CHAPTER 3 FOREIGN DIRECT INVESTMENT AND FINANCIAL SECTOR DEVELOPMENT: THEORY AND EMPIRICAL EVIDENCE.
The main purpose of this chapter is to explain the literature underpinning the relationship between FDI and financial sector development. The deficiencies and gaps in the existing literature are highlighted and the new knowledge to be added by the current study is explained. The chapter proceeds as follows. Section 3.2 discusses the impact of FDI on financial sector development. Section 3.3 focuses on the impact of financial sector development on economic growth. Section 3.4 examines the influence of financial sector development on FDI clearly showing where exactly the current study seeks to contribute to the body of existing knowledge. The section narrows the debate to the minimum threshold levels of financial sector development that must be exceeded before host countries attract significant FDI inflows and associated benefits, which is one of the main focus areas of the current study. Section 3.5 is the conclusion to the chapter.
IMPACT OF FOREIGN DIRECT INVESTMENT ON FINANCIAL SECTOR DEVELOPMENT.
Consistent with Soumare and Tchana (2015), there are three theoretical rationales that explain the different channels through which FDI influences financial sector development. The first is that FDI net inflows boost financial markets development by increasing the amount of funds in the host country’s economy. The proponents of this category argue that there are high chances that multinational firms that bring FDI inflow end up listing their shares on the stock exchange of the host country. FDI can increase the liquidity of the stock markets if a portion of foreign investments is used to acquire shares in the host country. This resonates with Levine (1997b) who argued that FDI improves both stock market and banking sector liquidity as it brings along huge capital injection into the host country.
The second theoretical rationale referred to as the political economy view argues that FDI inflows force the host country to embrace market friendly policies, regulations and controls that provide a good environment for promoting financial markets development. Kholdy and Sohrabian (2008) noted that FDI promotes financial sector development through forcing the host country government to liberalise the financial markets and allowing more competition in the financial sector. Removing impediments to foreign investors promotes stock market development index in the host country by facilitating its integration with other world stock markets (Levine, 1997b:6). The third theoretical rationale supported by Shahbaz and Rahman (2010) is that FDI inflows increase competition in the financial markets thereby making them more efficient.
Several empirical studies focused on the impact of FDI on financial sector development. Kholdy and Sohrabian (2008) investigated the impact of FDI on financial development in 22 developing countries with corrupt top government officials using the multivariate ECM with annual time series data from 1976 and 2003. They observed that FDI promoted financial development only in Korea in the long run whereas in the short run FDI positively influenced financial development in Brazil, Chile, Costa Rica, Mexico, Morocco, Nigeria and Philippines when domestic credit provided by financial intermediaries to GDP ratio (private sector credit) was used as a proxy for financial development. When domestic credit provided by the banking sector to GDP ratio (bank credit) was used as a measure for financial development, FDI significantly impacted on financial development in the long run only in Kenya, Korea, Morocco and Singapore whilst Chile, Kenya, Korea, Mexico, Nigeria and Turkey were the only countries whose financial development significantly benefited from FDI inflows in the short run (Kholdy and Sohrabian 2008: 492).
Furthermore, financial development was found to have been influenced by FDI in the long run only in Paraguay when liquid liability was used as a proxy of financial development (Kholdy and Sohrabian 2008: 492). Yet using the same measure of financial development, FDI was found to have positively influenced financial development in Brazil, Nigeria and Philippines in the short run (Kholdy and Sohrabian, 2008: 493). The use of banking sector development proxies as measures of the whole financial sector is too narrow and represents a methodological limitation. The simultaneity bias arising from a bi-directional causality between FDI and financial development was ignored. In other words, the methodology used (ECM) is not capable to addressing the endogeneity problem emanating from simultaneity bias.
Zakaria (2007) investigated the relationship between FDI and financial development using the multivariate VECM with annual time series data in 37 developing countries. Three methodological weaknesses are visible. The econometric technique used did not take into account the dynamic nature of FDI and financial development variables and is not capable of addressing endogeneity arising from the feedback effect that is normally a characteristic of FDI-financial development nexus. By excluding bond market development, the study described financial development from a very narrow perspective which is not a true representation of the whole financial sector. The view that FDI positively contributes towards the deepening and development of the banking sector, had very little or no support. This finding is consistent with Claessens, Klingebiel and Schmukler. (2001) whose study showed that FDI substitutes financial sector development in countries where firms struggle to raise capital from local financial markets and that FDI positively influenced stock market development in developing countries in the long run.
According to Zakaria (2007), the impact of FDI on financial sector development happens via the following channels. FDI might increase the number of foreign firms participating in the capital market of the host country. This is because foreign investors might want to raise additional capital from the domestic capital market to finance a portion of their investment or recoup their investment through liquidating their equity in the domestic capital markets.
“FDI is accompanied by the inflow of funds into the domestic financial markets thereby helping to ease credit constraints faced by local companies in developing or emerging markets” (Zakaria, 2007:4). This is consistent to a study done by Harrison and McMillan (2003:99) which observed that domestic companies in Ivory Coast faced more credit hurdles in comparison to foreign related companies. On the contrary, multinational enterprises crowd out local companies out of the domestic financial markets or exacerbate their credit hurdles if they excessively borrow from the domestic financial sector. The scenario according to Zakaria (2007:4) is more likely in emerging markets where the probability of foreign investors borrowing from the domestic financial sector is high due to the following reasons: (1) hedging against foreign exchange rate fluctuations, fixed interest rates means that domestic banks can only cover the extra cost of lending by giving preference to foreign investors and (3) foreign investors have better quality of collateral since they are more profitable in comparison to their domestic counterparts.
Using panel data analysis, Hericourt and Poncet (2009) examined the role played by FDI inflow into China in alleviating 1300 domestic firms’ credit constraints with firm level data from 2000 to 2002. Debt to assets (DAR) and interest coverage ratio (COV) were used as measures of firms’ credit constraints. FDI inflow enabled domestic firms to face less hurdles when trying to access credit from financial markets in China (Hericourt and Poncet, 2009:14). Their study focused on credit constraints which is a narrow aspect of the financial sector.
On the contrary, Harrison and McMillan (2003) using panel data approach found that FDI crowded domestic firms out of the capital markets in Ivory Coast. The following reasons could possibly be responsible for the contradicting findings: (1) differences in the number of firms used, (2) varying depth and size of the banking sector between the two countries involved and (3) differences in the proxies of credit constraints – the former ignored the lagged version of the ratios of DAR and COV as compared to the latter.
Harrison, Love and McMillan. (2004) investigated the impact of FDI on financing constraints at firm level using cross country panel data analysis with data from 1988 to 1998. Their study which involved measuring the financing constraints using sensitivity of investment to cash flow (cash stock) covered 7000 firms in 38 countries whose sample included both developing and developed countries. They assumed that the bigger the sensitivity, the more financial constraints the firm is facing as it implies firms relied more on internal financing for funding its investment (Harrison et al. 2004: 276). FDI which was used as a proxy for the overall performance of the country was found to have allowed firms to easily have access to finance or contributed to the decrease in finance constraints (Harrison et al. 2004: 282). Consistent with Hericourt and Poncet (2009), their study focused on the narrow aspect of financial sector development and also shied away from minimum threshold analysis.
Sultana and Pardhasaradhi (2012) examined the impact of FDI and foreign institutional investors (FII) on the Indian stock market using correlation coefficient and OLS (ordinary least squares) model with average annual data of indices (Sensex and Nifty) from 2001 to 2011. Their study observed a strong uni-directional causality relationship running from FDI to the Sensex and Nifty stock market indices and that FDI alongside foreign portfolio investments had a significant impact on the growth of the Indian stock market.
Dhiman and Sharma (2013) also investigated the impact of FDI on the Indian stock market development (Sensex and Nifty stock market indices as proxies) using correlation coefficient and regression analysis with average annual data from 2001 to 2012. A bullish trend on the Indian stock market was found to have been closely and directly linked to FDI inflows into the Indian economy (Dhiman and Sharma, 2013:79). Moreover, large quantities of FDI is needed to help develop infrastructure such as banking, warehouse, railways, roads and insurance services, especially, in emerging markets which lack sufficient funds to invest in infrastructural development necessary to keep pace with the fast rate of economic growth (Dhiman and Sharma, 2013:75).
Both studies (Sultana and Pardhasaradhi, 2012; Dhiman and Sharma, 2013) excluded the impact of FDI on other aspects of financial development such as banking sector and bond market and ignored the minimum threshold analysis applicable in such non-linear causality relationships. The methodologies they both used do not have capacity to identify and address the endogeneity problem that arises from the feedback effect between FDI and financial development.
Raza, Iqbal, Ahmed, Ahmed and Ahmed. (2012) investigated the influence of FDI alongside domestic savings, inflation and exchange rates on stock market development in Pakistan using OLS regression model with time series annual data from 1988 to 2009.
Their study reported that FDI positively influenced stock market development in Pakistan whilst a combination of FDI inflows, increase in domestic savings, stable inflation and exchange rates doubled stock market development in Pakistan (Raza et al. 2012: 31).
Zafar, Qureshi and Abbas. (2013) studied the relationship between FDI and stock market development in Pakistan using Johansen co-integration and Granger causality tests with quarterly time series data (from third quarter of 1998 to third quarter of 2009). No co-integration and causality was detected between FDI and stock market development in Pakistan which indicates a shortcoming on the part of the methodology used because the two variables have been conclusively found by literature to have a causal relationship.
Both studies by Raza et al. (2012) and Zafar et al. (2013) neither focused on threshold levels analysis nor addressed endogeneity problem that emanates from the bi-directional causality between FDI and stock market development in Pakistan. Moreover, their study delved into the narrow aspect of financial sector development which excluded the banking sector and the bond market. The findings cannot therefore be generalised for the whole financial sector in Pakistan.
Using vector autoregressive (VAR) and VECM models, Abzari et al. (2011) studied the causal relationship between FDI and financial development with annual panel data of 8 developing countries (Nigeria, Egypt, Malaysia, Indonesia, Bangladesh, Pakistan, Turkey and Iran) during the period from 1976 to 2005. Three proxies of financial development proposed by King and Levine (1993a), Levine and Zervos (1998) and Levine, Loayza and Beck. (2000) which include liquid liability (ratio of liquid liabilities of the financial system to GDP), bank credit (ratio of domestic credit provided by banking sector to GDP) and private sector credit (ratio of domestic credit provided by financial intermediaries to GDP) were used whilst net FDI as a ratio of GDP was employed as a measure of FDI.
Their study observed the following: (1) FDI inflow positively affected private credit in Iran and Pakistan, (2) bank credit was influenced favourably by FDI inflow in Turkey, Bangladesh and Nigeria and (3) FDI positively impacted on liquid liability in Pakistan, Turkey and Nigeria. The presence of foreign investors boosts capital market liquidity in the host country because their presence motivates domestic firms to increase participation in the capital market, argued Abzari et al. (2011:152). Two methodological shortfalls are evident. These include inability of the model used to address endogeneity arising from the reciprocating effect between FDI and financial development. Furthermore, the exclusion of stock and bond market development represents a narrow description of financial development. Threshold analysis was not part of the focus area of their study.
Girma, Gong and Gorg. (2008) examined the relationship between sectoral FDI, access to finance and innovation activities in Chinese state and private firms using the panel Tobin model. Their observations are threefold: (1) inward FDI benefited Chinese firms which had uninterrupted access to domestic finance or bank loans, (2) FDI inflow positively influenced domestic innovation capacity only among Chinese firms with access to domestic finance and (3) FDI had a significant impact on domestic credit finance among privately owned firms and vice versa for state controlled firms (Girma et al., 2008: 377).
Raza and Jawaid (2014) studied the relationship between FDI, stock market capitalisation and economic growth in 18 Asian countries using a combination of an ARDL bounds testing and Toda and Yamamoto (1995) approaches with annual cross country data ranging from 2000 to 2010. They observed a long run relationship between the three variables under study. If FDI competes with domestic firms, the latter’s market share, productivity and share prices plummets thus chasing away investors from the host country’ stock market (Raza and Jawaid, 2014:381). The Granger causality test showed that stock market capitalisation was negatively influenced by FDI in the short run and a feedback effect between FDI and stock market capitalisation was also detected.
SUMMARY OF LIST OF APPENDICES
CHAPTER 1: BACKGROUND AND INTRODUCTION
1.2 STATEMENT OF THE PROBLEM
1.4 OBJECTIVES OF THE STUDY
1.5 JUSTIFICATION OF THE STUDY
1.6 DEFINITION OF KEY TERMS
1.7 PARTICIPANTS IN FDI
1.8 LIST OF ABBREVIATIONS
1.9 STRUCTURE OF THE THESIS
1.10 CHAPTER CONCLUSION
CHAPTER 2: FDI THEORY AND EMPIRICAL ISSUES
2.1 CHAPTER INTRODUCTION
2.2 MOTIVES AND MODES OF FDI
2.3 THEORIES OF FDI
2.4 DIFFICULTIES IN CHOOSING THE MOST SUITABLE FDI THEORY
2.5 RELEVANT FDI THEORY FOR THE CURRENT STUDY
2.6 DETERMINANTS OF FDI-AN EMPIRICAL PERSPECTIVE
2.7 ORIGIN, EVIDENCE FOR AND AGAINST MAIN FDI THEORIES
2.8 IMPACT OF FDI ON ECONOMIC GROWTH
2.9 CHAPTER CONCLUSION
CHAPTER 3: FDI AND FINANCIAL DEVELOPMENT: THEORY AND EMPIRICAL EVIDENCE
3.1 CHAPTER INTRODUCTION
3.2 IMPACT OF FDI ON FINANCIAL DEVELOPMENT
3.3 IMPACT OF FINANCIAL DEVELOPMENT ON ECONOMIC GROWTH
3.4 IMPACT OF FINANCIAL DEVELOPMENT ON FDI: THEORY AND EMPIRICAL PERSPECTIVE
3.5 CHAPTER CONCLUSION
CHAPTER 4: RESEARCH METHODOLOGY
4.1 CHAPTER INTRODUCTION
4.2 MAIN VARIABLES USED IN THE STUDY
4.3 THE ENDOGENEITY PROBLEM
4.4 THE EVOLUTION OF THRESHOLD REGRESSION MODELS
4.5 THRESHOLD REGRESSION MODELS USED IN PREVIOUS FDI-FINANCIAL DEVELOPMENT STUDIES
4.6 RESEARCH DESIGN
4.7 GENERAL MODEL SPECIFICATION OF THE FDI FUNCTION
4.8 ESTIMATION MODEL – A DYNAMIC PANEL THRESHOLD REGRESSION MODEL
4.9 ROBUSTNESS CHECKS
4.10 CHAPTER CONCLUSION
CHAPTER 5: ESTIMATION AND EMPIRICAL RESULTS
5.1 CHAPTER INTRODUCTION
5.2 PRE-ESTIMATION DIAGNOSTICS
5.3 ENDOGENEITY TESTS
5.4 MAIN ESTIMATION TECHNIQUE – DYNAMIC PANEL THRESHOLD REGRESSION ANALYSIS
5.5 STATIC PANEL THRESHOLD REGRESSION RESULTS – SENSITIVITY ANALYSIS
5.6 CHAPTER CONCLUSION
CHAPTER 6: CONCLUSIONS, RECOMMENDATION AND IMPLICATION FOR FURTHER RESEARCH
6.1 CHAPTER INTRODUCTION
6.2 EMPIRICAL RESULTS DISCUSSION
6.3 CONTRIBUTION OF THE STUDY
6.5 CONSTRAINTS OF THE STUDY
6.6 RECOMMENDATIONS OF THE STUDY
6.7 SUGGESTIONS FOR FUTURE RESEARCH
LIST OF APPENDICES
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THE IMPACT OF FINANCIAL SECTOR DEVELOPMENT ON FOREIGN DIRECT INVESTMENT IN EMERGING MARKETS