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Foreign Direct Investment and Economic Growth: A Cross-Country Exploration in Asia
using Panel Cointegration Technique
Samrat
Roy# and Kumarjit Mandal#AbstractThe existing macro literature on Foreign Direct
Investment-Growth nexus has identified the potential gains of FDI to recipient
countries only if they attain threshold level of absorptive capacities. The present
study has made an effort in this direction to investigate whether FDI affects
economic growth based on a panel data for 27 Asian economies over the period 19752010.This paper applies panel cointegration technique to establish the long-run
equilibrium relationship between foreign direct investment and economic growth. The
findings strongly suggest that though FDI is growth enhancing in Asia, yet the
extent of its impact depends on the threshold levels of absorptive capacities
measured by the levels of human capital and infrastructure. Those Asian economies
which satisfy these threshold levels can only enjoy the benefits of FDI. Thus this
study provides convincing evidence of the synchronized efforts by the Asian
economies to attract FDI for their economic growth.
JEL Classification codes:
F23, O16, O40Key words: Foreign Direct Investment, Economic Growth, Panel
Cointegration, Panel
EstimationI. IntroductionThe structural
transformation in the global economy in terms of changes in market orientation
opened up a new paradigm in the treatment of private capital and capital
accumulation in theoretical and empirical discussions. The issue of capital flows
is considered to be the most accessible route for economic growth whereby
investment is regarded as the engine of growth. The worldwide changes in the
mindset and pro-business orientation have recognized the importance of Foreign
Direct Investment as one of the possible options to stimulate growth momentum.
Discussions on foreign capital and growth originate from pre-classical views.
Basically the issue of foreign capital originated from the mercentalist investmenttrade mechanism which was enhanced through protection of domestic producers and
making exports competitive. In spite of the rise in saving potentials in exportsurplus countries, a large proportion of savings could not be invested due to poor
investment opportunities. The classical political economists went beyond the
intuitive thoughts of mercantilists and they focused on the causal relations of the
economic phenomena. Gradually the neo-liberal policies had been effective since the
18th century. The neo-classical doctrine regarded the issue of capital mobility as
the significant determinant of economic growth. The emerging capital mobility in
terms of FDI had led to the resurgence of neo-classical orthodoxy. International
capital movements had been the main component of neo-classical growth theory and
policy (Nurkse, 1953).The relevance of FDI is felt through compensation mechanism
in breaking the vicious circle of poverty. The genesis of vicious circle of
poverty can be explained by low real income leading to low capacity to save which
lowers productivity and potentials for investment. The lack of capital squeezes the
capacity to save and forces investment to get back to the low rate of real income
(Nurkse, 1953).Thereby FDI can stimulate the additional resources to break the
vicious circle and act as a complementary tool for domestic resources. The FDIgrowth nexus can be analyzed within the framework of economic development. The
investigations regarding the impact of FDI should not deal only with the direct
causality on economic growth but also on the pre-conditions necessary for growth.
Within the framework of neo-classical models, the impact of FDI on the growth of
output is constrained by the existence of diminishing returns in physical capital
without any long run effect. With the advent of endogenous growth theories, FDI
could be regarded as the recourse of new technology and high skilled labour.
Consequently, FDI has been integrated into theories of economic growth as the
"gains-from-FDI" approach (Krugman, 1998). In the past two decades, there has been

a major shift in the size and composition of the cross-border financial flows to
developing countries, especially the Asian countries. The Asian countries have
experienced upsurge in private capital flows due to liberalization in their capital
accounts. One of the fundamental motivations for attracting private capital was the
much needed funds that the foreign investors require for recapitalizing their
economic systems.Among the Asian economies, Indonesia, South Korea, Thailand,
Philippines and Singapore are the enthusiastic liberalizers (RajanR, 2004). The
major drivers of foreign capital have been the favorable policies towards
encouraging cross border mergers and acquisitions in the financial sector. However
in case of India and China, the move towards liberalization is cautious (Rajan,
2004). Though China has been a late entrant to open up for foreign participation as
compared to other Asian countries, it recorded a high pace in attracting foreign
capital. Indias economic reforms have made Indian business versatile and enhanced
the robustness of the industry. Hence the search for higher returns in Asian
economies motivated the study to investigate the theoretical and empirical
relationship between FDI and economic growth.Against this backdrop, this paper
looks into the long run dynamics between foreign direct investment and economic
growth for 27 Asian economies# within the time frame, 1975-2010.The empirical
specification underlines the concept of endogenous growth theory. This study looks
for cointegration within a panel framework. The cointegrating relation is further
estimated using panel econometric techniques to determine the threshold level of
absorptive capacity for the host country. Unlike previous studies, this paper
contributes to the existing literature by identifying the selected Asian economies
under study individually in terms of their attainment of the threshold level of
absorptive capacities captured by the levels of human capital and infrastructural
development respectively. This paper is divided into six sections. Section II
provides an overview regarding the existing literature. Section III discusses on
the empirical specification followed by data and methodology issues in Section
IV.SectionV reports the empirical results followed by conclusion in Section VI.II.
Recent LiteratureEconomic growth can be explained by a variety of social,
political, economic and institutional factors. The FDI-Growth nexus has gained
importance in the growth literature in its varied dimensions. The overview of the
studies confirm various dimensions such as fundamental theories of FDI, various
macro economic variables that influence FDI, the impact of economic integration on
the movements of FDI followed by advantages and disadvantages of FDI (Yusop 1992;
Jackson and Murkowski 1995; Cheng and Yum 2000; Lim and Maisom 2000). The
theoretical models refer to the propositions of FDI led Growth; Growth led FDI and
their interdependency through feedback mechanism.The hypothesis of FDI-led Growth
emerged with the development of endogenous growth theory. FDI-led-Growth has been
propounded by Goldsmith(1969) who stated that financial intermediaries can be
stimulative to economic growth either by capital accumulation or by raising the
levels of saving and investment rate(Shaw,1973).This view originates from
Schumpeter(1911) growth theory. Subsequently, the empirical studies of Sala-iMartin(2002) provides strong evidence to this proposition.FDI accompanied by human
capital, exports and technology transfer will play a proactive role in generating
growth momentum(Borenzstein and Lee, 1998 and Lim and Maisom,2000).These growth
inducing factors should be nurtured to realize the potential gains from FDI.
Microeconomic studies also corroborate this proposition in the sense that spillover
efficiency occurs when domestic firms are capable of absorbing the benefits of MNCs
embodied in FDI. Besides FDI also creates backward and forward linkages which get
stimulated through MNCs in spurting up economic growth and development. Blomstrom,
Kokko and Zejan (1992) concluded that productivity will rise due to the spillover
effects of FDI. De Mello (1997) pointed out two main channels through which FDI
stimulates growth. This involves the skill acquisitions through management
practices and labour training. The study of De Mello supported by findings of OECD
(2002) confirms that FDI contributes positively to income growth and productivity
provided that the host country has attained a certain degree of absorptive
capacity. A number of macroeconomic studies corroborated the proposition that FDI
is conducive to the economic growth. It is viewed as the composite bundle of

capital stock which augments the existing level of knowledge and instills
managerial expertise. According to Frankel et al (1999), FDI accelerates growth
through the creation of investment demand in terms of filling in saving gaps. This
proposition is further supported by the findings of Zhang (2002). Zhang pointed out
the contribution of FDI to economic growth in terms of
the provision of financial resources, transfer of technology, boosting competitive
potentials and enhancing domestic savings and investment. However the study by
Carkovic and Levine (2002) does not confirm any conclusive results in favor of this
proposition.
Another strand of literature emerges from the GDP driven FDI
hypothesis which is strongly based on MNC theory. According to the Eclectic
Paradigm, Dunning (1977) argues that MNCs with certain ownership advantages will
invest in another country having locational advantages and benefits can be captured
effectively by "internalizing" production through FDI.Various locational factors
influence FDI such as market size, infrastructural parameters, political stability
and governance. The expansion in market size proxied by GDP of the host country is
expected to result in higher profitability. An upsurge in the investment potentials
will create better opportunities for FDI inflows (Corden, 1999).However the FDIGrowth nexus is better viewed in terms of endogeneity problem or feedback
mechanism. The issues related to causality plague all studies that attempt to
capture the impact of a factor or a group of factors on economic growth. The
complex phenomenon of economic growth reinforces the feedback mechanism. The
findings of Chowdhury and Mavrotas (2003) conclude mixed results in the direction
of causality between FDI and economic growth. They considered Toda and Yamamoto
(1995) specification of causality apart from traditional Granger-causality
approach.The above propositions have been addressed by researchers in their
empirical studies based on cross-sectional, time-series and panel data sets. The
cross-sectional studies illustrate that FDI in form of mergers and acquisitions
will be conducive to economic growth. Industry specific studies mainly focus on
spillover effects (Smarzynska, 2004 and Driffield et al, 2002).However, in the
context of methodological issues the cross-sectional studies suffer from serious
endogeneity problems and unobserved heterogeneity. Even if the coefficient of FDI
appears significant in the growth equation, it is not always reliable. The issue of
causation is of prime importance since it captures the holistic view of economic
growth process. A large number of empirical studies are actually based on timeseries analysis which not only look for causation but also looks into long run
relationship. These studies apply cointegration techniques followed by errorcorrection mechanism. In case of cross-country analysis, the studies look for
cointegrating relationship with respect to individual country basis. The
proposition of FDI led growth is investigated in many of the studies. In this
context, Adewumi (2006) examined the contribution of FDI to economic growth in
Africa using annual series, by applying time series analysis from 1970 to 2003. He
found that FDI contributes positively to economic growth in most of the countries
but it is not statistically significant. However, Herzer et al. (2008) applied time
series techniques from 1970-2003 for 28 developing countries, 10 countries from
Latin America, 9 countries from Asia and 9 countries from Africa. They found weak
evidence that FDI enhances either a long-run or short-run GDP. Their findings
indicate that there is unclear evidence on the impact of FDI on economic growth.On
the other hand, Zhang (2002) looks at 11 countries on a country-by-country basis,
dividing the countries according to the time-series properties of the data. Tests
for long-run causality based on an error correction model, indicate a strong
Granger-causal relationship between FDI and GDPgrowth. For six counties there is no
cointegration relationship between the FDI and growth and for only one country
Granger causality exists from FDI to growth. Unlike cross-country analysis, Kaushik
et al (2008) used Johansen's co-integration analysis and a vector error-correction
model to investigate the relationship between economic growth, export growth,
export instability and gross fixed capital formation (investment) in India during
the period 1971- 2005. The empirical results suggested that there exists a unique
long-run relationship among these variables and the Granger causal flow is
unidirectional from real exports to real GDP. However there are a number of

concerns with the time series issues. Though the studies confirm that the variables
namely FDI and economic growth are integrated of the same order and hence proper
estimation techniques are applied, the small samples typically used may distort the
power of standard tests and can lead to misguided conclusions. Thus proper steps
need to be adopted for utilizing the data in the most efficient manner by taking
care of country specific effects, controlling endogeneity problems and including
appropriate instruments. The studies based on panel data sets attempts to take care
of the deficiencies in time series analysis.The above mentioned propositions are
also addressed by panel studies which look for panel cointegration and panel
causation. For instance, Basu, Chakraborty and Reagle (2003), for 23 developing
countries from (1978-1996), found a cointegration relationship between FDI and
GDP.Moreover, Hansen and Rand (2006), for 31 developing countries from 1970-2000,
found that there is a cointegration relationship between FDI and GDP. Their
findings indicated that FDI inflows are positively correlated with GDP, whereas GDP
has no long-run effect on FDI. Hence, the above existing literature points out
various dimensions to justify the propositions under the preview of FDI-Growth
nexus. Keeping in mind the shortcomings of cross-sectional and time series studies,
this paper examines the impact of FDI on the economic growth in Asia within panel
framework. A panel framework is constructed to look into the absorptive capacities
of the Asian economies. This paper contributes to the existing literature in terms
of its search for cointegrating relation and thereby estimating for policy
conclusions. Unlike the previous studies, this paper attempts to determine the
threshold levels of human capital and infrastructure necessary for economic growth
III. Empirical SpecificationThis section examines the importance of FDI on economic
growth taking care of absorptive capacity of the host country on the basis of a neo
classical production function. According to Zhang (2001), FDI can influence growth
in two ways. Firstly this paper considers the direct impact of FDI on economic
growth with the help of the following production function, where output is a
function of labour, domestic capital and foreign capital respectively. Thus the
production function can be stated as : Specification-IYit = f( Lit ,Kdit ,
Kfit)
...........................................................................
......................(1)
Where Yit denotes output
Kdit and Kfit denote domestic and foreign capital stock respectively
Lit denotes the labour forceHere the subscript it refers to the panel set up
consisting of i=1.......N number of sample countries having t=1.......T number of
time-periods.Secondly the impact of FDI can be endogenized by the measure of
absorptive capacity. Actually Sala-i-Martin (2002) pointed out the difficulties for
selecting the potential determinants of economic growth in the context of empirical
discussions. In his study he considered 67 variables but among which only 18
variables are srongly correlated with economic growth. The strongest indication is
found for enrollment in secondary education and level of infrastructure. Taking
these findings into account, this paper considers the inclusion of gross enrollment
in secondary education as a proxy of human capital and levels of infrastructure
development as the measures of absorptive capacity which affect growth. Thus the
Equation 1 can be modified as:Specification-IIYit = f(Lit , K dit , Kfit ,Secedcnit
, Infrait ) .................................(2) where gross enrollment in
secondary education is represented by Secedcn and level of infrastructure is
denoted by Infra respectively.The inclusion of these two variables are also
supported by the findings of Levin and Raut (1997) and Roy and Berg (2006) who
concluded that these variables are growth-enhancing.As per the contributions of
Romer (1990) and extending the hypothesis of Boreinstein et. Al (1998), the issue
of absorptive capacity can be captured by the interaction terms such as the levels
of FDI multiplied by the levels of human capital and infrastructure. If the
coefficients related to the interaction terms are found to be positive and
statistical significant, then the countries having high levels of human capital and
infrastructure will be conducive to economic growth.The Equation 2 can be modified
as below:Specification-IIIYit = f(Lit , Kdit , Kfit , Secedcnit , Infrait ,
Secedcnit*Kfit ,Infrait*Kfit )...........(3)Here the indirect impact of FDI on
economic growth can be investigated by the interaction# #t#e#r#m#s#,#

#S#e#c#e#d#c#n# #a#n#d# #I#n#f#r#a# #m#u#l#t#i#p#l#i#e#d# #b#y# #f#o#r#e#i#g#n#


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#(#F#D#I#P#C#i#t#)# #+# ##3#l#o#g# #(#S#E#C#E#D#C#N#i#t#)# #+# # # # # # # # # # #
# # # # # # # # ## # # # # # # # # # # # # # # # # # # # # # # ##4#l#o#g#
#(#I#N#F#R#I#N#D#E#X#i#t#)# #+##5#l#o#g# #(#F#D#I#P#C#i#t#*#A#S#C#i#t#)# #+# ##i#
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#r#e#a#l# #t#e#r#m#s# #a#s# #a# #p#r#o#x#y# #f#o#r# #e#c#o#n#o#m#i#c# #g#rowth used
as dependent variable for all specifications log (GCFPCit): natural logarithm of
Gross Domestic Capital Formation per capita in real terms as a proxy for domestic
capital. The inclusion of this variable is supported by the findings of Olofsdotter
(1998) and Sahoo (2006) in explaining the determinants of economic growth.log
(FDIPCit): natural logarithm of inward FDI flows per capita in real terms as a
proxy for foreign capital.The inclusion of this variable is supported by UNCTAD
studies (1999).log (SECEDCNit): natural logarithm of the percentage of gross
enrolment in secondary education as a proxy for human capital. A higher level of
human capital is expected to boost up the potentials of FDI in stimulating growth
(Aleksynska et al. 2003).log (INFRINDEXit): natural logarithm of infrastructure
index computed for all the selected countries on the basis of variables# related to
all types of infrastructure, namely transport, ICT, energy and banking.
log(FDIPCit*ASCit): The multiplicative product of FDI with the host countrys
absorptive capacity variables (ASCit) , namely gross enrollment in secondary
education and infrastructure captures the interaction term or the indirect impact
of FDI on economic growth. This will determine the education and infrastructure
threshold levels. i and t : Country (i) and time period (t) respectively
###################################################################################
##############################################################################i# #
# # #:# # #u#n#o#b#s#e#r#v#e#d# #c#o#u#n#t#r#y# #s#p#e#c#i#f#i#c# #e#f#f#e#c#t#
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threshold level (in terms of absorptive capacity developments) for
FDI inflows
to have a positive impact on economic growth.The threshold level of host countrys
absorptive capacity is computed by the partial differentiation of FDI on growth.#
The above specified growth model is empirically tested in a panel structure
comprising of 27 countries in Asian continent covering the period,1975 to 2010.This
paper looks into the time-series properties of panel data followed by panel
estimation methods.IV. Data and MethodologyThe scope of this study is limited to 27
Asian economies covering the period 1975 to 2010. The secondary data on the

variables namely GDP per capita (PPP), Gross Domestic Capital Formation (GCF) ,
Foreign Direct Investment Inflows(FDI), Gross enrolment in secondary education
(SECEDCN) and total labour force are collected from World Development Indicators
published by World Bank. The variables Gross Domestic Capital Formation (GCF) and
Foreign Direct Investment Inflows (FDI) are converted to real terms at constant
prices. The Infrastructure Index is constructed with the help of Principal
Component Analysis (PCA)#. The empirical treatment involves the applications of
panel based econometric procedures namely panel cointegration techniques and panel
estimation procedures. Panel cointegration analysis ensures the attainment of long
run equilibrium relationship between economic growth and its explanatory variables
as specified in the growth equation (4).Non-stationarity of the macro economic
variables pose problems in the estimation results. Ordinary least Squares
Regression results with non-stationary variables will lead to spurious results. For
the identification of a possible long run relationship the variables should be
integrated of the same order. However the standard time-series unit root tests
namely Augmented Dicky Fuller test and Phillips-Perron test have less power given
the sample size and time frame of the study. Recent literature suggests that panelbased unit root tests have higher power than unit root tests based on individual
time series. Recent developments in the panel unit root tests include: Levin, Lin
and Chu (LLC), Im, Pesaran and Shin (IPS), Maddala and Wu and Hadri. Among the
different panel unit root tests developed in the literature, LLC and IPS are the
most popular. Both of the tests are based on the ADF principle. However, LLC
assumes homogeneity in the dynamics of the autoregressive coefficients for all
panel members. In contrast, the IPS is more general in the sense that it allows for
heterogeneity in these dynamics. Therefore, it is described as a Heterogeneous
Panel Unit Root Test. In addition, slope heterogeneity is more reasonable in the
case where cross-country data is used. In this case, heterogeneity arises because
of differences in economic conditions and degree of development in each country. As
a result, the test developers have shown that this test has higher power than other
tests in its class, including LLC. Hence IPS test is more preferred that LLC.The
next step is to test for cointegrating relationship. The concept of cointegration
was first introduced into the literature by Granger (1987). Cointegration implies
the existence of a long-run relationship between economic variables. The principle
of testing for cointegration is to test whether two or more integrated variables
deviate significantly from a certain relationship (Abadir and Taylor, 1999). In
other words, if the variables are cointegrated, they move together over time so
that short-term disturbances will be corrected in the long-term. This means that
if, in the long-run, two or more series move closely together, the difference
between them is constant. Otherwise, if two series are not cointegrated, they may
wander arbitrarily far away from each other (Dickey et. al, 1981).The shortcomings
of traditional cointegration procedures led to the application of panel
cointegration techniques. A heterogeneous panel cointegration test developed by
Pedroni (2001) overcomes the problems of small samples and allows different
individual cross-section effects for heterogeneity in the intercepts and slopes of
the cointegrating equation. Pedronis method includes a group of tests for arguing
the null hypothesis of no cointegration in heterogeneous panels. The first group of
tests is termed within dimension. It includes the panel-v, panel rho(r), which is
similar to the Phillips, and Perron (1988) test, panel non-parametric (PP) and
panel parametric (ADF) statistics. The panel non-parametric statistic and the panel
parametric statistic are analogous to the single-equation ADF-test. The other group
of tests is called between dimensions. It is comparable to the group mean panel
tests of Im et al. (1997). The between dimensions tests include four tests:
group-rho, group-pp, and group-adf statistics. Hence Pedroni test establishes the
long run relationship.The FDI led Growth proposition is further analyzed using
panel estimation technique namely Random Effect estimator. Random Effect estimator
controls the heterogeneity by by including time-dummy variables for each group
(Wooldridge 2006).It is more appropriate for testing unbalanced panel data, where
there are limitations or missing observations in the panel data set (Asteriou and
Hall 2007). However both Fixed and Random effect estimations are conducted in panel

framework. Difference between Fixed effect and Random effect models arises in the
sense that fixed effect assumes that each country differs in its constant term,
whereas latter assumes that each country differs in its error terms. Random effect
model treats the intercepts for each section not as fixed but as random parameters
(Asteriou and Hall 2007). However, the choice between RE or FE is dependent on
whether unobserved component and other control variables are correlated. It is
important to have a test for examining this assumption (Wooldridge 2006). Hausman
(1978) developed a test to choose between Random Effect and Fixed Effect
estimators. V. Empirical Results The main purpose is to justify long run dynamism
of FDI on economic growth and to investigate whether the countries have the
absorptive capacities to reap the potential gains of FDI.This paper applies the
panel econometric techniques to justify the propositions using a growth equation
stated in Section-III. This paper attempts to establish the presence of
cointegration among the variables specified in the growth equation in Section III.
For this exercise the first step is to ensure
stationarity for the panel variables. As discussed in the Methodology section,
this paper applies panel unit root tests namely IPS, LLC, ADF-Fisher and PP-Fisher
tests respectively. Table 1 presents the results of the tests both at level and at
first-difference including constant and constant with time trend. The four panel
series variables namely GDPC, GCFPC, FDIPC, INFRINDEX and SECEDCN are found to be
non-stationary at their level form, which accepts the hypothesis regarding the
presence of panel unit root with and without time trend respectively. The last part
of Table1 shows the results of IPS, LLC, ADF-Fisher and PP-Fisher tests at their
first-differences with and without time trend respectively. The results confirm
that all the panel series variables are stationary at their first difference that
is the null hypothesis regarding the presence of panel unit root is rejected at 5%
level of significance. Further the results provide strong evidence regarding the
series that they are all individually integrated of order one (I (1)) across
countries.To investigate regarding the existence of long run relationship between
the panel variables, it is necessary to look for panel cointegration. This exercise
is justified since all the variables are integrated of same order, I (1).Pedroni
(2001) test is conducted to ensure the presence of cointegration with the presence
of individual intercept as well as intercept with constant trend. The summary of
the results of Pedroni panel analysis with intercept and with both intercept and
trend are reported in Table 2.With regard to the Specification 1 as specified in
Section III, Pedroni tests are carried out. This model specifies that output per
capita proxied by GDPC (GDP per capita) is a function of domestic capital per
capita proxied by GCFPC (Gross Domestic Capital Formation per capita and foreign
capital proxied by FDIPC (Foreign Direct Investment per capita) respectively. At
intercept level in the absence of trend, all the test statistics provide strong
evidence regarding the presence of cointegration among the panel series variables,
GDPC, GCFPC and FDIPC respectively. These results strongly reject the non-presence
of cointegration in heterogeneous panels for first and second group of tests or the
tests for within dimension and between dimensions respectively. With the inclusion
of trend except one test statistic, all the remaining test statistics reject the
null hypothesis (no cointegration) at 5% level of significance. Hence this paper
ensures the presence of long run equilibrium relationship among the above stated
variables which justifies the underlying theory of neo-classical type production
function.To capture the endogenous impact of FDI on economic growth, this paper
focuses on the domestic absorptive capacity factors as specified in Specification2. Two variables namely gross enrollment in secondary education (SECEDCN) and
infrastructure index (INFRINDEX) are included to capture the essence of absorptive
capacity in the given production function. Recent literature provided evidence that
a host country will effectively transform the benefits embodied in FDI flows if the
host country attains a threshold level of human capital and infrastructure. The
inclusion of these two variables is justified if the long run equilibrium
relationship established in Specification 1 remains sustained.To confirms this
proposition, Pedroni test is conducted again with respect to Specification 2. Table
3 presents the results both with intercept and with intercept and trend

respectively.Pedroni test confirms that five out of seven test statistics reject
the null hypothesis of no cointegration at 5% level of significance in the presence
of only intercept without trend. However in the presence of both intercept and
trend, four out of seven test statistics confirm the presence of panel
cointegration.To justify the presence of mixed results, the findings of Harris and
Sollis (2003) needs to be mentioned. According to Harris and Sollis (2003) it is
quite natural for different tests to generate mixed results when some of the series
are cointegrated or not. Since majority of the statistics conclude in favour of
cointegration combined with the fact that panel studies are more reliable in
intercept only, it can be concluded that there is long run cointegration among the
panel variables, GDPC, GCFPC, FDIPC, INFRINDEX and SECEDCN respectively. The
findings in this case reflect that the inclusion of these two variables does not
ambigously confirm panel cointegration unlike the previous case. However given the
time span 1975 to 2010, the result is not surprising. As pointed out in previous
literature, the productivity levels of these economies are hampered due to the
incidence of business cycles within this longer time span. This destabilizes the
tendencies of these economies to attain long run steady state relationship due to
the fragility of the financial structure and weakening of investors confidence
(Ali-Yosouf 2002). Since the aforesaid variables capture the essence of
productivity, the inclusion of them in the production function (Specification-2)
provides mixed results. However according to Harris and Sorris, the panel variables
are cointegrated. This paper further attempt to estimate the cointegrating
relationships in logarithmic form established above with the help of panel
estimation techniques. In addition this paper contributes to the existing
literature by determining the threshold level of absorptive capacity in the host
country. Before proceeding to the estimation results, the standard Breusch-Pagan
Lagrange Multiplier (LM) Test for the adequacy of the poolability assumption is
conducted. The results reported in Table 4 confirm very high computed value of LM
statistic which favors the fixed effect/random effect model over cross-section
model.Hausman test is then conducted to choose between random and fixed model for
all the specifications. The test statistic in this case accepts the null hypothesis
of random effect model. The growth equation already specified in Equation 4 of
Section III is finally estimated and the Table 4 reports the estimation results.
Specification 1 refers to the basic model with core variables and all of them are
statistically significant at 5% level. It is observed that the variable, FDIPC
significantly contributes to economic growth such that one percent increase in FDI
inflows increases economic growth by 0.14 percentage points. This finding
corroborates with the conclusions of Zhang (2001). FDI boosts up the competitive
potentials through the transfer of technology, acquisition of capital stock and
enhancing the growth momentum. However unlike the previous literature, the
estimated coefficient of GCFPC is negative but statistically significant for all
specifications. It can be inferred that domestic investment proxied by gross
domestic capital formation is not conducive to economic growth for Asian economies
due to the mismatch between capital requirement and saving capacity. On the
contrary as mentioned above FDI inflows stimulates economic growth. However the
complementarities between domestic and foreign investment is examined through
interaction term and its impact on economic growth is analyzed under specification
4.5. Specification 2 presents the estimated results of the growth equation with the
inclusion of absorptive capacity variables, SECEDCN and INFRINDEX respectively.The
coefficients of FDIPC and GCFPC (as a proxy for domestic investment) are
statistically significant but they affect economic growth with opposite signs. The
coefficient of SECEDCN (education) estimated under random-effect model is found to
be positively significant confirming the positive correlation between the level of
human capital and economic growth (Barro,1995).In this case one percent increase in
the level of secondary educational attainment increases economic growth by 0.457
percentage points. This justifies the inclusion of this variable in the growth
equation. The coefficient of infrastructure index positively and significantly
contributes to economic growth such that it rises by 3.062 percentage points due to
the improvement in infrastructure. However as addressed in World Bank (1994)

studies, Asian economies need to improve the effective usage of infrastructure


stocks and services. Though this variable significantly contributes to economic
growth yet the works of Alexander and Estache (2000), Reinikka and Svenson (1999)
and Canning and Bennathan (2000) confirms the link between infrastructural
investment and economic growth is at best ambiguous.To look more closely into the
indirect impact of FDI on economic growth, the interaction terms are included in
the estimation procedures. Specification 3 tests the hypothesis that the
contribution of FDI to economic growth is conditional to the level of
infrastructural development. The coefficient of FDI in column 4.3 is negative but
the interaction term of FDI with INFRINDEX is positive and significant. According
to the propositions stated in Section III of this paper, this result suggests that
relation between FDI inflows and economic growth is contingent to the threshold
level of infrastructural development for Asian countries. Following the procedure
as mentioned#, the infrastructure threshold for Asian economies in panel structure
is computed. It equals 0.78.This value is obtained by considering derivative of the
growth equation with respect to FDIPC and setting them equal to zero. By solving it
the infrastructure threshold value is found to be positive. By taking exponential
of this value the minimum level of threshold is computed. Among the Asian countries
under study, only those countries which will satisfy this infrastructure threshold
level will enjoy the benefits of FDI inflows and it will
be conducive to economic growth. Specification 4 tests the hypothesis regarding
the growth effect of FDI in terms of interaction term with secondary education as a
proxy for human capital. It reports that FDI has a negative impact on economic
growth while the interaction term with secondary education is positive and
significant to economic growth. The coefficient of the interaction term captures
the effect of a well-educated workforce on the absorptive capability of the
economy. Using the similar procedure, secondary education threshold is computed and
reported in Table 4. It is found to be positive which confirms that that a minimum
level of human capital is required for FDI to contribute positively to growth,
confirming the results of Borensztein et al. (1989). By taking exponential of the
education threshold value, it is suggested that the Asian economies having
relatively well educated labour force satisfying this threshold level will have the
potentials to reap the benefits of FDI inflows. The graphical interpretation of the
absorptive capacities of individual countries is explained in Figure-1.The
horizontal axis plots the countries against the average level of secondary
education threshold plotted in the vertical axis. Among 27 selected countries
under study, six countries namely Bangladesh, Pakistan,Nepal,Oman,Papua Guinea and
Oman are below the threshold education level which equals 35.75.The remaining 21
countries satisfied this threshold level and are capable enough to absorb the
spill-over effects of FDI inflows over the period from 1975 to 2010. Specification
5 examines the impact of the interaction term between FDI inflows and domestic
investment on economic growth. The results differ from the previous studies. It is
observed that FDI inflows positively contributes to economic growth but its impact
is found to be negative and significant as far as the estimated coefficient of the
interaction term is concerned. According to the discussions in Section III, it can
be concluded that the positive effects of FDI diminishes with the improvement in
domestic investment. Thus the empirical results obtained are to some extent on the
expected lines and this call for policy recommendations.
VI. Conclusion This
paper investigates the impact of FDI on economic growth in Asia using a crosscountry sample of 27 economies for the period 1975 to 2010.There has been a
paradigm shift in the orientation towards FDI in Asian countries for the last two
decades. This paper further supports the view that FDI can act as tool to
supplement growth momentum but the effect of FDI depends on the threshold
conditions of the host country. The panel cointegration technique is applied to the
empirical specification of neo-classical type production function. Further the
panel estimation techniques are carried out for policy results.The empirical
results clearly reveal that there exists panel cointegrating relation and hence the
estimation procedure can be justified. This finding asserts that the production
function in per capita terms exist in the long run. The inclusion of the absorptive

capacity variables does not deviate the results from the attainment of long-run
equlibrium.Hence their inclusion is justified. The random effect panel estimation
procedure is applied to the panel cointegrating relation. The results clearly
reflect that FDI contributes positively to economic growth followed by significant
coefficients for human capital and infrastructure, which supports the empirical
literature.The study further contributes to the existing literature in respect of
absorptive capacity variables. In the context of existing FDI-Growth literature,
this study provides evidence to the proposition that the ability to absorb the
advantages embodied in FDI inflows is conditional on the capability of the host
country with respect to human capital and the level of infrastructure. The
findings confirm that certain Asian economies do not satisfy the threshold
education and infrastructure levels and hence these countries need to invest more
in education and infrastructure.A more ambitious policy to upgrade the local
environment, enhance human capital endowment in terms of skills and expertise
,creating strong infrastructure base in tandem with FDI inflows is complementary to
economic growth. Hence Asian economies can reap the benefits of foreign capital in
terms of its capabilities measured by the levels of human capital and
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Panel Unit Root Test Results At
Levels##Variables#Constant#Constant and Trend###ADF test#PP test#IPS test#LLC

test#ADF test#PP test#IPS test#LLC test##GDPC#-0.20 #-0.29#


-0.68#
-1.04#-0.54#-0.66#-0.87#-0.86##GCFPC#-1.14#-0.47#
-1.07#
-0.41#-0.47#0.51#-0.76#-0.76##FDIPC#-0.49#-0.76#
-1.06#
-0.23#-0.56#-0.42#-0.36#0.32##INFRINDEX#-0.66#-0.54#
-1.45#
-0.67#-0.12#-0.36#-1.08#0.88##SECEDCN#-0.59#-0.34#
-0.76#
-0.54#-1.25#-1.45#-1.08#-1.23##
Panel Unit Root Test Results At First-Differences##GDPC#-13.54*#-9.32*#
-12.45*#
-7.22*#-11.56*#-8.78*#-10.55*#-8.54*##GCFPC#-11.32*#-8.76*#
-11.65*#
-6.59*#-12.32*#-9.66*#-10.43*#-7.836*##FDIPC#-12.64*#-7.69*#
-18.46*#
-8.92*#-13.43*#-7.65*# -9.58*#-8.78*##INFRINDEX#-11.32*#-8.41*#
-10.62*#
-6.61*#-11.42*#-8.56*# -7.68*#-7.44*##SECEDCN#-10.44*#-7.67*#
-7.99*#
-8.23*#-10.32*#-8.21*# -7.43*#-8.08*## APPENDIXTable 1Panel Unit Root
Test Results
Table 2 Pedroni Panel Cointegration Test
Results(Specification I) Test Statistics#Individual Intercept#Individual
Intercept and Constant Trend###
Statistic#
Prob.#
Statistic#
Prob.###
Within Dimension##Panel rhoStat#3.477556*#0.0003#0.496942*#0.3096##Panel v-Stat#-8.886716*#0.0000#5.195046*#0.0000##Panel PP Stat#-11.05264*#0.0000#-12.04549*#0.0000##Panel ADF
Stat#-8.060624*#0.0000#-8.497430*#0.0000###
Between Dimension##Group rho Stat#-5.502022*#0.0000#-2.641395*#0.0041##Group PP
Stat#-10.16093*#0.0000#-13.42647*#0.0000##Group ADF Stat#-8.69874*#0.0000#7.790504*#0.0000##
Note: 1. All statistics are from Pedronis procedure (1999).
2. * indicates rejection of the null hypothesis of no co- integration
at 5%
levels of significance.
Table 3 Pedroni Panel Cointegration Test Results
(Specification II)Test Statistics#Individual Intercept#Individual Intercept and
Constant Trend###
Statistic#
Prob.#
Statistic#
Prob.###
Within Dimension##Panel rho-Stat#0.706823#0.2398#-1.662650#0.9518##Panel vStat#-2.483361*#0.0065#-0.452409#0.3255##Panel PP Stat#-12.70203*#0.0000#14.65569*#0.0000##Panel ADF Stat#-8.618903*#0.0000#-9.029617*#0.0000###
Between Dimension##Group rho Stat#-0.299385#0.3823#1.449232#0.9264##Group PP
Stat#-14.69785*#0.0000#-18.05361*#0.0000##Group ADF Stat#-7.243145*#0.0000#7.493950*#0.0000##Note: 1. All statistics are from Pedronis procedure (1999).
2. * indicates rejection of the null hypothesis of no co- integration at 5%
levels of significance
Table 4Impact of FDI on economic growth; 19752010 (Random Effect Estimator) Dependent variables: log of GDP per capita (GDPC)
Variables#Equation Specifications###1#2#3#4#5##GCFPC#-0.12* (0.000)#-0.044*(0.000)#
-0.041*(0.000) # -0.043*
(0.000)#-0.03*0.000##FDIPC#0.14*(0.000)# 0.067*(0.000)#
-0.28* (0.000)# -0.13* (0.000)#0.09*0.000##INFRINDEX##3.062*(0.000)#
3.37*
(0.000)#
3.071*
(0.000)#3.01*0.000##SECEDCN##0.457*(0.000)# 0.406* (0.000)#
0.495* (0.000)#0.423*0.000##FDIPC*INFRINDEX### 0.35* (0.000)# ###FDIPC*SECEDCN###
# 0.15* (0.007)###FDIPC*GCFPC#####-0.016* ( 0.000)##Constant#3.87*(0.000)#2.69*
(0.000)#2.08* (0.000)#2.28* (0.000)#1.57*0.000##Breusch-Pagan Test (LM Test)#81.14*
(0.000)#93.32*(0.000)#75.32*(0.000)#78.43*(0.000)#77.65*0.000##No of
Observations#972#972#972#972#972##Threshold Value###0.80#0.86###P value of Hausman
Test#0.1621#0.2627#0.1127#0.1651#0.1482##
Note: * indicates
significance of the variables at 5% levels Figure-1Education Threshold#Note: The
dotted line represents the education threshold level equal to 35.75.The Asian
economies lie below and above this threshold on the basis of their average
secondary education levels for the period, 1975-2010.# Corresponding Author,
Assistant Professor, St. Xaviers College (Autonomous), 30 Mother Teresa Sarani
Kolkata-700016, E-mail samratsxc@gmail.com# Associate Professor, Department of
Economics, University of Calcutta,56A B.T.Road
Kolkata -700050,India,E-mail
kumarjitm@hotmail.com
# List of Countries : Bahrain, Bangladesh, Brunei, China,
Cyprus, India, Indonesia, Iran, Israel, Japan,
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