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FDI has no independent influence on growth, says new study

Geneva, 5 June (Chakravarthi Raghavan) - Inflows of foreign direct investment (FDI) do not exert an independent influence on economic growth, according to a new study by two US academics at the University of Minnesota (in Minneapolis).

The research study, ‘Does Foreign Direct Investment Accelerate Economic Growth?’ is by Maria Carkovic and Ross Levine of the University of Minnesota.

Prof Levine is at the Finance Department of the Carlson School of Management at the University of Minnesota, and is a well-known expert and authority in econometrics.

The study uses new statistical techniques and two new databases to reassess the relationship between economic growth and FDI, enabling in the econometric study controls for endogeneity of all explanatory variables, including international capital flows. This has been used to reassess the relationship between economic growth and FDI, and reaches the conclusion that there is no causal link between FDI and growth nor does FDI exert any independent influence on economic growth.

The macroeconomic study buttresses several micro- and firm-level studies that have found that FDI does not boost economic growth, and have also frequently found no positive spillover running from foreign-owned to domestic-owned firms.

For over two decades now a number of international organizations, the World Bank, the International Monetary Fund, the World Trade Organization, and parts of the UN system, including UNCTAD’s Division on Investment, Technology and Enterprise Development (which produces an annual World Investment Report) have been busy promoting FDI as an instrument for boosting economic growth, and for technology spillovers and other benefits.

The major industrialized nations, including the United States, the European Union and Japan, have also been aggressively promoting at the World Trade Organization, the interests of their own transnational corporations and pushing for multilateral regimes on trade and investment (with rules on disciplines on host countries and their rights and ability to regulate and direct such investment flows) as a way of boosting economic growth and development of developing countries. The real objective, enunciated as long ago as the First World War by John Maynard Keynes is to ensure rentier incomes for their investors.

Several of these activities, including technical support activities at international and intergovernmental levels to help developing countries to negotiate at the WTO, are subtly tailored towards promoting investment, competition and other new issues, and are financed through extra-budgetary funding of these organizations by Japan and the EU members (like Britain, Germany, the Netherlands and the like).

None of the promoters have been able to provide so far any empirical evidence of a causal link or assure or guarantee that writing such rules would bring in FDI and result in growth and development.

And the developing countries (and many regions in industrialized world too) have not only been easing restrictions on FDI (as a response to the drying-up of commercial bank lending to developing countries in the 1980s), but aggressively offering tax-incentives and subsidies to attract FDI.

Coincidentally, or as a response to such policy changes, there has been a surge of non-commercial private capital flows to developing countries in the 1990s.  Such flows to the emerging market economies exceeded $320 billion in 1996, and reached $200 billion in 2000.

[The UNCTAD Trade and Development Report 2002, has cited estimates of the Institute of International Finance and the IMF. The IIF has estimated equity investment (both direct and portfolio) in developing and transition economies in 2002 at $130.6 billion, compared to $147.1 billion in 2001. The IMF has estimated it at $156.3 billion in 2002, compared to $149.4 billion in 2001.

[Various organizations putting out data about foreign capital flows use varying definitions and country classifications, and their data are not easy of comparison, and even data from the same outfits (which vary from first estimates, revised estimates, and much later actuals - and frequently published with some footnotes, but with no explanations for the variations) are of use only in terms of trends. Most of the data too are based on the IMF Balance of Payments statistics, with its own definitions and methodological problems.]

Several micro-economic country- or firm-level studies have questioned them. A study by B.Aitken and A.Harrison (1999, American Economic Review) found no evidence of technology spillovers running from foreign-owned to domestic-owned firms. Several others including by D.Germidis (1977, OECD Development Centre), M. Haddad and Aitken (1993, Journal of Development Economics) and E.Mansfield and A.Romeo (1980, Quarterly Journal of Economics).

Carefully read, these studies provide little support for the view that FDI accelerates overall economic growth - and in the linear view of economics, promote development in developing world.

These micro-level studies have often been sought to be countered by macroeconomic studies using aggregates of FDI flows for a cross-section of countries. These often come up with a view about the positive role of FDI in generating growth, especially in particular environments. Some of these studies say that there is a positive-growth effect of FDI in countries having a highly-educated work force, others that while education is critical, associate the positive effect with countries being rich. Some associate positive-effect of FDI to growth with countries having sufficiently developed financial markets, and others with ‘trade-openness’ as crucial for growth effects of FDI.

The Carkovic-Levine paper cautions that such macro-economic studies have to be viewed sceptically, since they do not control for the ‘simultaneity bias’ (or several elements present at the same time as FDI that may contribute to or cause growth) nor for country-specific effects nor for lagged dependent variables in growth regressions.

The Carkovic-Levine study has used new statistical techniques and databases, and has constructed panel datasets with data averaged over each of the seven 5-year periods between 1960 and 1995, and has used ‘Generalized Method of Moments’ (GMM) panel estimators that can extract consistent and efficient estimates of impact of FDI flows on economic growth, and able to exploit time-series variations in data. The method also allows for accounting for unobserved country-specific effects, for inclusion of lagged dependent variables as regressors and controls for endogeneity of all explanatory variables including international capital flows.

Carkovic-Levine study examines whether the growth-effects of FDI depend on the level of educational attainment of the recipient country, the level of economic development of the recipient country, the level of financial development of the recipient country, and its trade openness.

The study finds that the exogenous component of FDI does not exert a robust, positive influence on economic growth. Specifically, it adds, there is no reliable cross-country empirical evidence supporting the claim that FDI per se accelerates economic growth.

The study, Carkovic and Levine caution, should not be viewed as suggesting that foreign capital is irrelevant for long-run growth nor does the study discuss the determinants of FDI.

The study’s other findings include:

·        The exogenous component of FDI does not exert a reliable, positive impact on economic growth.

·        FDI remains significantly and positively linked with growth when controlling for inflation or government size, but FDI becomes insignificant when controlled for trade openness, black market premium or financial development.

·        The impact of FDI on growth, or rather the lack, is not found to be dependent on stock of human capital. Some of the regressions used suggest that FDI is only growth enhancing in countries with low educational attainment.

·        The regression analysis do no provide much support for the view that FDI flows to financially developed economies exert an exogenous impact on growth.

·        Nor does the study find a robust link between FDI and growth and trade-openness of an economy.

·        While FDI flows may go hand in hand with economic success, they do not tend to exert an independent growth effect.

·        The paper does not prove that FDI is unimportant. Rather, its analysis reduces the confidence in the belief that FDI accelerates GDP growth.

·        FDI inflows do not exert an independent influence on economic growth.

·        While sound economic policies may spur both growth and FDI, the results of the various analysis in the Carkovic-Levine study are inconsistent with the view that FDI exerts a positive impact on growth and that this is independent of other growth determinants. – SUNS5133

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