MIDTERM PROJECT THE IMPACT OF FDI ON ECONOMIC GROWTH OF NINE SOUTH EAST ASIAN COUNTRIES

FOREIGN TRADE UNIVERSITY SCHOOL OF INTERNATIONAL BUSINESS ECONOMICSMIDTERM PROJECT THE IMPACT OF FDI ON ECONOMIC GROWTH OF NINE SOUTH-EAST ASIAN COUNTRIES Course: Development EconomicsLe

FOREIGN TRADE UNIVERSITY SCHOOL OF INTERNATIONAL BUSINESS ECONOMICS

MIDTERM PROJECT THE IMPACT OF FDI ON ECONOMIC GROWTH OF

NINE SOUTH-EAST ASIAN COUNTRIES

Course: Development EconomicsLecturer: Nguyễn Thị Hải Yến

Member list

Nguyen Thi Tuong Van 1811140106Nguyen Kim Huong 1810140027

Nguyen Thi Quynh Hoa 1811140080

Nguyen Truc Quynh 1810140057

Nguyen Thu Huyen 1810140030

Luong Thu Hien 1811140077

Nguyen Thi Thanh Huyen 1810140029Luong Thu Thao 1810140061

Nguyen Hien Thao Chi 1811140071Nguyen Duy Anh 1810140003

Table of Contents

Chapter 2: Theoretical framework 52.1 Theories explain FDI under the framework of international trade theories 52.1.1 Product life cycle theory (Vernon, 1966, 1971; Wells, 1968) 52.1.2 Macroeconomic approach (Kojima, 1973) 52.2 Theories explain FDI under the framework of firm and industrial

organization (IO) literature theories 62.2.1 Market imperfections theory (Hymer, 1970) 62.2.2 The Internalization Theory (Buckley and Casson, 1976; Swedenborg, 1980)6

2.2.3 The Eclectic theory of FDI (Dunning 1977, 1988, Dunning and McQueen,

Chapter 3: Literature review 83.1 Literature review of factors affecting economic growth worldwide 83.2 Literature review of factors’ effects on South East Asia’s economic growth 113.3 Gap in the literature 143.4 Research question 14

4.1 Variables description 164.1.1 Dependent variables 164.1.2 Independent variables 16

5.2 Discussion 225.2.1 Meaning of the empirical results 225.2.2 Suggestions to boost economic growth rate in southeast asian countries 245.2.3 Vietnam: how to increase the growth rate and strategies to apply in the

context of Covid-19 pandemic 25Chapter 6: Conclusion and recommendations 28

Lists of figures

Figure 2 Fixed effects model 21

Chapter 1: Introduction

Foreign direct investment (FDI) is generally recognized as a powerful catalyst to

stimulate economic growth, especially in developing countries Thanks to FDI,

capital-poor countries can possess employment opportunities and build up

physical capital It provides local labor forces the chance to enhance their

working skills through transfer of technology from developed countries (Makki

and Somwaru, 2004) Most importantly, economic restructuring and

export-market expansion can also be supplemented by FDI, thus domestic economies

could be further integrated in the global economy

However, numerous researches have shown mixed results about the relationship

between FDI and economic growth Following recent critiques of the conventional

presumption of a one-way causal relation between FDI and growth (Kholdy, 1995), new

studies have looked into the probability of a two-way (bidirectional) or non-existent

causality between variables of interest To put it another way, not only can FDI

influence GDP growth (both positively and negatively), but GDP growth may also

influence FDI inflows, or there could be no causal correlation at all Some have seen

the positive linkage between FDI and economic growth in Southeast Asia For instance,

Zhao and Jiang (2007) stated that the economic growth in China accelerated rapidly,

along with the presence of foreign investment ever since the introduction of new trade

policy In Malaysia, FDI is believed to have contributed 17% of the country’s economic

growth (Mun et al., 2008) On the contrary, when reviewing literature which included

880 regression estimates of the impact of FDI on economic growth, Iamsiraroj and

Ulubaşoğlu (2015) found out that roughly 17% of 108

published papers reported a negative relationship between FDI and economic growth Bruno, Campos, and Estrin (2017), on investigating 175 studies conducted on Eastern European, Asian, Latin American, and African data over the period 1940 to 2008, also concluded that 11% of 1100 macro (economy wide) estimates on the economic growth

– FDI association were negative

Many factors, such as level of human capital and local productivity, domesticinvestment, infrastructure, or macroeconomic stability, lead to suchheterogeneous results Therefore, it is challenging to isolate and assess theimpact of FDI on its own In many cases, because of those factors, results evenshow no existence of FDI-led economic growth

Since the Association of Southeast Asian Nations (ASEAN) was born on August 8,

1967, it has been developing and growing Starting with 5 nations, ASEAN is now consists of 10 members: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam In 1992, The ASEAN Free Trade Area (AFTA) was signed to increase ASEAN’s competitive edge by eliminating tariffs and non-tariff barriers within ASEAN members The full regional economic integration was set on December 31, 2015, to establish the ASEAN Economic Community (AEC) One

of the primary goals of AFTA is to attract more multinational enterprises (MNEs) to have foreign direct investment (FDI) in the ASEAN area.

Normally, among ASEAN countries, Singapore always received the highestamount of FDI net inflows, with more than 50 percent of the total The FDI netinflows into Singapore increased from $53,547.0 million to $72,098.3 million in

2014 The main destination of those FDI net inflows is the financial sector, which

is quite different from other countries, such as ASEAN 5 countries, where themain use of FDI inflows is manufacturing Further, Brunei, Cambodia, Laos, andMyanmar attracted only a small percentage of total FDI net inflows

However, Singapore's leading FDI decline was gentler than the globalcontraction of 42 per cent to US$859 billion, from US$1.5 trillion in 2019 Thecollapse left FDI flows more than 30 per cent beneath the trough that followedthe global financial crisis in 2009 Within Asean, Malaysia experienced thesteepest decline, with FDI plunging by 68 per cent to US$2.5 billion FDI fell inThailand by 50 per cent to US$1.5 billion, in Indonesia by 24 per cent to US$18billion, and in Vietnam by 10 per cent to US$14 billion The Philippines buckedthe trend; its FDI flows rose by 29 per cent to US$6.4 billion.

Nevertheless, the report said the strength of South-east Asia as an FDI engineremained evident South-East Asia registered over US$70 billion in newgreenfield investment projects last year, the largest volume among developingregions This was a more moderate contraction in announced greenfieldinvestments (-14 per cent) than in other developing regions

Especially in the case of Vietnam, since the global economic recession in 2008,FDI net inflows % of GDP sank to a low for the following three years The ratestill declined during the 2011-2014 period, albeit more slowly than during theprevious three years Specifically, in 2014, the figure fell back to its 1992 level at4.8% Accordingly, GDP growth rate fluctuated around 5.8% for the 2008-2014period As the recession is over, from 2014 to 2018, a recovery in FDI net inflow

% of GDP (from 4.8% to 6.3%) has resulted in a recovery in GDP growth rate(from 5.9% to 6.8%) (World Bank, 2018)

Generally speaking, thanks to the 1987 Law on Foreign Investment, Vietnameseinvestment environment has gained more interest from foreign investors FDIinflows arrived from over 100 nations and territories and contributed 19% to theGDP, 19% to domestic budget revenue, over 55% to industrial output value, and70% to total export turnover in 2017 (Huong, 2017) Thus, it is widely believed thatFDI is one of the crucial factors in stimulating Vietnam’s economic growth

This research will investigate the causality between FDI and economic growth in

9 South-East Asian countries, using ordinary least squares regression Thedependent variable is GDP growth rate, representing economic growth Theindependent variables are FDI net inflows, FDI net inflows % of GDP, marketsize, gross capital formation and openness to trade Multiple tests wereconducted, including the ADF Fisher Unit Root test, Johansen test, OLS test,Heteroscedasticity test, Normality test, and Granger causality test

After selected theories of FDI are presented, other researches on the same topic would be considered The methodology would present the variables used, hypothesis, research design and how data is collected Test outcomes and analysis are in the empirical results and discussion part Given the current world situation being heavily affected by the COVID-

19 pandemic, the results were applied to assess the current situation regarding FDI and give predictions The conclusion is presented last, which includes limitations, suggestions for further research on the topic and policy recommendations.

Chapter 2: Theoretical framework2.1 Theories explain FDI under the framework of international trade theories

2.1.1 Product life cycle theory (Vernon, 1966, 1971; Wells, 1968)

i Theoretical emphasis: a country’s export strength builds; foreign production starts; foreign production becomes competitive in export markets; import competition emerges

in the country’s home market (Vernon, 1966, 1971; Wells, 1968)

ii FDI linkage: This theory provided a linkage between FDI and internationaltrade One of the key issues regarding FDI is the reasons why firms prefer investingabroad over exporting As the theory suggested, if the costs of exporting and foreign-market catering are more than those of locating and producing overseas, FDI isjustified It also mentioned the significance of specific host-country factors, such ascheap labor, in determining FDI

iii Limitations: It could not explain the sources of ownership advantages forforeign firms Additionally, Buckley and Casson (1976) argued that the theory cannotaccount for non-export substituting FDI and the tendency of producing non-standardized products aboard

2.1.2 Macroeconomic approach (Kojima, 1973)

i Theoretical emphasis: FDI’s flow could be attributed to the comparativedisadvantages of the home countries and the potential advantages of the hostcountries, respectively This theory places FDI in changing economic contextsand points out its future trends

ii FDI linkage: The theory emphasized that FDI should be trade-oriented and be subordinate to the free trade policy, not reversely When assessing FDI, it is essential to look at the present technology in the receiving country, consider the monopolistic element, and the internationalization of production and marketing to make use of

economies of scale Kojima (1973) criticized the usage of trade barriers andstressed on agreed international specialization.

2.2 Theories explain FDI under the framework of firm and industrialorganization (IO) literature theories

2.2.1 Market imperfections theory (Hymer, 1970)

i Theoretical emphasis: Firms’ strategy to seek market opportunities is designed onthe ground that investing overseas is ideal since they possess certain capabilitiesthat foreigner competitors don’t (Hymer, 1970) Thus, firms have proprietarycontrol in the international markets to enjoy oligopolistic market power

ii FDI linkage: Considering FDI as an outcome of international marketimperfections, the theory pointed out the obtainable benefits of exploiting oligopolisticadvantages as the driving forces behind FDI The Multinational Enterprises (MNE)appears due to the market imperfections that led to a divergence from perfectcompetition in the final product market FDI is a firm-level strategy decision rather than

a capital-market financial decision

iii Limitations: The market imperfection theory lacked justification for the reasonsbehind firms’ decision to produce overseas, as against options like producing at home andexporting, or licensing production to local agents in foreign countries

2.2.2 The Internalization Theory (Buckley and Casson, 1976; Swedenborg, 1980)

i Theoretical emphasis: Since the transaction costs involved in trading throughexternal markets are too much to bear, firms are better off to take ownershipadvantages through internal networks by establishing local production facilities.This theory suggested that firms will exploit their advantages through FDI,rather than through alternative market-based arrangements

ii FDI linkage: The theory provided explanations for FDI by identifyingcircumstances in which internalizing operations are preferable to external arm's-lengtharrangements like licensing Given the imperfect market’s advantages, internalizingproduction across national borders by undertaking FDI appears to be a logical strategyfor multinational corporations (MNE)

2.2.3 The Eclectic theory of FDI (Dunning 1977, 1988, Dunning and McQueen, 1981).

i Theoretical emphasis: This theory is a mix of three different theories of FDI (O-L-I) O (Ownership): Firms with exclusive possession of intangible assets have chances to surpass local firms in doing business abroad L (Location): Foreign markets should offer some location advantages, which make foreign production more profitable than producing at home and exporting abroad I (Internalization): There must be some internalization advantages that encourage firms to transact their intangible assets through internal organizational networks, rather than through the market.

ii FDI linkage: This theory suggested that determinants of FDI can be groupedinto supply-side factors (O and I advantages) and demand-side factors (L advantages).Thus, attractiveness to FDI varies considerably between nations

Chapter 3: Literature review3.1 Literature review of factors affecting economic growth worldwide

Foreign Direct Investment (FDI) has been considered a crucial factor in economicgrowth across countries However, the existing research has generated mixedresults This inconsistency has been seen in numerous studies using both largecross-country samples and small single-country samples over the last decades.Makki and Somwaru (2004) looked at 66 developing countries over three decadesand found out that FDI and trade accounted for economic growth in all thosecountries They suggested that governments of those countries should implementpolicies that further promote FDI and trade With a model based on endogenousgrowth theory, they assessed empirically the effects of FDI and trade on economicgrowth using FDI, trade, human capital, domestic investments, initial GDP percapita, inflation rate, tax rate, and government consumption as IVs

Meanwhile, Wang's research (2009) has come up with ambiguous results about theuse of total FDI, which was attributed to the differences in sector-level FDI inflows.Nevertheless, he believed that analyzing the FDI of different sectors (manufacturingand nonmanufacturing) provided a better assessment of FDI's impact on economicgrowth To study 12 Asian economies from 1987 to 1997, Wang used anendogenous growth model with five IVs, namely FDI, domestic investment, humancapital, labor force, and initial GDP He concluded that manufacturing FDI was themost influential in increasing the country's economic growth

Herzer (2012) presented contradictory results to those above With data from 44developing countries from 1970 to 2005, Herzer found that the effect of FDI isnegative on average It was his use of panel cointegration with four main variables(general level of development, trade openness, human capital, and development oflocal financial markets) that showed such different results compared to others

However, it’s important to note that the differences between each country in thestudy were substantial.

To analyze FDI's impact on economic growth in specific countries, many studies used regression models In Malaysia's case, Omer and Yao (2011) used data over a period

of 39 years from 1970 to 2008 and proved that, in the long term, inward FDI and economic cycles could be Granger Causally related With further studies from VAR model, they concluded that it has a fast effect on the Malaysian economy Shaari, Hong

& Shukeri (2012) used VAR model with cointegration technique to examine therelationship of FDI on real GDP and thus concluded FDI's substantial impact on economicgrowth In Anwar’s and Nguyen’s study (2010) of Vietnam's case, the chosen determinants

of FDI were market size, infrastructure development, labor market, and level of openness.Like Omer and Yao (2011), they found out that GDP has a granger cause to FDI, and viceversa using annual data from 1971 to 2010 A similar conclusion was drawn from the case

of Romania during the 1990-2011 period Nistor (2014) used foreign direct investmentinflows (FDI), government expenditure (GE), and gross fixed capital formation as thecentral IVs and found out that FDI inflows positively impacted GDP, and thus, economicgrowth

On the other hand, as mentioned above, Herzer (2012) reported a negative correlation between FDI and growth, but the result varies widely among countries studied Dinh et

al (2019) also were cynical about the results of other studies in which FDI is reported

to have a positive impact on GDP growth rate They studied that relationship in 30 developing countries over the 2000–2014 period They believed that foreign capital flows, endogenous financial development, domestic financial development, domestic capital reserve, and human capital are the ideal independent variables to examine the impact of FDI on economic growth After studying numerous panel data sets, they concluded that FDI had no statistically significant long-run effect on GDP The sample provided no long-run positive and unidirectional impact of FDI on GDP anywhere.

This result is explained by the long-run FDI-GDP relationship depending on characteristics

of the investment resulting from FDI, such as type, sector, scope, duration, and the proportion of domestic businesses in the industry For some countries, there was even strong evidence of FDI limiting growth in the long and short term Moreover, the differences

in the effect of FDI cross-country could not be explained by geography, which suggests further research on each country's particular case.

It is necessary to look at the linkage between FDI-related variables and GDP growth rate before further research is conducted Urgaia (2017) studied the panel data of FDI and GDP growth rates in seven East African countries, then concluded that there existed bi-directional inter-temporal causal relationships between them in the short, medium, and long terms Employing the time scaling wavelet decomposition in the framework of dynamic panel ARDL, he concluded that factors affecting the domestic economic sector are mainly FDI net inflow, index of openness, terms of trade, and official exchange rates In general, the combined mean coefficients also witnessed an increase over time scaling horizons Basu and Guariglia (2007) also found out that FDI facilitates GDP growth Furthermore, their empirical results indicated there was a bidirectional causality between these two variables for the economies with a higher level of economic openness Still, there was a unidirectional causality running from GDP to FDI for closed economies In some instances, FDI might lead to inequality, and the more FDI was poured in, the less the share of agriculture in GDP became.

As we can see, when examining the impact of Foreign Direct Investment oneconomic growth, studies using large cross-country samples often employed manyindependent variables The most common ones are FDI, trade openness, humancapital, and domestic investment In researches using single-country samples, FDI,market size, labor market, and level of openness were the standard independentvariables chosen to prove the relationship between FDI and GDP

Regarding openness to trade, researchers have shown doubt as to whether developing countries gain from a more open economy Ulaşan (2014) studied a variety of openness indicators and concluded that the linkage was neither robust nor significant.

An increase in the openness to trade tends to reduce the GDP growth rate Trade openness has been linked to the level of development in middle-income countries, but that to economic growth was not proven (Sakyi et al., 2012) Rodriguez and Rodrik (1999) reviewed the positive correlation that had been concluded by previous researches, and pointed out that there were no conclusive evidence of the linkage Recent researchers have even witnessed a negative correlation between openness to trade and economic growth For instance, Huchet-Bourdon et al (2017) concluded that trade openness might have a negative impact if a country specializes in low-quality products when accounting for trade quality and variety in their models This result was also seen in studies of specific countries, namely Jordan (Akayleh, 2014).

3.2 Literature review of factors’ effects on South East Asia’s economic growth

Literatures have shown mainly positive views on the effect of FDI on growth.However, while most research indicates that FDI influences GDP, the degreevaries significantly

Many existing literature suggest that there is a bidirectional causality between FDIand growth Hsiao and Hsiao (2006) examined the Granger causality relationshipbetween GDP, exports and FDI in eight countries, including four South East Asiancountries (Singapore, Malaysia, Thailand and Philippines) Using time series data, itconcludes that for Singapore, there are two unidirectional causalities: FDI causesexports and FDI also causes GDP, in other words, it’s an FDI-led-growth economy

Regarding the same paper, using panel data analysis, which include eight countries’ cross-sectional data, the authors came to the conclusion that domestic product growth and inward FDI play crucial roles in promoting exports for these eight Asian countries.

They also concluded that inward FDI is crucial and significantly benefits thegrowth of GDP through increased exports, for example, by opening the export-oriented industrial processing zones for inward FDI in these eight Asianeconomies Generally, inward FDI has reinforcing effects on GDP: FDI not onlyhas a strong direct impact on GDP, but also indirectly increases GDP throughexports by interactive relations between exports and GDP.

Using multivariate cointegration analysis, Granger-causality tests within the framework

of vector error-correction modeling to analyze the dynamic relationships among trade, FDI, technology transfer, output and domestic investment in the selected ASEAN economies; Lee and Tan (2007) proves that FDI has an indirect role in influencing growth through technology transfer mechanism FDI, however, has a direct significant influence on output and also on domestic investment activities.

Sjöholm (2013) examined the determinants of FDI in South East Asia and theireffects on the host countries The impacts of FDI on South East Asia countriesinclude industrialization, growth, and trade Moreover, literature on spillovereffects, in other words, externalities of FDI, also shows positive effects Thestudies on spillovers in Southeast Asia focus on the effect on productivity, butthere are also studies on wage spillovers Almost all of them find evidence ofpositive spillovers: local firms benefit from the presence of foreign firms

However, the degree of the effects varies, depending on many different factors

According to Sjöholm (2013), the relative importance of FDI depends on thesize of the countries, and an alternative measure of the role of inward FDI is theratio of the inward stock of FDI to GDP

Using a baseline regression model, Rao, Sethi, Dash and Bhujabai (2020) demonstrated that every 1 per cent increase in FDI leads to 0.15 per cent increase in GDP growth in

the region annually When time and country specific effects are considered.every 1per cent increase in foreign aid leads to 3.6 percent increase in GDP growth.

Regarding the same paper, joining WTO has not had a positive impact ongrowth for some of the economies in the South East Asia region For instance,trade and foreign capital flows could have hurt domestic investors anddampened uncompetitive domestic markets

Except for a few economies such as, India, Singapore, Maldives and Malaysia,the rest of the economies have not been able to reap the benefits of tradeliberalization due to lack of institutional reforms, corruption, infrastructuresbottlenecks, civil war and the absence of a well-developed financial market

In the case of Vietnam, Nguyen (2017) examined the long run and short run impacts of FDI and export on economic growth of Vietnam during the 1985-2015 period using the ARDL approach With a maximum lag length of 2 for annual data collected from World Bank data sources, she concluded that 1% increase in FDI is associated with approximately 0.15% increase in GDP growth in Vietnam from 1985 to 2015.

Tu (2018) showed that FDI had significant effects on economic growth in bothlong run and short run in Vietnam for the period 1986-2015 using the ARDLmodel According to his study, an increase of 1% in FDI will raise economicgrowth by 0.19% with an optimal lag length of 2, showing the important impact

of FDI on economic growth in the case of Vietnam from 1986 to 2015

In the case of Malaysia, according to Mun, Lin and Man (2008), using ordinaryleast square (OLS) regressions and time series data, FDI has direct positiveimpact on GDP because when the FDI rate increases by 1 %, this will lead thegrowth rate to increase by 0.046072%

Interestingly, a paper conducted by Sharif and Zulkornain (2009), there is neither strong evidence of a bi-directional causality between the two variables nor a long-run

relationship between FDI and GDP in Malaysia Using the Toda - Yamamoto approach and the Autoregressive distributed lag (ARDL) models, the paper concludes that the role of FDI on growth in Malaysia should be in an indirect relationship between those two variables, such as technology transfer and productivity.

3.3 Gap in the literature

It is often asserted with confidence that foreign direct investment (FDI) is beneficialfor economic growth in the host economy However, as seen above, the resultsfrom previous research were inconsistent, and there remain gaps in the literature.The differences among studies appear mainly because of variable selection

Therefore, we use the latest data sets and add more variables to assess theimpact of FDI on GDP in the long run The two control variables included areopenness to trade and gross capital formation

Q3: What impact does labour force have on the GDP growth rate of nine

Southeast Asian countries from 2002 to 2018?

Q4: How can market size affect the GDP growth rate of nine Southeast Asian countries from 2002 to 2018?

H3: Labour force has an impact on GDP growth rate of nine Southeast Asian countries.

H4: Market size has an impact on the GDP growth rate of nine Southeast Asian countries

Chapter 4: Methodology4.1 Variables description

This research comprises five variables, one dependent factor (GDP growth rate)

and four independent factors (FDI net inflow, market size, labour force and

openness to trade)

4.1.1 Dependent variables

GDP (Gross Domestic Product) is the monetary value of all finished goods and

services made within a country during a specific period It is computed without

making deductions for depreciation of fabricated assets or for depletion and

degradation of natural resources GDP growth rate is the percentage increase or

decrease of GDP compared to the previous measurement cycle Since GDP is

considered an indicator of the “size” of an economy and the standard of living for a

country, GDP growth rate is a tool to measure how fast the economy is growing

The determinants of GDP include personal consumption, business investments,

government spending, exports and imports As a result, the GDP growth rate is

also affected by these factors

To calculate GDP growth rate of an economy for a single period, the following

formula can be used:

Foreign direct investment (FDI) is the net inflow of investment to obtain a management interest (10% or more of voting stock) in an enterprise operating in another economy It

is the total amount of equity capital, reinvestment of earnings, other long-term capital, and short-term capital as shown in the balance of payments.

FDI has become a valuable source of private external finance for developing countries.

It not only represents investment in production facilities but has also become a means

of transferring production technology, skills, innovative capacity, managerial practices between countries and accessing international marketing networks In some countries, FDI has been acting as a catalyst for accelerating economic growth We will clarify the causal relationship between FDI and GDP growth rate in Vietnam in this research.