Foreign Direct Investment in Developing Economies: does it Crowd in Domestic Investment?


     Foreign direct investment (FDI) has been prised by developing countries for the bundle of assets that multinational enterprises (MNEs) deploy with their investments. Most of these assets are intangible in nature and are particularly scarce in developing countries. They include technology, management skills, channels for marketing the products internationally, product design, quality characteristics, brand names, etc. In evaluating the impact of FDI on development, however, a key question is whether MNEs crowd in domestic investment (as, for example, when their presence stimulates new downstream or upstream investment that would not have taken place in their absence) or whether they have the opposite effect of displacing domestic producers or pre-empting their investment opportunities.
     An economic growth literature has demonstrated that domestic investment is one of the most robust determinants of economic growth, as also has been supported by Levine and Renelt (1992) and Mishra et al. (2001). The empirical literature also has stated that foreign capital inflow positively affects domestic investment in the host countries rather than crowding it out (Reisen and Soto, 2001). A number of studies in this area of research have provided evidence that foreign capital flow has a positive impact on domestic investment (Bosworth and Collins, 1999; De Mello, 1999; Razin, 2003; Mody and Murshid, 2005 and Mileva, 2008). If FDI has to crowd out domestic investment or fail to contribute to capital formation, there would be good reason to question its benefit for recipient developing countries. Moreover, given the scarcity of domestic entrepreneurship and the need to nurture existing entrepreneurial talent, a finding that MNEs displace domestic firms would also cast doubt on the development effects of FDI. These questions become all the more important when one considers that FDI is far from marginal. FDI contributes a significant and growing share of total gross capital formation in developing economies. In fact, FDI is much larger proportion of investment in developing economies than in developed countries, especially in Latin America in recent years.
     The major findings of this study can be summarized as follows. It has been found out that FDI has positive effects on the host country’s domestic investment, regardless of its entry mode supporting the “crowding-in-hypothesis”. In the short-run, one percentage point increase in FDI as a percentage of GDP leads to an increase in total investment as a percentage of GDP in the host country by about 10.7 percent, while in the long run the effect is about 31 percent. In dollar terms, one US Dollars crowds in $1.7 US Dollars of total investment in the short run and $3.1 US Dollars in the long-run.
     Since the primary objective of this study is to empirically examine the effects of FDI on domestic investment in the host countries, there is need to disentangle the influence of FDI on our dependent variable. Therefore, the study has incorporated a dynamic model with flexible accelerator effects, policy-related factors, open-economy factors and institutional factors.
     The analysis has been based on a dynamic investment equation that includes FDI in the host country along with a set of control variables. The dynamic feature of the model arises from the inclusion of the lagged dependent variable among the explanatory variables, which are discussed below. Thus, in the light of this discussion, the benchmark investment equation may be expressed in the following linear form:
DIi,t = β0 + β1DIi,t-1 + β2FDIi,t +
+ β3GDPGi,t + β5INFi,t + β6OPENi,t + β9INSTITUTI,t + εI,t
εI,t = ηi + νi ,t i = 1, 2 … N and t = 1, 2, … T
     Where (i) is the host country subscript, (t) is the time subscript, (β)s are unknown parameters to be estimated and (ε) is the usual random disturbance term. The dependent variable (DI) is domestic investment as a percentage of GDP. The main interest of this empirical exercise is the sign and magnitude of (β2) (i.e. the effects of FDI inflows on domestic investment in the host country).
     The results have shown that domestic investment is a function of past domestic investment. As lagged dependent variables enter the right-hand-side of the equation, dynamic panel data model is an appropriate econometric model that takes into account the persistence of the dependent variable. Instrumental variables have been used to solve the endogeneity problem within explanatory variables. That is, large and significant coefficient of the lagged dependent variable has indicated a high inertia in domestic investment, supporting the findings of Borenzstein et al., 1998; Bosworth and Collins, 1999; Agosin and Mayer, 2000; Mody and Murshid, 2005; and Mileva, 2008).
     It has been found that the output growth measured by the GDP growth rate is positively significant at the 1 percent level in all models, supporting the main hypothesis of the accelerator theory. For instance, the output growth effect has been expected to raise domestic investment by around 58 percent in the short run. Thus, the importance of accelerator effect on driving domestic investment has been also pointed out on the studies of Greene and Villanueva (1991), Razin (2003), Wang and Li (2004), Agosin and Machado (2005), Mody and Murshid (2005), Mallick and Moore (2006), and Mileva (2008). As aforementioned due to macroeconomic instability and uncertainty, high inflation rate tends to decrease domestic investment (McCulloch, 1989; Greene and Villanueva, 1991; Seren and Solimano, 1993; Oshikoya, 1994; and Ndikumana, 2000). In this study, the inflation rate effect is significant at the 5 percent level and it has been estimated to discourage domestic investment by about 0.04 percent and 0.12 percent in the short and long run, respectively. This is not a surprising result since most Latin American, Central Asian and Central Eastern European Baltic countries have experienced high inflation rates during 1990s (UNCTAD, 2002). The coefficient of openness to trade is positive and significant at 10 percent level, which is consistent with the hypothesis that there is a positive relationship between openness to trade and domestic investment. In other words, an economy which is highly integrated to the world can bring more investments in tradable sectors to increase the productivity and competitiveness (Ndikumana, 2000; Acosta and Loza, 2004; and Mileva, 2008).
Deputy Head of Department Ministry of Economy and industry
of Uzbekistan Doctor of Philosophy in Economics (Phd)


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