Academic journal article Journal of Southeast Asian Economies

Does FDI Enhance Economic Growth? New Evidence from East Asia

Academic journal article Journal of Southeast Asian Economies

Does FDI Enhance Economic Growth? New Evidence from East Asia

Article excerpt

I. Introduction

During the past two decades, there has been a major shift in degree of capital inflows into East Asian countries because the investment atmosphere of East Asia has been increasingly attractive. The growth rates of most countries were high and the investment returns offered attractive yield to foreign investors. In theory, capital inflows should offer large benefits to host countries in terms of improving resource allocation, facilitating cross-border transfers of knowledge and technology, improving risk diversification, and promoting financial market reforms. However, if the recent surge in capital inflows is in the form of short-term capital inflows, it will render the economies unstable. Nevertheless, in East Asian countries, foreign direct investment (FDI) seems to be perceived as most important, both in terms of its size and its impacts compared to other types of capital flows.

Many studies have concluded that FDI is a long-term capital inflow and has the smallest fluctuation compared to other types of capital flows (Corsetti 1998; Turner 1991; Samo and

Tylor 1999; and Claesssens et al. 1995), and Wiboonchutikula et al. (2001). Furthermore, FDI seems to be encouraging growth in the host economy rather than causing economic instability. For example, by applying the Solow-type standard neoclassical growth models, Brems (1970) suggested that FDI increased the capital stock and thus, growth in a host economy by financing capital formation. In neoclassical growth models with diminishing returns to capital, FDI has only a short-run growth effect as economies move towards a new steady state. Accordingly, the impact of FDI on growth is identical to that of domestic investment. Therefore, FDI should offer substantial benefits to host countries rather than having a negative impact on economic stability and growth.

FDI is often assumed to be more productive than domestic investment in endogenous growth models. The logic behind this is that FDI encourages the incorporation of new technologies in the production function of the host economy (Borensztein, De Gregorio, and Lee 1998). In this view, FDI-related technological spillovers offset the effects of diminishing returns to capital and keep the economy on a long-term growth path. Moreover, endogenous growth models imply that FDI can promote long-run growth by augmenting the existing stock of knowledge in the host economy through labour training and skill acquisition. The introduction of alternative management practices and organizational arrangements brought by FDI also assist growth (see, for example, de Mello 1997). Hence, through capital accumulation and knowledge spillovers, FDI may play an important role for economic growth. Furthermore, FDI can possibly stimulate economic growth through the international trade channel by augmenting domestic capital for exports, helping the transfer of technology and the manufacturing of new products for exports, facilitating access to new and large foreign markets, providing training programmes for the local workforce and upgrading technical and management skills.

However, according to Kose (2006), the impact of FDI to economic growth depends on a host economy's economic foundation. Countries meeting appropriate conditions such as enough level of financial market development, institution development, better governance, and appropriate macro policies tend to reap better growth and stability benefits, or "collateral benefits", from FDI. Kose concluded that the difference in initial economic conditions in the host economy would influence the macroeconomic outcomes of capital inflows.

In this study, we will analyse how FDI affects economic growth of the host economies in East Asian economies. The objective of this study is not only to examine the impact of FDI on host countries' growth but also to examine the effects of threshold conditions in East Asian economies. We will separate fifteen economies in East Asia into three groups with different initial economic conditions and compare the impact of FDI among them. …

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