Thesis Statement
The central aim of our project is to answer the following question: If two countries have equal levels of urbanization, same percentage of Foreign Direct Investment (FDI) inflows and similar development indicators, will they experience different rates of growth in their income if they have different political regimes ? FDI refers to the direct or indirect ownership of a company, incorporated business enterprise or assets in a host country by foreign residents with the aim of generating wealth. FDI is a significant catalyst of development , whereas economic growth is widely recognized as a major economic purpose of every society . Subsequently, another objective of this project is to investigate and estimate the complicated relationships between FDI and economic growth.
In the existing literature, authors mostly focus on differentiating countries by income level or level of development. Our project will go further and consider two sub-samples within the major sample: namely, the democratic and autocratic countries. The project will be aimed at examining the difference that the regime makes for the model specification exhausted with multiple explanatory variables . Incorporating the explanatory variables and running regressions will enable us to achieve and assess results and draw corresponding conclusions. Taking into consideration that the data sets are obtainable and lie within the framework of econometrics, the objectives of this project prove to be rational and achievable.
Description of the Project
In order to explore the thesis statement of our project to the full extent, the linkages will be built between institutions, agglomerations, urbanization, foreign direct investment and political regime for the sample of approximately 96 countries over a period between 1980 and 2010, which can be considered a valuable contribution to the existing scope of literature .
The international trade plays a major role in the development of countries. It is essential in the transition of benefits of modern technology and industrialization from developed countries to the underdeveloped ones. Economists tend to believe that markets which function on a free basis are more predisposed to facilitating economic growth. Conversely, such issues as corruption, which increases transactions costs, can slow down the growth of the economy by increasing its friction. According to Cartier-Bresson , opportunities for corruption are created by feeble protection of property rights and weak governance, whereas extensive regulation, bureaucracy, and red-tape, which are largely recognized as characteristic features of autocratic regimes, create opportunities for rent-seeking (25 – 27). In her article “The Political Economy of the Rent-Seeking Society,” Krueger argued that, competitive rent-seeking causes an economy to operate below its capacity and imposes deadweight losses. This may be perceived as another substantial argument in favor of a democratic regime, which promotes free market.
Empirical research for this project will be largely focused on analyzing the relationships between the countries’ economies and political regimes . Commonly, a country’s political regime determines its most decisive economic policies. Those policies may imply either state-driven and inwardly focused or free market-oriented development strategies. In the article “Economic Freedom and Foreign Direct Investment in Developing Countries,” Kapuria-Foreman strives to answer the question of whether the increased economic freedom causes additional foreign direct investment. According to the suggested conclusion, reducing government intervention, increasing the protection of property rights, and lowering barriers to foreign investment and capital flows are most likely to increase FDI (151). Hence, trade liberalization is behind the process of international trade; and trade openness is an important component of it. Arguably, the process of trade liberalization increases not only trade, but also foreign direct investment.
Democratic political regime seems to feature the most accommodating conditions for economic growth and FDI. It is widely advocated by numerous scholars, such as Sen, who referred to democracy as one of the most important phenomena of the twentieth century; Ober, who focused on a philosophical perception of a democratic regime; and Diamond, who reported on a survey on how people from post-communist Europe, Latin American countries, Africa and some Asian states view democracy . However, certain scientists, such as Easterley , argue that the countries with autocratic political regimes might experience even better economic growth and appear to be more profitable for foreign investors. He also stressed that, since autocracies do have significant political boundaries, the process of investing in such countries should be very conscientious . Moreover, autocracies often feature excessive concentration in urban agglomerations, which has a negative effect on the efficiency of FDI . Hence, the question of various political regimes and their connection to the national economic conditions seems to be quite controversial. Therefore, our project will seek examining the difference that the regime makes for the model specification exhausted with multiple explanatory variables .
When investigating the connection between FDI and economic growth, the article by Li and Liu is of great help. The authors provide detailed tests and stress on the importance of interaction of foreign direct investment with other factors, rather than of pure FDI effects. They also pay significant attention to differentiating between the developed and developing countries. However, although the importance of country classifications is underlined in numerous scholarly papers (Blonigen and Wang ), the preferences in our project will be given to other issues. Thus, the main conclusion drawn from the research by Li and Liu is that, while FDI to developing countries interacting with human capital has a positive impact on economic growth, the opposite happens with technology gap . Another valuable aspect of this work is the sample size estimated by the authors. They study 84 countries over a period between 1970 and1999, using panel data approach in order to capture country-specific features. Moreover, the study is focused on econometric techniques, which are incorporated in our project.
From the comparison of developed and developing countries, Li and Liu draw the following conclusions: FDI affects growth in a positive way in both types of countries. Moreover, there is an interesting fact related to interaction of FDI variable with technological gap. It turned out that developed economies, which possess initially high technology-absorptive capability, eventually gain a lot from large technology gap together with FDI term. Conversely, developing countries, having relatively low capability, lose in growth from large technology gap.
Although this project is not going to focus on technology gap, it will incorporate the other variables introduced by Li and Liu. It will consider using an indicator of political stability taken from World Bank Governance Indicators database. Moreover, Li and Liu go further to prove that growth itself affects FDI inflows, raising the question of endogeneity. The results they obtain yield statistically significant coefficients for GDP growth, logarithm of GDP (initial) and Trade as a measure of openness for both types of countries considered, all on 1% of 5% levels of significance . Due to the fact that reverse causality phenomenon is proved in several papers, our project concentrates on the one-way relationship, FDI affecting growth and, on the addition of specific terms, aimed at increasing the explanatory power of the model .
Another important variable that will be discussed in this project is institutional variable. Many papers attempted to examine the possibility of including multiple factors, not only institutional measures, into their growth equation so that not only FDI term is the variable of interest. Similarly, there are multiple papers that attempt to introduce instruments for FDI estimation: simple lagged FDI as in Alguacil, Cuadro and Orts , spatially weighted measures of FDI determinants, as in Poelhekke and Van der Ploeg. Batten and Vo performed a research, the main objective of which was to evaluate the effects of different institutional conditions and, hence, corresponding social policies, on the effectiveness of FDI regarding economic growth. They examined a broad sample of 79 countries over a period from 1980 to 2003 .
Batten and Vo’s research features sufficient evidence drawn from their empirical estimations, which will be taken into consideration in the current project. However, their paper fails to account for differences between developed and developing countries, or any differences at all, and pulls all countries in the sample together, which does not seem very rational. Conversely, since our approach will imply trying different variables added as explanatory, in panel data analysis there might often be an issue of omitted variables. This problem is likely to arise from the possibility that a variable correlated with one or ones included in the estimated equation is excluded (Verbeek).
In order to investigate the impact that institutions have on investment flows and economic growth, academic works of the following authors will be taken into consideration: Demekas, Hermes and Lensink, Alfaro et al. The crucial finding in the mentioned works is that well-functioning financial market in a host economy contributes to the impact of FDI inflows. Alfaro (2004) demonstrates that the interaction term of FDI and financial market development is positive and significant on a large sample of countries .
Hermes and Lensink provide a fine explanation of the utmost importance of markets. It is due to the fact that the financial system helps to allocate resources more efficiently and thus, the ability to receive positive results from spillovers increases, making FDI efficient. Consequently, the authors make a profound policy proposition stating that, firstly, the government should develop the financial system, and, after it is done, open the economy to capital inflows .
Two more important concepts that will be introduced in this project are agglomeration and urbanization. In order to consider the rich and long history of this field of study, we will refer to the works of such scholars as DeLong and Shleifer, Martin, Ottaviano, Puga, Brulhart and Sbergami . Although in our project we are not going to cater for all the concepts and approaches suggested by the above mentioned scholars, we will take urbanization and ‘primacy’ as a proxy and add them to the equation. Our choice of ‘primacy’ variable can be supported by Puga, who states that workers and firms themselves can increase their productivity functioning closer to the urban clusters, hence, agglomeration levels can in fact be somehow accounted for with the use of ‘primacy’ term, concentration of urban population.
The Contribution of the Student
Foreign direct investment has been viewed through numerous theoretical and empirical lenses, with researchers taking different snapshots of the phenomenon. This project will attempt to develop a comprehensive theoretical formulation that could help analyze patterns of FDI across different countries over a given period of time. FDI trends will be viewed and regarded as complex and multi-dimensional phenomena.
The most important factors affecting FDI are the following: urbanization level, ‘primacy’ which stands for ‘urban concentration’ (Henderson) and institutional factors. In order to investigate these factors properly, a thorough research needs to be performed. Initially, the research should be based on a profound study of academic papers on the relationship between FDI and economic growth; consequently, it will move to multifactor models, models with institutional variables; and, finally, papers concerned with an issue of urbanization. Such rational approach is intended to demonstrate the value and significance of the project’s contribution and help compare growth levels in countries that have different institutional conditions and similar levels of investment and urbanization.
The project will suggest that a theoretical model designed on the basis of certain countries might practically help in evaluating the differences between countries. It might be used when making decisions regarding economic policies, liberalization of the market and openness to international capital flows, or FDI .
Significance of the Project
Among the important questions our project will aim to answer is whether democracy is the best option for countries with unstable political situation. The significance of such contribution is great as its relevance to every sphere of contemporary life is evident. We will strive to find the answer to this question on an economic level, using econometric techniques to estimate the effects of foreign direct investment and other important factors on the sample of about 96 countries (with two groups, autocratic and democratic).
In the light of current political transformations experienced by some parts of the world, our model, probably transformed according to one’s needs, may help to evaluate the differences between countries and advise on the decisions regarding openness to international capital flows, or foreign direct investment.
The practical outcomes of our project will be produced on the basis of a thorough theoretical investigation outlined above. We will imply econometric techniques in order to design a model , which will illustrate the empirical conclusions of our project.
Growth=β_0+β_1 FDI+β_2 FDI*Democracy+β^’ X+u
Thus, attempting to draw a preliminary conclusion to the intended project outlined in the paper, we may reasonably argue that foreign direct investment does have a certain impact on the economic growth, and vice versa. This influence might be dual and widely controversial, but, nevertheless, it does take place in countries with different levels of economic development, different political regimes and varying levels of urbanization. For these reasons, our project is significant.
Works Cited
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Alfaro, Laura, Chanda, Areendam, Kalemli-Ozcan, Sebnem and Seline Sayek. “Does Foreign Direct Investment Promote Growth? Exploring the Role of Financial Markets on Linkages.” Journal of Development Economics 91.2, 2010. Web. 10 Sep. 2013. <http://bus.lsu.edu/achanda/fdi_may18_09.pdf>.
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