Luận văn a study on the impact of foreign direct investment on economic development of lao p d r

MINISTRY OF EDUCATION

MINISTRY OF EDUCATION AND TRAINING

LAOS NATIONAL UNIVERSITY

NATIONAL ECONOMICS UNIVERSITY

KHAMSEN SISAVONG

A STUDY ON THE IMPACT OF
FOREIGN DIRECT INVESTMENT ON
ECONOMIC DEVELOPMENT OF LAO P.D.R.

A thesis submitted to the National Economics University
in fulfillment of requirements for the degree of

Doctor of Philosophy in Economics

Hanoi, 2014

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i

DECLARATION

I hereby declare that this dissertation is my own work and effort. The
dissertation has not been submitted anywhere for any award. All the sources of
information used have been well acknowledged.

Date:

Signature

KHAMSEN SISAVONG

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ii

ACKNOWLEDGMENTS

The Vietnam – Lao Cooperative Program Doctor of Philosophy (PhD) between
NEU and NUOL is very important, necessary, valuable and beneficial to our nations
because this project allows Lao people to upgrade and enhance their level to Doctorate
Degree.
Therefore, I would like to acknowledge the leaders, Administrators, Professors
of the National Economics University of Vietnam and National University of Laos to
give me this excellence opportunities to achieve my dream of PhD.
I would like to express my gratitude to Prof. Dr. Tran Tho Dat, Assoc. Prof.Dr.
Nguyen Thanh Ha and other professors who were in the committees for evaluation of

my dissertation in the early stages of my PhD study.
I am deeply indebted to Assoc. Prof. Dr. Nguyen Thi Tuyet Mai,

my

supervisor who gives me clear guidelines and contributing her advises to my
dissertation.
I am also grateful to Prof. Dr. Somkod Mangnormek, Governor of Xiengkhuang
Province, member of Central Committee Party, Prof. Dr Kikeo Khaikhamphithoun,
Head of National Accademic of Politic and Public Administration, member of Central
Committee Party, Prof. Dr. Thongsalith Mangnormek, Head of National Economic
Research, Prof. Dr. Bounpong Keonoradome, President of Savannakhet University
who encouraged and supported me to reach my goal of PhD.
My special thanks go to my family, Sengsavanh College’s staff and my friends.
They are always pleased to encourage and to assist me during my PhD research.
Without your supports I could not complete and realize my dream.

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CONTENTS
DECLARATION ..........................................................................................................i
ACKNOWLEDGMENTS .......................................................................................... ii
ABBREVIATIONS .....................................................................................................v

LIST OF FIGURES .................................................................................................. vii
LIST OF TABLES ................................................................................................... viii
CHAPTER 1. INTRODUCTION................................................................................. 1
1.1 Research Background ............................................................................................1
1.2 Rationale for the Research .....................................................................................3
1.3 Research Objectives and Research Questions .......................................................4
1.4 Scope of the Study .................................................................................................6
1.5 Contributions of the Study .....................................................................................6
1.6 Dissertation Structure ............................................................................................8
CHAPTER 2. LITERATURE REVIEW ON THE IMPACT OF FDI ON
ECONOMIC DEVELOPMENT .................................................................................. 9
2.1. Definition and Indicators of Economic Development ..........................................9
2.1.1 Definition of Economic Development ...........................................................9
2.1.2 Indicators of Economic Development .........................................................10
2.1.3 Theoretical Economic Overview .................................................................11
2.2 FDI and its Impact on Economic Development ..................................................14
2.2.1 Definition and Determinants of FDI ............................................................15
2.2.2 Impact of FDI on Economic Development ..................................................30
CHAPTER 3. OVERVIEW OF ECONOMIC DEVELOPMENT AND FDI IN
LAOS 51
3.1. Overview of Laos’ Economy ..............................................................................51
3.1.1. Economic Growth .......................................................................................52
3.1.2 Economic Structural Changes ......................................................................53
3.1.3 Financial Sector Growth ..............................................................................54
3.1.4 Banking Sector Development .....................................................................55

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3.1.5 Inflation has been effectively managed ......................................................55
3.1.7 Workforce and Employment Balance ..........................................................56
3.1.8 Balancing the Sources of Funds for Development ......................................58
3.1.9 Balancing the State Budget ..........................................................................60
3.1.10 Balancing Imports and Exports..................................................................61
3.1.11. Sectoral Development, Regional and International Economic Integration
...............................................................................................................................65
3.1.12 Infrastructure ..............................................................................................88
3.2 Foreign Direct Investment in Laos ......................................................................90
CHAPTER 4. RESEARCH METHODOLOGY ...................................................... 95
4.1 Research Questions ..............................................................................................95
4.2 Variables and Measures .......................................................................................95
4.3 Data Description ..................................................................................................97
CHAPTER 5. RESEARCH FINDINGS .................................................................. 107
5.1 FDI and GNI per Capita....................................................................................107
5.2 FDI and Financial Capital .................................................................................108
5.3 FDI and Level of Technology............................................................................111
5.4 FDI and Human Capital .....................................................................................112
5.5 FDI and Energy and Natural Resources ............................................................113
5.6 FDI and Transportation and Communication ....................................................114
CHAPTER 6. CONCLUSIONS AND DISCUSSION ............................................ 116
6.1 Conclusions ........................................................................................................116
6.2 Implications of the Study ...................................................................................117
6.3 Limitations of the Study and Future Research Direction ..................................121
REFERENCES .......................................................................................................... 123

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v

ABBREVIATIONS

AFTA

Asean Free Trade Area

AGOA

Africasn Growth and Opportunity Act

APTA

Asia Pacific Trade Agreement

ASEAN

Association of South East Asian Nations

ATIGA

Asean Trade in Goods Agreement

BIT

Bilateral Investment Treaty

BOP

Balance of Payments

CAP

Carribean African Pacific

CEPEA

Comprehensive Economic Partnership in East Asia

EAFTA

East Asia Free Trade Area

ECE

Economic Commission of Europe

ECOWAS

Economic Organization of West African States

EU

European Union

FDI

Foreign Direct Investment

FPI

Foreign Portfolio Investment

FY

Financial Year

GDI

Gross Domsetic Income

GDP

Gross Domestic Product

GNI

Gross National Income

IMF

International Monetary Fund

IPRs

Intellectual property rights

ISCED

International Standard Classification of Education

ISIC

International Standard Industrial Classification

Lao PDR

the Lao People’s Democratic Republic

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LDCs

Least developed countries

MFs

Multinational firms

MIGA

Multilateral Investment Guarantee Agency

MNC

Multinational Corporation

NEM

New Economic Model

NIEs

Newly Industrializing Economies

NTA

National Tourist Authority

ODA

Official Development Assistance

OECD

Organization for Economic Co-peration and Development

OLI

Ownership, Locational, Internalization

OLS

Ordinary Least Square

OPIC

Overseas Private Investment Corporation

PPP

Purchasing Power Parity

SAPTA

South Asian Preferential Trade Agreement

TDS

Total Debt

UN

United Nations

US

the United States

VAT

Value Added Tax

WTO

World Trade Organization

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vii

LIST OF FIGURES

Figure 1: Economic structure 2006 – 2010 ...................................................................54
Figure 2 Export and Imports from 2005-2009. .............................................................64
Figure 3 Average size of agricultural land per household.............................................66
Figure 4. Average share of value added in the industrial sector 2006-2010 .................70
Figure 5. Structure of service sector 2006-2010 ...........................................................75
Figure 6 Foreign direct investment, net inflows (BoP, current US$) ...........................92

Figure 7. Distribution of FDI in Lao PDR (US$ m) .....................................................93
Figure 8. Share of accrual FDI by country (% of total, as of August 2009) .................93
Figure 9. Ten biggest foreign investors in Laos (1989 – 2012) ....................................94
Figure 10. Graph of Correlation between FDI and GNI per capita ............................107
Figure 11. Graph of Correlation between FDI and long-term debt service on external
debt ..............................................................................................................................110
Figure 12 Graph of Correlation between FDI and level of technology .....................112
Figure 13. Graph of Correlation between FDI and School enrollment, tertiary ........113
Figure 14. Graph of Correlation between FDI and Natural Resources ......................114
Figure 15. Graph of Correlation between FDI and Mobile cellular subscriptions .....115

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LIST OF TABLES

Table 1. Comparison between actual and targeted GDP growth rate in the Sixth Plan
(2006-2010) ...................................................................................................................52
Table 2. GDP per capita (plan vs. actual) ......................................................................53
Table 3. Share of labour by sectors ...............................................................................58
Table 4. Private domestic and foreign investment from 2006-2010 (USD billion) ......60
Table 5. Export structure of Lao PDR by commodities 2005-2009 (%).......................62
Table 6. Import structure of Lao PDR by commodities 2005-2009 (%).......................63
Table 7. Inter-Country Comparison on Opened Trade or Integration 2006-2010 ........86

Table 8. Export Market Structure with Main Trade Partners, 2008 ..............................87
Table 9. Foreign direct investment, net inflows ............................................................98
Table 10. GNI per capita ...............................................................................................99
Table 11. Gross capital formation (annual % growth) ................................................100
Table 12. Financial capital ..........................................................................................101
Table 13. Industry, value added (% of GDP) ..............................................................102
Table 14. Human capital..............................................................................................103
Table 15. Oil consumption per capita..........................................................................104
Table 16. Transportation and communication .............................................................105
Table 17. FDI and GNI per capita Coefficient of Correlation ....................................108
Table 18. FDI and Financial Capital Coefficient of Correlation .................................108
Table 19. FDI and Level of Technology Coefficient of Correlation...........................111
Table 20. FDI and Human Capital Coefficient of Correlation ....................................112
Table 21. FDI and Energy and Natural Resources Coefficient of Correlation ...........113
Table 22. FDI and Transportation and Communication Coefficient of Correlation ...114

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CHAPTER 1. INTRODUCTION
1.1 Research Background
Laos is a small landlocked country with an area of 236,800 square
kilometers. It shares its borders with Vietnam in the East, China in the North, and
Cambodia in the South, Thailand and Myanmar in the west. Two third of the

country is mountainous (northern part) thus its geographic circumstances constrain
both the quality and quantity of agriculture and cause difficulties to the
development of trade, social infrastructure and transportation and communication
links. However, the country has transformed from a landlocked to a land link and
cross road to other parts of the world.
Laos is located in the center of energetic and prosperous region of South East
Asia and possesses a high potential of natural resources, raw material and
hydropower. The country is divided into three main regions: northern, central and
southern regions. The current total population of Laos is 6.9 million (2012) with
major of those live in valleys of the Mekong river and its tributaries. The population
density is about 27 per. Sq. meter. Vientiane is the capital and the largest city, and
its population is about 800,000 residents.
After becoming independent in 1975, Laos established control over the
economy through the centralized fiscal and socialist government until 1985 but
during that period, the government had seen that the performance of the economy
was unable to reach expected goals. Economic management was weak due to the
lack of skilled labor force. External assistance was provided but projects were not
completed at a satisfactory level. In 1986, the Lao government implemented the
New Economic Mechanism (NEM) to open the country and provided incentives for
developers and investors and moved from a centrally planned economy to a market
oriented economic model.

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The goals of the NEM were: Launching open market policies and the
introduction of market economy principles. The reform has attracted FDI projects in
the agricultural, industrial, hydropower electricity, mining and the service sectors.
These sectors of development have played an important role in the support of the
economic development in Lao P.D.R.
Laos has continuously pursued significant economic and institutional
reforms, aiming at improving social and economic wellbeing of its population by
consistently building itself a market oriented economy. Laos has achieved
remarkable economic growth and macroeconomic stability. It has witnessed a
significant rise in public and private investment.
These factors contributed to the annual average growth rate of over 6 percent
per annum from 1990 to 2009 and the annual average growth rate of about 8 percent
in 2012.
In order to promote and attract FDIs in Laos, the government has created
Special Economic Zones (SEZ) in compliance with the general investment policies
of the government. The government has implemented incentive policies to promote
both domestic and foreign investment in the special economic zone by shortening
the investment approval process in SEZ, facilitating business operations,
production, and services based on the mechanism of “smaller administration units
but wider society” or “one stamp mechanism” to generate a good environment for
investment.
FDI inflows in Laos have grown dramatically over the past decade and have
played an important role in the growth of the world economy as well as the ASEAN
Nations. In the developing world, FDI has become the most stable and largest
component of capital flows. As a result, FDI has become an important alternative in
the development finance process (Global Development Finance, 2005.)

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Laos is a small and still poor country. Therefore, the investment from foreign
countries in terms of FDI is needed because FDI plays an important role in job
creation, economic growth, capital inflow, technology transfer, human resource
development, and wealth in the host country. Thanks to the economic reform, the
number of FDI projects and the income on international trade have increased
significantly and have had a direct impact on national income as well as GDP
growth.
1.2 Rationale for the Research
It has been suggested that Foreign Direct Investment (FDI) inflows have
played an important role in promoting economic growth in developing countries,
especially in the Southeast Asian countries (Nguyen, 2008). They are the source of
large capital, knowledge, expertise, technology transfer, and international market
access. Since the 1990's, the global flows of FDI have grown phenomenally and
have become the largest source of foreign private capital to reach developing
countries like Laos.
The attraction of the FDI is becoming increasingly important for Laos to
bring certain benefits to the national economy like the contribution to the GDP, the
total investment, and the balance of payment for the host country. However, the
impact of FDI largely depends on the economic conditions. Domestic investment,
personal savings, the mode of entry (merger, acquisition, or new investment), the
industry sector involved, and the country's ability to regulate foreign investment are
all factors affecting the impact size of the FDI (Earth Summit, 2002).
FDI has a substantial influence on social and infrastructure development as

well as technology transfer. It helps in stimulating employment, raising wages, and
replacing declining market sectors, consequently having cultural and social impact
if the investment is directed toward non-traditional sophisticated product (Earth
Summit, 2002).

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Attracting FDI is the major concern and a desired outcome of Laos to catch
up and achieve economic growth. Since investors have certain requirements to
invest abroad, the host countries must posscess a standard macroeconomic
environment to attract those investors to bring their capital, technology, and
expertise. Hence, the role of the government in devising policies and building
economic infrastructure is a pre-determinant to attract FDI.
Location-specific attractiveness, political and economic stability, the
property and profit tax system, the market size and labor-force composition,
geographic proximity, the number of competitors, freedom of entry and exit from
domestic financial markets are all factors influencing the volume and the type of
capital inflows to Laos. In addition, energy and water resources, transportation and
telecommunication infrastructure are critical elements that have a great influence on
capital inflows and investments in the host countries.
Given the importance of FDI especially in developing countries like Laos,
theoretically as well as practically, there are however still inconclusive arguments
for and against the role of FDI inflows in enhancing economic development in a

country (cf., Nguyen, 2008). It has still been debate about whether FDI inflows are
beneficial or not to economic development, and what governments should do to
attract and use FDI inflows effectively (Kokko et al., 2003; Longani & Razin, 2001;
Masina, 2002; Nguyen, 2008). In addition, it has been suggested that the
relationship between FDI and economic growth may be country and period specific
(cf., Adegbite & Ayadi, 2010). Therefore, this study aims to explore the impact of
FDI inflows on some indicators of economic development in the context of Laos, a
developing country in Asia.
1.3 Research Objectives and Research Questions
This study seeks to analyse FDI inflows into Laos and to investigate their
impact on the economic development of Laos. It identified this impact by
responding to the country's characteristics and infrastructure as determinants for

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capital inflows, transfer of technology, augmentation of human capital, and other
spillover benefits.
The desired outcome of this research aims at confirming the linkage between
FDI inflows in Laos and the economic development indicators including GNI per
capita, financial capital, level of technology, human capital, energy and natural
resources, transportation and communication.
The major economic development theories and models such as The Stage
Theory of Rostow, the Harrod-Domar model of savings and productivity of

investment, the Lewis Model of Dual Economy, the Dependency Theory, and other
scholarly models in the field assisted in establishing the base theory for the
research.
The research problem revolves around the notion that Laos is incapable to
achieve economic growth. Natural resources, human capital, financial capital,
transportation and communication, level of technology, and leadership, are all
important elements of sustainable economic growth. They are the foundation for
any economic development stimulation. The scarcity of these resources will stall the
economy and make it difficult to make growth progression.
Research Questions
This research tried to answer the questions: 1) What are the relevant
literature and the theoretical background on FDI and its impact on economic
development? and 2) Does FDI have a significant contribution to economic
development of Laos?
With regard to the impact of FDI on economic development, the research
aims to answer the following specific questions:
• Does FDI have a significant role on the GNI per capita?
• Does FDI have a significant role on the Financial Capital?

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• Does FDI have a significant role on the country's level of technology of
Laos?

• Does FDI have a significant role on Human Capital of Laos?
• Does FDI have a significant role on the Energy and Natural Resources
availability of Laos?
• Does

FDI

have

a

significant

role

on

the

Transportation

and

Telecommunication infrastructure of Laos?
1.4 Scope of the Study
This study focuses on the role of FDI on some indicators of economic
development in the context of Laos. Other aspects of development such as social
and environmental issues (i.e., poverty ratios of different sectors, education and
health care, environment pollution and damage) are not addressed in this
dissertation.

This study mainly employed the data to analyse the relationships between
FDI and Laos’ economic development indicators during the period 1990-2012. The
analyses of correlations were used to serve the objectives of this research.
1.5 Contributions of the Study
Investigation into the effects of FDI on the economies of host countries is
considered one of the two most important and most researched issues in
international business (Driffield & Love, 2007). This study aims to examine the
impact of FDI on several economic development indicators in the context of Laos.
The study is important to help Laos enjoy further economic development as well as
contributes to the literature of FDI and economic growth in the context of
developing countries.

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FDI has been suggested as a determinant of economic development in both
developed and developing countries. Its important role in promoting economic
growth and bringing many benefits to the economy is especially emphasized in the
context of developing countries. However, the literature also provides mix findings
pertaining to the effects of FDI, and there has been suggested that the link between
FDI and economic development may be country and period specific. Therefore, it is
important and meaningful to examine the impact of FDI inflows on economic
development in Laos, a developing country which has received very modest
research attention to date.

By focusing on six main research questions pertaining to the relationships
between FDI inflows and various indicators of economic development, the research
has contributed to both theoretical and practical sides. From theoretical perspective,
the research helps to enrich the knowledge about the important topic pertaining to
FDI’s impacts on economic development in general and in the context of a
developing country in particular. From practical perspective, the research findings
provide significant implications to policy makers in Laos.
The issue of FDI and its important role is more important for developing
countries and the countries in transition like Laos because they lack capital, know
how, and managerial skills. Understanding the role of FDI would help making good
policies to attract more FDI for the purpose of economic development. Therefore,
the results of this dissertation are expected to provide significant implications for
policy makers. The results can be applied in the area of attracting the FDI flows.
The dissertation can also provide recommendations for a better business conditions
for investment and doing business.
Briefly, the findings of this study help to enrich the knowledge about the
important topic pertaining to FDI’s impacts on economic development in general
and in the context of a developing country in particular. The study also provides
implications to policy makers.

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1.6 Dissertation Structure

This dissertation includes six main chapters. The brief content of each
chapter is presented in the following.
CHAPTER 1. INTRODUCTION
Chapter 1 briefly introduces the research background, research motivations,
the objectives, and the structure of the dissertation.
CHAPTER 2. LITERATURE REVIEW ON THE IMPACT OF FDI ON
ECONOMIC DEVELOPMENT
This chapter reviews the literature on economic development, FDI and
focuses on the impact of FDI on economic development.
CHAPTER 3. OVERVIEW OF ECONOMIC DEVELOPMENT AND FDI
IN LAOS
Chapter 3 focuses on providing an overview of the state of FDI in Lao
P.D.R., Lao government policies and Laos’ economic growth since 1990.
CHAPTER 4. RESEARCH METHODOLOGY
This chapter outlines the research methodology and data sources used to
answer the research questions.
CHAPTER 5. RESEARCH FINDINGS
This chapter presents the key findings on the relationships between FDI
inflows and various indicators of economic development in Laos over the period
1990-2012.
CHAPTER 6. CONCLUSIONS AND DISCUSSION
The final chapter summarizes the research findings, provides implications,
and discusses limitations of the study and offers suggestions for future research.

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CHAPTER 2. LITERATURE REVIEW ON THE IMPACT OF FDI ON
ECONOMIC DEVELOPMENT
2.1. Definition and Indicators of Economic Development

2.1.1 Definition of Economic Development
Economic Development is the progress in an economy and is a measure of
the welfare of humans in a society. It usually refers to the adoption of new
technologies, transition from agriculture-based economy to industry - based
economy, and general improvement in living standards (Businessdictionnary.com).

Similarly, the International Economic Development Council defines economic

development as an “activity that seeks to improve the economic well-being and

quality of life for a community, by creating and/or retaining jobs…”

(smallbusiness.chron.com).
Economic development is a normative concept. It means that it applies in the
context of people's sense of morality (right and wrong, good and bad). The
definition of economic development given by Todaro (1994) is an increase in living
standards, improvement in self-esteem needs and freedom from oppression as well
as a greater choice. The most accurate method of measuring development is the
Human Development Index which takes into account the literacy rates and life
expectancy which affect productivity and could lead to economic growth. It also
leads to the creation of more opportunities in the sectors of education, healthcare,
employment and the conservation of the environment. It implies an increase in the
per capita income of every citizen (Todaro, 1994).

Economic development can also be referred to as the quantitative and
qualitative changes in an existing economy. Economic development involves
development of human capital, increasing the literacy ratio, improve important
infrastructure, improvement of health and safety and others areas that aims at

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increasing the general welfare of the citizens. The terms economic development and
economic growth are used interchangeably but there is a big difference between the
two. Economic growth can be viewed as a sub category of economic development.
Economic development refers to government policy to increase the economic, social
welfare and ensure a stable political environment. Economic growth on the other
hand refers to the general increase in the country products and services output
(source: whatiseconomics.org).

2.1.2 Indicators of Economic Development
According to United Nations Human Development Report (2001) and report
research of bbc.co.uk, some key indicators of economic development are presented
as follows.
- GDP per capita (Gross Domestic Product- the value of all the finished
goods and services produced within a country’s borders in a specific time period).
- Human Development Indicators (life expectancy, Infant mortality rate,
Poverty, Access to basic services, Risk of disease)

- Literacy rates (Access to education )
- Measures of poverty
- Demographic indicators
- Unemployment
- Government spending priorities
- Gender equality
- Infrastructure development
In literature, previous studies have examined various aspects of economic
development such as economic growth, GDP per capita, transportation (road

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access), information network, industry establishment, techonology, financial capital
flow, foreign trade, and human capital (e.g., Adegbite & Ayadi, 2010; Kotrajaras et
al., 2011; Mengistu & Adams, 2007; Phimphanthavong, 2012; Prasad & Sharma,
2012).
In this study, the author examines the impact of FDI on economic
development in Laos, focusing on some economic development indicators
including:
- Gross National Income (GNI) per capita
The GNI per capita is the dollar value of a country’s final income in a year,
divided by its population. It reflects the average income of a country’s citizens.
Knowing a country’s GNI per capita is a good first step toward understanding the

country’s economic strengths and needs, as well as the general standard of
living enjoyed by the average citizen (Wikipedia).
- Financial Capital
- Level of technology
- Human Capital
- Energy and Natural resources
- Transportation and Communication

2.1.3 Theoretical Economic Overview
Rostow (1960) argued that all countries passed through the same historical
stages of economic development and underdeveloped countries were at an early
stage compared to the advanced world (e.g., Europe and North America). He
identified societies in their economic status as passing through one of five stages:
the traditional society, the preconditions for take-off, the take-off, the drive to
maturity, and the age of high mass- consumption.

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Lewis' Dual Economy model (1954) was based on the assumption that many
LDCs had dual economies with both a traditional agricultural 'informal' sector and a
modern industrial 'formal' sector. The traditional agricultural sector was described
with low income, low productivity, low saving, and high unemployment rate. The
industrial sector on the other hand was technologically advanced, with high

investment level operating in urban environment. According to this model, surplus
labor in the traditional agricultural sector should migrate to the modern sector where
the high rising marginal product is. Migrating surplus labor would have no effect on
agricultural productivity since marginal productivity of the rural workers is close
to zero.
In his 1954 paper on Economic Development with Unlimited Supplies of
Labour, Lewis argued that the modern sector would have larger savings,
accumulation of capital, and investment, and consequently economic growth.
Capital accumulation comes from the higher wages in the modern sector compared
to the rural sector. The underdeveloped countries have a larger population than
capital and natural resources, employing workers with insignificant productivity,
zero or even negative (Fields, 2004).
According to the traditional model of economic development and its
proponents like the Harrod-Domar growth model, the absence of the high level of
savings in underdeveloped countries contended that the stimulus for economic
growth could only be achieved from an outside capital provided by MFs through
foreign direct investment (FDI) since they have the capabilities and the resources to
provide that capital and transfer modern technology to the underdeveloped nations.
Harrod-Domar model suggested that the economy's rate of growth depends on the
level of saving and the productivity of investment; that is, the capital output ratio.
The model was developed to help analyze the business cycle. However, it was later
adapted to explain economic growth. It argues that the main ingredient of economic
growth is to expand the level of investment both in terms of fixed capital and human

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capital. To do this, policies are needed to encourage saving and/or generate
technological advances that enable firms to produce more output with less capital or
lower their capital output ratio (Pool & Stamos, 1990).
Opposing the traditional model, the equity structuralist model stated that
underdevelopment could only be explained in a historical context. The state of
underdevelopment was the result of colonization that allowed a small minority to
own and control the majority of the land, the primary raw materials, and the
illegitimate political power (Pool & Stamos, 1990).
Dependency theory (Pool & Stamos, 1990) on the other hand, has explained
the underdevelopment based on the Marxian analysis. It argues that the MFs have a
negative impact on developing nations and market structure, challenging both the
traditional and the structural models. Because of the MFs power of economy of
scale and barriers to entry (technology and capital resources), they are an obstacle to
competition from the local firms in the host countries.
The Dependency theory has presented the practice of transfer pricing
(overpricing imports and under pricing exports) by the MFs to gain benefits at the
expense of the developing countries. Additionally, developing countries were
targeted by MFs to transfer their economic surplus to the developed world by
extracting and controlling raw materials, and accessing cheap labor markets.
In his classic 1956 work, Solow proposed that the study of economic growth
should begin by assuming a standard neoclassical production function with
decreasing returns to capital. He suggested that the rate of saving and population
growth could determine the steady state of per capita income. Since these variables
vary across nations, they reach different levels of GDP per capita. Therefore, when
the rate of saving is high, the richer the country is, and when the population growth
is high, the poorer the country is (Mankiw et al., 1992).

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Mankiw et al. (1992) said that Solow's model was successful in predicting
the effects of saving and population growth on economic development but did not
predict the magnitude of that effect. Therefore, they augmented Solow's model by
including accumulation of human as well as physical capital to the formula of
economic growth. They concluded that for a given rate of human capital
accumulation, higher saving or lower population growth leads to higher level of
income and thus a higher level of human capital. Hence, accumulation of physical
capital and population growth has greater impacts on income when accumulation of
population growth rates. This would imply that omitting human capital
accumulation biases the estimated coefficient on saving and population growth.
Heady (1979) indicated that the real problem in the least developed countries
is the imbalance between the accumulation of capital and the production level.
These countries face a necessity to increase the exports level of their raw materials
of which their prices constantly fall, while imports of industrialized materials,
technology, and other finishes products of which the prices rise up. Consequently,
per capita income gap between the developed nations and LDCs is always
increasing, in addition to the relative increase of population growth.
2.2 FDI and its Impact on Economic Development
In literature, there are various FDI theories including production cycle theory
of Vernon, strategic behaviors, industrial organization, internalization eclectic
paradigm, complement theory of FDI, the theory of internationalization of FDI (OLI

paradigm), the resource based theory, the business network theory, the theory of
new economic geography, diversified FDI and risk diversification model, policy
determinants of FDI, etc. It is important to have critical points of view towards the
theories relating to FDI. This chapter focuses on some main issues related to FDI
theories and FDI’s impact on various aspects of economic development. However,
the first section will present definition of FDI and the reasons for FDI.

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2.2.1 Definition and Determinants of FDI
2.2.1.1 Definition of FDI and reasons for FDI inflows to developing countries
Definition of FDI
FDI has been defined by OECD (2012) and OECD International Direct
Investment Statistics (database), that are presented as follows.
FDI is defined as cross-border investment by a resident entity in one
economy with the objective of obtaining a lasting interest in an enterprise resident
in another economy. The lasting interest implies the existence of a long-term
relationship between the direct investor and the enterprise and a significant degree
of influence by the direct investor on the management of the enterprise. Ownership
of at least 10% of the voting power, representing the influence by the investor, is the
basic criterion used.
Inward stocks at a given point in time refer to all direct investments by nonresidents in the reporting economy, while outward stocks are the investments of the
reporting economy abroad. Corresponding flows relate to investment during a

period of time. Negative flows generally indicate disinvestments or the impact of
substantial reimbursements of inter-company loans.
The FDI index gauges the restrictiveness of a country's FDI rules through
four types of restrictions including foreign equity limitations, screening or approval
mechanisms, restriction on key foreign employment, and operational restrictions.
The OECD FDI regulatory restrictiveness indexes presented here
demonstrate that the service sector tends to have higher FDI restrictions across
countries, followed by primary sectors. The manufacturing sector remains the most
opened economic sector.
In the same line, according to investopedia.com, FDI refers to an investment
made by a company or entity based in one country, into a company or entity based

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in another country. FDI differs substantially from indirect investment such as
portfolio flows, wherein overseas institutions invest in equities listed on a nation's
stock exchange. Entities making direct investments typically have a significant
degree of influence and control over the company into which the investment is
made. Open economies with skilled workforce and good growth prospects tend to
attract larger amount of FDI than closed, highly regulated economies.
When analyzing FDI, it is important to differentiate it from Foreign Portfolio
Investment (FPI). FPI is passive, non-fixes holdings of foreign stocks, bonds, or
other financial assets. Investors look for profit from the rate of return on their

investment and no management control is assumed. It is noted that the most
accepted definition of FDI is the one given by the International Monetary Fund
(IMF). IMF defines FDI as the acquisition of at least 10% of the ordinary shares or
voting power in an enterprise by nonresident investors, and direct investment
involves a lasting interest in the management of an enterprise and includes
reinvestment of profits (cf., Agrawal & Khan, 2011). Therefore, the distinguishing
feature between FDI and FPI is that FDI has some form of control over operation
and influence over decision, but with control comes risk and commitment. Risk is
something which multinational enterprises (MNEs) prepared to take. MNEs can be
defined as “companies headquatered in one country but having some upstream
and/or downstream operations in other countries” (Lee & Rugman, 2009; p. 62). So,
those organizations which conduct FDI in other countries can be classified as
MNEs.
Reasons for FDI inflows to developing countries
Yoonbai (2000) examined the reasons behind the flow of FDI in countries
like Korea, Malaysia, Chile, and Mexico. The research found that this flow was
influenced by two factors on a global level: recessions faced by many industrialized
economies and the global interest rate drop. Internal factors like (a) country-specific
productivity shocks, (b) demand shocks, (c) inflation shocks,(d) monetary shocks,

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