FDI And Economic growth in the Philippines: Evidence From Simultaneous Equation Models

De La Salle University - Manila Economics Department

In partial fulfillment of the course requirements in LBYMET2 Section V24

Submitted to: Mr. Cabuay, Christopher James R.

Submitted by: Mary Chrisabelle G. Orbeta

August 12, 2013

BACKGROUND OF THE STUDY Globalization features flow of private capital in the form of Foreign Direct Investment (FDI) during the 1990s. Roy stated that FDI plays an important role in the development financing and contributes to productivity gains by generating new investment, advance technology, management expertise and export markets (2012). Countries lacking capital accumulation and technological progress usually grow much slower than countries with higher investment rate and enormous research and development expenditures. FDI encourages economic growth by increasing the total investment volume. Hence, more countries try to attract FDI for the benefits it can bring to an economy. Recently, the Philippines is one of the fastest-growing economies in Southeast Asia however, our country falls back when it comes to foreign investment compared to its neighboring countries. This year BSP targets to accumulate $3.2 billion of FDI as the year seems to be a favorable investment climate with sound macroeconomic fundamentals. Both the local and national government work to help the Philippines to attract FDI, but this will likely take some time before it is able to challenge its neighbors as an investment destination. On the other hand, simultanetiy of the economic variables is the most frequent problems when estimating an econometric model. Simultaneity takes place when an exogenous variable becomes endogenous correlated with the error term therefore, estimating is more difficult. In the attempt to examine the relationship of foreign direct investments (FDI) and economic growth, the complexity is obvious in such a way FDI is also attracted by economic growth due to the implication on capital gains. Moreover, FDI in turn, generates domestic investment and economic growth as a result of spill-over effects (Ruxanda & Muraru, 2010). In relation, researchers Mody and Murshid considered that the relationship between FDI and domestic investment is evident in developing countries which offer better marginal capital gains than the global interest rate which is appealing for FDI and subsequently supports domestic investment (2004). For developing countries, empirical evidence suggests that although FDI may affect growth, growth itself is a vital determinant of FDI (Udo & Obiora, 2006). This addresses the issue whether the economic growth for developing countries is a result of FDI or achieve economic growth first and eventually attract FDI. FDI may affect and generate economic growth by means of accumulating capital stock, inducing technological progress and decreasing unemployment (Accolley, 2003). Though FDI mainly contributes to the technological transfer from developed to developing countries, Roy and Berg still proved that FDI only flows between developed countries (2006). Udo and Obiora also supported

this statement, who mentioned that FDI has mostly gone to countries where capital labor ratio is higher (2006). This can be explained in the factors generating capital inflows which are the differences in the factor endowments with production, the desire to increase market access or to natural resources. The importance of FDI in the economic growth of countries has made much interest amongst economists and researchers. This study investigates the importance of FDI for economic growth in the Philippines from 1980 to 2012 using simultaneous equation systems. Meanwhile, Section 2 discusses all related literature studies made. Section 3 describes the theoretical framework used and Section 4 follows the model specification and methodology used. Section 5 gives the empirical analysis using Stata application and the last part, Section 6 gives the conclusion and policy recommendation to Philippine government. REVIEW OF RELATED LITERATURE There is a wide empirical study on the FDI-growth relationships and determinants of FDI inflow. Recently, Mankiw et al. pioneered a research which considers education to the standard growth equation as proxy for human capital (1992). Co et al. (1997) discovered the positive relationship of FDI on growth, which means that the host country must first attain a level of development to reap the benefits of higher productivity. On the other hand, De Mello (1997) found a negative correlation between FDI and domestic investment for developing countries. Borenzstein et al also made similar research and found that inward FDI positively affects growth with strongest impact from the interaction of FDI and human capital. De Mello found positive impact of FDI on economic growth for both the developing and developed countries however, the long-run growth in host countries is determined by the spillovers of knowledge and technology from foreign investors (1997). Likewise, Balasubramanyam et al. (1996) supported his hypothesis that the effect of FDI increases the exports of promoting countries and decreases for import-substituting economies. Meanwhile, Durham realized the importance of developing banking and financial system in increasing FDI (2004). He also added that only those countries with resilient institutional and investor-friendly environments are likely to benefit from FDI inflows. Comparing results from developed and developing countries, Blonigen and Wang argued that combining the two categories is inappropriate (2005). They added that determinants of FDI flows vary across income groups. Lastly, they find evidence that FDI benefits are significant only for developing countries. In addition, Vu and Noy carried out a sectorial analysis. They found that FDI positively but insignificantly affects economic growth but the effects differ across different countries and sectors (2009).

Moreover, Ghatak and Halicioglu (2006) investigated the relationship of FDI and economic growth using 140 countries, and found out that FDI affects real GDP per capita. Roy and Berg (2006) also found a positive and significant effect of FDI on economic growth in the United States (US) using the similar method of simultaneous equations model (SEM). On the other hand, Udo et al. (2006) found no significant evidence of FDI-economic growth relationship in West African Monetary zone which contradicts the two previous studies. As mentioned, it can be explained that FDI is only attracted to countries with higher GDP per capita. While Mehanna demonstrated that investment leads to growth on 80 developing countries (2003). In line with the presence of endogenous relationship between FDI and economic growth, Ruxanda and Muraru examined this relationship in the Romanian economy using simultaneous equation models which is also the basis of this paper (2010). They obtained the bi-directional connection between FDI and economic growth. This means that FDI inflow stimulates economic growth and in turn, higher GDP draws FDI. Moreover, Li and Liu also used similar method of simultaneous equations system of 84 countries (2005). They also found that FDI indirectly affect growth through its impact on human capital. These two studies are similar to our methodology but this paper uses country-specific (Philippines). In summary, the consensus in literature reveals that FDI increases growth trough productivity and efficiency gains of local firms (Umoh et al., 2011). However, these results for developing countries are not clear and with limited evidence. Furthermore, the impact of FDI on exports remain controversial and varies depending on the motive for such investment. The role of FDI seems to be country specific, it can be positive, negative, or insignificant, depending on the economic performance, institutional and technological situations in the recipient countries. Meanwhile, only few studies focus on specific countries and then considers the endogenous nature of FDI and growth which raises some questions on robustness of results. Zhang asserts that the extent of FDI impact on growth depends on the economic and social condition of a county (2001). Therefore, the impact of FDI on growth may be country or period specific. This provides the reason to investigate the relationship between FDI and economic growth in the Philippines.

THEORETICAL FRAMEWORK Economic growth and development depends of how an economy utilizes its land, labor and capital in production based from the standard neoclassical theories. Since most developing countries underutilize its land and labor, reveals low savings rate, and then the marginal productivity is likely to be greater. And so, neo-liberal theories of development

assume that interdependence between developed and developing countries can benefit the latter (Umoh et al., 2011). Moreover, the standard neo-classical theory expects the poorer countries to grow faster on average than richer countries because of diminishing returns on capital. It is expected for poor countries to connect with the rich over time by means of absorbing capital. On the other hand, market disequilibrium hypothesis of FDI follows the notion of a perfect economy and perfect market requires that supply and demand equilibrium adjusts prices. But this condition does not hold because of segmentation in the world market and unequal rates of returns in different countries (Umoh et al., n.d.). FDI flows would only take place until markets are stable. While disequilibrium condition provides incentive to invest abroad. For instance, when there is currency devaluation, and then there is an arbitrage profit from holding the assets in undervalued currencies. With this, investors will locate its international output production in countries with undervalued currencies. The main point is that when exchange rates return to equilibrium, the flow of FDI should end. In any events, corporations in countries with advanced technology would always find advantageous opportunities overseas and thus, have an incentive to invest abroad.

OPERATIONAL FRAMEWORK Data Description This study uses a country-specific and time-series data from World Bank which is composed of macroeconomic variables of growth domestic product, foreign direct investment, fixed capital formulation, exports, gross national savings, unemployment rate and trade balance. This dataset is downloadable in WorldBank website, spanning years from 1980 to 2012.

Model Specification Based from theory mentioned and following Ruxanda (2010), we used the following equations: ( ) ( )

Apriori Intuition/Specification Expectations (+) Good economic performance attract more foreign gdp, annual percentage growth rate of GDP at investors in a country because these investors are market prices based on confident enough to make profitable investments. Philippine Peso Thus, higher gdp growth means higher foreign . direct investments fcf, gross fixed capital (+) A high level of capital formation ensures needed finance for the industries growth and formation as development; thus, promotes economic growth. percentage of GDP Simply, if there is no capital, there is no investment and no growth. But it also depends how an economy allocates capital efficiently fdi, foreign direct investment as percentage of GDP exp, exports to account for the export driven behavior of GDP sav, gross domestic savings as percentage of GDP (+) FDI, on the other hand, seems to be positively influenced by the growth rate. If the theory says that FDI should cause growth in an economy. Exports have a positive impact on economic growth validating the export-driven hypothesis. National savings is used as proxy for domestic investment. The impact of domestic investment on FDI is stronger therefore, suggests that high domestic private investment is a signal for high returns to capital, which attracts more foreign investment Openness to trade promotes FDI because FDI will become more attractive and profitable as market growth, economic reform, and openness accelerate. Lastly, export quotas and high tariff rates deter FDI inflows which means, this variable is expected to have a positive coefficient.

Variables

(+)

(+)

open, openness to trade computed as sum of exports and imports as a share of GDP

(+)

RESULTS AND DISCUSSIONS Using the order condition of identifying an equation, both equations are over identified. The formula used for this is K-k > m-1. Predetermined variables in this study are four which is the value of K while endogenous variable of fdi and gdp corresponds to m.

Applying the formula for the first equation, 2>1 which means FDI is overidentified while for GDP, 2>1 then the second equation is also overidentified. Moreover, no simultaneity bias is present in the equation and so, the reduced form is used to estimate (See Appendix A). However, these results are not robust. Therefore, 2SLS estimation is used: fdi = 4.4073 + 0.1443gdp 0.1679sav 0.0196open 4.10*** 1.60 -3.25*** -1.08 gdp = - 4.9523 6.4677fdi + 0.0566fcf + 0.4317exp -0.50 -1.10 0.15 1.40 (3)

(4_

In equation (3), both sav and open variables are against our apriori expectations. While sav variable is the only significant determinant of fdi which is the opposite results of Edwards (1995) using a panel data. He added that this negative relationship is an accepted fact in the existing literature. Thus, a 1% increase in domestic savings decreases fdi by 0.16%. Meanwhile, theory predicts that openness can affect FDI positively or negatively depending on the type of the activity. And in the Philippines,, it negatively affects FDI. Greater openness is a disincentive for non-export oriented FDI as it might serve through export. Moreover, if restrictions are severe in the Philippines then this negative relationship is expected. As we all know, resources in the Philippines are restricted to foreign investors or with limited ownership which can be an explanation to this result. In equation (4), it is surprising to have a negative coefficient of fdi with respect to gdp because based from the discussion above, the higher the fdi, more money can be used to improve the economy. This negative relationship is similar to the study of Saqib et al (2013) using Pakistan data. This conflicting evidence led to expect that foreign direct investment in a developing countries like the Philippines would be negatively affecting its economic performance and growth and lastly, it holds the dependency theory. Lastly, no significant values are shown in this equation. Although fixed capital formulation increases gdp and export performance increases gdp, it does not seem meaningful for the total value of gdp. This implies that our gdp does not depend on these variables. It can be said that other factors such as remittances, population growth and account balance.

CONCLUSION AND POLICY RECOMMENDATION Estimating the relations between variables through system equations takes into account the simultaneity of the variables as well as problems in estimation. Therefore, offering the advantage of simultaneously estimating the coefficients from the system. By using this method, this study investigates whether in the Philippines, FDI has positive

impact on economic growth. Future analysis may include labor costs, government infrastructure and taxation as measure od FDI determinants. Philippines is one of the fastest economy in the Southeast Asia and it has great reliance on trade. With the negative impact of FDI to its economic growth, it is time for our government to emphasize on diffusion aspects in formulating FDI policies. These policies should be directed towards attracting FDI hand in hand, promoting financial development. Moreover, our country needs to have a targeted approach to FDI in such a way it can increase our gdp growth. This includes, the increase absorption capacity of local firms and corporations between government and firms to promote further their mutual benefit. Lastly, economic policies limiting FDI in the Philippines and encouraging domestic saving and investment should be implemented.

REFERENCES: Accolley, D. (2003). The Determinants and Impacts of Foreign Direct Investment. Retrieved from http://mpra.ub.uni-muenchen.de/3084/1/MPRA_paper_3084.pdf Balasubramanyam, V.N., M.A. Salisu and D. Sapsford, 1996. Foreign direct investment and growth in EP and IS countries. Economic J., 106(434): 92-105. Borensztein, E., J. Gregorio and J. Lee, 1998. How does foreign direct investment affect economic growth? J. Inter. Econ., 45(1): 115-135.9 Coe, D.T., E. Helpman and A.W. Hoffmaister, 1997. North-south R&D spillovers. Econ. J., 107: 134-149. De Mello, L.R., 1997. Foreign direct investment in developing countries and growth: A selective survey. J. Dev. Stud., 34: 1-34. Mody, A. & Murshid, A. P. (2004). Growing up with Capital Flows. Journal of International Economics. Roy, S. (2012). Foreign Direct Investment and Economic Growth: An Analysis for Selected Asian Countries. Journal of Business Studies Quarterly, 4 (1), 15-24. Roy, A. G. & Berg, H. F. (2006). Foreign Direct Investment and Economic Growth: A TimeSeries Approach. Economics Department Faculty Publications.Paper 32. Ruxanda, G. & Muraru, A. (2010). Fdi And Economicgrowth. Evidence From Simultaneous Equation Models. Romanian Journal of Economic Forecasting, 1, 45-58. Udo, E. A. and Obiora, I. K. (2006). Determinants of Foreign Direct Investment and Economic Growth in the West African Monetary Zone: A System Equations Approach. GTAP, paper presented at the 9th Annual Conference on Global Economic Analysis, Addis Ababa, Etiopia,

. regress fdi gdphat ssav open Source Model Residual Total SS 8.04137026 17.541689 25.5830592 df 3 29 32 MS 2.68045675 .604885827 .799470601 Number of obs F( 3, 29) Prob > F R-squared Adj R-squared Root MSE = = = = = = 33 4.43 0.0111 0.3143 0.2434 .77774

fdi

Coef. .1442751 -.1678801 -.0196147 4.407326

Std. Err. .0894034 .0512037 .0180303 1.064631

t 1.61 -3.28 -1.09 4.14

P>|t| 0.117 0.003 0.286 0.000

[95% Conf. Interval] -.0385755 -.2726034 -.0564907 2.229912 .3271257 -.0631568 .0172614 6.58474

APPENDICES

gdphat ssav open _cons

Appendix A Regressing in Reduced Form

SS 9.5359568 16.0471024 25.5830592 df 5 27 32 MS 1.90719136 .594337127 .799470601 Number of obs F( 5, 27) Prob > F R-squared Adj R-squared Root MSE = = = = = =

. regress fdi gdp ssav open fcf exp Source Model Residual Total 33 3.21 0.0211 0.3727 0.2566 .77093

fdi gdp ssav open fcf exp _cons

Coef. .0676192 -.1403654 -.0135077 .0245815 .0160827 2.865881

Std. Err. .0461488 .0881266 .0166892 .0505645 .0230991 1.983415

t 1.47 -1.59 -0.81 0.49 0.70 1.44

P>|t| 0.154 0.123 0.425 0.631 0.492 0.160

[95% Conf. Interval] -.0270703 -.3211861 -.0477511 -.0791683 -.0313127 -1.20375 .1623088 .0404554 .0207357 .1283314 .063478 6.935512

Appendix B 2SLS Regression

. reg3 (fdi=gdp ssav open)(gdp=fdi fcf exp),2sls Two-stage least-squares regression Equation fdi gdp Obs 33 33 Parms 3 3 RMSE .7857684 6.559713 "R-sq" 0.3001 -2.3375 F-Stat 4.34 0.73 P 0.0079 0.5359

Coef. fdi gdp ssav open _cons gdp fdi fcf exp _cons -6.46772 .0566314 .4316245 -4.95229 .1442751 -.1678801 -.0196147 4.407326

Std. Err.

P>|t|

[95% Conf. Interval]

.0903259 .051732 .0182163 1.075615

1.60 -3.25 -1.08 4.10

0.116 0.002 0.286 0.000

-.0365318 -.2714329 -.0560785 2.254249

.3250819 -.0643272 .0168492 6.560403

5.896431 .3689312 .3078291 9.906586

-1.10 0.15 1.40 -0.50

0.277 0.879 0.166 0.619

-18.27071 -.6818645 -.1845623 -24.78248

5.335269 .7951274 1.047811 14.8779

Endogenous variables: Exogenous variables:

fdi gdp ssav open fcf exp

. reg3 (fdi=gdp ssav open)(gdp=fdi fcf exp),3sls Three-stage least-squares regression Equation fdi gdp Obs 33 33 Parms 3 3 RMSE .7345839 6.504354 "R-sq" 0.3039 -2.7341 chi2 14.80 2.62 P 0.0020 0.4548

Coef. fdi gdp ssav open _cons gdp fdi fcf exp -7.001748 -.045664 .4474091 .1418893 -.1687516 -.0185652 4.39181

Std. Err.

P>|z|

[95% Conf. Interval]

.0828369 .0480701 .0152329 1.001844

1.71 -3.51 -1.22 4.38

0.087 0.000 0.223 0.000

-.0204681 -.2629672 -.0484211 2.428232

.3042467 -.074536 .0112907 6.355389

5.465771 .3077318 .2875407

-1.28 -0.15 1.56

0.200 0.882 0.120

-17.71446 -.6488072 -.1161603

3.710966 .5574793 1.010979

Appendix C Predicting vhat and gdphat

. regress fdi gdphat vhat Source Model Residual Total SS 2.02198988 23.5610694 25.5830592 df 2 30 32 MS 1.01099494 .785368978 .799470601 Number of obs F( 2, 30) Prob > F R-squared Adj R-squared Root MSE = = = = = = 33 1.29 0.2908 0.0790 0.0176 .88621

fdi gdphat vhat _cons

Coef. .0886992 .0676192 .9376236

Std. Err. .0910104 .0530495 .3411434

t 0.97 1.27 2.75

P>|t| 0.338 0.212 0.010

[95% Conf. Interval] -.0971689 -.0407222 .2409158 .2745673 .1759607 1.634331

. regress fdi gdp vhat Source Model Residual Total SS 2.02198995 23.5610693 25.5830592 df 2 30 32 MS 1.01099498 .785368976 .799470601 Number of obs F( 2, 30) Prob > F R-squared Adj R-squared Root MSE = = = = = = 33 1.29 0.2908 0.0790 0.0176 .88621

fdi gdp vhat _cons

Coef. .0886992 -.0210799 .9376236

Std. Err. .0910104 .105343 .3411434

t 0.97 -0.20 2.75

P>|t| 0.338 0.843 0.010

[95% Conf. Interval] -.0971689 -.2362191 .2409158 .2745673 .1940592 1.634331

. regress fdi gdphat ssav open Source Model Residual Total SS 8.04137026 17.541689 25.5830592 df 3 29 32 MS 2.68045675 .604885827 .799470601 Number of obs F( 3, 29) Prob > F R-squared Adj R-squared Root MSE = = = = = = 33 4.43 0.0111 0.3143 0.2434 .77774

fdi gdphat ssav open _cons

Coef. .1442751 -.1678801 -.0196147 4.407326

Std. Err. .0894034 .0512037 .0180303 1.064631

t 1.61 -3.28 -1.09 4.14

P>|t| 0.117 0.003 0.286 0.000

[95% Conf. Interval] -.0385755 -.2726034 -.0564907 2.229912 .3271257 -.0631568 .0172614 6.58474

. regress fdi gdp ssav open fcf exp Source Model Residual Total SS 9.5359568 16.0471024 25.5830592 df 5 27 32 MS 1.90719136 .594337127 .799470601 Number of obs F( 5, 27) Prob > F R-squared Adj R-squared Root MSE = = = = = = 33 3.21 0.0211 0.3727 0.2566 .77093

fdi gdp ssav open fcf exp _cons

Coef. .0676192 -.1403654 -.0135077 .0245815 .0160827 2.865881

Std. Err. .0461488 .0881266 .0166892 .0505645 .0230991 1.983415

t 1.47 -1.59 -0.81 0.49 0.70 1.44

P>|t| 0.154 0.123 0.425 0.631 0.492 0.160

[95% Conf. Interval] -.0270703 -.3211861 -.0477511 -.0791683 -.0313127 -1.20375 .1623088 .0404554 .0207357 .1283314 .063478 6.935512