Determinants of Foreign Direct
Investment in SAARC Countries
Chapter 1 INTRODUCTION:
Background of the Study:
Foreign direct investment is an important source of
insertion of foreign capital. It refers as direct investment by a country or
entity into another country by buying a company in a country or by intensifying
operations of business in a country. Foreign direct investment is defined as a
long-term investment by a foreign investor in an enterprise resident in an
economy other than that in which the foreign investor is based. It is generally
acknowledged that foreign direct investment produces economic benefits to the
recipient countries by providing capital, foreign exchange, technology,
competition and by enhancing access to foreign markets (Crespo and Fontoura,
2007). There are various definitions of investment. It is a buying of an asset
with the intention of making profit from it in future. It can also define as a
production of new capital goods, plants and equipment’s. Investment is an
acquired tool to produce and sell product. Real investment and financial
investment are the two main types of investment. Real investment is an increase
of productive capacity of economy in the form of more stock of plants and
equipment whereas financial investment is the investment made by investor that
does not increase the productivity of economy for instance purchase of bonds
and stocks of existing companies. One of the major types of investment is a
foreign private investment that is investment by the private entity in foreign
country. There are two categories of foreign private investment these are
foreign direct investment and foreign portfolio investment. Foreign portfolio
investment is purchasing of inactive bonds, stocks and other financial
instruments that does not involve in the active management of these securities
that are issued by investors and foreign direct investment is transmitting information and other countries
economy. It is investment that comes from foreign
Foreign direct investment can be the outside FDI or can be inward FDI. Outward
FDI it is direct investment in abroad and inward FDI is direct investment that
comes from abroad.
This research study will be
conduct to investigating the determinants of FDI in SAARC countries
India, Pakistan and Sari Lanka, investigating different factors that drive the
FDI into these countries for the period of 1990 to 2014.
It has been recorded that in the SAARC countries FDI is
minimum in the earlier stages but after the time period of 2005, increase in
the FDI for the SAARC countries is recorded (Awan et al: 2011). This research
tries to investigate the factors which motivate the foreign investors for the
investment in the SAARC countries. Understanding the true factors that will
affect the FDI flows towards different SAARC countries is always a challenge.
This study investigates the factors that cause the FDI inflows and its positive
or negative impact on FDI. In order to increase the future amount on investment
in SAARC countries by foreign countries, we should explore measure like foreign
exchange rate, inflation, market size, interest rate and trade openness.
Theories and Theorization:
From early 1980’s the policy makers’ start working on
market based trade and industry reform policies. Through these policies, the
governments gradually shifting their focus on trade and monetary incentives, to
attract the foreign countries investors to invest in host countries. These
incentives are tax allowances, credit facilities, and tariff cutback (Khan
& Nawaz 2010). In the 1990s, the
governments took further steps by relaxing the policy and opened different new
opportunities for FDI like agriculture, telecommunications, energy and
insurance. Unstable political environment and irregularity in policies are one
of the main reasons of the low level of FDI in SAARC countries as compared to
other developing countries. However, the reform period of 90’s shows a
remarkable progress for FDI inflows (Aqeel and Nishat, 2005). There are
based on foreign direct investment. Some of the theories are based on imperfect
capital market other are based on non-economic factors. Following are the theories
Theory, Heckscher and Ohlin Theory, Production Cycle Theory of Vernon, New
Trade Theory and Electic Paradigm.
This should be discussing further
Objective of Study:
The Following are the objectives
of this study.
To investigate determinates of FDI that are
responsible for fall and rise of FDI in SAARC countries.
2. This study
help to reveal the importance of interest rate, exchange rate, CPI (inflation),
trade openness and GDP besides of other determinants in attracting FDI.
3. The basic
idea behind the model proposed in this research is to give some stylized facts
about the pattern of FDI.
This study help different economies to develop plan
for the betterment of FDI in selected countries and that impact on worldwide
trade and as well as for the economics growth of selected countries in the near future.
Organization of Study:
The whole research is composed of four chapters, chapter
(1) introduce the topic and then explain the objective and significance of the
study chapter (2) review the literature and build up the hypothesis and
arguments for the study, chapter (3) will be based on the analysis and estimate
the variables through regression models and the chapter (4) will conclude and
summaries’ the results.
The level of FDI in a host country is influenced by a numerous factors. A
number of studies have identified the determinants of inbound FDI with respect
to different countries. In the following discussion, a brief review of the
literature relevant to the variables of interest included in this study is
given. The presence of a lot of vast literature on FDI provides arguments that
with the rise in globalization increase the importance of FDI in economic
growth and development Tintin (2013) but such investment slows high level of
dependency on the host country political and socio-economic condition.
The available literature on FDI, may be divided into two broad groups, in
one group researchers have studied the impact of FDI on economic growth, that
how FDI influence the growth of host country, second the determinants of FDI
were identified. Both of the groups are explained here.
Impact of FDI on Economic Growth:
The impact of FDI on economic growth was studied by Li
and Liu (2005) and found that the FDI plays a great role in enhancing the
economic growth. They found positive and significant relationship of FDI and
human capital. The same study was put forward by the De Meelo (1999) and found
the positive relationship of FDI and economic growth both in developing and
developed countries. The causality relationship of FDI and economic growth was
studied by Javorcik (2004). with the inclusion of other variables like political
stability, exchange rate and unemployment to study the impact on FDI.
Borensztein et al.
(1998) conducted a research in 69 developing countries for the period of 20
years and found that FDI is very important tool for the economic growth and for
bringing technology in host country. They further elaborate that we are
expecting more FDI if the home country has more human capital available in the
country. They also argue that economic growth is only possible when the host
country has the availability of advance technologies.
Herman and Lensink (2003) concluded a research in Latin
America and Asia and found that financial development is very important for the
FDI to have impact on economic growth of the receipt country. They tested 67
financially developed countries in which they found that 37 well financial
developed countries have improved impact of FDI on economic growth. Ayanwale
and Adeolu (2007) conducted a research in Nigeria on FDI and economic growth
for the period of 1970-2002. The data were collected from central bank of
Nigeria, IMF and federal office of statistics using. Using OLS for the
estimation of data, they found that FDI has positive impact on economic growth
of Nigeria. They argue that the communication sector and oil sector have more
potential to grow the economy where as manufacturing sector has negative impact
on economic growth because there is lack of skilled labor in Nigeria. They
emphasized that the government needs to improve skill labor in order to
contribute in the economic growth of the country.
Determinants of FDI:
In the second group, the different determinants of FDI
were investigated. The initial research suggested the investor companies select
the low cost, high labour force and developing countries were selected for the
investment but after that the research of Mundell (1957) makes a struggle to
explain that different factors like trade barriers, rich and poor countries at
capital base and geographical distribution of investment suggest that the low
level countries at base of GDP, wage etc are not only the targeted countries.
With time to time the researchers have identified different variables that
motivate and influence the investors to invest in the host country. Such
variables are market size, economic stability, labour market, geographical and
The research of Alam and Shah (2013) identify the influencing role of market role, quality of
infrastructure and labour cost on FDI by conducting a research in OECD
countries. A research study was conducted by Villeverate and Maza (2012) in
Spanish economy for the period of 10 years. They use different variables in
their study but dramatically they found the negative relation of Market size
with the FDI, which is one of the main positive influencing determinants of FDI
in all most all countries. This study provides the argument that all the
determinants do not show the same results in all countries and also for not all
The Nigerian economy for the period of 1970 to 2009 was investigated by
Gabriel (2012) and found that for the economic development FDI is one of the
most important catalysts. They concluded that FDI has not only a role in
economic development but also has great impact on the technological
development, transferring taste and infrastructural development. It was
investigated that FDI has a great role in different countries and that’s why
most of the researchers study the determinants of FDI in different countries
and suggest that the determinants of FDI in all countries are not remain the
same. That is this research selects SAARC countries for the determinants of FDI
Foreign Direct Investment (FDI)
Foreign direct investment is an important source of insertion of foreign
capital. It refers as direct investment by a country or entity into another
country by buying a company in a country or by intensifying operations of
business in a country.
Exchange rate is measured as determinant of FDI and different researchers
gave their results. Researchers said that currency devaluation in a country
results in decreasing the production cost in that country. Because when it will
be measured in foreign currency it will result in increased inflow of FDI,
which may cause foreign investors wealth to grow (Froot and Stein, 1998 &
Klein and Rosenger, 1994).
in Exchange Rate Increase FDI of the host country.
The economic stability is measured with inflation by Vijayakumar and
Sridharam (2010) and found that it seems to be insignificant determinant of FDI
inflows in BRICS countries. While the other determinants used by them show
significant relation like trade openness. When the inflation rate increases it
results in instability in the economy of the country. Supported by Nonnenburg
and Mendonca (2004) that when inflation is taken as proxy for level of economic
stability, than its sign on both policies of country will result in
in Inflation decrease the FDI of the Host Country.
Bibi et al (2014) found negative relation between FDI and inflation by
applying Co-integraiton and DOLS (Dynamic Ordinary Least Square) times series
data for the period 1980 to 2011 that has been supported by New trade theory
which state that companies who are the early entrant in the market becomes a
leading companies due to the advantage of economies of scale. As FDI inflows increases
market size also increase that leads to more industries in host countries which
results in more production that help in achieving economies of scale.
in Interest Rate increase the FDI of the Host Country.
Charkrabarati (2001) carried out research on the
determinant of FDI and did sensitivity analysis of cross country regressions he
found trade openness is one of the determinants of FDI which is a measured as
exports plus import. As due to globalization markets are expanding and more
investments are made in trading countries trade openness is very important.
in Trade Openness increase the FDI of Host Country.
Market size (GDP):
Artige and Nicolini (2006) explored market size that has
been measured by GDP is a fundamental determinant of FDI by carried out
descriptive research on “Evidence on the Determinants of Foreign Direct
Investment: The Case of European countries. Jordaan (2006) did research in
university of Pretoria on 16 developing countries over the period of 19 years
and found that FDI is an investment made by foreign countries. It expand
marketplace increase the market size and boost the purchasing power of people
from which firms can gain higher return and in turn increase profitability
leads to economic development.
in Market Size increase the FDI of the Host Country.
The study investigates the factors which affect FDI
crosswise four SAARC countries- Bangladesh, India, Pakistan and Sri Lanka. The
time period has been selected from 1990 to 2014. In the beginning of early
1990’s the SARC countries has shown remarkable increase in FDI. The selected
variables are Inflation rate (CPI), Gross Domestic Product (GDP), exchange rate
(ER), foreign direct investment (FDI), interest rate (IR) and trade openness
(TO). The time period, countries and variables were selected keeping in mind
the availability of data. For
selection of these variables one of the motives is that these variables were
not studied collectively, furthermore
Foreign Direct Investment
Net Inflow to percent of
Consumer Price Index 2005=100
Gross Domestic Product
GDP(current US $)
Real Effective Exchange
Real Interest Rate in
Exports plus Imports to the
percent of GDP
Table 1 Variables and Proxies
each variable has been studied by different researcher across different
countries as the Puah et al (2007) studied
the inflation in OECD countries, Gabriel (2012), Jha et al. (2013), Cuyvers et at.
(2011) and Alam and Shah (2013) selected the exchange rate is explanatory
variable. The Cuyvers et al. (2011)
and Jha et al. (2013) studied
interest rate as explanatory variable. Trade openness was studied by the
Cuyvers et al. (2011) and Jha et al. (2013) and Alam and Shah (2013).
The data was collected from world development
indicators of World Banks website and UNCTAD. Yearly based data was collected
for the research period of 1990 to 2014