Impact of Foreign Direct Investment (FDI) and Information Communication Technology (ICT) on economic growth

Contents

Abstract

1 Introduction

2 Literature review
2.1 Theoretical foundations and definitions
2.2 Links between ICT, FDI and economic growth

3 Empirical analysis
3.1 Framework
3.2 The Research Question
3.3 Methodology and scope
3.4 The Data
3.5 Model Specification
3.5.1 Growth Accounting Specification
3.6 Econometric test and empirical result presentation
3.6.1 Econometric tests for model choice
3.6.2 Empirical results

4 Summary, conclusion and recommendation

A Appendix
A.1 Additional Graphs

Abstract

The main aim and purpose of this seminar is to examine, analyze and present the impact of FDI Inward stock and ICT capital on the economic growth of an economy considering the sample countries. As a general structure, the essay would first give an introduction about economic Globalization and its indicators particularly focusing on FDI and ICT. On the literature review part of the essay, cited definitions and theoretical background of FDI and ICT are presented. In an attempt to strengthen the essay, a brief insight into Economic growth and the linkage between FDI, ICT and economic growth is included. The empirical analysis of this essay investigates econometric relations and presents econometric results from the conducted analysis based on the collected data from the sample countries. Growth accounting approach using supply-side Cobb- Douglas production function is applied to look at the economic impact of growth rate of FDI Inward stock and growth rate of ICT capital on economic growth. The econometric analysis is structured in a way to first look at the separate impacts of the two independent variables on economic growth which is measured by growth rate of real GDP. Secondly, as a final model, the combined impact of the two independent variables on the growth rate of real GDP is presented and discussed. Standard panel data models are applied to investigate the empirical relationship pertaining to the selected BRICS countries (Brazil, Russia, India, China and South Africa). Data collected from year 1995 to 2015 is considered for the forthcoming econometric analysis. Finally, summary of the work with conclusion and policy recommendation is given.

Keywords: Economic Growth; FDI Inward stock; ICT; Growth Accounting

1 Introduction

Economic Globalization in its general definition means the international context of Trade, Capital flow, Migration and Information Communication Technology expansion. With the general definition, it can be concluded that looking at specific and combined effects of these sub-parts will help to gain an overall understanding of the concept economic Glob- alization. Development of economic Globalization in the modern era of Globalization is thus explained on numerous literature works with respect to its dominant factors.

Tilly and Welfens (2000, pp. 14) indicated the fact that rising international trade, increasing foreign direct investment, more intensive international technology transfer and a faster global exchange of information via telecommunications and the internet characterize the world economy at the end of the 20 th century. Giving further evidence, OECD Handbook on Economic Globalisation Indicators (2005, pp. 16) indicated three major forces that have contributed importantly to the Globalization process as: i) the liberalisation of capital movements and deregulation, of financial services in particular; ii) the further opening of markets to trade and investment, spurring the growth of inter- national competition; and iii) the pivotal role played by information and communication technologies (ICT) in the economy.

Considering these indicators of economic Globalization, it is important to understand what role they are playing in economic growth of countries. To what extent is economic growth vital and what are its major enhancement areas differs across countries depending on the current economic state of countries. Although economic growth could be a concern for all countries across the world, the need to enhance it would be a current issue to be addressed when it comes to developing economies. Developing economies are deemed to be the major beneficiaries of the positive impacts of economic Globalization. Analyzing how the major indicators of economic Globalization are being used to bring about economic growth in the developing economies is the major focus of this work.

The essay will focus on the well known five major emerging economies: Brazil, Russia, India, China and South Africa (hereafter referred as BRICS). BRICS countries as emerg- ing economies are having an economic integration platform coming from different major continents of the world (BRICS countries come from Asia, Africa, Europe, and America). As noted on the BRICS Website, after its 10 years of development, this economic inte- gration platform of BRICS has grown into an important platform for cooperation among emerging markets and developing countries. Additionally, the fact that all the countries are members of the G20 coupled with the observations of the economic figures of this group shall be considered as a big motivation for this work. Together, they account for 26.46% of world land area, 42.58% of world population, 13.24% of World Bank voting power and 14.91% of IMF quota shares. According to IMF’s estimates, BRICS countries generated 22.53% of the world GDP in 2015 and has contributed more than 50% of world economic growth during the last 10 years. (Source: https://www.brics2017.org)

2 Literature review

2.1 Theoretical foundations and definitions

Foreign Direct Investment (FDI)

OECD (2008, pp. 17) defined FDI by stating that direct investment is a category of cross-border investment made by a resident in one economy (the direct investor) with the objective of establishing a lasting interest in an enterprise (the direct investment enterprise) that is resident in an economy other than that of the direct investor. The motivation of the direct investor is a strategic long-term relationship with the direct investment enterprise to ensure a significant degree of influence by the direct investor in the management of the direct investment enterprise.

As an introductory definition of FDI, Bende-Nabende (1999, pp. 1) quoted OECD (1978) and depicted a definition: Foreign direct Investment (FDI) constitutes a resource flow which is particularly useful for the economic development of developing countries es- pecially for their industrial development. It provides a unique combination of long-term finance, technology, training, know-how, managerial expertise and marketing experience. FDI includes: (i) Outlays for the establishment of a new enterprise or for the expansion of an existing enterprise whose operation is controlled by the foreign investor. (ii) Fi- nancial outlays for the acquisition of an existing enterprise (or part of it) either through direct purchase or through purchases of equity, with a controlling interest by the foreign investor. The notion of control is not defined, but control is assumed when the foreign investor owns at least between 10 and 51 per cent of the enterprise’s value according to different definitions used by different governments. (iii) Intra-corporate long-term loans.

The New Economy and Information Communication Technology (ICT) OECD glossary of statistical terms (2008, pp. 357) defined the term “New Economy” as a term that describes aspects or sectors of an economy that are producing or intensely using innovative or new technologies. This relatively new concept applies particularly to industries where people depend more and more on computers, telecommunications and the Internet to produce, sell and distribute goods and services.

The core element of the New Economy is the ICT sector itself: on one hand the telecommunication sector, which is above all characterized by high growth rates of patents since 1990s, and on the other hand the information technology sector (Welfens, 2002, pp. 8).

According to OECD (2017, pp. 24), the ICT sector is defined as the sum of the following industrial activities: computer, electronic and optical products, software pub- lishing, telecommunications, computer programming, consultancy and related activities, and information service activities. This definition is according to the OECD ICT sector definition which is based on ISIC ¹ Rev.4.²

Economic growth and productivity

Modern economic literature notes that the starting point of the study of economic growth model is the neoclassical growth model which was originally developed by Robert Solow and Trevor Swan and commonly referred as Solow-Swan model. A brief introduc- tion to this model and its subsequent developments through time will be reviewed as below.

Aghion and Howitt (2009, pp. 27) defined the neoclassical growth model as a model which emphasizes the role of capital accumulation. It is here mentioned that this model shows how economic policy can raise an economy’s growth rate by inducing, people to save more. But the model also predicts that such an increase in growth cannot last indefinitely. In the long run, the country‘s growth rate will revert to the rate of technological progress, which neoclassical theory takes as being independent of economic forces, or exogenous. Underlying this pessimistic long run result is the principle of diminishing marginal productivity, which puts an upper limit to how much output a person can produce simply by working with more and more capital, given the state of technology.

Looking at the theoretical background, neoclassical growth model focused on produc- tion function and savings function. The neoclassical model imposes equilibrium condition on goods market to determine the level of economic growth.

As explained by Bende-Nabende (1999, pp. 78), neoclassical economists introduced the concept of convergence in their models which assumed diminishing returns to capital and hypothesised that poorer economies that have a lower initial level of capital stock per worker tend to have higher returns (marginal productivity) and higher growth rates which eventually make them catch-up or converge with the richer economies in the long- run (i.e. long-run tendency towards the equalisation of levels of per capita income or per worker product). The main deficiency of these models arose from the assumption of diminishing returns to capital, which meant that the growth of output could not nearly be accounted for by the growth of inputs. Hence, the appearance of the large residual which was attributed to technical progress, which was an exogenous factor. This issue raised questions as to whether the long-term per capita growth should actually be determined by an exogenous factor and prompted new researchers to develop models in which the key determinants of lon-grun growth are endogenous or explain the model, and consequently led to the birth of the new or endogenous growth theory.

The new or endogeneous growth theory considers the vital contribution of investment in human capital, innovation and knowledge to economic growth. Welfens and Jungmit- tag in Barfield et al. (2003, pp. 33) explained the basic models of the new growth theory by mentioning that a large part of new growth theory assumes a beneficial know-how “transfer” from a knowledge-generating sector which performs R&D to the sector of the economy in which companies simply adopt it. The importance of knowledge is further explained by the authors who emphasized that part of this knowledge as a result of R&D efforts is paid for by the receiving firms while some part diffuses without appropriate compensation. The external effects of knowledge creation which are also referred as spillover effects are followed by increasing returns in production of the remaining sectors and cause all-over economic growth.

2.2 Links between ICT, FDI and economic growth

While reviewing several literature works on this specific topic, it was found very necessary to understand and explain how these two indicators of economic Globalization (FDI and ICT) are prompting economic growth. Additional emphasize would then be given on links between the two and how their combination/integration is functioning to enhance economic growth.

With respect to FDI, a major point that should be indicated is the key positive spillover effects. As explained by Bende-Nabende (1999, pp. 81) (citing Chudnovsky (1993)), FDI can stimulate economic growth through the creation of dynamic comparative advantages that lead to new technology transfers, capital formation, human resources development (i.e. spillover effects on domestic suppliers, research institutes, employment and training of more skilled personnel, and the introduction of new managerial and organisational techniques), and expanded international trade.

To summarize the positive effects of FDI activities on economic growth of host devel- oping countries, and support same with empirical evidence, this work highlighted the factors (New Technology Transfer, Capital Formation, Human Resource Development and International Trade) through which the spillover effect of FDI act to bring about economic growth are complementary and inter-linked.³

Alfaro et al. (2009, pp. 113) gave the following notation on benefits of FDI. Owing to the technology and know-how embodied in FDI, alongside the sheer foreign capital, host economies are expected to potentially benefit from these investments through knowledge spillovers. These spillovers can occur through various channels such as technology trans- fers, introduction of new processes and managerial skills to the domestic market, where further productivity gains can be realised via backward and forward linkages between foreign and domestic firms. Alongside these technological improvements FDI can simply contribute to capital accumulation. The foreign capital injected into the host economy could contribute to physical capital formation, while employee training can contribute to skill development in the country. In other words, FDI can contribute to the develop- ment effort of a country via factor accumulation – physical and human capital – or via improvements in total factor productivity (TFP).

Despite these benefits being mentioned, the authors did not confirm that these benefits are empirical presumable. Such a notation by itself makes empirical study on FDI very interesting.

Looking at ICT contribution to economic growth, Welfens (2008, pp. 317) cited the endogenous growth model of ZON/MUYSKEN (2005) that have highlighted, in a refined LUCAS-model, the role of ICT in a modern growth model. Accordingly, it is here mentioned that ICT is important in final goods production and its rise of capital intensity has a positive expansion impact on the knowledge accumulation process. Such impacts of ICT thus contribute to higher steady state growth of output. Supported with these notations, the author highlighted that knowledge accumulation plays an important role for economic growth.

After a brief review of the individual impact of the two indicators, explanation of their interaction effect on economic growth is deemed necessary.

The below three reasons why modern computer and information technology (ICT) should stimulate FDI is depicted in Welfens (2002, pp. 32). The first one is that, due to the ICT driven expansion of knowledge intensive industries, more firms with ownership specific advantages will seek to exploit such advantages through international FDI. Secondly, as ICT itself in its broad definition is innovation intensive sector, FDI in ICT including vertical international integration of firms is subjected to intensive growth. Lastly, ICT by nature will have the tendency to allows firms to organize in a more decentralized fashion across a larger geographical radius. This should thus encourage expansion of multinational companies in the form of their involvements in FDI.

The fact that FDI will influence ICT through diffusion shall also be considered here. Dimelis and Papaioannou (2010, pp. 82) focused on this particular impact in developing countries. Accordingly, FDI as the most important channel for technology transfer will contribute to economic growth, also indirectly, by accelerating the diffusion of general purpose technologies (GPTs). The most prominent and up-to-date example of a GPT is ICT (citing Bresnahan and Trajtenberg, 1995). Such accelerated diffusions on ICT will, over time, result in major developments in the sector which are this expected to raise productivity and lead to accelerated economic growth. On this particular work of Dimelis and Papaioannou (2010) the importance of FDI in fostering investment in ICT in developing countries is also supported with an empirical evidence.

At the bottom line one should clearly expect that Trade, FDI and ICT will reinforce each other. This virtuous circle should contribute to higher productivity growth and GDP growth. (Welfens, 2002, pp. 32)

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¹ ISIC Rev.4 The International Standard Industrial Classification of all economic activities by United Nations.

² ISIC Rev.4 has been officially released on 11 August 2008. As of this date, all previous draft versions become obsolete. The structure on the UN Classifications website has been updated accordingly.(https://unstats.un.org/unsd/cr/registry/isic-4.asp)

³ See: Bende-Nabende, 1999, pp. 80-115