Foreign Direct Investment in OECD countries

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Literature Review

Foreign capital has become a significant component in any modern economy. The importance of foreign direct capital inflows for economic development embarked extensive research and debate within economists. Economists argue that FDI managed by MNEs inherently benefits domestic firms by an increase in both output and income. A study published by Brooks and Sumulong (2003) carefully analyses the positive impacts of FDI in host economies on the stimulation of economic growth. The study points out that technology and knowledge spillovers from FDI are one of the main beneficiaries to domestic industries as mentioned earlier. MNE´s are notably larger than local firms, whether measured in terms of market sales or employment. It follows that MNEs influence in Research and Development (R&D) activities outweigh their domestic counterparts. Hence, foreign firms introduce superior managerial technology, new or improved products (or services), more efficient logistical processes and significantly advanced marketing methods into their local affiliates and subsidiaries. Furthermore, foreign firms provide employee training programs which contribute to higher labor productivity in host economies.
A study conducted by Blomström and Kokko (1998) which is largely consistent with the study by Brooks and Sumulong (2003), reveals that FDI carried out by MNE´s encourages market efficiency through competition in both local and international markets. The entry of competitive foreign firms provides improved products or services for lower prices, which in turn yields enough incentive for domestic firms to enhance their products or services, and lower prices in order for them to stay in business. The presence of foreign firms in host countries distributes positive spillover through channels such as ‘watch and imitation’. Domestic firms simply watch and imitate their competitive foreign counterparts, adopt new technologies faster, innovate managerial structures and engage R&D activities (Blomström and Kokko 1998).
With regard to the positive effects of FDI on host countries, empirical studies find a positive relationship between unemployment levels and the influx of foreign investments. When the foreign firms set up production facilities in the recipient country, the firm directly hires local workers to engage in production activities. As discussed in Moran (2006), foreign capital accumulation positively affects host countries’ labor market, labor productivity and lobar skills. Similarly, Jude and Silaghi (2015) argue that FDI positively contributes to labor market specifically in advanced economies through the creation of new jobs and the investment of less-labor intensive technologies. A cross-country study carried out by Hijzen et. al. (2003) in Germany and the United Kingdom finds out MNE´s entrance is associated with the creation of more new workplaces, although this effect is also associated with wage inequality especially within low-skilled workers. Bandick and Karpaty (2011) find, using Swedish manufacturing labor data that FDI reduces unemployment in the country, and the effect is even stronger for skilled labor. Overall, the studies suggest that although FDI may decrease unemployment in the short-run in advanced economies by introducing laborsaving methods, it creates a steady employment growth rate by increasing labor productivity.
Another interesting positive impact associated with FDI is the export expansion in host economies. MNE´s operate economies of scale in marketing and production, hence higher ability to gain access and compete in international markets. A study by Stehrer and Woerz (2009) uses OECD economies between the years 1980-2000 to examine the impact of FDI inflow on export promotion. According to the study, “FDI inflow promotes output growth” and a significant catalyst to export expansion. In a similar fashion, Lane and Lion (2005) published an empirical study based on a panel of 84 OECD and non-OECD countries to investigate the effect of FDI on economic growth, specifically export-led output increases. The study also confirms the positive economic growth effect of FDI inflow and higher productivity. In addition, the authors demonstrate in the study that a ten percent increase in FDI inflow reflects at least a four percent increase in gross domestic production (GDP).
Contrary to the overwhelming believe of the positive effects of FDI on economic growth and productivity in OECD economies, there is a significant amount of literature that demonstrate the negative effects. FDI inflows and the presence of foreign firms in a host economy distorts competition. This negative competition could be due to; a) vigorous competition from foreign MNE´s may force domestic firms to produce on less-efficient scale of production (produce low efficient goods or services) which eventually compel them to ‘crowd out’, and b) foreign firms have access to abundant financial resources in comparison to domestic firms which eventually imposes local firms to crowd out (Agosin and Mayer, 2000). As cited earlier, foreign firms are larger and operate lower marginal costs which put them in a better position to carry out R&D, hence lower profits discourage local firms to undertake R&D, as a result, lower long-term domestic productivity. A study by Mencinger (2003) precisely investigates the relationship between FDI inward and GDP in OECD countries, specifically CEE members. The author finds a negative causal relationship between FDI and economic growth. He explains this by arguing that the main entry mode of foreign firms in developed economies is by takeovers, which defeats local competitors due to their inability to compete with bigger foreign enterprises that enjoy economies of scale.

Summary and hypotheses

To surmise the review of FDI and economic growth study, there are many factors that can explain FDI and economic growths relation, with a large amount of varying determinism and factors that have been seen influential in different periods. The Solow-Swan growth model focused on the accumulation of physical capital and labor to explain growth while viewing technological progress as exogenous. The endogenous growth theories argues that capital cannot only be increased but also accumulated through an increasing variety of capital goods and quality improvements that drive new technological progression.
The literature review has shown that FDI used to be treated mainly as an addition to capital accumulation, nowadays, however, FDI has been treated as a significant contributor to the rate of technological progress, with capital accumulation effects vary. The benefits of FDI on economic growth will be a direct transmission. The direct transmission increases the physical capital stock and its quality, but also the variety of goods supplied. Indirect transmission, increasing managers’ knowledge and expertise to effectively increase quality. Second-round transmission through increased R&D efforts and skilled labor spillovers, however, limited depending on the industry, competition and productivity gaps. And knowledge spillovers.
The drawbacks of FDI on economic growth will involve the crowding out from domestic investment. Thus, distorting the natural development of domestic regions and industries, but also reducing the availability for domestic firms’ sources of finance. FDI investment will also cause an increase in imports, which can cause a disturbance in the balance of payments.
With the literary review and theories as a base, we establish the hypothesis as follows:
Hypothesis 1: FDI inflow is anticipated to have a positive, direct effect on the rate of GDP growth per capita in the sample of OECD member countries, all else equal
Hypothesis 2: Interaction between FDI and absorptive-capacity variables are anticipated to have a positive, direct effect on the rate of GDP growth per capita, all else equal
It is interesting to mention that ‘absorptive capacity’ refers to a country’s ability to recognize the value of FDI and assimilate it into economic development.

Empirical specification

The study of country economic growth determinants fundamentally requires a description of a statistical model of cross-country growth variations, which permits to distinguish the effects on the economic growth of different included variables. Such models are commonly based on the widely known Neoclassical Growth Theory.
An originative study published by Mankiw, Romer and Weil (MRW) (1992) which is seen as a classic contribution to the discussion of economic growth, argues that models such as the Solow growth model fail to take account cross-country differences. As mentioned earlier, the neoclassical theory of Solow growth model attempts to explain long-run economic growth by indicating constant returns to scale, changes in the population growth rates, exogenous growth rates of technology and the savings rate. This model proved to be convenient at explaining an individual country’s long-run rates but was considered premature at accounting cross-country differences. MRW (1992) therefore augmented the Solow growth model by adding accumulation of human capital and physical capital may better examine cross-country variations. They derived a model that complies with the traditional Cobb-Douglas production function for capital,for human capital, and for level of technology. MRW adds that technology cannot be considered the same for all countries but a rather  country-specific determinant of growth. Similar studies that focus on economic growth and FDI such as Lucas (1988), among others, confirm the findings of MRW back the augmented Solow growth model.
In like manner, to analyze the empirical effect of FDI on economic growth in OECD countries, we have to specify a statistical regression model. We adapt an empirical estimation model specified by Borensztein et al (1998), which can be presented as:

Data description

There are multiple sources for data regarding FDI. The macroeconomic data are largely collected from the World Bank, UNCTAD and OECD databases. These sources are extremely extensive and are widely used in similar empirical analyses. Twenty-one OECD member countries are included in the data estimation; which are Austria, Belgium, Canada, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Italy, Netherland, Norway, Poland, Portugal, Slovakia, Spain, Sweden, UK, and the US. The rest of the member states are not included on the grounds of data availability issues. The tested timeframe will be from 1998 to 2017, a period where most of the interested data is available.
FDI variables are obtained from the OECD database (2019). It is commonly measured in two ways; net FDI inflows or stocks. Net FDI inflows seem more appropriate and most commonly used in other studies because we are interested in the effects of FDI in the host country. Data for other explanatory variables that have been proved to affect FDI, such as population growth, inflation, trade openness, and government expenditures are also taken from the OECD database. Population growth refers to the annual population growth rate, inflation rate refers to the consumer price index (CPI) as in 2010, trade openness refers to the export and import ratio relative to GDP, and government expenditure refers to all government expenditure as a percentage of GDP.
Human capital variable is a significant measure correlated with economic growth. There are no available data for human capital per se, however, it is commonly used average years of schooling (education) as one proxy for human capital. High educational attainment is correlated with growth and high levels of labor productivity. The variable of education level based on average years of schooling, namely higher-level education, is adapted from Penn World Table (Feenstra et al., 2019).
It is difficult to construct correct and comprehensive measures of the financial system services for a cross-section of countries over twenty years; hence, some of our sample countries were restricted by the availability of liquid liabilities which many reviewed studies use. However, following King and Levine (1993), we include a measure of private credit sector. This indicator measures the financial intermediary to the private sector relative to GDP. It also implies that private credit sector shows the capacity local firms can investment domestically such as in new technologies. The data regarding this indicator is taken from the OECD database.
Institutions are found to be effective catalyst and strongly correlated to economic growth over time. Therefore, institutions are important determinant of long-term economic development and act as an absorptive capacity for FDI. We, therefore, try to include a proxy for institutional development. This indicator is called ‘Index of Economic freedom’ and is taken from the Heritage Foundation (2019). The index covers four crucial of economic prosperity over which governments usually exercise policy jurisdiction; rule of law, government size, regulatory efficiency, and open markets. In estimating these four broad categories, the index uses 12 qualitative and quantitative components, the overall score being derived by averaging the 121 factors with a scale of 0 to 100.

Data limitation

Despite its merits, this study suffers from drawbacks and limitations, mainly owing to a few problems inherent in the use of cross-sectional panel data and the unavailability of data. Unlike other reviewed studies, this research specifically focuses on OECD member states. However, not all member states have observable data for the selected timespan in the interested variables, which resulted in the exclusion of several countries in our sample. For a country to be applicable in our sample it needed to have all the variables throughout the twenty-year timespan. For instance, Chile does not have reported data for inflation rates, government consumption and trade openness which has been proved to be important for the effects of FDI. Hence, only 21 countries are feasible for our study. In addition, the inclusion of many variables in the model, considering the limited timespan, may weaken the estimates of the model.

Endogeneity problems:

It should be noted that conducting cross-country regressions might exhibit several endogeneity shortcomings. This is due to the causality direction between FDI and economic growth rate, which is one of the main issues economists’ face, since economic growth rate emerges from FDI inflows and this brings up the question whether economic growth rises due to capital inflows or the other way around. Hence, a correlation can exist between the FDI variable and the error term.
A commonly used remedy for the endogenous shortcomings is the inclusion of instrumental variables. It is important that these instrumental variables are only correlated with the endogenous variable and not the error term. Therefore, we have decided to include the lagged FDI and logarithmic of initial GDP.

Empirical Analysis

The goal of our empirical verification is to analyze the effects of FDI on the rate of GDP growth in our sample of OECD countries. As we mentioned above in the hypotheses, we are expecting to find that FDI have a positive direct effect on economic growth in the sample countries. For the estimate values to be statistically significant in the analysis, they need to demonstrate P-values less than 5 percent.
Generally, panel data estimation is broadly used to evaluate economic growth models, specifically those that estimate FDI impacts on economic growth. After running several regressions with pooled OLS, random and fixed methods, it has become obvious to perform Hausman’s Test (for Fixed effects vs Random effects) and Breusch & Pagan Lagrange Multiplier Test (for Pooled OLS vs Random effects) to decide the most suitable method for the regression model. More of this is explained in the result section.
Below we provide a descriptive summary of the statistics in Table 1 between 1998 and 2017. As can be observed from the table, there is substantial variation in the variable of main interest, i.e. FDI variable, as well as growth rates. FDI inflows is defined as financial inflows that consist of “equity transactions, reinvestment of earnings, and intercompany debt transactions” (OECD, 2019). Hence, FDI inflow values can be negative if these three components are not positively balanced.
Human capital variable seems to be evenly distributed which were rather expected (because OECD countries have similar average years of schooling). At the same time, population growth rate demonstrates negative minimum value, which suggests that some of these countries experience population loss.

Table of Contents
1. Introduction 
1.1 Background
1.2 Foreign Direct Investment in OECD countries
2. Theories 
2.1 OLI framework
2.2 Solow Swan Growth model
2.3 FDI and economic growth relation in theory
3. Literature Review
3.1 Summary and hypotheses
4. Empirical specification 
4.1 Data description
4.2 Data limitation
4.3 Endogeneity problems:
4.4 Empirical Analysis
5. Results 
6. Discussion and Conclusion 
7. References
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The effects of foreign direct investment inflows on economic growth in OECD countries

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