio to GDP. H=Human capital. Y 0 =Initial GDP per capita. A=set of other variables that. affect economic growth.

10 My Empirical Model Model 1 g it =c 0 +c 1 FDI it +c 2 H it +c 3 FDI it H it +c 4 Y 0it + c 5 FIN it +c 6 FDI  FIN it + c 7 IQ it +c 8 FDI  IQ it + t + u i + it. u i= unobservable individual country specific term eg differences in steady state growth paths among countries.  t=time dummies, proxy global shocks.  it= random error term. Sample period: 1970 to 2003 in 7 five year intervals:

11 Data-proxies VarProxySource gLog difference in the growth of Real GDP per capita, over 5-year intervals from 1970 to 2003 World Bank ’ s World Development Indicators (WDI), 06 from ESDS International databank FDILog of FDI as % of GDP (net inflows) World Bank ’ s WDI from the ESDS International databank

12 Data-proxies Cont HAverage years of schooling Barro & Lee (2000) IQEconomic freedom (combines indices of political freedom, civil liberties and polities) Freedom House figures from the QOG database (2006) FINLog of private credit by deposit money banks and other fin. Intermediaries as % GDP Beck,Levine, et.al.(2001) but updated in 2005.

13 Data: Countries in Sample

14 Data: Challenges Collection of data for several countries (83) for several years (35 years). Sources of data. Reliability. Single sources for homogeneity of methodology. ESDS databank helps ease the above problems, and hence is invaluable in macroeconomic research.

15 System GMM System GMM (ABBB estimator) is an estimation technique used in dynamic panel data models: Relatively new as it was created by Arellano and Bover (1995) and Blundell and Bond(1998). Advantages: Estimates do not longer suffer from omitted variable bias caused by the unobserved country specific effects. It is able to control for endogeneity of all the explanatory variables. Useful where the dataset in persistent and the time periods are relatively short.

16 Results: (LINEAR) FDI (0.8847) H (0.2780) FDI.H ( ) FIN (2.9781)*** FDI.FIN (1.3455) IQ ( ) FDI.IQ (0.3192) Y0Y (0.4427) AR(1) / AR(2) : P-Values0.00***/ 0.44 HANSEN TEST: p-values0.28 T-ratios in parenthesis;Dept var:growth rate of gdp per capita.

17 Results: (WITH QUADRACTIC TERMS) FDI (-0.976) H (2.303)** H^ (-2.475)** FDI.H (1.837)* FDI.H^ (-2.533)** FIN (3.269)*** FDI.FIN (3.626)*** IQ (-1.567) FDI.IQ-0.001(-0.291) Y0Y (0.2883) AR(1)/AR(2): P Values0.00***/0.63 Hansen test: p-values0.54

18 Conclusion The positive impact of FDI on economic growth depends on the level of human capital and financial development of the host country. Human capital affects the relationship between FDI and economic growth in a non linear way.