Impact of Foreign Direct Investment (FDI) and Human capital on

Economic Growth in Nepal

INTRODUCTION

1 Background of the Research

Foreign Direct Investment (FDI) plays a catalytic role in economic growth. It is a source of
capital formation. Likewise, it helps technology to spillover, supports human capital formation,
enhances international trade integration, creates competitive environment and strengthens
enterprise development. There are three common motives of foreign direct investment: resource-
seeking, market seeking and efficiency-seeking (Dunning, 1993). Moreover, FDI also seeks
strategic assets in a local economy – brands, new technology or distribution channel. Developing
countries, emerging countries and countries in transition have come to consider FDI as a source
of economic development and modernization, income growth and employment (OECD, 2002).
The impact of FDI on an economy can be considered in terms of a number of indicators such as
its potential contribution to: technology and skills; establishment of new industries and export
promotion; formation of new clusters as anchor investors; and creation of linkages with, and
associated upgrading of local enterprises (UNCTAD, 2004).
An empirical assessment suggests that the role of foreign direct investment (FDI) in the
economic growth of the host countries is obviously important. There is a widely shared view that
FDI accelerates host countries’ growth by (1) augmenting domestic savings and investment, (2)
helping transfer of technology from the “leaders,” (3) increasing competition in the host
country’s domestic market, (4) increasing exports and earning foreign exchange, and (5)
imparting several other types of positive externalities (spillovers) to the economy at large. On the
other hand, however, it is sometimes suggested that FDI may (1) repatriate funds almost to the
same extent as it brings in funds; (2) transfer technologies that are inappropriate for the host
country’s factor proportions; (3) “kill” indigenous enterprise through an intense competition,
especially due to the strong economic power of multinational companies that bring FDI; (4)
primarily target the host country’s domestic market and thus not increase exports; (5) cause
distortions in the host country’s policies so as to benefit the foreign investors; and (6) create
distortions in the host country’s social and economic structures by infusing inappropriate social
and cultural norms and behavior patterns (Ram & Kevin, 2002).
2 Foreign Direct Investment (FDI) and Economic Growth
FDI is an essential source of capital inflow and enhances both human and physical capital development to
the host country (Busse and Groizard, 2008). As a result of this, many policy makers and academics are
more concerned about policies that attract FDI inflows in order to enhance economic growth from
positive spillover effects of FDI. In addition to this direct external source of capital, FDI facilitates the
transfer of advanced technologies and management practices from developed countries to developing
countries. This introduction of new technologies to the host country however requires a minimum level of
human capital threshold in order to absorb the anticipated positive spillover effect of FDI. The absorptive
capability of the host country together with the introduction of advanced technology is the vital
determinant for long-term economic growth (Nelson and Phelps, 1966). Despite the fact that many
studies have emphasized the positive relationship between FDI and economic growth the results
are still ambiguous. Some authors confirmed the general positive effect of FDI on economic
growth on the contrary many authors stress that there is negative relationship or no effect on
economic growth at all.
3 Human Capital and Economic Growth
The common concept that investment in human beings results in increased economic growth is
very old and goes back to the period of Adam Smith (1776). The economists of classical school
of thought also stressed upon the investment in human beings. Human capital and economic
development both are interrelated to each other for some additional basis. Furthermore, it is also
necessary for the government to spend additional amounts on education and health sector. By
human capital we consider acquired mental and physical ability of human beings through
education, skill development, training, health care. Generally, the concept of Human Capital is
used for education, skill development, health and other capacities of people that can enhance
their productivity and efficiency (Todaro, 2015).Without sufficient and qualitative human power
in terms of health, knowledge and skills, it is difficult to exploit other means of production such
as capital and natural resources effectively. The development of human resource is one of the
essential conditions for economic growth (Harbinson and Myers, 1964). Human capital also has
significant long run impact on an economy’s income and employment (Romer, 1986; Lucas,
1988; Barro, 1998). Human capital formation takes place through on the job training, schooling,
and other knowledge gained through experience and learning by labour force (Becker, 1974).
Stock of human capital determines the technological absorptive capacity of country (Nelson and
Phelps, 1966). Human capital creates positive spillovers to economy ( Ciccone and Peri, 2002).

4 Statement of Problem
1. What is the impact of FDI on economic growth of Nepal?
2. What is the impact of Human Capital on economic growth of Nepal?

5 Objective of the study:

1. To investigate the impact of FDI on economic growth.
2. To analyze the role of Human Capital on economic growth.
3. To examine whether there is association of short run or long run relationship (if so) between
FDI and Human Capital on economic growth.

6 Significance of study:
Both FDI and Human capital serves as a catalyst for economic development in Nepal. Since, it
is a least developed country (LDC) characterized by slow economic growth, socioeconomic
underdevelopment and a low level of human development, It is emerging from a politically and
socially fragile post-conflict situation, structurally generated poverty and inequality, and deeply
entrenched forms of social exclusion. Nepal remains one of the few countries to have
accomplished impressive human development gains over the last two decades. But having started
from a very low base, it is still has a low human development status. The economic growth of the
country has averaged 4 percent over the last decade. Absolute poverty decreased from 42 percent
in 1995 to 25 percent in 2010 and decreased further to 23.8 percent in 2015. However, there are
large disparities in the rates of poverty by gender, social group and geographical area. Nepal
aspires to emerge as an inclusive, equitable, and prosperous middle-income country by 2030
with the spirit of a welfare state. The country aims for sustainable poverty reduction and human
development with low vulnerability and higher human security. The country has set the goal of
graduating from LDC status by 2022. Of the three criteria for graduation — per capita gross
national income. (GNI), human assets and economic vulnerability — the country is likely to
achieve two of them and lag behind in terms of GNI per capita (NPC, 2015). With target set by
government of Nepal and implementation of new structure of government, it is pertinent to study
the significant impact of FDI and Human capital on its economic growth and considering
suitable policy recommendation.

HYPOTHESIS OF STUDY
Considering the objectives of the study, following hypothesis will be tasted:
Hypothesis 1
Hypothesis H01: there is not any significant impact of FDI on economic growth of Nepal.
Hypothesis Ha1: there is significant impact of FDI on economic growth of Nepal.

Hypothesis 2 - Financial Capital

Hypothesis H02: The level of contribution of FDIinflow to Nepal is not significantly related tothe
financial capital for India and China.

Hypothesis 3 - Human Capital

Hypothesis H03: The level of contribution of FDIinflow to Nepal is not significantly related to
human capital for India and China.

Hypothesis 4 - Governmental Factors

Hypothesis H04: The level of contribution ofFDI inflow to Nepal is not significantlyrelated to the
governmental factors for India and China.

SIGNIFICANCE OF STUDY
Foreign Direct Investment plays an energetic role in developing the evolving market trends.
There is a strong relationship between economic growth and foreign investment as it enables
poor capital country to build up physical capital, create employment opportunities, develop
productive capacity, enhance local labor skills through provision of technologies and
management and also help the domestic market to diversify in global world. FDI will improve in
existing technical process of the country. It also improves quality of product and service and also
increase the attempt of better human resources. FDI also helps to reduce unemployment by
creating new jobs and thus it reduces social problems. It also gives competitive advantage to the
well-run business regardless of the race, color and creed. It also helps in diversification of the
local markets.

REVIEW OF LITERATURE
1.6. LITERATURE REVIEW

There exists an extensive body of empirical and theoretical literature up till date that has been
researched and attempt to establish various relationships between economic growth and
macroeconomic variables and these theoretical findings are mostly in e-books and textbooks and
the empirical findings found in academic journals, articles and publications. This chapter will
critically analyze the previous literatures which contain information and ideas surrounding the
nature of the main idea of this research topic on economic growth. The review of literature will
start with definitions of dependent and independent variables included in the study with
international context and national context related to our study.

THEORETICAL REVIEW

Several theoretical frameworks were presented in thisresearch. First, the main base theory of the
researchfocused on Dunning’s ‘eclectic theory/paradigm’(1988b, 1998). Dunning’s theory
explains the firm’scontribution by investing abroad if the host countrypossesses
certainadvantages to allow an inflow of FDIto a foreign country. FDI must also be coupled
witheconomic growth and political stability for the hostcountry to be willing to invest abroad
(Dunning,1988a). Dunning’s eclectic theory/paradigm alsoprovided three main forms of foreign
investment byMNCs conducting FDI. These are exports, contracts andresource transfer.
The second theorist included Hymer (1960) whofocused on oligopolistic theory. He observed
that FDIwas a means of transferring knowledge and assets, bothtangible and tacit, in order to
organize productionabroad in a foreign country. Hymer’s own dissertationdescribes operations
into foreign countries as costly,due to conditions of hostility and cultural diversity.
The third theory was developed by Adler &Hufbauer (2008). This theory was called inward and
outward FDI theory, which identified technologicalspillovers as a contributing factor for
impacting FDI.

1.6.1 VARIABLES DESCRIPTION:

For this research study four macroeconomic variables have been selected to analyze the impacts
of selected variables of India and China’simpact on FDI to Nepal. These variables are then
divided into dependent (FDI) and independent variables. A brief description to rationalize each
dependent and independent variable are given below;
Dependent Variable:
A dependent variable is the variable being tested and controlled in a scientific experiment. The
dependent variable is 'dependent' on the independent variable. As the value of independent
variable changes. The effect on the dependent variable is observed and recorded. The dependent
variable in this research will be amount of FDI per year provided to Nepal.

Independent Variable:

For the purpose of this study, four key macroeconomic variables will be selected in order to
empirically analyze their effects on the dependent variable; the GDP growth rate. They include:
1. GNI Per Capita: Measured by a country’s Gross National Income through GNI per capita atlas
based on the country’s domestic monetary system.
2. Financial Capital: Measured by gross fixedcapital formation and gross capital
formation(Dunning, 1988).
3. Human Capital: Measured by school enrollment andtotal unemployment (Sawalha, 2007).
4. Governmental Factors: Measured by the worker’sremittances and employees’ compensation as
itpertains to a country’s labor system.

EMPIRICAL REVIEW
INTERNATIONAL CONTEXT

NEPALESE CONTEXT

1.7 RESEARCH METHODOLOGY

This study will be focuses on the impact of macroeconomic variables of India and China
economic growth of Nepal; after review of previous literature will provide a step by step
guide to a detailed research design and methodologies that will be employed in testing
various hypothesis, data collection method, while also giving a general overview of the
macroeconomic variables under analysis.

1.7.1 RESEARCH DESIGN:

The research design followed in the study is analytical as well as descriptive. So, it
utilizes quantitative approach. The research is completely based on time-series secondary
data. This research’s objective is to include the documentation of the effects of specific
 macroeconomic variables of Nepal on the economic growth and also goes promote to
conduct a relative analysis between these selected objects on the reasons surrounding the
difference in economic performance; relevant secondary data will be obtained and
critically analyzed over a 27year period from 1990-2017. The absence of quarterly data
which would have helped narrow down our data to specifically pin point a period of
certain trends has cause a limitation to this research.

1.7.2 DATA COLLECTION:

Secondary time series data for the sample size will be collected using renowned renowned
databases such as World Bank, International Monetary Fund, Central Bureau of Statistics,
Nepal Rastra Bank, Ministry of Finance, various issues of Economic Survey.

1.7.3 METHODOLOGY:
In order to analyze the data for this study, the study will be including descriptive analysis
of time series data. Descriptive tools such as frequency distributions, means, percentages,
variance and cross tabulations between the identified variables etc. are used. This will be
presented as some summary statistics. This involves the use of tables, graphs, spread
sheets, of a research. Secondly, study will include analytical analysis, in this session
correlation matrix of the used variables is presented to know how the dependent variable
is proportional to explanatory variables in the regression model.

In order to analyze the effects of FDI, unemployment rate, inflation and interest rate on
economic growth, the following model will be used
GDPPCt = α + β1FDIt + β2IFt + β3INTt + β4UMPt …………… 1
Where:
GDPPC= GDP Per Capita
FDI = foreign direct investment net inflow (% of GDP)
INF = inflation (consumer price index) as a %
INT= official bank lending rate
UMP= unemployment rate (% of total labor)
t= time series
 α = intercept
βi = parameter where i = 1, 2, …..., 5.

1.8 LIMITATION OF STUDY

This research’s methodology is limited by certain factors however this will not erode the
significance and foundation of this study. The key limitation is secondary time series
annual data. The study will include analysis of data of the period 1990 to 2017 only, this
study will not include the data before 1990.

1.9 ORGANIZATION OF THE STUDY

This study is divided into five chapters, which are as follows:

Chapter I includes general background, description of the study area, Statement of the
problem, Objective of the study, Significance of the study, Limitations of the study and
organization of the study. Similarly, chapter II devoted for the brief review of literature
available. Review of Books, International and National research reports, Unpublished
PhD dissertations m. philland Master level unpublished dissertations, Journals articles,
different planning and policies by government etc. are included in this chapter. Further
chapter III presents methodology used in the study. It consists of research design, nature
and sources of data, data collection techniques, method of sampling, data processing and
analysis. However, chapter IV includes the data analysis and findings. In this chapter,
data collected from various relevant sources is presented and analyzed by using various
statistical and econometrics tools and finally chapter V the last chapter and it includes
summary, conclusion and recommendation from the results of the study. A
supplementary section, which includes references, Annex, is also included.

The list of factors to be tested includes:

1. GNI Per Capita: Measured by a country’s GrossNational Income through GNI per capita on
the country’s domestic monetary system.
2. Financial Capital: Measured by gross fixedcapital formation and gross capital
formation(Dunning, 1988).
3. Level of Technology: Measured by high technologyexports and industry, value added
(Blomstrom&Sjoholm, 1999; Dunning, 1988a).
4. Human Capital: Measured by school enrollment and total unemployment (Sawalha, 2007).
5. Energy and Natural Resources: Measured by theratio of know how that offers certain
locationspecific advantages (LSA) to a foreign countrythrough energy use and fuel imports
(Dunning,
1988a).
6. Transportation and Communication: Measured by theratio of total vertical and
horizontalintegration of local firms through air transport,fixed line and mobile phone subscribers
andInternet users (Dunning, 1988a).
7. Market type: The ability to create a marketingconcept through FDI potentials and highly
competitive value chain as measured bymerchandise trade (Dunning, 1988b; Kotler, 1997;Porter,
1996).
8. Environment Factors: Measured by the agriculturevalue added, which has a direct and
indirectaffect of MNCs conducting FDI ventures (Kobrin,1976).
9. Governmental Factors: Measured by the worker’sremittances and employees’ compensation as
itpertains to a country’s labor system.
Purpose of the Research
The purpose of this dissertation is to identify thecharacteristics of several countries that impact
FDIto the Nepal. Thestrategy for investing into Nepal restswith Nepal’s ability toaccept changes
by accepting FDIfor economic reform.
The purposes of this research are stated below.
1. The first purpose of this research was reform forinternational participation and economic
changeswould influence the Nepal to positionitself for changes in order to attract
foreigninvestment. This researchprovided policy makers in Cuba and multi-nationalcorporations
with a list of factors in othercountries that affect FDI to Cuba and otherdeveloping countries.
2. The natural resources that a country possessesthrough its FDI product firms would benefit
thecountry’s overall competitive advantages, such asagricultural, land and unskilled labor.
According to the theories of Dunning(1988) and Kotler (1997), the prerequisite for anation to be
highly competitive requires changingthe levels of labor productivity and augmentingcapital for
furtherreforms once an inflow of FDIis established (Dunning, 1988). Taking intoconsideration
the process in shaping the futureof the Republic of Cuba by using thesefundamental aims, the
second purpose of thisresearch was to investigate two important areasof consideration including:
(a) whether theacceptance of an inflow of FDI to Nepal showed asignificant relationship with all
of the 13 hostcountries analyzed in this study; and
(b) whetherthere is a significant relationship between FDIto Nepal and the three categories of
countries,classified as advanced, developing and lessdeveloped countries.
3. The researcher considered Nepal’s system ofgovernment, which is and has been
centrallyplanned but augmented competitively in theinternational market. Nepal is a nation for
the last fiftyyearshas seen an economy in decline with littlecompetition for expansion and a large
potentialmarket. The country has gonethrough cyclical periods with an economy that
hasresponded very modest through the process ofreform (Mesa-Lago, 2001). The third purpose
ofthis study was todetermine whether FDI to Cubaunder a centrally planned economic system
wassignificantly related to the three categoriescountries.
4. The country’s ability in attracting FDI throughcertain restrictions such as the United
Statesembargo and other government restrictions thathave decreased Cuba’s overall FDI.
Coupled with adeteriorating economy and the United States lawsto include the Helm-Burton and
the ToricelliActscreated obstacles to promote investments andtrade in the island nation through a
thirdcountry. Infact, the Helm-Burton Law imposes a fine of asmuch as 1 million United States
dollars againstAmerican companies that violate Washington’strade embargo that includes
tourism by companiesfrom the host countries through a third country(Urquhart, 1997)(Pellet,
1976, 1986). The abilityto create a diverse group of business interest inending the embargo and
motivating 11 millioncitizens 90 miles from Cuba is a multi-billiondollarmarket waiting to occur
in the traveltourism(Birnbaum, 2002, p. 1). The fourthpurpose was to determine whether the
UnitedStates impacted FDI to Nepal.
Theoretical Framework
Several theoretical frameworks were presented in thisresearch. First, the main base theory of the
researchfocused on Dunning’s ‘eclectic theory/paradigm’(1988b, 1998). Dunning’s theory
explains the firm’scontribution by investing abroad if the host countrypossesses
certainadvantages to allow an inflow of FDIto a foreign country. FDI must also be coupled
witheconomic growth and political stability for the hostcountry to be willing to invest abroad
(Dunning,1988a). Dunning’s eclectic theory/paradigm alsoprovided three main forms of foreign
investment byMNCs conducting FDI. These are exports, contracts andresource transfer.
The second theorist included Hymer (1960) whofocused on oligopolistic theory. He observed
that FDIwas a means of transferring knowledge and assets, bothtangible and tacit, in order to
organize productionabroad in a foreign country (Sethi, Guisinger, Phelan& Berg, 2003, p. 31).
Hymer’s own dissertationdescribes operations into foreign countries as costly,due to conditions
of hostility and cultural diversity.
The third theory was developed by Adler &Hufbauer (2008). This theory was called inward and
outward FDI theory, which identified technologicalspillovers as a contributing factor for
impacting FDI.
The inward flow of FDI influenced economic integrationto developing and less developing
countries such as Nepal. Such integration would also create outward flowof FDI once firms were
able to transfer theiroperation away from the host country and reallocatetheir resources by
adjusting their technologicalskills to FDI recipient countries (Adler & Hufbauer,2008).
A fourth major theory focused on Kotler’s (1975)marketing development, which was a direct
result ofthe emerging interest in applying marketing practiceand concepts to nonprofit
organizations. Kotler’s(1967) buyer behavior theory focused on theproduction, selling, and
customer-oriented marketingphilosophies re-directed towards the latterorientation in marketing
practices. Sheth and Wright(1973, 1974) also viewed the buyer behavior theory interms of social
and public services such as populationcontrol, education, health care, transportation,
andnutrition. The augmentation of redirecting a hostcountry to invest abroad is the common link
in addingvalue for a nation to compete outside in theinternational arena (Kotler, 1997).
Therefore, severalwell-known theories such as those of Dunning (1988)and Kotler (1997) played
in explaining why firms
entered developing and less developing countries suchas Nepal where badly needed capital was
required foreconomic growth.
The fifth theory includes Porter’s competitivestrategic decision-making and his three
genericstrategies. Both of these strategies that are part ofthis study’s fifth theory was developed
by Michael E.Porter (Free Press, 1985). Porter (1985) discussed thevalue chain concept. The
core questions to be answeredwere “what activities added value to a firm,” “whatgeneric chain
was to be expanded,” as well as how toredefine the suppliers and customers through
marketingstrategies (Weinstein & Johnson, 1999, p. 300).
Justification and Rationale
The study provided a summary of theoristsdeveloped by Dunnning (1988b), Hymer (1960,
1970),
Adler &Hufbauer (2008), Kotler (1975) and Porter(1985). These theories provide the framework
requiredto fulfill and justify the objective of the study,which was to test if FDI to Cuba was
significantlyrelated to variables in 13 countries categorized asadvanced, developing, and less
developed. Severaljustifications are presented. First, the studyattempted to examine specific
hypotheses related toFDI to Cuba and macro-variables in 13 countries.Second, the study
provided all parties concerned withinformation about factors in other countries that caninfluence
FDI to Nepal. Third, the study was thefoundation for future research on FDI to Nepal andother
developing countries. Fourth, this studyidentified a subset of micro-variables in 13 countriesthat
impacted FDI to Nepal and possibility of otherdeveloping countries. Lastly, the study observed
theeffectiveness of the U.S. trade embargo on FDI to Nepal.
The rationale of the study is unique since itattempted to observe a relationship between the
macrovariablesin 13 countries and the FDI to Nepal. Most ofthe previous studies by ….. focused
in identifying the variables from one country or acombination of only a selected few with the
Nepal. This was the first study that utilized amacroeconomic approach in order to examine FDI
to Nepal. Hence, there will be no comparative study ofprevious research done of multiple
countries, with FDIto Nepal.
In summary, the research studies the relationshipbetween the FDI to Nepal and the macro-
variables in 13countries.
Scope and Limitations of this Study
Consequently, the scope of the study focused onFDI inflow from 13 countries selected. The
countrieswere divided into three categories, includingadvanced, developing, and less
developingcountries.The countries in the advanced category include theUnited States, Japan,
France, Germany and Spain. Thefive countries (United States, Japan, France, Germanyand
Spain) are selected based on their current andpast economic relationship and FDI investment
with the Nepal. The United States despite the existingtrade embargo with Cuba was a viable
market in thepast and is currently providing humanitarian aid andFDI investment on a cash basis
only. The secondcategory of countries includes China, India and theRussian Federation. All three
countries are involvedin significant FDI to Cuba and have previouslyinvested into the Nepal. The
third category of countries includesJamaica, Haiti, Peru, Madagascar and Cuba. India was chosen
based on its past and current FDIinvestment with Nepal. Haiti, Peru, Madagascar and had similar
economic conditions to Cuba (Journalof Commerce, 1998; Mesa-Lago, 2005). Haiti,Madagascar
and Cuba share similar economic trades,but not necessarily with Cuba, while Peru’s
naturalresources that includes mining excavation allocatessimilar characteristics with Cuba’s
natural resources.This study did not look at all countries thatcould impact Cuba’s FDI. The
second limitation wasdata. Cuba’s data was incomplete and possibly biased.Hence, variables
from Nepal could not be included inthe model. The third limitation was the data usedwere
primarily only from 1990 to 2017. The fourthlimitation was the data for a few countries were
notavailable and affected the testing of four hypotheses.The fifth limitation will be the inability
to compare Nepal’s economy with the once centrally plannedeconomies of Eastern Europe
(Czech Republic, Slovakia,Poland, Germany) and Asia (China, South Korea) sinceCuba’s
economy remains stagnant with no major form ofreforms for the last fifty years, as well
asunavailability of data.
Definition of Key Terms
International Markets
International markets are integrated within theglobal markets, resulting from an import and
exporttrades where physical and environmental forces existed. As a greaterdegree, the
international market employed in thisstudy referred to advanced, developing and leastdeveloping
countries whose economies were either inits infancy and or in a mature stage.
Internationalmarkets allowed products to be traded, facilitatingproduct development from the
host country and creatinga continuous incremental improvement of cost, andquality; therefore,
making the product liable and
attractive for overseas markets.
Foreign Direct Investment
FDI defined, as the buying of permanent property,businesses in a foreign country and the ability
tocompare the amount of money foreign creditors owe to anation, as well as ownership value
owned in othercountries (Nickels, McHugh & McHugh, 2005, p. 74). FDIseparated into an
expansionary type seeked to exploitthe firm specific advantage in the host country,
whiledefensive FDI seeks cheap labor in the host country toreduce cost production (Chen & Ku-
YH, 2000). FDI wasalso defined as the cross border control of facilitiesthrough acquisition,
lease, or new construction(Deichmann, 2004). According to UNCTAD’s (2001), FDIinvolved
the equitycontrol of at least ten percent ofa facility’s value and as a result can
establishedoperation from the host country. According to Dunning(1979), FDI implementation
may confer to suchadvantages as parent-local firm economies of scale inproduction,
diversification of risk and broader accessto production inputs and markets.
CHAPTER 2
References

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