Foreign Direct Investment as a Significant Source for Economic Growth - Literature review Example

FDI Research Proposal: A Literature Review Name Course Instructor College Date of Submission Introduction It has come out clear that Foreign Direct Investment (FDI) is a significant source for economic growth. The connection between FDI and economic growth is a well-researched topic in the development economics text, both in theory as well as empirically. A lot of scholars argue that FDI inflows may possibly fill up the opening stuck between preferred investments and locally marshalled saving. FDI can boost tax returns and perk up management know-how, plus employment skills in host countries. Moreover, FDI may help out the host nation to rupture out of the vicious cycle of underdevelopment (Todaro & Smith, 2003, Hayami, 2001). Research in this subject matter has been stepped up for the duration of the last decade owing to the bigger part of FDI in the entire capital inflows from the developed world to the developing world. There is contradictory proof in literature as regards the subject of to how, and to what level, FDI impacts economic development. FDI might have an effect on economic expansion straightforwardly for the reason that it supplements capital build-up, and the transfer of fresh technologies to the receiver country (Hayami, 2001). FDI could as well boost economic growth in some way where the express transfer of technology adds to the stock of knowledge in the host country in the course of labour training and expertise acquirement. This paper seeks to concentrate on the indirect impact of FDI inflows on human capital development by looking at education level of labour forces, Research and Development (R&D) spending done by governments and Multinationals (MNs), and economic growth (GDP growth annually) in developing countries (Todaro & Smith, 2003). FDI Definition FDI has been defined in numerous ways. The Balance of Payment handbook 5th publication explains FDI as a class of worldwide investment that imitates the goal of an inhabitant in one economy (the direct investor) acquiring a long-term interest of an inhabitant in another economy (the direct investment venture). The long-term interest signals the coming into being of a lasting association connecting the direct investor and the direct investment venture plus a noteworthy level of control by the investor on the running of the venture (Todaro & Smith, 2003). A direct venture connection is set up at the time the direct investor gets hold of 10 percent or more of either the ordinary shares or voting clout of a venture abroad. This not only consists of the opening deal initiating the FDI link between the direct investor and the direct investment venture but also all successive principal transactions between them along with allied ventures based in different economies. Once a firm embarks on FDI, it develops into a multinational (MN) venture (Rodríguez-Clare, 1996). Strategists accept as true that FDI brings into being helpful property on host economies. The gains are in the form of externalities along with the embracing of new technologies which can be in the form of certification, contracts, simulations, and training of workers as well as the prologue of new processes by the overseas firms (Alfaro et al., 2004). MNs are said to spread technology along with management expertise to domestic firms. FDI is usually used as a proxy to evaluate the degree as well as flow of MNs actions. MNs, just like any other venture, have a main aim of make the most of profits and managing expenses. That's why, MNs concentrate in economies with top profits on investment and enabling setting for their success. For that reason MNs will spend more in economies that make available the finest blend of the conventional FDI determinant (Ajayi, 2004). Managerial Research Problem Governments in emerging economies recognize FDI as a major cause of economic growth as confirmed by strong competition by these economies to draw FDI at a level previously unobserved in global trade. Bengoa et al. (2003) pointed out that prospective foreign investors are now caught up in a dizzying collection of host government inducements. Accessible empirical proof, as opposed to more established theoretical evidence, demonstrates mixed results concerning the link between FDI and economic growth of the host economies, and the determinants of FDI. Generally, the impact of FDI on the host economy is reliant upon the relative quantitative significance of eminent spillovers. However, a definite intensity of “absorptive capacity” of the host economy in terms of technological advancement, educational level of the labour force, infrastructural advancement, financial as well as institutional development, etc., is at present by and large painstakingly essential. The theory of absorptive capacity has been articulated both at the microeconomic level and the macroeconomic level. Absorptive capacity has more often than not been linked to the stage of development of a given economy (Borensztein et al., 1998; Xu, 2000) and mainly with its human capital stock. Besides, Blomström et al. (1994) and Kokko & Blomström (1995) demonstrate that MNs use extra superior technology in economies and sectors with a higher split of skilled workforce. It is for the host economy to spread its net wide by tendering higher education levels so as to grow its human capital stock. Technological advancement is capital intensive and will therefore call for high levels of spending on R&D. The inspection of works done indicate that the impact of FDI on growth in host economies is still a contentious subject matter. The array of results might be because of the different samples along with the techniques used by different authors or the encouraging effects may perhaps be restricted by local circumstances of host economies. Even so, given the limitations of other studies it is still an extensive field of study. The developing economies are desperate to grow their economies and are ready to do that which it takes to achieve that goal. Strong empirical evidence comes in vital at this stage, to boost the confidence of these economies in vesting their hopes in more FDI inflow for the reason that FDI at present is considered a key driver of economic growth. Therefore, the advantage of drawing FDI to developing economies calls for strong empirical proof (Ajayi, 2004). Literature Review FDI is generally aggravated mutually by “pull” and “push” dynamics. The push dynamics are external to developing economies and focus mainly on growth and financial market circumstances in industrial economies. In contrast, the pull dynamics rely by and large on domestic policies and uniqueness of host economies. Whereas the push dynamics establish the sum of accessible resources, the push dynamics resolve their share between economies (Ajayi, 2004). The variety of theoretical plus empirical details for the impact along with influence of FDI (and growth) is with no uncertainty incredibly wealthy. A lot of studies among others have laid emphasis on favourable macroeconomic policy, improved liberalization of markets, huge domestic markets, moderate trade management, low labour expenses, and accessibility of natural resources, high-quality infrastructure and investment in human capital (Ajayi, 2003). This analysis thus draws from scores of these works with the exact aspiration of presenting an appreciation of the theoretical and empirical setting, views and current thinking on the connection between FDI and economic growth. The concept that has been analyzed in intensely is the absorptive capacity of host economy firms, and the effect of the technological gap between overseas firms and domestic firms. According to Narula & Marin (2003, p.23), “absorptive capacity incorporates the capacity to internalize knowledge created by others and amending it to fit their individual definite applications, processes as well as routines”. It is kept that there has to exist some technological gap between the two groups of firms for spillovers to come about. Narula & Marin (2003) analyze the case of Argentina taking into account the two above-mentioned topics - absorptive capacity plus technological gap. They found out that, apart from the technology gap, the effect of the foreign incidence at the sectoral stage is unhelpful when absorptive capacity is not considered. When a proxy for the absorptive capacity of domestic firms is incorporated – in particular, investment in new equipment linked to product design or process improvement or investment in tuition activities – they encounter upbeat spillovers to those domestic firms with an absorptive capacity, thus buttressing the significance of this determinant factor. An economy’s capacity to gain from FDI has been revealed to be restricted to the “absorptive capacity” i.e. domestic conditions such as development of home financial systems or learning level (human capital) of the economy (Borensztein et al., 1998). In contributing to this, Alfaro et al (2004) indicates that financially developed economies experience upper growth rates from increased FDI and that local conditions such as development of financial markets and educational level of the economy have an effect on the impact of FDI on growth. Bengoa et al. (2003) find that the benefit to the host economy calls for satisfactory human capital, political plus economic stability as well as open market environment. The substance of absorptive capacity comes out as a firm conclusion in nearly all studies on this topic. Kinoshita (2001) employs R&D outlay as a proxy for absorptive capacity, as it is well thought-out that this raises the ability of domestic firms to emulate new technologies (Cohen & Levinthal, 1989; Griffith et al., 2000, 2003). Using statistical data for the Czech Republic, Kinoshita (2001) proves that domestic firms merely gain from the existence of MNs when they carry out R&D aggressively. R&D bustle and FDI hence emerge to be paired in their influence on the efficiency of domestic firms. Keller & Yeaple (2003) analyse the case of the United States and bring to a close that only firms dealing in high technology sectors – which spend more in R&D – profit from helpful FDI spillovers. A lot of latest studies have concentrated on issues regarding FDI from the ‘bottom-up’ – centred mostly on the advancement of subsidiaries as distinctive and separate organisational bodies. These studies have made known that disparity in innovative abilities across subsidiaries, and over time, depends on a lot more than the centralised resolutions of the holding company (Marin & Martin 2004). One allegation is that subsidiaries may themselves affect the potential for generating spillovers into the domestic economy. According to Marin & Martin (2004), just two studies have begun to look at this likelihood. Braconier et al. (2001) used MN subsidiaries’ R&D spending as a superior measure of FDI actions in Sweden than the other normally used measures of overall FDI monetary flows. However, they did not establish substantiation of spillovers with that indicator. Todo & Miyamoto (2002) used two indicators of technological activities in MN subsidiaries to approximate spillovers in Indonesia: the normally used R&D-based indicator (R&D spending) and what they describe as human resources development indicator (measured by the subsidiaries’ expenses on schooling). They established that only subsidiaries occupied in R&D and training had an encouraging impact on the yield of domestic firms. Borensztein et al. (1998), work that has been extensively cited, studied the outcome of FDI on economic growth in cross country regression structure. With statistics on FDI outflows from OECD economies to 69 developing economies over the period 1970-1989, they established that FDI is vital for embracing new technologies, contributing fairly more to growth above domestic outlay. Moreover, they indicated that by means of the connection between FDI and the level of human capital, FDI has a considerable positive outcome on economic growth. However, they qualify their findings by stating that the higher output of FDI simply holds if the host economy has a bare minimum threshold stash of human capital resources. The connection between the level of development of the receiver economy and the extent of FDI spillovers has as well been recognized through two extra points of view. To begin with, in the perspective of the labour mobility channel, a lesser spillover intensity ought to come about in less developed economies. Generally, MNs shell out higher wages than domestic firms, among other grounds so as to steer clear of labour turnover (Lipsey and Sjöholm, 2004). In less developed economies, this wage discrepancy is typically higher, making more complex the transfer of workers from MNs to the domestic firms. Secondly, it is painstaking less expected that less developed economies (with a lesser absorptive capacity) will draw MNs with well-built linkages with domestic traders and clients (Rodríguez-Clare, 1996). The origin of FDI is also argued to have an influence on the ability to generate spillovers to domestic firms. The diverse sources of FDI can be articulated through a number of factors such as culture, language, levels of protection as well as the sectoral arrangements of FDI, among other factors. For example, in a study for the Indian economy, Banga (2003) found that Japan invests in more harmonized sectors whereas the United States preferably invests in capital-intensive sectors. Taking into consideration the kind of the Indian economy, the prospect is that Japanese FDI generates extra spillovers. Research Question This research seeks to establish the impact of FDI on the economic growth of developing economies. It is clear that FDI could have either a positive or negative impact on the developing economies. The impact depends upon among others the macroeconomic policy, financial systems and education level of the host economy. In that regard, this paper is out to establish the preparedness of the host economy to take advantage of FDI inflow in terms of its absorptive capacity and technological gap. Most research has focused on determinants of FDI but much has not been done as regards a combination of education level and R&D spending. Education level is important in that it indicates the aptitude of the host economy’s educated workforce to gain from the training and expertise offered by the MNs. Since the MNs enter with superior and more advanced technology, what level of its spending on R&D is the host economy ready to offer so as to benefit the domestic firms? What is the influence of FDI on the education level measured by annual degree graduates and technological preparedness measured by R&D spending in the host economies? Theoretical Framework and Hypotheses Romer’s (1986), in his seminal work improved the endogenous growth models theory by introducing a theory of technological change into a production process. According to Helpman (2004) the endogenous growth theory stressed two crucial channels for investment to have an effect on economic growth: Firstly, is by the impact on the variety of obtainable products, and secondly, by the impact on the accumulation of knowledge available for R&D. Endogenous growth theory economic models have been used to study the cause of FDI on economic growth through the flow of technology (Barro, 1990; Barrel & Pain, 1997). FDI can as well support economic growth through formation of vibrant comparative advantages that predispose to technological advancement (Balasubramanyam et al., 1996; Borensztein et al., 1998). Romer (1990) and Grossman & Helpman (1991) have standardized Romer’s (1986) model and suppose that endogenous technological improvement is the key driver of economic growth. Further, Romer (1990) states that FDI speeds up economic growth by reinforcing human resources, the most vital aspect in R&D endeavour; whereas Grossman & Helpman (1991) underline that a boost in competition along with innovation will lead to technological improvement and amplify productivity and, as a result, prop up economic growth in the long-term. In account of all these contributions, this paper will adopt an endogenous growth model as suggested by Romer (1986) and improved by Romer (1990) and Grossman & Helpman (1991) by considering both the human capital stock by level of education (yearly degree graduates) and technological advancement. R&D is considered as separate for the government and the MNs. Other variables are the FDI inflow and annual GDP. Model FDI = GDP + RD1 + RD2 + EL + Ut Where FDI = Foreign Direct Investment (inward Stock) GDP = Real Gross Domestic Product at constant price RD1 = R&D Spending by the Host Economy Government RD2 = R&D Spending by the MNs EL = Education Level of the Labour Force Ut = Error term. The equation above paves way for the core research hypothesis stating that MNs optimistically influence the pace of economic growth per capita in the host economy in consideration for a several other variables that comprise: the GDP growth per capita of host economy, R&D Spending by the Host Economy Government, R&D Spending by the MNs, and Education Level of the Labour Force. The impact of the GDP growth of the host economy should be positive. The impact of the GDP level of the host country should be positive. The impact on R&D Spending by the Host Economy Government, R&D Spending by the MNs, and Education Level of the Labour Force should also be positive. Proposed Contribution to Knowledge Meyer (2003, p. 22), notes that despite of the burly proof pertaining to the significance of absorptive capacity at both levels of study (micro and macro); “the complete potential of the theory of absorptive capacity is nevertheless to be exploited. Generally, the impact of FDI on growth is far from understandable and the impact differs across economies under diverse economic situations. In that regard, this research ought to look at the theory in extra detail to affirm what contributes to a strapping absorptive capacity on the domestic firms as well as on the economy as a whole. Also, the study contributes to the literature on the impact of FDI on economic growth as well as the theory of absorptive capacity. References List Ajayi, I. S., (2004), Issues of Globalization in Africa: The Opportunities and the Challenges, Journal of Social Sciences, 2 (1), 113-128 Ajayi, S. 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