The impact of foreign direct investment and economic growth on CO2 emission empirical study in ASIA

Keywords: Foreign direct investment; economic growth; CO2 emissions; SEM; Asian countries... The effects of economic growth on environmental quality CO2 emissions are analyzed by many pr

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

The impact of foreign direct investment and

Empirical study in ASIA

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

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

DO DANG NGOC GIAU

Academic Supervisor:

Dr PHAM KHANH NAM

HO CHI MINH CITY, NOVEMBER 2015

DO DANG NGOC GIAU

ACKNOWLEDGEMENTS

This process of writing a thesis is a collaborative experience involving the support and helps from many people I want to express my gratitude to those who give me the tremendous support to complete this thesis

I greatly express my special thanks to my supervisor Dr Pham Khanh Nam for all his academic recommendations through finishing this process

I would like to express my deepest gratitude to Dr Truong Dang Thuy for his suggestion which help me handle some problems in this thesis

I wish to express my heartfelt gratitude to Dr Vo Hong Duc who gives me some logical ways in order to present confidently in this thesis

During my time at VNP, I receive a great encouragement and help from some friends, so I am grateful to Mr.Vo Van Hung, Mr.Trinh Hoang Viet and Ms Vo Tan Thanh Diep, for motivating me to overcome all difficulties in the process of thesis Especially, I greatly thanks to Mr Pham Ngoc Thach and Mr Nguyen Son Kien for their help and sharing of their econometric knowledge

Keywords: Foreign direct investment; economic growth; CO2 emissions; SEM;

Asian countries

ABBREVIATIONS

GDP: Gross Domestic Product

FDI: Foreign Direct Investment

CO2: Carbon Dioxide

SEM: Structural Equation Modeling

FEM: Fixed Effects Model

REM: Random Effects Model

OLS: Ordinary Least Squares

PHH: Pollution Haven Hypothesis

EKC: Environment Kuznets Curve

TABLE OF CONTENTS

CHAPTER 1 INTRODUCTION 8

1.1 Problem statement 8

1.2 Research Objectives 10

1.3 Research Questions 10

1.4 Research Scope and Methodology 10

1.5 Thesis Structure 11

CHAPTER 2 LITERATURE REVIEW 12

2.1 Pollution Haven Hypothesis 12

2.2 Pollution Halos Hypothesis 14

2.3 Environmental Kuznets Curve Hypothesis (Theory of economic growth – environmental quality) 15

2.4 Empirical studies related to Pollution Haven Hypothesis 16

2.5 Empirical studies related to Pollution Halos Hypothesis 18

2.6 Empirical studies on the impact of FDI, economic growth on CO2 emissions 19

2.7 Empirical studies on the three-way linkages between FDI-economic growth-CO2 emissions 22

CHAPTER 3 RESEARCH METHODOLOGY 25

3.1 Analytical framework 25

3.2 Model specification 27

3.3 Data and Defining Variables 32

3.3.1 Data 32

3.3.2 Defining Variables 34

3.4 Econometric methodology 37

3.4.1 Panel analysis 37

3.4.2 Structural equation modeling 43

CHAPTER 4 EMPIRICAL RESULT 46

4.1 Overview about CO2 emissions, economic growth and FDI in Asia 46

4.2 Descriptive statistics 48

4.3 Regression diagnostic 49

4.4 Regression results 51

4.4.1 Regression result from panel method 51

4.4.2 Regression result from structural equation model 53

CHAPTER 5 CONCLUSIONS AND POLICY IMPLICATIONS 59

5.1 Conclusion 59

5.2 Policy implications 60

CHAPTER 1 INTRODUCTION

1.1 Problem statement

In recent years, climate change and environmental degradation are the major concerns toward many countries all over the world, especially in ASIA These problems cause many difficulties in poverty reduction and economic development (World Bank, 2015) Moreover, human health is threatened as well as cost for health-care sector is increased by environmental degradation Neria (2014) suggested that approximately 3 million people worldwide die every year by environmental pollution Many researchers found that one of major factors, which causes the climate change and environmental degradation is carbon dioxide (CO2 emissions) (Pittock, 2003; Solomon et al., 2007) They has pointed out that the surge of CO2 emissions level pushes greenhouse gases in atmosphere and leads to climate change threats to socio-economic systems

As a matter of fact, environmental degradation is caused by human activities such

as industrialization, burning of fossils fuel and deforestation Human activities are operated to develop economy and improve life quality Under enormous pressure of sustainable economic development goal, many countries increase extraction, production and especially industrialization Consequently, these activities cause high pollution level

It goes to show that economic growth is one of the main reasons of environmental degradation (Dell et al 2008) The effects of economic growth on environmental quality (CO2 emissions) are analyzed by many previous studies The link of emissions and

economic growth is closely related to the context of Environment Kuznets Curve

(EKC) hypothesis The EKC theory suggests that the emission level increases with a rising in per capita growth of GDP, and it declines after reaching at ―turning point‖ (sustainable income level) From above discussions, this thesis will emphasize on analyzing the impact of economic growth on CO2 emissions

Furthermore, the impacts of Foreign Direct Investments (FDI) on environmental quality are discussed by many researches The study of Smarzynska (2001) suggested

that FDI would be considered as main determinant of environmental quality Even though FDI contributes to promote economic growth, it reduces the environmental quality

According to Pollution Haven Hypothesis, FDI leads to the decline in environmental

quality since most of polluting industries from developed countries tend to move to developing countries in order to avoid abatement cost from stringent environmental legislation Thus, pollution may increase together with the rising in FDI at recipient

countries On the contrary, Pollution Halos Hypothesis claims that FDI may improve

environmental quality in host countries via transferring superior technology and ―green‖ input products Moreover, recipient countries obtain more chances to learn the skills of environmental management system from foreign countries In both points of view, there are two possible impacts of FDI on environmental quality This thesis will examine the impact of FDI on CO2 emission base on two theories

In 2014, Asia was one of regions which received the highest amount of FDI in comparison with the rest of the world, accounting for 30 percent global FDI inflows (UNCTAD, World Investment Report 2014) More importantly, FDI is considered as vital resource of economic growth toward Asian countries The increasing of FDI into Asia leads to promote economic growth in many Asian countries In addition, environmental degradation is one of the main concerns in many ASIAN countries According to the statistic of World Health Organization in 2013, Asia has the highest number of polluted cities As such, this pollution causes many damages to human health Therefore, pollution becomes enormous pressure toward Asian countries Until now, there are many studies of the relationship between environmental quality, economic growth and FDI The empirical results of these studies are ambiguous Therefore, this thesis attempts to answer the question whether FDI and economic growth have influence

on CO2 emissions for Asian countries

The finding from this thesis will provide evidence support the current literature related to the impact of FDI, economic growth on CO2 emissions Moreover, this study

gives several suggestions for policy maker in order to achieve the goal of reducing CO2 emissions as well as improving environmental quality in Asian countries

1.2 Research Objectives

This thesis is to understand the impact of foreign direct investments (FDI) on environmental quality in the context of Asian countries, based on argument of Pollution Haven Hypothesis and Pollution Halos Hypothesis

In addition, this thesis attempts to investigate the relationship between economic growth and environment quality The results would provide research evidences on the general relationship between FDI, economic growth and environmental quality This knowledge would be a contribution to the literature on the linkages between the economy and environment

1.3 Research Questions

In order to achieve the research objectives, this thesis attempt to the answer these following questions:

 Does foreign direct investment lead to increase CO2 emissions in ASIA?

 Does economic growth cause an increase in CO2 emission in ASIA?

1.4 Research Scope and Methodology

This thesis investigates the influence of FDI, economic growth and other determinants (trade openness, level of democracy and scale of economic activity) on CO2emissions by using Asian countries sample The data is collected from 1991 to 2013 due

to its availability

Since the possibility of endogeneity between CO2 emissions, economic growth and FDI (based on suggestion from previous studies that will present in empirical studies), this thesis applies Structural Equation Model (SEM) to estimate the simultaneous equation model which presents the effects of economic growth and FDI on CO2 emissions

1.5 Thesis Structure

This thesis consists of five main chapters

 Chapter 1: Introducing the research

 Chapter 2: Reviewing theoretical framework and previous empirical studies that

related to the effects of economic growth, FDI on CO2 emission

 Chapter 3: Presenting the conceptual framework, the way to build model and

econometric technique for estimating result of analysis

 Chapter 4: Showing the estimation result that interprets the relationship between

variables

 Chapter 5: Summarizing the main finding and bringing out some limitation as

well as suggestion for future studies

CHAPTER 2 LITERATURE REVIEW

This chapter presents both the theoretical and empirical aspects of the relationship between FDI and CO2 emissions There are two sections in this chapter The first section

is to discuss about two of theory: Pollution Haven Hypothesis and Pollution Halos Hypothesis The second section is about the empirical studies including previous studies that have investigate the relationship between FDI and CO2 emissions based on Pollution Haven Hypothesis and Pollution Halos Hypothesis Moreover, this chapter will discuss about the empirical studies related to causal relationship between FDI-CO2 emissions and economic growth

2.1 Pollution Haven Hypothesis

From the theoretical view, Pollution Haven Hypothesis (PHH) prefers that FDI has

a negative effect on environmental quality PHH argues based on Heckscher-Ohlin theorem (Heckscher, (1919) and Ohlin (1933) According to, comparative advantage of Heckscher-Ohlin theorem, Pollution Haven Hypothesis has considered ―lax‖ of environmental regulation as a comparative advantage in polluting industries In addition, Dasgupta et al (1999) supposes that the countries with low environmental standards might be a ―pollution haven‖ for polluting industries As stated by Hechscher-Ohlin theorem, a region with an abundant factor such as labor or capital would have a comparative advantage in producing goods that use abundant locally factor Therefore, this region should specialize in producing and exporting these comparable goods Accordingly, in developed countries, especially countries have a large of polluting industries, tightening up environmental policy is synonymous with the high abatement cost An increase in production cost together with a high penalty fee will lead to the relocation in ―dirty‖ industries In other words, cost of the inputs for pollution-intensive production is increased by stringent environmental law such as fee, taxes or permitting costs toward polluting goods In order to avoid cost of the stringent environmental regulation, the relocation of polluting industries will be expanded to countries where

national environmental standards are lower With the low environmental regulation, a

nation therefore has a comparative advantage in attracting polluting industries As already

discussed above, the pollution is likely to increase as a result of relocation of polluting

industries and potential threat from foreign investment It goes to show that Pollution

Haven Hypothesis state that ―dirty‖ industries tent to move to countries with weaken

environmental regulation and cause environmental damage

Aliyu (2005) suggests that there are three dimensions of Pollution Haven

Hypothesis First, Global free trade make polluting industries relocate to ―lax‖

environmental policies to avoid abatement cost Second, the developed nations or

industrial and nuclear energy production have a propensity to dump hazardous waste to

developing countries Finally, overexploiting non-renewable resources of multinational

cooperation in poor countries to produce petroleum products causes many environmental

problems such as climate change or arises in CO2 level

To support the PHH theory in general and to investigate the relationship between

economic activities and stringent environmental legislation, previous studies have

focused on following econometrics equation:

(1)

In which Y is economic activity, R is regulatory stringency, X are other

determinants that may affect Y

To advocate the PHH theory, the sign of α is expected to be negative, which means

the level of environmental regulation has negative effects on economic activities In the

left hand side of equation, the previous studies have used international trade, foreign

direct investment, net export and so forth as proxies for economic activities

However, measuring the level of environmental regulation is difficult The problem

is answer the question how much the cost from regulation is In order to measure level of stringent environmental regulation, environmental taxes or fees,

permitting cost… had been utilized in the earlier research In addition, some studies have

also used emission level to present for stringent environmental regulation with argument that large of number emissions is signal of weaken environment regulation However, using cross-section data gets some troubles in estimation Namely, cross-section date is considered that it may not control the unobservable heterogeneity and endogeneity problem Then estimation result could be biased Hence, the subsequent studies applied panel data to handle unobservable problem In some cases, the stringent and pollution are determined simultaneously Then, instrument variable becomes a better way to solve endogeneity problem The findings of subsequent studies are better than previous ones and provide a higher statistical significance for estimators To sum of, it could be deduced that FDI has negative effects on environment through the relocation of polluting industries and movement of capital

2.2 Pollution Halos Hypothesis

In contrast with PHH theory, Pollution Halos Hypothesis (Halos Effects Hypothesis) suggests that industrial location and capital flow from foreign countries play

an important role in improving environmental quality in host countries by transferring superior technologies, cleaner production methods and diffusing better environmental management skills The Halos theory not only focuses on FDI firm’s decision from effects of environmental regulation but also concerns about the environmental performance in recipient countries (Zarsky, 1999) First, in general, multinational firms may bring the cleaner energies, newer techniques from foreign countries to domestic countries that may enhance production productivity It is not surprising as a wealthy and developed economy has enough capital ability for investment outside its border As a result, the domestic firms have more opportunities to learn ―green‖ techniques that result

in reducing pollution level Furthermore, improving environmental quality is also depended on environmental knowledge as well as environmentally conscious behavior that are diffused from trained workers from foreign countries Second, it is thought that multinational firms themself are usually stringent in environmental legislation and have a better environmental management due to characteristics of developed economy Zarsky

(1999) offered evidence for this statement with the sample of OECD countries Specifically, OECD is regarded as a powerful economy and a potential resource for other countries, especially poor countries The main activities of these countries focus on discussing and issuing policies related to economic development, trade, improving technology and environment Therefore, OECD firms have a stringent environmental management system However, sometimes, foreign countries pay attention to the environmental standard in host countries or require an equal standard in some cases According Zarsky (1999), ―there will be no ―Halos‖ effects if the foreign company itself

of economic growth, entire society focuses on promoting production with all of available resources Therefore, environmental damage increase sharply, and furthermore pollution

is created from industrialization However, subsequent to reach certain level of income, demand of environmental quality is paid attention Thence, entire society as well as government concentrates on improving environmental quality together with economic growth Nonetheless, most of examination of the EKC in many studies related to air

pollution concern (Shafik, 1994; Liu, 2007) As a result, EKC has become the theoretical base for government in order to control volume of air pollution (such as CO, CO2, SO2 emissions) by increasing economic growth

2.4 Empirical studies related to Pollution Haven Hypothesis

Theory of Pollution Haven Hypothesis has been tested by many empirical researches Most of empirical studies investigate the effects of level of stringent environmental regulation on the competitiveness (net export, net inflow of foreign investment, new plant birth and so forth) (Copeland, 2013)

Keller and Levinson (2002) carried out the research on 958 new foreign-owned factories in United State over period from 1977 to 1994 In order to measure level of stringent environmental regulation, the industries-adjusted index of environmental abatement cost is used The higher the industries-adjusted index in a region is more stringent environmental regulation Moreover, the unobserved heterogeneity that is potential correlated between FDI and level of environment regulation is controlled by Fixed Effects estimation However, by using GMM approach, the result implies that high stringent level causes a decrease in FDI, especially in pollution industries

In another study, Aliyu (2005) also tested the PHH in two groups of countries from 1990-2000 They are eleven OECD countries and fourteen non-OECD countries In this study, it is assumed that stringent environmental legislation increases FDI of polluting industries out of country and amount of pollution tends to go up in recipient countries.More important, based on testing whether PHH exists or not, this research uses environmental tax as proxy for stringent,so as to check the influence of environmental tax

on movement of industries Accordingly, the result of this research provides the statistical significance in the positive relationship between environment tax and outcoming of polluting industriesin developed countries Unfortunately, the effects of FDI inflow in developing countries on pollution (CO2 emissions) is not consistent

In an analysis of firm level data on US-based multinational companies from 1966 to

1999, Hanna (2010) provided evidences supporting for PHH through investigating the effects of environmental legislation on FDI flows Clean Air Act Amendments (CAAA)

is one of the first organizations in United States, which may influent on environmental policy and controls the level of national air pollution all over the world Under CAAA’s control, the result indicates that level of regulation faced by multinational firm is increased, and so movement of FDI based on multinational firm out of United States grows Besides, stringent environmental regulation may drop the productivity of foreign firms because the enormous pressure from environmental regulation induces them not to operate with full capacity

Hassaballa (2013) conducted the test between PHH and Pollution halos hypothesis

by estimating the effects of FDI inflow on emissions in developing countries This research finds that FDI inflows have positive effects on environmental quality and consistent with Pollution haven hypothesis in some countries such as Algeria, Cameroon, Iran, and Mexico Moreover, this research also gives evidence about the causality between FDI inflow and pollution emissions by applying Granger causality test

Furthermore, some previous studies test PHH theory However, their results are ambiguous Eskeland and Harrison (2003) carried a study to test PHH in three countries (Co^te d’Ivoire, Venezuela, Morocco) The result implied that regions with high level of pollution get more foreign investment Since cleaner energy is used in foreign factories that operate in high level of pollution region, it is not matter in industrial relocation In another work, Elliot and Shimamoto (2008) measured stringent environmental regulation

by firm’s total amount of investment cost for pollution abatement in each of the manufacturing industries surveyed by the Japanese Ministry of Economy Assumption of this research is that high pollution abatement costs in Japan makes company move out of nation The study is conducted in three countries: Indonesia, Philippine, Malaysia These countries are FDI recipient from Japan The empirical result indicates that influence of high environmental regulation on industries relocation is significant Nonetheless, the

coefficient has negative sign in Philippine This means that outbound FDI from Japan is not affected by stringent environmental regulation in Japan

2.5 Empirical studies related to Pollution Halos Hypothesis

Recently, some studies provide evidences supporting The Halos theory Most studies examine the spillovers effects from FDI to environment In addition, while there are many researches show the negative relations between FDI and environment, some provide the mixed results

Several studies have found positive effects of FDI on environmental quality Cole et

al (2008) examined whether foreign ownership made domestic firms increase the access

to cleaner technology and reduced fuel energy consumption This research investigated the sample of 84 firms of six sectors in Ghana in the period 1991-1997 He found that foreign firms have an influence on environmental performance in domestic firms Specifically, the local firms have more chances to practice new technology, make use of environmental-friendly input products from foreign countries More importantly, the local firms operate with efficiency energy since learning from high skill of environmental management Nevertheless, the decision to apply this technology may be depended on the experience of the firm’s head Blackman and Wu (1998) provided the same conclusion about the positive effects of FDI In this work, these authors analyze the effects of FDI on energy consumption in Chinese power sectors by conducting a survey in 20 FDI plant According to the survey result, the volume of FDI into power sector in China increases and lead to most of FDI plants improved in their productivity and scale since FDI transfers high technology and new equipment

Doytch and Uctum (2011) suggested that capital inflows bring benefit to developed countries, which supports for Halos Hypothesis Furthermore, they also investigate on firm-level and find that FDI which put into services sector do not lead to an increase in

CO2 emissions However, another result from this study is opposite to Halos Hypothesis when measure pollution by CO emissions and consistent with Pollution Haven Hypothesis Another contribution of this study in comparison with the previous studies is

the application of the Generalized method of moments (GMM) to estimate dynamic panel data Besides testing the Pollution Halos Hypothesis, Doytch and Uctum (2011) also set

up an examination for Pollution Haven Hypothesis and Environment Kuznet Curve Some studies also analyze Halos Effects Hypothesis; nonetheless, the result is still mixed For instance, Dasgupta et al (2000) investigated the effects of regulation, plant-level management policies and other determinants on environmental compliance of firms This study uses the data of manufacturers in Mexico in 1995 and applies the two-stage least square technique to analyze probit equation Unfortunately, the estimated result implies that environmental performance of firms is not affected by foreign ownership of firms which are OECD firms Moreover, the result indicates that the plants with new equipment, high technology do not seem to provide a better environmental management for local firms This result of study is not in line with Halos Hypothesis

2.6 Empirical studies on the impact of FDI, economic growth on CO 2 emissions

Reviewing the theories on the relationship between foreign direct investments, economic growth and environmental quality is very necessary and helpful Nonetheless,

it is not less of learning from previous empirical evidences since these studies not only provide the results about the effects of FDI and economic growth on environment but also investigate other possible determinants which may have effects on environment Laing (2006) set up examination to find an answer for the question ―Does foreign direct investments (FDI) harm to host countries?‖ with the sample of 260 cities in China between 1996 and 2003 The author expects that FDI may bring benefit and do not damage environmental quality Furthermore, this study investigates the relationship between trade openness, income and environmental quality (measured by SO2 emissions)

In addition, a major concern in this study is the possibility of endogeneity problem due to omitting variable Laing then uses two variables ―geography location‖, ―trade policy‖ as the instruments for foreign direct investments to handle the endogeneity concern The analysis is estimated using Fixed Effects method for both with and without instrument variables scenario The result presents that the correlation between FDI and SO2

emissions is negative, suggests that SO2 emissions in a city of China could be reduced with the increase of FDI FDI has been proven to improve environment via transferring of new technology and ―green‖ goods

Several studies have looked at FDI inward and outward in explaining changes in environmental quality Bernauer and Koubi (2009) provided empirical studies about the effects of globalization and democracy on environmental quality in 153 countries over period from 1990 to 2004 by using regression analysis for panel data In this study, channels of Globalization are regarded in three aspects: trade openness, capital flows and international policy cooperation which contribute to increase economic development Accordingly, together with globalization, particularly economic development, pollution tends to increase based on the context of Environmental Kuznets Curve (EKC) In this study, these authors (Bernauer and Koubi, 2009) have measured economic growth by the real GDP and find the result consistent with EKC theorem Moreover, FDI is a proxy for capital flow and is discriminated between FDI inward and FDI outward since they believe that FDI may bring benefit and cost for nation The finding of this study indicates that FDI inward causes enormous pressure on environmental quality Conversely, FDI outward improves environment Besides, Factor Endowments Theory is also considered

in this study to examine the influence of trade openness on environmental quality Last but not least, these authors examine the impact of democracy on environment By using the ranking of democracy level from Polity IV database and degree of participation in international environmental treaties, the study result implies that high level of democracy does not reduce environmental quality while participation in international environmental treaties do not present the effects on environment

Sharma (2011) conducted a study about the determinants (consist of trade liberalization, income, urbanization, and energy consumption) of environment (CO2 emissions) for global panel including 69 countries during 1985-2005 The sample is divided into three groups of income level: high, middle and low income This study applies GMM method (suggested by Arellano and Bond (1991)) to estimate the dynamic

model because of the effects of lagged level of CO2 emissions This study indicates different results among three groups of income level countries To be more specific, the result implies that while income has positively significant effects on CO2 emissions in middle and low-income regions, it has no effects in high-income region Besides, urbanization is one of main determinant that affects CO2 emission in high-income countries

Grossman and Krueger (1991), Selden and Song (1994), Rothman (1998) estimated the relationship between economic growth and environmental quality and provide evidences supporting for EKC This means pollution tends to increase in the first stage of economic degradation but beyond the sustainable point of average income, pollution will

be decline Following the empirical findings from previous studies, Asghari (2013) uses the reduced form of econometric model and panel data of six countries in Middle East and North Africa (MENA) from 1980 to 2011 to estimate the effects of FDI on environmental quality by applying the Fixed Effects Model For the dependent variable in analyzed model, author chooses CO2 emission of industrial pollutants as proxy To get some sense of the factors which affect environment, other control variables are considered that the real Gross domestic product (GDP), share of industry in GDP, trade, population density and corruption perception index This paper implies that FDI inflow transfers cleaner technology to make environment become better This result again provides evidence support Halos Hypothesis In addition, this paper provides evidences consistent with the conclusion of Blackman and Wu (1998), Cole (2008)

In a related study, Halicioglu (2008) found positive effects of income, foreign trade and energy use on environmental quality in Turkey In the same way, Farhani (2013) carried out the research about the impact of economic growth and other determinants on CO2 emissions This research uses panel data in eleven countries of Middle East and North Africa (MENA) over period 1980-2009 He (Farhani, 2013) estimated regression

in two groups by using Fully Modified Ordinary Least Square (FMOLS) and Dynamic Ordinary Least Square (DOLS) methods First, he investigates environmental effects of a

group of indicators including income, energy consumption, and trade liberalization The result of FMOLS and DOLS indicate that the increases in energy use and trade lead to CO2 emissions go up In addition, the effect of income on CO2 emissions is in line with EKC Second, with address of urbanization variable (using urban population in total) into model, he finds the similar result with the positive and significant effects on CO2 emission, apart from negative effects of urbanization determinant The estimated result reveals that the conduction of urbanization reduces the CO2 emissions in the respect of energy use This means that the coefficient of energy consumption variable becomes lower than in equation without urbanization

2.7 Empirical studies on the three-way linkages between FDI-economic

growth-CO 2 emissions

The influence of foreign direct investments and economic growth on environmental quality is analyzed by many previous studies However, in recent studies, many researchers propose that among FDI, economic growth and environment is the possibility

of bidirectional relationship This mean that the relationship between three couple of CO2

both directions, including unidirectional effects and feedback effects Making an

examination of bidirectional relationship between these determinants is very necessary

First, this thesis will consider the interaction between FDI and economic growth (GDP growth as a proxy) Applying annual data of macro determinants from 1960 to

2005, Ang (2008) provided evidence that the GDP and GDP growth have positive effects and play an important role in attracting FDI flows in Malaysia This means that the growth of economy results in more FDI inward Besides, the author also implies that trade openness and infrastructures are contributing to promote FDI inflows The result of this study has been confirmed by Chakrabarti (2001), Fedderke and Romm (2006) In the similar way, Anwar and Sun (2011) constructed a simultaneous equation that present the interaction between ―foreign investments‖, ―domestic capital‖ and ―economic growth‖ This research is analyzed for Malaysia over period from 1970 to 2007 by using time

series data Based on suggestion of Arellano and Bond (1991), authors used GMM technique to estimate the simultaneous equation As such, they find the unexpected result that there is insignificance unidirectional effect from economic growth to foreign investments However, the foreign investments have positive and statistically significant effects on economic growth In order to find strong evidence for the two-way links between FDI and economic growth, Anwar and Nguyen (2010) made an investigation for

61 cities in seven regions in Vietnam from 1996 to 2005 By using the simultaneous equation model and GMM estimation, this paper reports the result that the two-way links between economic growth and FDI inflow exist in four regions (i.e Red River Delta, North East, South East and Mekong River Delta) Specifically, the FDI inflows increase with economic growth and economic growth is also increase with arise of FDI inflows This result is consistent with Tsai (1994)

Second, there are many studies confirm causal links of pollution and economic growth Halicioglu (2009) analyzed the relationship among economic growth, energy use, trade openness and CO2 emission by using time series data in Turkey from 1960 to 2005 Soytas and Sari (2009) set up an investigation for economic growth, energy use and CO2 emissions in Turkey during 1960-2000 In addition, Ghosh (2010) examined the economic growth and CO2 emission relation in India over period 1971-2006 Applying Ganger Causality Test, these studies report a same conclusion that between economic growth and CO2 emissions (proxy for pollution) have two-way effects However, some studies find the mixed results for economic growth and pollution nexus Take examples, study in Malaysia of Ang (2008) and study in South Africa of Menyad and Rufael (1995) confirmed the evidence about the relationship between the CO2 emissions and economic growth, indicating that arise of CO2 emissions causes economic growth declines and without feedback effects from economic growth on CO2 emissions

Third, it is believed that between FDI and pollution are causal nexus Hoffmann et

al (2005) used the Granger causality test to test the relationship between FDI inflow and

CO2 emissions (as a proxy for pollution) by using sample of 112 countries in over the

world This paper divides sample into three groups of countries (low, middle and high income) and they report the unidirectional causality from CO2 emission to FDI inflow in low income countries but middle income countries is opposite Another study, Zhang (2011) provided the result that factor of finical development including FDI can lead to the changing in CO2 emission in China

been discussed in recent studies In addition, study of Omri et al (2014) is to understand the bidirectional between CO2 emissions, economic growth and FDI Their study is analyze for panel including 54 countries in 1990-2011 and applies GMM technique to estimate simultaneous equation which present the causal nexus between these variable The result implied that there are two-way linkages between CO2 emissions –FDI, economic growth – FDI and the unidirectional nexus from CO2 emissions to economic growth without feedback effects Similarly, Tang and Tan (2015) attempt to investigate relationship between CO2 emissions, economic growth and FDI for Vietnam from 1976 to

2009 By applies cointergration and Granger causality test, this research reveal the result that FDI and income play important role in effects on CO2 emissions Moreover, this study provides evidence support three-way linkages causal relationship among income,

CO2 emissions and FDI

In sum of the previous studies which are already reviewed, it is obvious that there is the causality between CO2 emissions- FDI- economic growth (income)

Firgue 1: Conceptual Framework

Source: Author’s analysis

Trade openness

Capital Stock

FDI

Economic Growth

CO 2 Emissions

Activity Polity

The graph illustrates the influence from economic growth and foreign direct investment and other determinants (trade openness, level of democracy and scale of economic activities to CO2 emissions level Moreover, as a mention from previous studies, there are possible feedback effects from CO2 emissions on GDP growth and FDI, this graph, therefore also indicated this relationship In addition, the possible two-way linkage between economic growth and FDI is also presented on conceptual framework

In order to capture the impacts of variables on CO2 emissions level, this paper presents the expected signs in the table 1 FDI may either harm to environment quality (increase CO2 emissions) that is pursuant to Pollution Haven Hypothesis or reduce the environment degradation that is based on Halos Hypothesis Therefore, in the table 1, the impact of FDI on CO2 emissions is expected in two signs which is negative or positive effect Besides, the CO2 emissions will increase following to growth of economy (according to Environment Kuznets Curve) Hence, the impact of economic growth on

CO2 emissions is expected positive On the result of previous studies such as Hossain (2011), Bernauer and Koubi (2009), Trade openness and scale of economic activity are expected that have negative impacts on CO2 emissions Regard to Polity variable which account for level democracy, it is attributed to have negative effect on level CO2 emissions

Table 1 The expected signs of variables used in the research

Trade openness Level of liberality (% GDP) +

Polity Level of democracy( from -10 to 10) -

Activity Scale effects of economic activity (US$ per square

CO2 and FDI, economic growth and FDI, CO2 and economic growth Gujarati (2012)proved that when two-way relationships between endogenous variable and some of exogenous variables exist, the application of common method for single equation is not significant any longer, necessitating more than one equation to find the appropriate result Therefore, this analysis will set up three equations for each case of CO2, FDI and economic growth as dependent variable in order investigate to the causal relationship among them Omri (2013) suggested that Cobb-Douglas production function is appropriate to present the relationship between CO2, FDI and economic growth

Cobb-Douglas production function is established by Douglas (1976) In economics, the Cobb-Douglas production function has been used to present the causal link between output and the combination of factors Two main factors in Cobb_Douglas function are

labor and capital According to Cobb-Douglas, it is accepted that the output of production

is result from combination of labor and capital invest Thus, functional form of Douglas is:

( ) Where:

 Y: output or total production

 A: total factor productivity

 α and β: output elasticity of capital and labor respectively The value of α and β are assumed constant

In the early studies, economic growth is regarded as output of economy and used in production function For instance, Omri (2013); Omri, Nguyen and Rault (2014)has applied Cobb-Douglas to investigate the relationship between energy consumption (contain CO2 emissions), economic growth and FDI On the finding of the previous studies, Cobb-Douglas is considered suitable for examination the relationship of

CO2emissions-FDI-economic growth in this research First, It is recommended that the economic growth is affected from volume of energy using (suggested by Ang, 2008; Omri, 2013) Second, energy consumption releases CO2 emissions directly Finally, the

CO2 is regarded as a factor that has directly impact to economic growth .On the other hand, FDI is considered as an important factor in growth of economy (suggested by Award and Sun, 2011; Award and Nguyen, 2010) From discussion above, this paper will expand the Cobb-Douglas as follow

where:

 Y : real GDP

 A : total factor productivity

 CO 2: carbon dioxide emissions

 FDI :foreign direct investment

 L : labor input

 K : capital stock (consider as capital input)

 α, β, ψ and λ : output elasticity of capital stock, labor, FDI, energy consumption, respectively These values are assumed constant return to scale, this mean α+β+λ+ψ = 1 And ε is the error term

In this study, the effects of energy consumption will be explored through impact of

CO2emissions Because, Pereira and Pereira (2008) argued that the ratio of CO2emissions will be reduced if energy combustion activity go down This lead to the suggestion that the energy consumption is linear related to CO2emissions ( )

Dividing two side of equation (1) to labor (L) to get per capita for each variable and the new equation obtained:

( ) ( ) ( ) ( )

Based on reviewed empirical studies, the research question concerning whether FDI, economic growth impact on CO2 emissions or not, will be answered by investigating the two way linkage between CO2 emissions, GDP growth and FDI using three simultaneous equations built from the original of production function

Equation 5:

( ) ( ) ( ) ( ) ( )

According to previous studies, Equation (5) is formulated to examine the impact of

CO2 emissions, economic growth and another determinant on foreign direct investment

It is believed that FDI attraction into a nation is depended on economic development situation (suggested by Chakrabarti, 2001; Ang, 2008) Specifically, volume of FDI inflow will be increased when economic growth goes up Moreover, level of

CO2emissions may influent FDI inflow Putting CO2emissions into this equation is proposed by Omri, Nguyen and Rault (2014) who found that the negative influence into FDI inflow is caused from increasing ratio of level of CO2emissions In addition, in this equation also test the significance effects of other determinant of FDI that is trade

openness Asiedu (2002) and Ang (2008) hold the view that trade openness help to remain the attractive FDI in a nation As regards the capital stock, Anwar and Sun (2010) hold the view that FDI may be affected by capital stock

Equation 6:

( ) ( ) ( ) ( ) ( )

More importantly, to approach the purpose of this paper, equation (6) investigate the effects on CO2 emissions of FDI, economic growth and other variable In this equation, FDI and economic growth are considered as mains factors According to the earliest studies, Farhani (2013), Hossian (2011), Bernauer and Koubi (2009) claimed that economic growth is a unit root cause of environmental damage They found the decrease

of CO2 emissions and environmental degradation in general will occur as a result in increasing of economic growth Similarly, FDI also plays an important role in influence

to environment In particular, Hoffmann et al (2005), Acharyya (2009) offer some empirical evidences which suggest that FDI lead to increase CO2 emission In contrast, in some case FDI contribute to improve environmental quality For example, Yanchun (2010) found the reverse relation between FDI and CO2 emissions In the other aspect, this study also examines the significance of other variable which have been use in previous studies They are trade openness, polity, scale of economic activity (these are suggested by Bernauer and Koubi, 2009; Copeland and Taylor, 2001)

The simultaneous equations model

After building an econometric system including three equations indicate the relationship between FDI, economic growth and CO2 emissions The simultaneous equation model is obtained that:

( ) ( ) ( ) ( )

( ) ( ) ( ) ( )

( ) ( ) ( ) ( ) Where:

 i : the country

 t : the time period

 :capital stock per capita



: foreign direct investment inflow per capita

 : CO2 emissions per capita

 trade : trade openness

 activivity : the scale of economic activity

 polity : level of democracy

3.3 Data and Defining Variables

3.3.1 Data

Data of variables in this research are gathered from list of available countries from World Development Indicators of World Bank database, Emission Database for Global Atmospheric Research (EDGAR), statistic database of United Nations Conference on Trade and Development The sample covers annual data from 1991 to 2013 for 35 countries in ASIA Although there are 53 countries in ASIA, countries with missing data

or information are excluded in this sample List of countries is presented in table below

Table 2 List of Countries

List of 35 countries in sample of study

3.3.2 Defining Variables

CO2 emissions was measured in tons and transformed into per capita Even though there are many types of emissions to measure pollution, CO2 is relevant proxy for environment pollution Since CO2 emissions are a major pollutant in air pollution created from human activities and it is like to be controlled Moreover, it is a unit root cause of Climate change and Green House Gas Many empirical studies have used CO2 to determine environment degradation such as Hossain, 2011; Tang and Tan, 2014; He and Richard, 2010 In this paper, CO2emissions data is collected from Joint Research Center from 1991 to 2013 It is calculated form fossil fuel use and processes (cement production, carbonate use of limestone and dolomite, non-energy use of fuels and other combustion) for each world country Excluded are: short-cycle biomass burning (such as agricultural waste burning) and large-scale biomass burning (such as forest fires) (according to definition of Joint Research Center)

Foreign direct investment (FDI)

FDI stands for foreign direct investment inflow per capita It is measured by US dollar at current price Given theoretical and empirical evidence from literature review, FDI is approached by FDI inflow Most of earliest studies offer the empirical result that is implied that FDI inflows have directly effects on pollution Moreover, there are many researches using FDI inflow to investigate the relationship between foreign investment with economic growth and with environment such as Pao and Tsai (2010); Cole and Elliott (2006); Hassaballa (2013) In this research, FDI data is retrieved from United Nations Conference on Trade and Development from 1991 to 2013

Economic growth (GDP growth)

It can be deny that the economic growth is always impact on environmental quality

A dozen analyses have examined the relationship between economic growth and environment such as Selden and Song(1994), Grossman and Krueger (1995) Beside the