Foreign direct investment, financial development and economic growth in asian developing countries

VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS FOREIGN DIRECT INVESTMENT, FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN ASIAN DEVELOPING COUNTRIES A thesis submitted in

VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FOREIGN DIRECT INVESTMENT, FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH

IN ASIAN DEVELOPING COUNTRIES

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By NGUYEN THUC DUY ANH

Academic Supervisor:

DR NGUYEN VAN PHUC

HO CHI MINH CITY, DECEMBER 2011

I am also very grateful to all lecturers of the Vietnam-Netherlands Programme for giving me knowledge and guidance to fulfill the M.A Programme

I would like to thank all the members of the Vietnam-Netherlands Program, especially, VNP Library for helping me to have necessary documents and research papers during my completion of the thesis

Finally, I am indebted to my parents and my dear husband whose love, sympathy and encouragement enabled me to complete this thesis I am also thankful to my classmates for their warm encouragement

ACRONYMS AND ABBREVIATIONS

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UNCTAD United Nations Conference on Trade and Development

Development

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ABSTRACT

This research investigates the role of domestic financial development plays in enhancing FDI's positive effects on economic growth in Asian developing countries In other words, we examine whether countries with better domestic financial system can utilize FDI more efficiently The empirical analysis uses balanced panel data of24 Asian developing countries in the period 1995-2009 This research applies the various models and techniques in panel data regression Linear static models for panel data named constant coefficients model or pooled regression model (POOLED), fixed effects regression model (FEM) and random effects regression model (REM) are employed We analyze all models and employ many kinds of test including poolability test, Hausman test, LM test, fixed effects tests and Wald tests to select the most appropriated estimated model The research findings show that FDI alone does not have directly effect on economic growth but does have when combined with financial development Well-developed domestic financial markets promote the process of technological diffusion associated with FDI in Asian developing countries Therefore, FDI and domestic financial development are complementary in increasing the rate of economic growth in the region There is a threshold level of domestic financial development above which

FDI starts to have positive impacts on economic growth

TABLE OF CONTENTS

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CHAPTER 1 INTRODUCTION 1

1.1 Problem statement 1

1.2 Research objectives 2

1.3 Research questions 3

1.4 Research scope and data 3

1.5 Organization ofthe thesis 4

CHAPTER 2 LITERATURE REVIEW 5

2.1 The impact ofFDI on economic growth 5

2.2 FDI, financial development and economic growth: theoretical framework and • empirical studies 1 0 2.2.1 Theoretical framework 10

2.2.1.1 Neoclassical growth model 10

2.2.1.2 Endogenous growth model 11

2.2.1.3 Technological change model 11

2.2.2 Empirical studies about the role of financial development in FDI-Growth nexus 15

2.3 The measures of financial development 21

2.4 The determinants of economic growth 23

2 5 Chapter remark 2 5 CHAPTER 3 RESEARCH METHODOLOGY 27

• 3.1 Variables measurements 27

3.1.1 Dependent variable: Economic growth (GROWTH) 27

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-3 1.2 Independent variables 2 7 3.1.3 Control variables (CONTROLS) 31

3.2 Data collection 33

3.3 The estimation strategy 34

3.3 1 Panel regression models 3 5 3.3.1.1 Constant coefficients model (POOLED) 35

3.3 1.2 Fixed effects regression model (FEM) 3 5 3.3.1.3 Random effects regression model (REM) 37

3.3.2 Choice of panel regression model (Testing panel models) 38

3.3.2.1 The F-Test for individual and time effects in FEM models: 38

3.3.2.2 The Chow Test for the POOLED against the FEM (Test for poolability): 39

3.3.2.3 The Hausman Specification Test for the FEM against the REM 39 3.3.2.4 The Breusch-Pagan (1980)- Lagrange Multiplier (LM) Test for the POOLED against the REM 40

3.3.3 Testing assumptions of the error term 41

3.3.4 Model specification 41

3.4 Summary of the analytical methods 43

3.5 Hypothesis statements 43

CHAPTER 4 RESEARCH RESULTS 45

4.1 The descriptive statistics of the sample 45

4.2 Empirical results 46

4.2.1 Examining the impact ofFDI, on its own, on economic growth 46

4.2.1.1 Choosing the appropriate model 47

4.2.1.2 Test for heteroskedasticity 48

4.2.1.3 Results discussion 50

4.2.2 Examining the role of financial development in FDI-Growth nexus 51

4.2.2.1 Choosing the appropriate model 52

4.2.2.2 Test for heteroskedasticity 53

4.2.2.3 Results discussion 55

4.3 Chapter remark 62

CHAPTER 5 CONCLUSION AND RECOMMENDATION 64

5.1 Conclusion 64

5.2 Recommendation 66

5.3 Research limitation and suggestion for further study 68

REFERENCES 70

APPENDIX A LIST OF ASIAN DEVELOPING COUNTRIES A-1 APPENDIX B DATA SOURCES AND DESCRIPTIVE STATISTICS B-2 APPENDIX C PANEL MODEL TESTS C-1 APPENDIX D REGRESSION MODEL RESULTS D-11

LIST OF TABLES

Table 3.5-1: Summary of expected signs of all variables 44

Table 4.2-1: Summary of testing panel model results for model (4.1) 47

Table 4.2-2: Summary the result of Testing Heteroskedasticity for Model ( 4.1) 48

Table 4.2-3: REM regression model (4.1) result 49

Table 4.2-4: Summary of testing panel model results for model ( 4 2) 52

Table 4.2-5: Summary the results of Testing Heteroskedasticity 53

Table 4.2-6: Two-way FEM regression model results 54

Table 4.2-7: The Wald Test on joint significance ofPOP 55

Table 4.2-8: The Wald Test on joint significance ofEDUC 56

Table 4.2-9: Final two-way FEM regression model results 57

Table 4.2-10: Asian developing countries have financial system reaching a sufficient level of development so that FDI has positive effect on economic growth 62

Table A-1: List of 24 Asian developing countries in data sample A-1

Table B-1: Variables definitions and Data sources B-2

Table B-2: Summary statistics of GROWTH B-3

Table B-3: Summary statistics ofFDI B-3

Table B-4: Summary statistics of Financial Development Indicators B-4

Table B-5: Summary Statistics ofFDixFINANCE B-4

Table B-6: Summary statistics of control variables B-5

Table B-7: Correlation matrix of the explanatory variables for GROWTH B-5

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-LIST OF FIGURES

Figure 3.4-1: Steps ofthe analytical methods 43

Figure C-1: The POOLED model1 C-1

Figure C-2: The FEM model1 C-1

Figure C-3: The REM model1 C-2

Figure C-4: The POOLED model 2a with LL Y used as financial development

indicator C-2

Figure C-5: The POOLED model 2b with PRIVATECREDIT used as financial development indicator C-3

Figure C-6: The FEM model2a with LL Y used as financial development indicator C-3

Figure C-7: The FEM model 2b with PRIVATECREDIT used as financial development indicator C-4

Figure C-8: The REM model2a with LL Y used as financial development indicator C-4

Figure C-9: The REM model 2b with PRVATECREDIT used as financial development indicator C-5

Figure C-1 0: Hausman Test for FEM and REM of model 1 C-7

Figure C-11: Hausman Test for FEM and REM ofmodel2a- using LLY C-8

Figure C12: Hausman Test for FEM and REM of model 2b with PRIVATECREDIT C-8

-Figure C-13: Test for cross-section fixed effects in the FEM model 2b - using PRIVATECREDIT C-9

Figure C-14: Test for cross-section fixed effects in the FEM model2a- using LL Y C-9

Figure C-15: Test for time fixed effects in the FEM model2a- using LLY C-10

Figure C-16: Test for time fixed effects in the FEM model 2b - usmg PRIV A TECREDIT C-1 0

Figure C-17: HET Test for the REM model 1 C-10

Figure C-18: HET Test for the Two-way FEM Model2a- using LLY C-10

Figure C-19: HET Test for the Two-way FEM Model 2b - using PRIVATECREDIT C-10

Figure D-1: The REM model 1 with Robust Standard Errors D-11

Figure D-2: The Two-way FEM Regression Model2a with Robust Standard using LLY D-12

Errors-Figure D-3: The Wald Test on joint significance of POP D-12

Figure D-4: The Two-way FEM Regression Model 2a with Robust Standard using LL Y after eliminating POP D-13

Errors-Figure D-5: The Wald Test on joint significance ofEDUC D-13

Figure D-6: The Two-way FEM Regression Model 2b with Robust Standard Errors-using PRIV A TECRED IT D-14

Figure D-7: The Wald Test on joint significance of POP D-14

Figure D-8: The Two-way FEM Regression Model 2b with Robust Standard Errors-using PRIV ATECREDIT after eliminating POP D-15

Figure D-9: The Wald Test on joint significance ofEDUC D-15

Figure D-1 0: The final Two-way FEM Regression Model 2a- using LL Y D-16

Figure D-11: The final Two-way FEM Regression Model 2b - using PRIV ATECREDIT D-16

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CHAPTER 1

INTRODUCTION

This chapter will introduce the thesis topic and identify the problems going to be

analyzed in the thesis It gives the research objectives, research questions and

research scope The chapter also provides the structure of thesis

1.1 Problem statement

Many developing countries want to attract more FDI because of the belief that FDI

can have a positive impact on economic growth through the transfer of technology,

productivity gains, introduction of new processes to the domestic market, employee

training, managerial skills and international production networks Such positive

impact does not occur automatically, but rather, depends on absorptive power of

receipt country For a long time, the importance of absorptive power focuses only

on human capital and trade regime In recent years, the level of financial

development has emerged as an important channel via which FDI enhances growth

In fact, a higher level of financial development allows the host country to exploit

FDI more efficiently through many ways First, providing of more credit facilities

allows firms to purchase new machines, upgrade existing or adopt new technologies

and upgrade the skills of managers and labors Second, the presence of an efficient

financial system facilitates FDI to create backward linkages, which Improve

production efficiency and then benefit the local suppliers Therefore, financial

development plays a crucial role in allowing host country to absorb the spillovers

associated with FDI

In addition, global FDI inflows have declined due to global financial crisis in 2008

It forces developing countries to have more competitive advantages to attract FDI

Besides of traditional channels such as favorable polices, infrastructure, lower labor

cost , better financial development of developing countries can be new channel to attract more FDI

Many recent studies have shown that the positive impact of FDI is dependent on the extent of financial sector development in host countries However, most of these studies provide international evidence (Hermes and Lensink, 2003; Alfaro et al., 2004; Lee and Chang, 2009; Chee and Nair, 2010) There are still few studies examining the role of financial development in enhancing the contributions of FDI

on economic growth in Asian developing countries Vietnam is one of Asian developing countries where the effects of FDI on economic growth have been debated Then understanding the role of financial development plays in enhancing the contributions of FDI on economic growth in these countries would be useful for Vietnam in increasing its ability to exploit benefits ofFDI more efficiently

1.2 Research objectives

The research aims to investigate the role of financial development plays in enhancing FDI' s positive impacts on economic growth In other words, we examine whether countries with better domestic financial system can utilize FDI more efficiently In particular, it focuses on the following specific objectives:

(1) Examine the impact of FDI on economic growth in Asian developing countries

(2) Investigate the role of financial development in FDI-Growth nexus m Asian developing countries

The research findings will be useful to achieve the overall goal of the thesis: to provide experienced knowledge for governments of Asian developing countries, especially Vietnam, in compiling policies to exploit benefits of FDI efficiently as well as to attract more FDI

1.3 Research questions

This thesis will attempt to answer the following questions:

(1) Does FDI have direct positive effects on economic growth m Asian developing countries?

(2) How does financial development affect FDI-Growth nexus m Asian developing countries?

1.4 Research scope and data

This research is interested in Asian developing countries for the three reasons Firstly, the role of capital and technology is very important to developing countries Then, understanding how to utilizing FDI efficiently in these countries are most considered Secondly, Asia region has been the most attractive destination for foreign direct investment in the world and Vietnam is one of developing economy

in Asia Finally, there are still few studies examine the role of financial development in enhancing the contributions of FDI on economic growth in Asian developing countries

The empirical analysis is performed using balanced panel data from twenty-four Asian developing countries over a span of 15 years (1995 - 2009) Data was collected from the World Development Indicator (WDI 2011) & the Worldwide Governance Indicators (WGI) published by the World Bank, the United Nations Conference on Trade and Development (UNCTAD) and Barro-Lee Dataset (2010)

A list of countries included in this research is provided in the table A.1 of the Appendix A

1.5 Organization of the thesis

This thesis has five chapters After this introductory chapter, chapter two to will survey the literature relating to theory of economic growth, the relationship among FDI, financial development and economic growth, as well as the measures of financial development Then, empirical studies regarding to the roles of financial development in enhancing the positive effects of FDI on growth are introduced

Chapter three presents research methodology, estimation strategy and describes the data used in this study Panel methods and techniques are also discussed in this chapter

Chapter four presents and discusses model results

The final chapter summarizes the findings of the previOus chapters It g1ves conclusions and implications for polices of growth and attracting FDI in Asian developing countries

CHAPTER2

LITERATURE REVIEW

The main purpose of this chapter is to review theoretical and empirical literature for the links among FDI, financial development and economic growth The chapter is divided into four main parts The first part contains the concepts and the relationship between FDI and economic growth The second part, theoretical framework and empirical studies about the links among FDI, financial development and economic growth are presented in detail The third part reviews literature for measures of financial development The final part provides a brief history of determinants of economic growth In summary, the conceptual framework is expressed

2.1 The impact of FDI on economic growth

According to the 4th editor of the OECD Benchmark Definition of Foreign Direct Investment, "FDI reflects the objective of establishing a lasting interest by a resident enterprise in one economy (direct investor) in an enterprise (direct investment enterprise) that is resident in an economy other than that of the direct investor The lasting interest implies the existence of a long-term relationship between the direct investor and the direct investment enterprise and a significant degree of influence on the management of the enterprise The direct or indirect ownership of 10% or more of the voting power of an enterprise resident in one economy by an investor resident in another economy is evidence of such a relationship." This section will review the literature on the impacts of FDI on

economic growth in both the theoretical mechanisms and the empirical evidence

Theoretically, the neo-classical and the endogenous growth models have the different viewpoints about the relationship between FDI and economic growth in recipient country According to the neo-classical models, FDI can only affect

of capital accumulation and technology change In particular, FDI affects the growth rate via research and development investment (R&D) and human capital variables The benefits of FDI inflows are not only technology transfer but also crucial knowledge transfer in terms of training, skill acquisition, new management practices, and organizational arrangements This is well-known that FDI generates positive spillovers for the local economy

However, FDI can also generate negative spillovers for the local economy known as the crowd-out effect, the balance of payment problem and the enclave economy Firstly, the crowd-out effect of FDI happens when the multinational enterprises

(MNCs) or foreign investors take away the investment opportunities of domestic firms or tend to displace domestic producers Another signal of this effect is the ratio of FDI inflows over the total gross fixed capital formation is greater than the ratio of domestic investment over the total gross fixed capital formation If FDI enters the economy in sectors in which the competing domestic firms already exist, FDI may reduce domestic investments undertaken by domestic producers or reduce the entry of new local firms Especially, in case foreign investors finance their projects by borrowing from the local financial markets under conditions of scarce resources, domestic interest rates may increase as a result, thereby domestic firms may not able to obtain their necessary credits It leads to the worst possibility is that domestic firms may be driven out of business If FDI enters the economy in new sectors, it may pre-empt investments by domestic firms due to advantages of finance and technology and human capital However, the proper government

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supports may help domestic firms to enter the market successfully FDI is also enters the economy via mergers and acquisitions (M&A) activities which are just the transfer of ownership of existing assets from domestic to foreign firms Thus, FDI is not real investment in this case Regardless of the way FDI enters the economy, its crowd-out effect may occur There will be serious problems in the host country if foreign investors deliberately make their monopoly of major sectors, retard technology transfer, focus on exploiting and exporting natural resources or transfer profits to their headquarters abroad to avoid local taxes Thereby, FDI inhibits the development of host country Empirical evidence found that the crowd-out effect of FDI took place in most developing countries where domestic market conditions were poor and government policies were inefficient

Agosin and Mayer (2000), for example, examined the crowd-out effect of FDI for three developing regions (Africa, Asia and Latin America) with panel data for the period 1970-1996 and the two sub periods 1976-1985 and 1986-1996 Their results indicated that there had strong crowd-out effect in Latin America, neutral effect in Africa and crowd-in effect in Asia Gorg and Strobl (2002) found that foreign investment reduced the number of local firms and discouraged the entry of new local firms in the high-tech sector in Ireland Examining the effect of FDI on domestic investment for province-level panel data in the period for 1986-1999, Braunstein and Epstein (2002) found that FDI had the crowd-out effect on domestic investment in China However, general conclusion from empirical studies is that the problem of crowd-out effect ofFDI can avoid if the host country's government has relevant policies For example, Korea had polices to restrict foreign investments in certain industries Then, they have had the emergence of successful domestic producers in reality

Secondly, the balance of payments problem may occur because of FDI It is argued that the impact of FDI inflows on the host country's balance of payments may be positive at the beginning, but the impact turns to be negative in the medium term

This may be due to after establishing the business; foreign firms increase imports of intermediate goods and services or new machines and then begin to repatriate profits However, the impact of FDI on the balance of payments strongly depends

on the exchange rate regime of the host country For example, given a specific situation as the demand for foreign exchange of a FDI firm exceeds the supply of foreign exchange generated by that firm If the host country has a fixed exchange rate regime, increasing in the demand for foreign exchange may increase deficit in its balance of payments In contrast, if the host country has flexible exchange rates, the gap between the demand and supply for foreign exchange can be corrected by movement in the exchange rate (a depreciation in this case), thereby the balance of payments may not be affected

Thirdly, FDI may create the enclave economy When foreign firms in FDI sector create benefits for themselves, not for the whole economy of the host country, the enclave economy is emerged Such foreign films typically operate in the field of mining and raw materials exploitation that requires high technology, capital intensive and use a small amount of local labors The host country may face the problem of raising the real exchange rate due to sudden inflows of large amounts of foreign capital This means FDI has no backward or forward linkage effects in the host country Then the process of technological diffusion will not happen As a result, the host country does not exploit FDI's benefits to increase economic growth However, it is not suggested that the host country need to prevent foreign investors from entering the field of mining and raw materials exploitation Rather, the government of host country should issue prudent policies to avoid excessive exchange rate appreciation and ensure the process of technology transfer will be realized

To sum up, positive effects or negative effects of FDI on economic growth of a host country much depend on local conditions Numerous empirical studies of the

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relationship between FDI and economic growth have found many important conditions of host countries such as:

Human capital: Borensztein et al (1998), Xu (2000) and Li and Liu (2005) found

that FDI had positive impact on growth only when the recipient country reached a certain threshold of stock of human capital

Openness: Balasubramanyam et al (1996) and De Mello ( 1997) emphasized trade

openness as being crucial condition for realizing the potential growth impact of FDI

macroeconomic stability such as political stability, low inflation, balance fiscal account is always an attractive destination for foreign investors Additionally, if host country's government has relevant and credible policy environment for FDI, it will significantly influence location decisions of foreign investors Exploring the relationship among FDI, economic freedom and economic growth in Latin America countries, Bengoa and Sanchez-Robles (2003) found that FDI has positive relationship with economic growth However, political, economic stability and liberalized markets were required conditions to realize FDI's benefits in host countries Brooks et al (2003) reviewed FDI's impacts in developing Asia and investigated the importance of the policy context in which FDI had positive and negative effects on economic growth in host countries Their results suggested that the policy environment in the host country and particularly in the local area of the host county where FDI was located was very important to realize positive impacts ofFDI on economic growth

Financial development: Only in recent years, it is argued that local financial

development as an important precondition for FDI to have positive impact on economic growth Well-developed financial system will allocate resources efficiently It helps domestic firms, especially medium and small-sized firms get

the!ir necessary capital to upgrade existing or adopt new technology By this way,

2.'2.1.1 Neoclassical growth model:

The neoclassical growth model was first presented by Solow (1956) The production function in this model takes a Cobb-Douglas form and including three inputs - capital (K), labor (A) and technological progress (A):

Y = A.Ka L1-a

Key determinants of growth are capital accumulation, labor force growth and technological change and over time, incomes of poor and rich countries should converge Solow assumes technology increases independent (exogenous) of the model The key assumption of Solow model is that capital is subject to diminishing returns Growth is only affected in the short-run and determined by the rate of capital accumulation as the economy converges to the steady state The long-run rate of growth is exogenously determined by the model Solow predicts that an economy will converge towards a steady state that depends only on the rate of technological progress

2.i1.2 Endogenous growth model:

In 'the mid-1980s, a group of economists led by Romer (1986) developed new growth theory, called endogenous growth theory Models of endogenous growth discard the neoclassical assumption of diminishing marginal returns to capital All

2.2.1.3 Technological change model:

Endogenous growth models discarded diminishing returns to capital (including human capital) According to Barro and Sala-I-Martin (1995, p 212), "This absence

of diminishing returns meant that long-term per capita growth was feasible in the absence of technology progress" Nevertheless, they argued that the global absence

of this diminishing return might be not realistic Therefore, they developed the technology change model in order to escape from diminishing returns in the long-run (see Barro and Sala-I-Martin, 1995, p 212-238)

In technological change model, technology progress showed up as an expansion of the number of varieties of producers and consumer products

Hermes and Lensink (2003) employed the technological change model to illustrate the theoretical link between foreign capital flow and economic growth via financial development They assumed that technical progress showed up in the model through the variety of capital goods available This study closely follows their approach

An1 economy is modeled by three types of agents: final commodity producers or

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finhs, innovators and consumers Innovators produce capital goods and producers

or firms produce final goods Every producer rents varieties of capital goods from innovators in order to produce final goods The purchase price of the capital good is cakulated basing on the present value of the returns from inventing and producing,

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de~oted as V(t) According to Barro and Sala-I-Martin (1995, p 218), assuming

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th* there is free entry into the business of being an inventors so that anyone can pay

the R&D cost (denoted as 17) to secure the present value V(t) and in equilibrium (

V(t)=17 holds), the constant rate of return is given by:

(2.1)

Where r is interest rate, a measures the proposition of capital income 1 L is labor

input; A is TFP parameter2 representing the level of technology and 17 is the cost of R&D

FDI is entered the model by assuming that there are fixed unity maintenance costs, and fixed set-up costs (R&D costs, 11) In accordance with Borensztein et al (1998), more FDI leads to a decrease in the costs of innovation The idea is it is cheaper to imitate existing products than to innovate in new things The possibility to imitate will increase if other countries produce more goods than host countries This indicates that a negative relationship exists between FDI and R&D cost; i.e higher FDI inflows bring about lower innovation costs through imitation activities Therefore, the costs of innovation can be modeled as follows:

l7 = f ( FDI)' where all I 8FDI < 0

I a-The coefficient in Cobb-Douglas production function

2 TFP- Total Factor Productivity, denoted by A in Cobb_Douglas production function: Y =Ax Lax Kfl

In the finance and growth literature, it is well known that financial sector can stirlmlate economic growth via capital accumulation and enhancing the average

lev~l of technology (King and Levine, 1993a; b; Levine, 1997) Hence, the impact

of financial development is introduced into the equation (2.1) via A, the level of

technology In this view, A can be written as a function of the development of the

(2.3)

Where B is the elasticity of marginal utility and p is the discount rate

In the steady state equilibrium, the growth rate of consumption equals the growth rate of output, denoted as g Substituting equation (2.2) into (2.3), the link among FDI, financial development and economic growth is finally established as follows:

It is clear from equation (2.4) that an increase in FDI (i.e f(FDI) decreases

because off' ( FDI) < 0) leads to an increase in the growth rate of output (g) and

the effect of FDI depends on the development of the financial sector (/(FINANCE)

) Specifically, an increase in FDI lowers set-up costs (for technology adaptation)

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and raises the return on assets (r) This contributes to rise in saving and hence

country has higher the level of technology, i.e well-developed financial system

In this model, the role of financial development is understood via the level of technology However, this link needs to be clarified further Firstly, the financial

syst~m has an important role in allocating financial resources for investment projects On the one hand, it increases the volume of resources available to finance investment by mobilizing savings It also monitors investment projects, hence contributes to increase the efficiency of the projects carried out (see Levine, 1998) Thus, via mobilizing savings, allocating resources efficiently and monitoring investment projects, well-developed financial system will promote economic growth

Second, financial institutions can help domestic firms to avoid substantial obstacles

in upgrading existing or adopt new technologies Such obstacles are money and risk Well-developed financial institutions allow domestic firms to get necessary crepit and reduce risk Thereby, financial development encourages domestic firms

to invest in new technologies or to upgrade their existing technologies Huang and

Xu ( 1999) said that financial institutions solved informational and incentive problems related to R&D activities, and then promote innovation Therefore, well-developed financial institutions not only encourage domestic firms to adopt new technologies but also promote technological innovation Thus, they have significant contributions to the process of technological diffusion and then enhance economic

growth

Third, in many cases domestic firms need to be financed to upgrade their own technology, adopt new technologies, or upgrade the skills of their employees It is clear that the development of financial system determines to what extent domestic firms may be able to realize their plans Thus, financial development is considered

as a channel through which technology spillover may take place

Finally, the development of the domestic financial system may also determine to what extent foreign firms will be able to borrow in order to extend their innovation activities in the host country, which would further increase the scope for technological spillovers to domestic firms Thus, the availability and quality of domestic financial markets also may influence FDI and its impact on the diffusion

of technology in the host country

In conclusion, domestic financial development plays an important role in complementing with FDI to enhancing the process of technological diffusion, thereby increasing the rate of economic growth

2.2.2 Empirical studies about the role of financial development in FDI-Growth nexus

Recently, there has been a lot of concern about the relationship between FDI and financial system Basing on the endogenous growth theory, most recent studies found the complementary impact of FDI and financial development on economic growth

Hemes and Lensink (2003) employed a model of technological change to illustrate the theoretical link between FDI and economic growth via financial development A crucial assumption in their model was the domestic financial system influenced growth through the level of technology The impact of the financial sector entered the model via TFP parameter, the level of technology FDI was introduced in the model via a function to specify the cost of innovation The cost will fall as FDI inflow increases because innovation is cheaper due to technology transfer from foreign to local firms The link between FDI and economic growth via financial development was indicated as follows:

Where a measures capital's share of income (the coefficient in Cobb-Douglas

production function); L is labor input; F is FDI, f(F) is innovation cost; H is development of the financial sector, f(H) is TFP parameter representing the level of

technology; e is the elasticity of marginal utility; pis the discount rate and g is the growth rate of output The study showed that the effect of FDI (F) on the growth rate of output (g) depended on the financial development (H) Specifically, an

increase in the total volume of FDI leaded to a lower level of set-up costs (for technology adaptation) and raised the return on assets This in turn increased in saving and hence higher growth rate in consumption and output This effect would

be greater if the level of technology in host country was higher (higher f (H)), in other words financial system was developed better

Hemes and Lensink (2003) created an unbalanced panel data set of four five-year periods (1975-79, 1980-84, 1985-89 and 1990-95) of67 developing countries They applied three different estimation techniques for this panel data set: estimations with

a common constant (pooled OLS), with fixed effects and with random effects The interest variables in their model were FDI to GDP ratio (LFDI), the private sector bank loans to GDP ratio (LCREDP) chosen here as a measure of financial development, LFDI interacted LCREDP Their results showed that financial systems in 3 7 countries in Latin America and Asia had been developed enough to let FDI significantly contribute to economic growth Other countries in Sub-Saharan Africa had very weak financial systems As a result, FDI did not significantly contribute to economic growth in these countries The main conclusion of this study can be if the local financial system is well developed, it can positively contribute to the process of technological diffusion associated with FDI

Alfaro et al (2004) examined whether economies with better-developed financial markets were able to benefit from FDI to promote their economic growth Differing from the approach of Hermes and Lensink (2003), Alfaro et al assumed a small economy consisting of two sectors: the foreign production sector (FDI sector) and

the domestic production sector A continuum of agents in such economy, indexed

by their levels of ability, can either work for foreign companies or become local entrepreneurs in domestic production sector In Alfaro et al 's model, FD I contributes growth via spillover effects on the productivity of local entrepreneurs The number of local entrepreneurs in domestic sector depends on the availability of credit and thus on the efficiency of the domestic financial system According to the authors, efficient financial markets are characterized by ease of access to credit by capable local entrepreneurs and allowing more entrepreneurs to take advantage of benefits from FDI In contrast, an inefficient financial system fails in serving the financial needs of local entrepreneurs Therefore, fewer entrepreneurs can be established or survived to benefit from FDI As results, the effects of FDI on economic growth are diminished The regression model in their empirical analysis

IS

Where GROWTH is the growth rate of real GDP per capita of the country; FDJ is the net FDI inflows; FINANCE denotes the financial development (using both banking sector indicators and stock market indicators); CONTROLS are control

variables

Alfaro et al employed the ordinary least square for a cross-section data of 71 countries over the 1975-1995 periods Their estimation results showed that FDI had positive effects on economic growth However, the development level of local financial markets was crucial condition for these positive effects to be realized Similarly, Lee and Chang (2009) provide evidence that the relationship between FDI and growth is endogenously affected by the development of the domestic financial sector Their study overcomes some of the shortcomings in previous studies by applying recent advances in panel cointegration and panel error correction models for a set of 3 7 countries using annual data for the period 1970-

2002 The authors analyzed the dynamic interrelationships among FDI, financial

There are three important findings in their results First, when a country has a solid financial system as its foundation, it can effectively reap the benefits from FDI inflows Second, the healthy development of the financial system is a drawing force for FDI Third, it could be easier in the long-run to attract even more FDI if a well-developed financial system is supplemented with an active economic policy

The most recent study is Chee and Nair (2010)'s study They examined whether local financial development was an important channel via which FDI enhanced growth in the Asia-Oceania region Different roles of financial development in the developed, developing and least developed countries in the region were also considered in their study

They employed fixed effects model and random effects model for a panel sample of

44 Asia and Oceania countries of the period 1996-2005 The regression model is

GROWTH; 1 =flo+ fJ1 FD1; 1 + fJ2 FDit + fJ3 (FD!it xFD; 1 )+ fJ4 (dLDC; xFD1; 1 xFD; 1 )+

fJ5 (dDC; xFDiir xFD; 1 )+P; 1 B+&it

where GROWTH is per capita GDP growth rate; FDI is inflows of FDI (% GDP);

FD denotes financial sector development proxied by liquid liabilities or private

credit (% GDP); FDlit x FDit is used to capture the role of financial sector development in enhancing the contributions of FDI on economic growth; dLDC is

dummy variable for least developed countries; dDC is dummy variable for

developing countries; P consists of other variables that affect economic growth

(control variables)

FDlit x FDit is also interacted with country classification dummies ( dLDC and

dDC) to capture the difference in the complementary effect of FDI and financial sector development for developed, developing and least developed Asian and Oceania countries Differing from previous studies, the author added 2 variables -

dLDCi x FDlit x FDit and dDCi x FD!it x FDit in the regression model

In order to correct for serial correlation and heteroskedasticity, the authors used Generalized Least Squares (GLS) for the fixed effects model and the White's robust standard errors for the random effects model Their results showed that local financial development was an important channel via which FDI contributed to increased economic growth in Asia-Oceania region The role of financial development in developing countries was as important as in developed countries Whereas, this role is more important in least developed countries because the complementary impact ofFDI and financial development on growth was higher

In addition to the international evidence of the role of financial development in enhancing the growth effect of FDI presented above, there is a number of evidence

in specific countries Ljungwall and Li (2007) investigated whether the development of financial sector is the factor in the link between FDI and economic growth in China They applied the Generalized Method of Moments estimation to panel data of28 Chinese provinces over the period 1986-2003 Their results showed that the interaction between FDI and financial development enhances economic growth

Choong and Lim (2009) analyzed the interaction between FDI and financial development in promoting Malaysia's economic growth Using the technique of co-

integration and error correction model, an endogenous growth model is estimated for Malaysia, covering the sample period of 1970-2001 Their study provided additional evidence of the interaction between FDI and financial development exerts a significant effect on economic growth In another study in Malaysia, Ang (2009) applied V AR framework, Vector Error Correction model to time-series data

in the period 1965-2004 He found that FDI and financial development had complementary impact on total output of Malaysia in the long-run Particularly, well-developed financial development assisted FDI to create backward linkages that improved production efficiency and then benefit the local suppliers This means that the role of financial development is very important to strengthen Malaysia's ability

in absorbing the FDI's benefits and attracting FDI as well

In Vietnam, the relationships between FDI and economic growth and between financial development and economic growth have been convinced by many studies For example, Nguyen (2006) applied a simultaneous equation model to test the relationship between FDI and economic growth In her study, data are collected form General Statistics Office (GSO) over the period 1996-2003 Her findings show that FDI and economic growth are important determinants of each other in Vietnam Tran (2009) clarified the nature of the relationship between financial development and economic growth in the case of Vietnam In his study, OLS method was applied

to quarterly time-series data from 1995 to 2006 The result of his study showed that financial development is closely linked with economic growth Anwar and Nguyen (2009) examined the link between financial development and economic growth by using a panel data covering 61 provinces of Vietnam over the period 1997-2006 Generalized Method of Moments was used in their research They found a strong positive relationship between financial development and economic growth in Vietnam A little attention, however, has been investigated financial development plays an important role in enhancing benefits of FDI on economic growth in Vietnam due to lacking of data

2.3 The measures of financial development

According to the World Economic Forum's Financial Development Report 2010,

''financial development is defined as the factors, policies, and institutions that lead

to effective financial intermediation and markets, and deep and broad access to capital and financial services" Since, the concept of financial development is

complicated; there is no single proxy for the level of financial development in the literature

Empirically, financial development proxied by different measures that can be classified into two groups: those relating to the banking sector (or credit markets) and those relating to the stock market (or equity markets)

For the first group, we review four proxies used in most researches, for example King et Levin (1993a; b), Levine (1997), Levin et al (2000), Alfaro et al (2004 ),

• The first proxy, Liquid Liabilities of the Financial System, equals currency

held outside the banking system plus demand and interest-bearing liabilities of banks and nonbank financial intermediaries divided by GDP It is one of the major indicators to measure the size of financial intermediaries, which includes the central bank, deposit money banks and other financial institutions Therefore, Liquid Liabilities provides a measure for the overall size of the financial sectors (or

"financial depth") without distinguishing between different financial institutions

• The second proxy, Commercial-Central Bank Assets, equals the ratio of

commercial bank assets to the sum of commercial bank and central bank assets It measures the degree to which the central bank versus commercial banks is allocating credit Intuitively, this measure implies that banks are likely to offer better financial functions than central banks However, banks are not the only financial intermediaries providing valuable financial functions and banks may

simply lend to the government or public enterprises Therefore, the difference between banks and central banks may be not clear

• The third proxy, Private Sector Credit by Deposit Money Banks and Other

Financial Institutions, equals the value of credits by financial intermediaries,

excluding credits issued by the central bank, to the private sector divided by GDP

It measures general financial intermediary activities provided to the private sector This measure, and the one that follows, focus solely on the claims on the private sector Levin et al (2000) interpreted that higher level of this proxy as indicating higher levels of financial services and therefore greater financial intermediary development

• The fourth proxy, Private Sector Credit by Deposit Money Banks, equals the

credit by deposit money banks to the private sector as a percentage of GDP (it does not include non-bank credits to the private sector)

For the second group, we draw on the proxies introduced in Levin and Zervos (1998), which in tum used in Alfaro et al (2004):

• The fifth proxy, Value Traded, equals the total shares traded on the stock

market exchange divided by GDP This is a measure of stock market liquidity, capturing trading relative to the size of the economy

• The sixth proxy, Turnover, equals the value of the trades of domestic shares

on domestic exchanges divided by the value of listed domestic shares It is another measure of stock market liquidity However, Turnover measures trading relative to the size of the stock market (differing from Value Traded)

• The seventh proxy, Capitalization, equals the value of listed domestic shares

on domestic exchanges divided by GDP It measures the size of the stock market and common used as an indicator of stock market development

"

•

Generally, proxies relating to credit market (in the first group) are most common used to measure the level of financial development in developing countries It is because of the limited data of the young stock markets in developing countries

2.4 The determinants of economic growth

Numerous studies have been conducted to determine the determinants of economic growth Using differing approaches, these studies have pointed out different explanatory parameters and offered various perceptions to the sources of economic growth

Barro (1998), a pioneer in the econometric analysis of the main factors associated with growth, used the growth rate of real GDP per capita as indicator of economic growth and various explanatory variables such as the initial level of real per capita GDP, initial level of human capital, fertility rate, the life expectancy at birth, government consumption, the rule-of-law index, investment ratio, political rights, inflation and trade openness According to his findings, the growth rate was enhanced by higher initial schooling and life expectancy, better maintenance of the rule of law, lower fertility, lower government consumption, lower inflation, and improvements in the trade openness In addition, for given values of these variables, growth is higher if a country begins with a lower starting level of real per capita GDP Other studies have also found negative and significant effect of initial per capita GDP on growth (Romer, 1993; Sala-i-Martin, 1997)

Investment is identified by both neoclassical and endogenous growth models as the important determinant of economic growth There are many empirical studies convinced the positive relationship between investment and economic growth (Barro and Sala-I- Martin, 1995; Sala-i-Martin, 1997)

Human capital is pointed out as the main source of economic growth in endogenous growth models Many studies have measured the level of human capital by using

proxies related to education such as school enrolment rates, average years of school attainment at the secondary and higher level There have been a lot of evidence supporting education is a key determinant of economic growth (see Barro, 1991; Barro and Sala-i-Marin, 1995)

Openness to trade has been measured by the two methods: Sachs and Warner openness index and the share of total trade (exports plus imports) within the total output (GDP) The connection between trade policy and economic growth has been debated for many decades However, trade liberalization has never been stopped in reality and there has been numerous empirical studies found the positive relationship between FDI and economic growth Sachs and Warner (1995), Edwards (1998) and Dollar and Kraay (2000) proved that countries having more open to trade and capital flows had higher GDP per capita and higher growth rate

Macroeconomic conditions and policy-related variables have been attracting more attention since they can create the framework in which economic growth occurs (see Barro, 1991; 1998; Barro and Sala-i-Martin; 1995) An economy can be influenced by economic policies through many ways, for example, improvement of political and legal institutions, investment in public services, and so on Several macroeconomic factors affecting growth have been identified in the literature However, inflation, fiscal policy, budget deficits and tax burdens have been underlined In general, a stable macroeconomic environment may favor growth, especially, through reduction of uncertainty In contract, unstable macroeconomic may have a negative impact on growth through its effects on reducing of productivity and investment (e.g higher risk)

Foreign Direct Investment (FDI) has recently played a crucial role of international economic activity Several models of growth theory have stressed its role as a primary source of technology transfer However, the empirical literature examining the impact ofFDI on growth provided both negative and positive evidence ofFDI's

effects (e.g Borensztein et al., 1998; Lensink et al., 2000; Lensink and Morrissey, 2006)

In empirical studies of the role of financial development plays in the relationship between FDI and growth, Hermes and Lensink (2003), Alfaro et al (2004) and Chee and Nair (2010) used a limited number of variables from a large set of variables that have been used in the literature to explain economic growth as control variables in growth regression models: investment ratio, level of human capital, inflation, openness, index of political rights, government consumption, population growth rate, government effectiveness index

2.5 Chapter remark

To summarize, this chapter has presented three main points Firstly, FDI can have positive effects and/or negative effects on economic growth of a host country Such effects strongly depend on local conditions of host country

Secondly, the technology change model is employed to illustrate the theoretical link between foreign capital flow and economic growth via financial development FDI

is entered the model by assuming that there are fixed unity maintenance costs, and fixed set-up costs (R&D costs) More FDI leads to a decrease in the costs of innovation The idea is it is cheaper to imitate existing products than to innovate in new things This indicates that a negative relationship exists between FDI and R&D cost; i.e higher FDI inflows bring about lower innovation costs through imitation activities Domestic financial development is entered the model via the level of technology of the host country An increase in FDI lowers set-up costs (for technology adaptation) and raises the return on assets This contributes to rise in saving and hence higher growth rate in consumption and output This effect will be greater if a host country has higher the level of technology, i.e well-developed financial system

Finally, well-developed domestic financial development can contribute to the process of technological diffusion associated with FDI via allocating financial resources, mobilizing savings, encouraging local firms to adopt new technologies or

to upgrade their existing technologies and promoting innovation; thereby increasing the rate of economic growth Therefore, domestic financial development is a crucial precondition in order to FDI can contribute to economic growth in a host country

CHAPTER3

RESEARCH METHODOLOGY

The purpose of this chapter is to discuss and justify the methods of selecting relevant variables, building growth model and estimation strategy We begin with a description of the variables used in this thesis Then, econometric models and estimation strategy will be discussed The sources of data are also mentioned in this part Finally, the summary of estimation techniques using in the analysis will conclude this chapter

3.1 Variables measurements

3.1.1 Dependent variable: Economic growth (GROWTH)

Economic growth is an increase in national income or per capita national income and commonly measured by per capita GDP growth rate In this study, the dependent variable is the annual growth of real per capita GDP usmg the World Bank's atlas method, and is taken from World Bank The usage of GROWTH is found in many empirical studies in the last chapter

3.1.2 Independent variables

Foreign direct investment (FDI):

FDI is one of the key variables of interest in this study There are two measures of FDI, reported in World Development Indicators (published by World Bank, 2011): gross FDI and net FDI inflows According to World Bank, "The gross FDI figures reflect the sum of the net value of inflows and outflows accounted in the balance of payments financial accounts The net FDI inflows measures the net inflows of investment to acquire a lasting management interest (10 percent or more ofvoting stock) in an enterprise operating in an economy other than that of the investor It is the sum of equity capital, reinvestment of earnings, other long-term capital, and short-term capital as shown in the balance of payments."

Our model focuses on the inflows to the economy, and those inflows that remain in the economy Therefore, we prefer using the net FDI inflows as a percentage of GDP to measure FDI This FDI's measure was used in the studies of Hermes and Lensink (2003), Alfaro et al (2004), Lee and Chang (2009), Chee, and Nair (2010)

As in literature review, depending on the local conditions of a host country, FDI can have positive and negative effects on economic growth Empirical studies examining the role of FDI on economic growth have had inconsistent results Hermes and Lensink (2003), Omran and Bolbol (2003) and Alfaro et al (2004) found that FDI had significant and negative individual impact on growth Whereas, Chee and Nair (20 1 0) showed that FDI, on its own, had positive and significant effects on growth In this research, we hypothesize that FDI has positive effect on economic growth

On the subject of the choice of an indicator of the financial development, we note that several indicators have been suggested in the literature to measure the level of financial development These indicators focus on the size, activity and efficiency of financial intermediaries and markets The choice of all indicators of financial sector development would be ideal since each has particular strengths and weaknesses It

is impossible, however, because for several of these indicators, data are only available for a limited number of countries Therefore, this study chooses three indicators to measure the level of financial sector development since their data are available for all countries in the data set

Liquid Liabilities, denoted as LL Y: It is an absolute size measure of financial intermediates without distinguishing between the financial sectors or between the use of liabilities and equals the share of M3 or M2 (when M3 is unavailable) in GDP This commonly used measure has shortcomings It may not accurately estimate the effectiveness of the financial sector in ameliorating informational asymmetries and easing transactions costs However, under the assumption that the

size of financial intermediary sector is positively correlated with the quantity and quality of financial services, many researchers use this measure of financial depth (e.g King end Levine, 1993a; Levine et al., 2000; Hermes and Lensink, 2003; Alfaro et al., 2004; Lee and Chang, 2009; Chee and Nair, 2010)

Commercial-Central Bank Assets, denoted as BANK: It is a relative size measure of financial intermediates Specifically, it measures the relative importance of deposit money banks relative to central banks and equals the ratio of commercial bank assets to the sum of commercial bank and central bank assets Levine et al (2000) stated, "The intuition underlying this measure is that banks are more likely to identify profitable investments, monitor managers, facilitate risk management, and mobilize savings than central banks" Thus, King and Levine (1993a) suggested that including BANK to augment and complement the conclusions deduced from using

Liquid Liabilities, LL Y

Private Sector Credit by Deposit Money Banks and Other Financial Institutions,

denoted as PRIV ATECREDIT: It is the value of total credits to the private sector divided by GDP It excludes credits issued by central and development banks PRIVATECREDIT does not directly measure the amelioration of information and transaction costs, but it is interpreted that higher level of PRIV A TECREDIT as indicating higher levels of financial services and therefore greater financial intermediary development Levine et al (2000) argued that PRIV ATECREDIT was

a better measure for financial sector development since it improved on other measures of financial development used in the literature

Data of the three financial market indicators are collected from A New Database on Financial Development and Structure (World Bank, updated November 2010)

Schumpeter ( 1911) argued that financial sector had an essential role for technological innovation and economic growth In 1980s, endogenous growth models underlined the role of financial development for long-run economic growth via the impact of financial services on capital accumulation and technological