Does Economic Growth Promote Foreign Direct Investment? Evidence from India and Malaysia

By Pradhan, Rudra Prakash | South Asian Journal of Management, January-March 2008 | Go to article overview

Does Economic Growth Promote Foreign Direct Investment? Evidence from India and Malaysia


Pradhan, Rudra Prakash, South Asian Journal of Management


The paper explores the promotion of Foreign Direct Investment (FDI) towards economic growth (and vice versa) in the economy. The empirical investigation has been undertaken in two Asian countries namely India and Malaysia during the period from 1970 to 2004. The empirical analysis confirmed that it is economic growth that promotes FDI in both the Indian and Malaysian economy. On the contrary, FDI does not promote economic growth in these two countries. The paper justifies the possible reasons for the same and strongly argues that FDI promotes economic growth indirectly via productivity spillovers and exports pillovers effect. In the end, the paper also suggests few possible areas for the promotion of FDI towards economic growth and vice versa.

INTRODUCTION

The source of economic growth has been a central issue in the field of economic security since the 1950s. The Neoclassical growth model suggests a great accounting method for explaining the same (Solow, 1956). The method shows that economic growth can be explained by using three different indicators, viz., physical capital accumulation, labor force growth, total factor productivity growth (Singh, 2005). But the present paper deals with the linkage between accumulation of physical capital and economic growth. The former can be obtained through domestic sources as well as through foreign sources, which is mostly incurred in the form of Foreign Direct Investment (FDI). It represents the movement of capital inland out of the country with the intention of buying physical assets to start a business. The contribution of FDI to economic growth has been well documented in economic literature (Romer, 1993; De MeUo, 1997; Mody and Wang, 1997; Dua and Rashid, 1998; Zhang, 1999; Demurger, 2000; Yusop et al, 2002; Zebregs, 2002; Dias, 2003; Lensink and Hermes, 2003; and Sjoholm and Okamoto, 2005).

Foreign Direct Investment is a dire need for a country. This is because of its multifaceted features in the economy, which include fulfilling saving-investment gap, relaxing foreign exchange constraints and flowing as a bundle of capital, technology, knowledge, marketing, competitiveness, etc., (Grossman and Helpman, 1992; Walz, 1997; and Pradhan, 2003). These are the main avenues by which FDI can contribute to economic growth. FDI affects economic growth by generating increasing returns in production via externalities, i.e., by productivity spillovers and exports spillovers (See Figure 1).

In developing countries, FDI's effect on economic growth is logistically more in contrast to its domestic investment. This could be more realistic, when there is sufficient absorptive capacity available in the host country (Borensztein et al, 1998). The reason for the same is that FDI inflows are not only confined to modern manufacturing of developing countries but also to the primary sectors. This is why most of the developing countries welcome multinational companies (MNCs), since they are usually associated with FDI (Kumar, 2005).

They offer various packages such as creation of Special Economic Zones (SEZs), streamlined administration, flexible labor laws, Intellectual Property Rights (IPRs) protection, opening up of additional sectors, access to world markets, trade openness, fiscal incentives, infrastructure and many more to attract the same (Lim, 1983; Chai, 1998; GOI, 2003; Venkateswarlu and Rao, 2004; and Pradhan, 2006). To make their operations more effective, MNCs also take with them high levels of technology, as they recognized that it is one of the significant factors that can strengthen their international competitiveness. In this process, FDI contributes to higher economic growth by incorporating new inputs and techniques (Feenstra and Markusen, 1994). But it is important to note that the growth consequences of FDI depends upon what types of sectors receive the same and that change in sectoral flows strengthen the positive effects and weaken the negative ones (Wei, 1996; Dutt, 1997; and Kathuria, 1998). …

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