Foreign direct investment, financial development and economic growth in asian developing countries

INSTUTION OF SOCIAL STUDIES

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLANDS

VIETNAM- NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FOREIGN DIRECT INVESTMENT, FINANCIAL
DEVELOPMENT AND ECONOMIC GROWTH
IN ASIAN DEVELOPING COUNTRIES
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

NGUYEN THUC DUY ANH

Academic Supervisor:

DR. NGUYEN VAN PHUC

HO CHI MINH CITY, DECEMBER 2011

CERTIFICATION

I hereby certify that the substance of the thesis has not already been submitted for
any degree and is not being currently submitted for any other degree.
I also certify that, to the best of my knowledge, and help received in preparing the
thesis and all sources used have been acknowledged in the thesis.

Signature

Nguyen Thuc Duy Anh
Date: ..................... .

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ACKNOWLEDGMENTS

I would like to express my gratitude to all those who gave me the possibility to
complete this thesis.
I am deeply grateful to my supervisor Dr. Nguyen Van Phuc from Ho Chi Minh
City Open University whose support, stimulating suggestions and encouragement
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helped me in all the time of research for and writing of this thesis.
I am also very grateful to all lecturers of the Vietnam-Netherlands Programme for
giving me knowledge and guidance to fulfill the M.A Programme.
I would like to thank all the members of the Vietnam-Netherlands Program,
especially, VNP Library for helping me to have necessary documents and research
papers during my completion of the thesis.
Finally, I am indebted to my parents and my dear husband whose love, sympathy

and encouragement enabled me to complete this thesis. I am also thankful to my
classmates for their warm encouragement.

;

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ACRONYMS AND ABBREVIATIONS
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FDI

Foreign Direct Investment

FINANCE

Financial Development

WDI

World Development Indicators

WGI

Worldwide Governance Indicators

UNCTAD

United Nations Conference on Trade and Development

OECD

Organization for Economic Cooperation and
Development

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MNCs

Multinational Enterprises

M&A

Mergers and Acquisitions

R&D

Research and Development

POOLED

Pooled Regression Model

FEM

Fixed Effects Regression Model

REM

Random Effects Regression Model

OLS

Ordinary Least Square

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ABSTRACT

This research investigates the role of domestic financial development plays in
enhancing FDI's positive effects on economic growth in Asian developing
countries. In other words, we examine whether countries with better domestic
financial system can utilize FDI more efficiently. The empirical analysis uses
balanced panel data of24 Asian developing countries in the period 1995-2009. This
research applies the various models and techniques in panel data regression. Linear
static models for panel data named constant coefficients model or pooled regression
model (POOLED), fixed effects regression model (FEM) and random effects
regression model (REM) are employed. We analyze all models and employ many
kinds of test including poolability test, Hausman test, LM test, fixed effects tests
and Wald tests to select the most appropriated estimated model. The research
findings show that FDI alone does not have directly effect on economic growth but
does have when combined with financial development. Well-developed domestic
financial markets promote the process of technological diffusion associated with
FDI in Asian developing countries. Therefore, FDI and domestic financial
development are complementary in increasing the rate of economic growth in the
region. There is a threshold level of domestic financial development above which
FDI starts to have positive impacts on economic growth .

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TABLE OF CONTENTS
CHAPTER 1. INTRODUCTION ................................................................................ 1
1.1 Problem statement ..................................................................................................... 1
1.2 Research objectives ................................................................................................... 2
1.3 Research questions .................................................................................................... 3
1.4 Research scope and data ............................................................................................ 3
1.5 Organization ofthe thesis .......................................................................................... 4
CHAPTER 2. LITERATURE REVIEW .................................................................... 5

2.1 The impact ofFDI on economic growth ................................................................... 5
2.2 FDI, financial development and economic growth: theoretical framework and

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empirical studies ...................................................................................................... 10
2.2.1 Theoretical framework ............................................................................ 10
2.2.1.1 Neoclassical growth model .......................................................... 10
2.2.1.2 Endogenous growth model ........................................................... 11
2.2.1.3 Technological change model. ....................................................... 11
2.2.2 Empirical studies about the role of financial development in FDIGrowth nexus .......................................................................................... 15

2.3 The measures of financial development.. ................................................................ 21
2.4 The determinants of economic growth .................................................................... 23
2. 5 Chapter remark ........................................................................................................ 2 5
CHAPTER 3. RESEARCH METHODOLOGY ...................................................... 27

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3.1 Variables measurements .......................................................................................... 27
3.1.1 Dependent variable: Economic growth (GROWTH) .............................. 27
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3 .1.2 Independent variables .............................................................................. 27
3.1.3 Control variables (CONTROLS) ............................................................. 31
3.2 Data collection ........................................................................................................ 33
3.3 The estimation strategy ........................................................................................... 34
3.3 .1 Panel regression models .......................................................................... 3 5
3.3.1.1 Constant coefficients model (POOLED) ..................................... 35
3.3 .1.2 Fixed effects regression model (FEM) ......................................... 3 5
3.3.1.3 Random effects regression model (REM) .................................... 37

3.3.2 Choice of panel regression model (Testing panel models) ..................... 38
3.3.2.1 The F-Test for individual and time effects in FEM models: ........ 38
3.3.2.2 The Chow Test for the POOLED against the FEM (Test for
poolability): ................................................................................ 39
3.3.2.3 The Hausman Specification Test for the FEM against the REM. 39
3.3.2.4 The Breusch-Pagan (1980)- Lagrange Multiplier (LM) Test for
the POOLED against the REM .................................................. 40
3.3.3 Testing assumptions of the error term ..................................................... 41
3.3.4 Model specification ................................................................................. 41
3.4 Summary of the analytical methods ........................................................................ 43
3.5 Hypothesis statements ............................................................................................. 43

CHAPTER 4. RESEARCH RESULTS ..................................................................... 45
4.1 The descriptive statistics of the sample ................................................................... 45
4.2 Empirical results ...................................................................................................... 46
4.2.1 Examining the impact ofFDI, on its own, on economic growth ............ 46
4.2.1.1 Choosing the appropriate model .................................................. 47
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4.2.1.2 Test for heteroskedasticity ........................................................... 48
4.2.1.3 Results discussion ........................................................................ 50
4.2.2 Examining the role of financial development in FDI-Growth nexus ...... 51
4.2.2.1 Choosing the appropriate model .................................................. 52
4.2.2.2 Test for heteroskedasticity ........................................................... 53
4.2.2.3 Results discussion ........................................................................ 55
4.3 Chapter remark ........................................................................................................ 62

CHAPTER 5. CONCLUSION AND RECOMMENDATION ................................ 64
5.1 Conclusion ............................................................................................................... 64

5.2 Recommendation ..................................................................................................... 66
5.3 Research limitation and suggestion for further study ............................................. 68
REFERENCES ............................................................................................................ 70

APPENDIX A. LIST OF ASIAN DEVELOPING COUNTRIES ...................... A-1
APPENDIX B. DATA SOURCES AND DESCRIPTIVE STATISTICS .......... B-2
APPENDIX C. PANEL MODEL TESTS ............................................................. C-1
APPENDIX D. REGRESSION MODEL RESULTS ........................................ D-11

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LIST OF TABLES
Table 3.5-1: Summary of expected signs of all variables ............................................. .44
Table 4.2-1: Summary of testing panel model results for model (4.1) ......................... .47
Table 4.2-2: Summary the result of Testing Heteroskedasticity for Model (4.1) ......... .48
Table 4.2-3: REM regression model (4.1) result .......................................................... .49
Table 4.2-4: Summary of testing panel model results for model (4. 2) ......................... 52
Table 4.2-5: Summary the results of Testing Heteroskedasticity .................................. 53
Table 4.2-6: Two-way FEM regression model results ................................................... 54
Table 4.2-7: The Wald Test on joint significance ofPOP ............................................. 55
Table 4.2-8: The Wald Test on joint significance ofEDUC ......................................... 56
Table 4.2-9: Final two-way FEM regression model results ........................................... 57
Table 4.2-10: Asian developing countries have financial system reaching a
sufficient level of development so that FDI has positive effect on economic growth ... 62
Table A-1: List of 24 Asian developing countries in data sample ............................... A-1
Table B-1: Variables definitions and Data sources ...................................................... B-2
Table B-2: Summary statistics of GROWTH .............................................................. B-3
Table B-3: Summary statistics ofFDI ......................................................................... B-3
Table B-4: Summary statistics of Financial Development Indicators ......................... B-4

Table B-5: Summary Statistics ofFDixFINANCE ..................................................... B-4
Table B-6: Summary statistics of control variables ..................................................... B-5
Table B-7: Correlation matrix of the explanatory variables for GROWTH ................ B-5

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LIST OF FIGURES
Figure 3.4-1: Steps ofthe analytical methods ................................................................ 43
Figure C-1: The POOLED model1 ............................................................................. C-1
Figure C-2: The FEM model1 ..................................................................................... C-1
Figure C-3: The REM model1 .................................................................................... C-2
Figure C-4: The POOLED model 2a with LLY used as financial development
indicator ........................................................................................................................ C-2
Figure C-5: The POOLED model 2b with PRIVATECREDIT used as financial
development indicator .................................................................................................. C-3
Figure C-6: The FEM model2a with LL Y used as financial development indicator .C-3
Figure C-7: The FEM model 2b with PRIVATECREDIT used as financial
development indicator .................................................................................................. C-4
Figure C-8: The REM model2a with LL Y used as financial development indicator .C-4
Figure C-9: The REM model 2b with PRVATECREDIT used as financial
development indicator .................................................................................................. C-5
Figure C-1 0: Hausman Test for FEM and REM of model 1 ....................................... C-7
Figure C-11: Hausman Test for FEM and REM ofmodel2a- using LLY ................. C-8
Figure C-12: Hausman Test for FEM and REM of model 2b with PRIVATECREDIT ...................................................................................................... C-8
Figure C-13: Test for cross-section fixed effects in the FEM model 2b - using
PRIVATECREDIT ...................................................................................................... C-9
Figure C-14: Test for cross-section fixed effects in the FEM model2a- using LLY C-9

Figure C-15: Test for time fixed effects in the FEM model2a- using LLY ............ C-10

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Figure C-16: Test for time fixed effects in the FEM model 2b - usmg
PRIVATECREDIT .................................................................................................... C-1 0
Figure C-17: HET Test for the REM model 1 ........................................................... C-10
Figure C-18: HET Test for the Two-way FEM Model2a- using LLY .................... C-10
Figure

C-19:

HET

Test for

the

Two-way FEM

Model

2b

-

using

PRIVATECREDIT .................................................................................................... C-10

Figure D-1: The REM model 1 with Robust Standard Errors .................................. D-11
Figure D-2: The Two-way FEM Regression Model2a with Robust Standard Errorsusing LLY ................................................................................................................. D-12
Figure D-3: The Wald Test on joint significance of POP ......................................... D-12
Figure D-4: The Two-way FEM Regression Model 2a with Robust Standard Errorsusing LLY after eliminating POP ............................................................................. D-13
Figure D-5: The Wald Test on joint significance ofEDUC ..................................... D-13
Figure D-6: The Two-way FEM Regression Model 2b with Robust Standard
Errors-using PRIVATECRED IT .............................................................................. D-14
Figure D-7: The Wald Test on joint significance of POP ......................................... D-14
Figure D-8: The Two-way FEM Regression Model 2b with Robust Standard
Errors-using PRIVATECREDIT after eliminating POP .......................................... D-15
Figure D-9: The Wald Test on joint significance ofEDUC ..................................... D-15
Figure D-1 0: The final Two-way FEM Regression Model 2a- using LLY ............ D-16
Figure D-11: The final Two-way FEM Regression Model 2b -

using

PRIVATECREDIT ................................................................................................... D-16

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CHAPTER 1

INTRODUCTION
This chapter will introduce the thesis topic and identify the problems going to be
analyzed in the thesis. It gives the research objectives, research questions and
research scope. The chapter also provides the structure of thesis.

1.1 Problem statement
Many developing countries want to attract more FDI because of the belief that FDI
can have a positive impact on economic growth through the transfer of technology,
productivity gains, introduction of new processes to the domestic market, employee
training, managerial skills and international production networks. Such positive
impact does not occur automatically, but rather, depends on absorptive power of
receipt country. For a long time, the importance of absorptive power focuses only
on human capital and trade regime. In recent years, the level of financial
development has emerged as an important channel via which FDI enhances growth.
In fact, a higher level of financial development allows the host country to exploit
FDI more efficiently through many ways. First, providing of more credit facilities
allows firms to purchase new machines, upgrade existing or adopt new technologies
and upgrade the skills of managers and labors. Second, the presence of an efficient
financial system facilitates FDI to create backward linkages, which Improve
production efficiency and then benefit the local suppliers. Therefore, financial
development plays a crucial role in allowing host country to absorb the spillovers
associated with FDI.
In addition, global FDI inflows have declined due to global financial crisis in 2008.
It forces developing countries to have more competitive advantages to attract FDI.

Besides of traditional channels such as favorable polices, infrastructure, lower labor

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cost..., better financial development of developing countries can be new channel to
attract more FDI.
Many recent studies have shown that the positive impact of FDI is dependent on the

extent of financial sector development in host countries. However, most of these
studies provide international evidence (Hermes and Lensink, 2003; Alfaro et al.,
2004; Lee and Chang, 2009; Chee and Nair, 2010). There are still few studies
examining the role of financial development in enhancing the contributions of FDI
on economic growth in Asian developing countries. Vietnam is one of Asian
developing countries where the effects of FDI on economic growth have been
debated. Then understanding the role of financial development plays in enhancing
the contributions of FDI on economic growth in these countries would be useful for
Vietnam in increasing its ability to exploit benefits ofFDI more efficiently.

1.2 Research objectives
The research aims to investigate the role of financial development plays in
enhancing FDI' s positive impacts on economic growth. In other words, we examine
whether countries with better domestic financial system can utilize FDI more
efficiently. In particular, it focuses on the following specific objectives:
(1) Examine the impact of FDI on economic growth in Asian developing
countries.
(2) Investigate the role of financial development in FDI-Growth nexus m
Asian developing countries.
The research findings will be useful to achieve the overall goal of the thesis: to
provide experienced knowledge for governments of Asian developing countries,
especially Vietnam, in compiling policies to exploit benefits of FDI efficiently as
well as to attract more FDI.

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1.3 Research questions
This thesis will attempt to answer the following questions:
(1) Does FDI have direct positive effects on economic growth m Asian

developing countries?
(2) How does financial development affect FDI-Growth nexus m Asian
developing countries?

1.4 Research scope and data
This research is interested in Asian developing countries for the three reasons.
Firstly, the role of capital and technology is very important to developing countries.
Then, understanding how to utilizing FDI efficiently in these countries are most
considered. Secondly, Asia region has been the most attractive destination for
foreign direct investment in the world and Vietnam is one of developing economy
in Asia. Finally, there are still few studies examine the role of financial
development in enhancing the contributions of FDI on economic growth in Asian
developing countries.
The empirical analysis is performed using balanced panel data from twenty-four
Asian developing countries over a span of 15 years (1995 - 2009). Data was
collected from the World Development Indicator (WDI 2011) & the Worldwide
Governance Indicators (WGI) published by the World Bank, the United Nations
Conference on Trade and Development (UNCTAD) and Barro-Lee Dataset (2010).
A list of countries included in this research is provided in the table A.1 of the
Appendix A.

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1.5 Organization of the thesis
This thesis has five chapters. After this introductory chapter, chapter two to will
survey the literature relating to theory of economic growth, the relationship among
FDI, financial development and economic growth, as well as the measures of
financial development. Then, empirical studies regarding to the roles of financial
development in enhancing the positive effects of FDI on growth are introduced.

Chapter three presents research methodology, estimation strategy and describes the
data used in this study. Panel methods and techniques are also discussed in this
chapter.
Chapter four presents and discusses model results.
The final chapter summarizes the findings of the previOus chapters. It g1ves
conclusions and implications for polices of growth and attracting FDI in Asian
developing countries.

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CHAPTER2
LITERATURE REVIEW
The main purpose of this chapter is to review theoretical and empirical literature for
the links among FDI, financial development and economic growth. The chapter is
divided into four main parts. The first part contains the concepts and the
relationship between FDI and economic growth. The second part, theoretical
framework and empirical studies about the links among FDI, financial development
and economic growth are presented in detail. The third part reviews literature for
measures of financial development. The final part provides a brief history of
determinants of economic growth. In summary, the conceptual framework is
expressed.

2.1 The impact of FDI on economic growth
According to the

4th

editor of the OECD Benchmark Definition of Foreign Direct

Investment, "FDI reflects the objective of establishing a lasting interest by a

resident enterprise in one economy (direct investor) in an enterprise (direct
investment enterprise) that is resident in an economy other than that of the direct
investor. The lasting interest implies the existence of a long-term relationship
between the direct investor and the direct investment enterprise and a significant
degree of influence on the management of the enterprise. The direct or indirect
ownership of 10% or more of the voting power of an enterprise resident in one
economy by an investor resident in another economy is evidence of such a
relationship." This section will review the literature on the impacts of FDI on
economic growth in both the theoretical mechanisms and the empirical evidence.
Theoretically, the neo-classical and the endogenous growth models have the
different viewpoints about the relationship between FDI and economic growth in
recipient country. According to the neo-classical models, FDI can only affect
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growth in the short run because of diminishing returns to physical capital (Barro and
Sala-i-Martin, 1995; De Mello, 1997).
In contract, recent endogenous growth models imply that FDI can affect growth
endogenously in the long run if it generates increasing returns in production via
externalities and productivity spillovers (Barro, 1991; Barro and Sala-i-Martin,
1995; De Mello, 1997). In these models, FDI was thought to be an important source
of capital accumulation and technology change. In particular, FDI affects the

growth rate via research and development investment (R&D) and human capital
variables. The benefits of FDI inflows are not only technology transfer but also
crucial knowledge transfer in terms of training, skill acquisition, new management
practices, and organizational arrangements. This is well-known that FDI generates
positive spillovers for the local economy.
However, FDI can also generate negative spillovers for the local economy known as
the crowd-out effect, the balance of payment problem and the enclave economy.
Firstly, the crowd-out effect of FDI happens when the multinational enterprises
(MNCs) or foreign investors take away the investment opportunities of domestic
firms or tend to displace domestic producers. Another signal of this effect is the
ratio of FDI inflows over the total gross fixed capital formation is greater than the
ratio of domestic investment over the total gross fixed capital formation. If FDI
enters the economy in sectors in which the competing domestic firms already exist,
FDI may reduce domestic investments undertaken by domestic producers or reduce
the entry of new local firms. Especially, in case foreign investors finance their
projects by borrowing from the local financial markets under conditions of scarce
resources, domestic interest rates may increase as a result, thereby domestic firms
may not able to obtain their necessary credits. It leads to the worst possibility is that
domestic firms may be driven out of business. If FDI enters the economy in new
sectors, it may pre-empt investments by domestic firms due to advantages of
finance and technology and human capital.
6

However, the proper government


supports may help domestic firms to enter the market successfully. FDI is also
enters the economy via mergers and acquisitions (M&A) activities which are just
the transfer of ownership of existing assets from domestic to foreign firms. Thus,
FDI is not real investment in this case. Regardless of the way FDI enters the

economy, its crowd-out effect may occur. There will be serious problems in the host
country if foreign investors deliberately make their monopoly of major sectors,
retard technology transfer, focus on exploiting and exporting natural resources or
transfer profits to their headquarters abroad to avoid local taxes. Thereby, FDI
•

inhibits the development of host country. Empirical evidence found that the crowdout effect of FDI took place in most developing countries where domestic market
conditions were poor and government policies were inefficient.
Agosin and Mayer (2000), for example, examined the crowd-out effect of FDI for
three developing regions (Africa, Asia and Latin America) with panel data for the
period 1970-1996 and the two sub periods 1976-1985 and 1986-1996. Their results
indicated that there had strong crowd-out effect in Latin America, neutral effect in
Africa and crowd-in effect in Asia.

Gorg and Strobl (2002) found that foreign

investment reduced the number of local firms and discouraged the entry of new
local firms in the high-tech sector in Ireland. Examining the effect of FDI on
domestic investment for province-level panel data in the period for 1986-1999,
Braunstein and Epstein (2002) found that FDI had the crowd-out effect on domestic
investment in China. However, general conclusion from empirical studies is that the
problem of crowd-out effect ofFDI can avoid if the host country's government has
relevant policies. For example, Korea had polices to restrict foreign investments in
certain industries. Then, they have had the emergence of successful domestic
producers in reality.

Secondly, the balance of payments problem may occur because of FDI. It is argued
that the impact of FDI inflows on the host country's balance of payments may be
positive at the beginning, but the impact turns to be negative in the medium term.
7

This may be due to after establishing the business; foreign firms increase imports of
intermediate goods and services or new machines and then begin to repatriate
profits. However, the impact of FDI on the balance of payments strongly depends
on the exchange rate regime of the host country. For example, given a specific
situation as the demand for foreign exchange of a FDI firm exceeds the supply of
foreign exchange generated by that firm. If the host country has a fixed exchange
rate regime, increasing in the demand for foreign exchange may increase deficit in
its balance of payments. In contrast, if the host country has flexible exchange rates,
the gap between the demand and supply for foreign exchange can be corrected by
movement in the exchange rate (a depreciation in this case), thereby the balance of
payments may not be affected.

Thirdly, FDI may create the enclave economy. When foreign firms in FDI sector
create benefits for themselves, not for the whole economy of the host country, the
enclave economy is emerged. Such foreign films typically operate in the field of
mining and raw materials exploitation that requires high technology, capital
intensive and use a small amount of local labors. The host country may face the
problem of raising the real exchange rate due to sudden inflows of large amounts of
foreign capital. This means FDI has no backward or forward linkage effects in the
host country. Then the process of technological diffusion will not happen. As a
result, the host country does not exploit FDI's benefits to increase economic
growth. However, it is not suggested that the host country need to prevent foreign
investors from entering the field of mining and raw materials exploitation. Rather,
the government of host country should issue prudent policies to avoid excessive
exchange rate appreciation and ensure the process of technology transfer will be
realized.

To sum up, positive effects or negative effects of FDI on economic growth of a host

country much depend on local conditions. Numerous empirical studies of the
8


relationship between FDI and economic growth have found many important
conditions of host countries such as:
Human capital: Borensztein et al. (1998), Xu (2000) and Li and Liu (2005) found
that FDI had positive impact on growth only when the recipient country reached a
certain threshold of stock of human capital.
Openness: Balasubramanyam et al. (1996) and De Mello ( 1997) emphasized trade
openness as being crucial condition for realizing the potential growth impact of
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FDI.
Macroeconomic

and

policy-related

variables:

A

host

country

having

macroeconomic stability such as political stability, low inflation, balance fiscal
account ... is always an attractive destination for foreign investors. Additionally, if
host country's government has relevant and credible policy environment for FDI, it
will significantly influence location decisions of foreign investors. Exploring the
relationship among FDI, economic freedom and economic growth in Latin America
countries, Bengoa and Sanchez-Robles (2003) found that FDI has positive
relationship with economic growth. However, political, economic stability and
liberalized markets were required conditions to realize FDI's benefits in host
countries. Brooks et al. (2003) reviewed FDI's impacts in developing Asia and
investigated the importance of the policy context in which FDI had positive and
negative effects on economic growth in host countries. Their results suggested that
the policy environment in the host country and particularly in the local area of the
host county where FDI was located was very important to realize positive impacts
ofFDI on economic growth.
Financial development: Only in recent years, it is argued that local financial
development as an important precondition for FDI to have positive impact on
economic growth. Well-developed financial system will allocate resources
efficiently. It helps domestic firms, especially medium and small-sized firms get
9


the!ir necessary capital to upgrade existing or adopt new technology. By this way,
'

financial development associating with FDI can promote the process of
technological diffusion (see Levine, 1997). Hermes and Lensink (2003), Alfaro et
al. (2004), Lee and Chang (2009) and Chee and Nair (2010) provided empirical
evidence supporting this proposition.
I
I

Atbong these conditions, this study will focus on the role of local financial
I

de~elopment to ameliorate the effects of FDI on growth in Asian developing
c~ntries.

2.2 FDI, financial development and economic growth: theoretical
framework and empirical studies
2.2.1 Theoretical framework
2.'2.1.1 Neoclassical growth model:

The neoclassical growth model was first presented by Solow (1956). The
production function in this model takes a Cobb-Douglas form and including three
inputs - capital (K), labor (A) and technological progress (A):

Y = A.Ka .L1-a
Key determinants of growth are capital accumulation, labor force growth and
technological change and over time, incomes of poor and rich countries should
converge. Solow assumes technology increases independent (exogenous) of the
model. The key assumption of Solow model is that capital is subject to diminishing
returns. Growth is only affected in the short-run and determined by the rate of
capital accumulation as the economy converges to the steady state. The long-run
rate of growth is exogenously determined by the model. Solow predicts that an
economy will converge towards a steady state that depends only on the rate of
technological progress.

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2.i1.2 Endogenous growth model:
In 'the mid-1980s, a group of economists led by Romer (1986) developed new
growth theory, called endogenous growth theory. Models of endogenous growth
discard the neoclassical assumption of diminishing marginal returns to. capital. All
'

key determinants of growth are determined within these models.
I

Te~hnological progress is no longer exogenous. It is generated m an economic
I

sy~tem and government policies can affect it. Endogenous growth models also
I

en}phasize the role of human capital and foreign trade in the growth process.
Human capital is an essential input for learning and producing knowledge. Foreign
trade is important to growth because it effects on economic of scale, externalities,
technological transfer and learning-by-doing (Romer, 1990).

2.2.1.3 Technological change model:
Endogenous growth models discarded diminishing returns to capital (including
human capital). According to Barro and Sala-I-Martin (1995, p. 212), "This absence

of diminishing returns meant that long-term per capita growth was feasible in the
absence of technology progress". Nevertheless, they argued that the global absence
of this diminishing return might be not realistic. Therefore, they developed the
technology change model in order to escape from diminishing returns in the longrun (see Barro and Sala-I-Martin, 1995, p. 212-238).
In technological change model, technology progress showed up as an expansion of
the number of varieties of producers and consumer products.

Hermes and Lensink (2003) employed the technological change model to illustrate
the theoretical link between foreign capital flow and economic growth via financial
development. They assumed that technical progress showed up in the model
through the variety of capital goods available. This study closely follows their
approach.

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I

An economy is modeled by three types of agents: final commodity producers or
1

I

finhs, innovators and consumers. Innovators produce capital goods and producers
or firms produce final goods. Every producer rents varieties of capital goods from
innovators in order to produce final goods. The purchase price of the capital good is
cakulated basing on the present value of the returns from inventing and producing,
I

de~oted as V(t). According to Barro and Sala-I-Martin (1995, p. 218), assuming
I

th* there is free entry into the business of being an inventors so that anyone can pay
the R&D cost (denoted as 17) to secure the present value V(t) and in equilibrium (

V(t)=17 holds), the constant rate of return is given by:
(2.1)

Where r is interest rate, a measures the proposition of capital income 1; L is labor
input; A is TFP parameter2 representing the level of technology and 17 is the cost of
R&D.
FDI is entered the model by assuming that there are fixed unity maintenance costs,
and fixed set-up costs (R&D costs, 11). In accordance with Borensztein et al. (1998),
more FDI leads to a decrease in the costs of innovation. The idea is it is cheaper to
imitate existing products than to innovate in new things. The possibility to imitate
will increase if other countries produce more goods than host countries. This
indicates that a negative relationship exists between FDI and R&D cost; i.e. higher
FDI inflows bring about lower innovation costs through imitation activities.
Therefore, the costs of innovation can be modeled as follows:

l7 = f (FDI)' where allI 8FDI < 0

I
2

a- The coefficient in Cobb-Douglas production function.
TFP- Total Factor Productivity, denoted by A in Cobb_Douglas production function: Y =Ax Lax Kfl

12


In the finance and growth literature, it is well known that financial sector can
stirlmlate economic growth via capital accumulation and enhancing the average
lev~l

of technology (King and Levine, 1993a; b; Levine, 1997). Hence, the impact

of financial development is introduced into the equation (2.1) via A, the level of

technology. In this view, A can be written as a function of the development of the
!

I

financial sector, denoted as FINANCE:
I

A= /(FINANCE), where aAjaFINANCE > 0
I

Th~m equation (2.1) can be rewritten as follows:

r =(

L
Jf(FINANCE)I/(I-a)
f(FDI)

(l-

a)azf(I-a)

(2.2)

a

Next, to introduce the link to economic growth, Hermes and Lensink (2003) start
with considering the behavior of households. It is assumed that households
maximize a standard inter-temporal utility function, subject to the income

constraint. The Euler equation (Barro and Sala-I-Martin, 1995, p. 63) for the growth
rate of consumption is given:
(2.3)
Where B is the elasticity of marginal utility and p is the discount rate.
In the steady state equilibrium, the growth rate of consumption equals the growth
rate of output, denoted as g. Substituting equation (2.2) into (2.3), the link among
FDI, financial development and economic growth is finally established as follows:

It is clear from equation (2.4) that an increase in FDI (i.e. f(FDI) decreases

because off' ( FDI) < 0) leads to an increase in the growth rate of output (g) and
the effect of FDI depends on the development of the financial sector (/(FINANCE)
). Specifically, an increase in FDI lowers set-up costs (for technology adaptation)
13


I•

and raises the return on assets (r). This contributes to rise in saving and hence

high~r growth rate in consumption and output.

This effect will be greater if a host

country has higher the level of technology, i.e. well-developed financial system.
In this model, the role of financial development is understood via the level of
technology. However, this link needs to be clarified further. Firstly, the financial
syst~m

has an important role in allocating financial resources for investment

projects. On the one hand, it increases the volume of resources available to finance
investment by mobilizing savings. It also monitors investment projects, hence
contributes to increase the efficiency of the projects carried out (see Levine, 1998).
Thus, via mobilizing savings, allocating resources efficiently and monitoring
investment projects, well-developed financial system will promote economic
growth.
Second, financial institutions can help domestic firms to avoid substantial obstacles
in upgrading existing or adopt new technologies. Such obstacles are money and
risk. Well-developed financial institutions allow domestic firms to get necessary
crepit and reduce risk. Thereby, financial development encourages domestic firms
to invest in new technologies or to upgrade their existing technologies. Huang and
Xu ( 1999) said that financial institutions solved informational and incentive
problems related to R&D activities, and then promote innovation. Therefore, welldeveloped financial institutions not only encourage domestic firms to adopt new
technologies but also promote technological innovation. Thus, they have significant
contributions to the process of technological diffusion and then enhance economic
growth.
Third, in many cases domestic firms need to be financed to upgrade their own
technology, adopt new technologies, or upgrade the skills of their employees. It is
clear that the development of financial system determines to what extent domestic
firms may be able to realize their plans. Thus, financial development is considered
as a channel through which technology spillover may take place.
14