FOREIGN INVESTMENT INFLOWS, GOVERNMENT INSTITUTIONS, EXTERNAL OPENNESS AND ECONOMIC GROWTH IN DEVELOPING COUNTRIES: A THEORETICAL AND EMPIRICAL INVESTIGATION O G DAYARATNA BANDA [BA (Hons) Econ., MPhil., Econ.] A THESIS SUBMITTED FOR THE DEGREE OF DOCTOR OF PHILOSOPHY DEPARTMENT OF ECONOMICS NATIONAL UNIVERSITY OF SINGAPORE 2005 i ACKNOWLEDGEMENTS First of all, I express my gratitude to the thesis supervisors Associate Professor Shandre Thangavelu and Associate Professor Tilak Abeysinghe for providing untiring guidance for writing the thesis. I would like to thank the administrative staff of the Department of Economics in the National University of Singapore for their support. I would like to acknowledge the support extended by Professors W. M. Sirisena, W. M. Tilakaratne, M. O. A. de Soysa, and Vijitha Nanayakkara (all in University of Peradeniya, Sri Lanka) and the members of the Department of Economics, University of Peradeniya. I tender my appreciation to the University of Peradeniya for providing me with study leave to pursue graduate studies. I am also grateful to all my friends for supporting me in various respects during this period. My special thanks go to Malitha, Lesly, and Dumindu whose generosity enabled my family to stay with me in Singapore. I would also like to thank my wonderful wife, Mal, who tirelessly looked after the family matters. Most of all, I must thank my cute little son, Vaasala, who always gives reasons for me to smile. Last but not least, I hereby pay tribute to the National University of Singapore for granting me the NUS Research Scholarship. Moreover, the excellent support facilities provided by the University immensely helped in undertaking the research. O G Dayaratna Banda, Singapore, 2005 i TABLE OF CONTENTS Acknowledgements i Table of Contents ii - v Summary vi - vii List of Tables viii - ix List of Figures x CHAPTER-I INTRODUCTION 1. 1. Background of the Research 1. 2. Statement of the Research Problem 1-3 1. 3. The Outline 3-5 CHAPTE-II SOURCES OF ECONOMIC GROWTH: A REVIEW OF EXISTING IDEAS 2.1. Classical Views 2. 2. Neo-classical Ideas 6-7 2. 3. Endogenous Technology Change and Growth 2. 4. Ideas Pertinent to Developing Economies 2. 4. 1. Human Capital 2. 4. 2. Role of Geographical Factors 8-9 ii 2. 4. 3. Economic Performance and Cultural Values - 10 2. 4. 4. Role of Political Freedom in Economic Performance 10 - 11 2. 4. 5. Economic Freedom 11 2. 4. 6. Domestic Policies 12 2. 4. 7. Government Institutions 12 - 13 2. 4. 8. External Openness 13 - 14 2. 5. Concluding Remarks 14 CHAPTER-III ASSESSING THE IMPACT OF FOREIGN OFFICIAL DEVELOPMENT ASSISTANCE ON FOREIGN DIRECT INVESTMENT: AN EMPIRICAL STUDY 3. 1. Introduction 15 - 20 3. 2. The Empirical Methodology 3. 2. 1. Empirical Models 20 - 25 3. 2. 2. Description of Variables and Data 26 - 29 3. 3. Results and Discussion 3. 3. 1. Results of Cross-Sectional Regressions 30 - 33 3. 3. 2. Results of GLS and GMM Estimation 33 - 36 3. 4. Concluding Remarks 36 - 37 iii CHAPTER-IV EFFECTS OF GOVERNMENT INSTITUTIONS, EXTERNAL OPENNESS, AND FOREIGN DIRECT INVESTMENT ON ECONOMIC GROWTH: A THEORETICAL FORMULATION AND A CROSSCOUNTRY EMPIRICAL STUDY 4. 1. Introduction 38 - 41 4. 2. The Model 4. 2. 1. Version-I:- Government Institutions Production Spillovers: A Two-Sector Model 41 - 49 4. 2. 2. Version-II:- Private Export Production Spillovers: A Three-Sector Model 49 - 58 4. 3. Empirical Investigation 4. 3. 1. The Empirical Models 58 - 60 4. 4. Empirical Results and Discussion 61 - 69 4. 5. Concluding Remarks 69 - 70 CHAPTER-V ENDOGENOUS GOVERNMENT INSTITUTIONS AND EXTERNAL OPENNESS IN A GROWTH MODEL 5. 1. Introduction 71 - 73 5. 2. The Model 5. 2. 1. The Structure of the Model 73 - 76 iv 5. 2. 2. Exogenous Government Institutions and External Openness 76 - 79 5. 2. 3. Endogenous Government Institutions and External Openness 79 - 93 CHAPTER-VI IN QUEST FOR PUZZLING GROWTH PERFORMANCE IN SRI LANKA: A CASE STUDY 6. 1. Introduction 94 - 97 6. 2. Foreign Investment 97 - 99 6. 3. Pressure of High Inflation 99 - 100 6. 4. External Openness 100 - 103 6. 5. Government Institutions 104 - 109 6. 6. Determinants of Economic Growth: Regressions 109 - 112 6. 7. Concluding Remarks 112 - 113 CHAPTER-VII POLICY IMPLICATION 7. 1. Introduction 114 7. 2. Improving the Incentive Structure for FDI Inflows 114 - 116 7. 3. Promoting Growth: Institutions and External Openness 117 - 124 Bibliography 125 - 135 Appendices 136 - 146 v SUMMARY This study focuses on examining two main issues related to economic growth in developing economies. First, the study investigates as to whether or not there is any systematic relationship between foreign official development assistance inflows (FDA) and foreign direct investment (FDI) inflows into developing economies. In order to investigate this issue, this study undertook an empirical study by employing panel framework for a sample of developing economies. The results of the study show that the relationship between aggregate FDA and FDI is ambiguous. Multilateral FDA has a negative impact on FDI inflows, whereas bilateral FDA positively affects FDI inflows. Furthermore, the empirical results suggest that government investment in infrastructure, external openness, and government institutions are important determinants of FDI inflows into developing economies. These findings indicate that the overall incentive structure of the economy that hosts FDI is the key for attracting FDI. The second objective of this study was to examine the mechanism(s) through which government institutions and external openness foster economic growth. Effects of government institutions and openness on growth are derived using a three sector model in the Neo-Classical growth framework that was supported by an empirical investigation using dynamic panel framework. According to the theoretical formulation, FDI, trade, and government institutions exhibit positive spillover and externalities onto the domestic economy, thereby leading to productivity improvements and economic growth. Empirical results of panel study show that FDI unambiguously positively impact on economic growth. The government institutions, trade, and FDI inflows positively contribute to economic growth in developing economies. A case study on Sri Lanka strongly supports vi the theoretical as well as empirical findings. The study also attempts to explain the role of endogenous institutions and external openness through a growth model. According to the set-up of the model, the government institutions and external openness induce incentives for undertaking R&D works by reducing rent-seeking activities and hence tend to foster economic growth. The results show that the economies devote more resources to building institutions, maintaining favorable external economic policies tend to increase R&D and to maintain higher growth. According to the findings of the thesis, government institutions and external openness are complementary determinants of economic growth. The main policy implication emerging from the findings of the study is that the developing economies must have to devote resources to improve the strengths of government institutions, and to adopt more open external economic regimes both for attracting FDI as well as for fostering economic growth. vii LIST OF TABLES Table 3.1: Modeling Foreign Direct Investment by OLS and 2SLS 31 Table 3.2: Modeling FDI by OLS and 2SLS 32 Table 3.3: Modeling FDI by GLS and GMM 34 Table 3.4: Modeling FDI by GLS and GMM 35 Table 4.1: Modeling Economic Growth by LSDV and GLS 61 Table 4.2: Modeling Economic Growth by LSDV and GLS 62 Table 4.3: Modeling Economic Growth by LSDV and GLS with Interaction Term 63 Table 4.4: Modeling Economic Growth by GMM 64 Table 4.5: Correlation Matrix 65 Table 4.6: Determinants of Growth of GDP by GMM 66 Table 4.7: Correlation Matrix 66 Table 4.8: Modeling Economic Growth by GMM 67 Table 4.9: Modeling Economic Growth by GMM 68 Table 4.10: Modeling Economic Growth by GMM 69 Table 6.1: FDA as a Percentage of GDP 98 Table 6.2: FDI Inflows as a Percentage of GDP 98 Table 6.3: Trade Distortions, Export Tariffs (% of Government’s Tax Revenue) 102 Table 6.4: Degree of External Openness: Trade Openness Index 103 Table 6.5: Strengths of Government Institutions: Separate Indexes 106 Table 6.6: Composite Index of Government Institutions 107 viii Table 6.7: Growth Performance and Policy Regimes in Sri Lanka: Growth of Per-capita GDP (Period Averages) 108 Table 6.8: Determinants of GDP Growth Rate 111 Table 6.9: The Determinants of Growth of GDP Per-capita in Sri Lanka 112 ix Khan, B. 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World Bank, various years, World Development Indicators, Washington DC: The World Bank. 135 APPENDICES Appendix-3.1: Plot of Scatter and a Nearest Neighbor Fit between aggregate FDA and FDI Figure 2: Mauritius Figure 1: Bangladesh LOESS Fit (degree = 1, span = 0.9000) .6 .5 FDI (%of GDP) FDI (%of GDP) LOESS Fit (degree = 1, span = 0.9000) .7 .4 .3 .2 .1 .0 -.1 AID (% of GDP) LOESS Fit (degree = 1, span = 0.9000) LOESS Fit (degree = 1, span = 0.9000) 1.0 0.8 0.6 FDI (%of GDP) FDI (%of GDP) Figure 4: Pakistan Figure 3: Kenya 0.4 0.2 0.0 -0.2 12 16 20 -1 24 Aid (% of GDP) Aid (% of GDP) Figure 5: Malawi Figure 6: Senegal LOESS Fit (degree = 1, span = 0.9000) LOESS Fit (degree = 1, span = 0.9000) 2.5 2.0 1.5 FDI (%of GDP) FDI (%of GDP) Aid (% of GDP) 1.0 0.5 0.0 -0.5 10 15 20 Aid (% of GDP) 25 30 10 12 14 16 18 Aid (% of GDP) 136 20 Figure 7: Sri Lanka Figure 8: Costa Rica LOESS Fit (degree = 1, span = 0.9000) LOESS Fit (degree = 1, span = 0.9000) FDI (%of GDP) FDI (%of GDP) -1 -1 -2 10 12 14 Aid (% of GDP) -2 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 Aid (% of GDP) Figure 9: Republic of Congo LOESS Fit (degree = 1, span = 0.9000) FDI (%of GDP) 2 Aid ( % of GDP) 137 Appendix 3.2: Classification of Legal Systems used as IVs Country Classification of Legal System Sri Lanka English Common Law Tradition (1) India English Common Law Tradition (1) Pakistan English Common Law Tradition (1) Bangladesh English Common Law Tradition (1) Malaysia English Common Law Tradition (1) Indonesia French Civil Law Tradition (2) Thailand English Common Law Tradition (1) Philippines French Civil Law Tradition (2) Singapore English Common Law Tradition (1) South Korea German Civil Law Tradition (3) Hong Kong English Common Law Tradition (1) Botswana French Civil Law Tradition (2) Kenya English Common Law Tradition (1) Congo, Rep. French Civil Law Tradition (2) Zimbabwe English Common Law Tradition (1) Senegal French Civil Law Tradition (2) Egypt French Civil Law Tradition (2) Madagascar French Civil Law Tradition (2) Brazil French Civil Law Tradition (2) Argentina French Civil Law Tradition (2) Bolivia French Civil Law Tradition (2) Chile French Civil Law Tradition (2) Colombia French Civil Law Tradition (2) Mexico French Civil Law Tradition (2) Venezuela French Civil Law Tradition (2) Peru French Civil Law Tradition (2) Cameroon French Civil Law Tradition (2) Costa Rica French Civil Law Tradition (2) Ecuador French Civil Law Tradition (2) Guatemala French Civil Law Tradition (2) Paraguay French Civil Law Tradition (2) Uruguay French Civil Law Tradition (2) Source: La Porta et al (1998) IV Variable (observations) 1 1 2 2 2 2 2 2 2 2 2 2 138 Appendix 3.3: Description of Data Foreign direct investment: The net FDI as share of GDP is used. Net FDI does not mean outward FDI is subtracted from inward FDI, rather it means that sum of equity capital, re-investment of earnings, other long-term capital as shown in balance of payments. This means net increases in assets or net decreases in liabilities are recorded as debits (recorded with a negative sign in the balance of payments). Hence, FDI flows with a negative sign indicate that at least one of the three components of FDI (equity capital, reinvested earnings or intra-company loans) is negative and not offset by positive amounts of the remaining components. In this sense, these data represent gross FDI inflows. Data is collected from the CD-ROM version of the World Development Indicators 2002, for the period from 1978 to 2001. To control for the size of the economy, FDI is expressed as share of GDP. Foreign Development Assistance (FDA): Aggregate FDA as share of GDP; bilateral FDA as share of GDP; and multilateral FDA as share of GDP are used. The data are collected from OECD (various years). The raw data were transformed into US dollar values using 1980 exchange rates. Market size: Per capita income is used as a proxy for the domestic market size. The data are from the CD-ROM version of the World Development Indicators (World Bank 2002). The GDP is used as an alternative measure of market size. Infrastructure: The government investment on infrastructure can be used as a proxy (International Monetary Fund, 2001). Each spending variable is reported as share of real GDP. Government spending on: (a) transportation and communication, (b) economic 139 affairs and services, (c) housing and community amenities, and (d) general public services are available. These variables are used to represent the infrastructure. Wage cost: The variable is constructed in the following manner: average wage in a country divided by weighted average of average wage in OECD countries (World Bank 2002). The included OECD countries are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Italy, Luxemberg, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, United Kingdom, and United States of America. Openness: Trade share index is computed as export plus imports divided by GDP. The data is from World Bank (2002). Quality of labour: adults’ literacy rate and infant mortality rate are used to denote education and health care as possible proxies for the quality of human capital. The data are from World Bank (2002). 140 Appendix 5.1: Derivation of Some Important Relations Derivation of equation 5.17: Since P&A ar from (5.11), (5.14) can be written as; = , LY = α gx PA  ar  ar LR = gx  L − = gxL −  α gx  α  (5.16) Since the long-run growth of the economy is driven by innovations, we have A& LR . = A a Substitute for LR from (5.16) to get; ar gxL − A& α = A a A& = A gxLα −r a α Utility maximization implies C& (r − ρ ) = , σ C A& C& α + σ = gxLα / a − ρ A C Denoting growth rate of the economy by y* and since y* = gxLα / a − ρ α +σ A& C& = = y* at the steady state, A C (5.17) Derivation of 5.23: Free entry into research sector implies that wage payments to workers of R&D sector, institutions-building sector, and external policy sector must exhaust the return from innovations; 141 wX LX + wG LG + wR LR = LR LRη gxPA A a gxPA A gxPA A gxPA A + LR µ + wR LR = LR a a a wR LR = LR gxPA A gxPA A gxPA A − LRη − LR µ a a a wR = (1 − η − µ ) gxPA A a (5.23) Derivation of equation 5.31: In order to obtain the equilibrium level of labour in the institutions-building sector, substitute for LR , LL and LX into (5.30);  (1 − η − µ )   (1 − gx)   µ  LG = L − LY −  LG  −  LG  −  LG  η η gx   η     (1 − η − µ )   (1 − gx)   µ  LG +  LG  +  LQ  +  LG  = L − LY η  η     gxη  (1 − η − µ ) (1 − gx) µ  + +  = L − LY LG 1 + η η gxη    LG   = L − LY  gxη  LG = ( L − LY ) gxη (5.31) Derivation of equation 5.40: In order to solve for the evolution of LY , differentiate z; 142 z& Y& K& = − z Y K (5.38) From the final goods production function;  A& L&  K& Y& = (1 − α )  + Y  + Y  A LY  K  A& L&  z&  K&  K& =  (1 − α )  + Y  + α  − z  K K  A LY  (1 − α ) L&Y z& A& K& K& = − (1 − α ) − α + LY z A K K (1 − α ) L&Y z& A& K& = − (1 − α ) + (1 − α ) LY z A K L&Y L z& / z Y C = − R+ − LY (1 − α ) a K K (5.39) Since LR = (1 − η − µ ) ( L − LY ) gx ; (1 − η − µ ) ( L − LY ) gx L&Y z& / z = − +z−χ LY (1 − α ) a (5.40) 143 Appendix 6.1: Construction of the Composite Index of Government Institutions A number of indexes of government institutions developed by Political Risk Services were used. The data were bought online from www.countrydata.com. The individual indexes are as follows. Rule of Law Index: Rule of law index (ROL) reflects the degree to which the citizens of the country are willing to accept the established institutions to make and implement laws and adjudicate disputes. The scores of the index ranges from to in which represent complete lawlessness and represent highest rule of law. Higher scores indicate sound institutions, a strong court system, and provisions for an orderly succession of government power. Lower scores indicate a tradition of depending on physical force or illegal means to settle claims. The Index of Corruption: The index of corruption (CUP) in government: means that the lower scores indicate a greater number of government officials are likely to demand special payments and that illegal payments are generally expected throughout lower levels of government in the form of bribes connected with import and export licenses, exchange controls, tax assessment, police protection, or loans. The higher scores indicate lower corruption while lower scores indicate higher corruption. The Quality of Bureaucracy Index: The quality of the bureaucracy index (BUQ): is defined in such a way that high scores indicate existence of established mechanism for recruitment and training, autonomy from 144 political pressure, and strength and expertise to govern without drastic changes in policy or interruptions in government services when governments change. This index also ranges from to where is highest quality of bureaucracy. The Ethnic Tensions Index: The ethnic tensions index (EHT) measures the degree of tension within a country attributable to racial, ethnicity, or language divisions. Lower ratings are given to countries where racial and ethnic tensions are high because opposing groups are intolerant and unwilling to compromise. The scores of this index also range from to 6. The Index of the Repudiation of Government Contracts: The risk of repudiation of contracts by government index (RGC): addresses the possibility that foreign businesses, contractors, and consultants face the risk of a modification in a contract taking the form of a repudiation, postponement, or scaling down due to an income drop, budget cutbacks, indigenization pressure, a change in government, or a change in government economic and social priorities. Lower scores signify a greater likelihood that a country will modify or repudiate a contract with a private business. The scores of this index range from to 10. The Index of Risk of Expropriation: The risk of expropriation of private property index (EPR): evaluates the risk of outright confiscation and forced nationalization of private property. The scales of this index range from 0-10, with higher values indicating better ratings, i.e. less risk. The Composite Index: The composite index: a 6-point composite index of government institutions is created using these indexes. The index is created in the following manner: 145  5  5  5  5   CUP *  +  ROL *  +  BUQ *  +  EHT *  + EPR + RGC           GOV =  ≤ GOV ≤ 10 This composite index specifies that the higher scores indicate that there are strong government institutions. Lower scores indicate that the government institutions are very weak. 146 [...]... the data over 1974-85 find 3 For instance, during 1980-2000 period, FDI inflows as a percentage of GDP in Singapore, Hong Kong, and Malaysia were 10.02%, 4.39%, and 4.27% respectively, whereas in Senegal, Madagascar, and Sri Lanka Ire 0.77%, 0.42%, and 0.97% respectively On the other hand, FDA as a percentage of gross national income during the same period in Singapore, Hong Kong, and Malaysia were... private capital mobility (Checki and Stern 2000, Kharas and Shishido 1991, Alesina and Dollar 2000, Bird and Rowlands 1997) is another explanation These studies do not pay specific attention to the impact of FDA on FDI, but examine the nexus between FDA and private capital inflows in general Some have examined the dynamic relationship between multilateral flows and private capital inflows For instance,... there had been a wave of private flows such as foreign direct investment (FDI) and portfolio flows from European countries to North America, Australia, and European Colonies in Latin America, Asia and Africa (Helleiner 1998) Foreign official development assistance (FDA) 1 programmes hardly ever existed and official multilateral lending agencies had yet to emerge FDA, noticeably, started to emerge during... foreign investment inflows, government institutions, external openness and their interaction in economic growth pertaining to developing economies 1 2 Statement of the Research Problems Foreign investment inflows have always been emphasized as being one of the main drivers of economic growth in developing economies A few rapidly growing countries, especially the newly industrializing economies, have attracted... 0.03%, and 0.45% respectively, whereas in Senegal, Madagascar, and Sri Lanka Ire 13.19%, 10.89%, and 6.88% respectively (World Bank 2002, OECD 2002) 17 that FDA was able to generate spillover effects that attracted private flows by alleviating credit rationing and improving creditworthiness Loans and grants of multilateral lending agencies play a crucial role of coordinating the process of international... ECONOMIC GROWTH: A REVIEW OF EXISTING INDEAS 2.1 Classical Views Since the era of classical economists, many researchers have sought to discover what makes a nation wealthy Adam Smith argued in that growth was caused by increasing either of the factors such as land, labour, and machinery The impact of labour on growth is induced by more efficient machinery Increases in the workforce derived from increasing... Kong), passive intervention (Taiwan), informed guidance (Japan), active leadership (South Korea and Malaysia), and direct management (Singapore) The performance of these East Asian economies seemingly depends on the performance and policies of their political institutions Notwithstanding, Bella Balassa (1988) scoffed at cultural values as a product of retrospection and insisted on a return to economic. .. amount and quality of labour increases; and innovations/inventions Policies affect growth directly through reducing costs or indirectly through affecting factor accumulation and technological progress The policies that would restrict trade, increase taxes on capital and/ or labour; and increase costly regulations on labour and business Restrictions on economic activity retard economic growth 2 4 7 Government. .. since private foreign investment has not been adequately forthcoming into such economies This motivates one to ponder whether FDA plays an informational role for private foreign investment In searching for the potential host economies, foreign investors appear to be using FDA to detect the investment climates for increasing investment Conversely, investment originating countries may be using FDA as... FDA-recipient countries are classified into: English common law (1), French civil law (2), German civil law (3), and Scandinavian civil law (4).5 The data for the instrumental variable is given in Appendix(3.2) The legal systems of the countries are, reasonably, assumed to play a vital role in determining official assistance to developing countries Donor community is increasingly concerned about legal . FOREIGN INVESTMENT INFLOWS, GOVERNMENT INSTITUTIONS, EXTERNAL OPENNESS AND ECONOMIC GROWTH IN DEVELOPING COUNTRIES: A THEORETICAL AND EMPIRICAL INVESTIGATION O G DAYARATNA BANDA. discover what makes a nation wealthy. Adam Smith argued in that growth was caused by increasing either of the factors such as land, labour, and machinery. The impact of labour on growth is induced. possess a particular physical manifestation but are embodied in the minds and writings of individuals and societies. Human capital can be invested in. Since human capital has no physical shape