The relationship between foreign direct investment, export and economic growth in some countries has gained high attention of the researchers and policy makers. Foreign direct investment is one of the most important components in the development of a country. Foreign direct investment is activities that give high impact on economic growth in developing countries such as Indonesia.
Harrod(1939)-Domar(1946) model stresses the importance of capital investment in economic growth. Harrod(1939)-Domar(1946) explained that the role of the investment for economic growth has two functions. The first function of investment is able to increase income and the second is able to grow the production capacity of the economy by increasing stock of capital. Foreign direct investment adds gross capital formation and raises the capital formation rate. The FDI also raises the productivity of capital through improved competition, positive technological externalities, and accelerated spillover effects. Most theories of FDI are also developed from the point of view of multinational corporations.
There are two main points of views on the FDI study. The first is the majority of the study claims that FDI has positive impacts on the host county. FDI becomes powerful tools and indicators for economic development and global integration. The second argument is the study claims that the FDI can cause growth in the economy only in short term condition and reduce growth in the long run.
Foreign direct investment theory
According to Moosa (2002), Foreign Direct Investment is a process where the economy actor (individual or corporate from a country (home country) gains owner assets to control production, distribution and other activities from one corporate in another country (host country).
Foreign Direct Investment is international capital flows which company from one country establish or expand its business and network cooperation in other countries. One prominent feature of foreign direct investment is the actions involve not only the relocation of resources but involve control of ownership. It means that the branch in other countries has obligation in financial and as a whole integrity to the main company so that the branch is the extension of the parent company in the sources country (Krugman and Obstfeld, 2004).
The theories that explain the positive impact of FDI on growth are capital formation theory and technological spillover theory:
- The capital formation theory implemented the role of FDI as capital. Neoclassical model Solow (1956) stated that an increase in the capital stock which is available in economy leads to production increase and correspondences to an increase in growth rate of output. Increase in foreign direct investment raises the overall level of capital stock of production because foreign direct investment is a source of physical and financial capitals to the host country. Neoclassical framework believes that an increase in foreign owned capital stock leads to higher growth because in this case foreign direct investment is additional capital. Neoclassical growth agreed that any increase in the growth rate after stock of foreign direct investment increase is sustainable only in short run and not in the long run.
- Technological spillover theory explains that foreign direct investment can exert an effect on economic growth beyond direct capital formation through technological spillover channel. The role of foreign direct investment is as diffuser of technology or knowledge which implies that it can have direct effect on growth.
Theoretical relation between FDI and export
Product Life Cycle theory (Vernon 1966) described positive role of FDI in promoting exports from host countries. According to Vernon, there are four stages of product life cycle. The stages are innovation, growth, maturity and decline. Product life cycle initial stage is characterized by high prices, high profits and wide promotion of product. There is limited opportunity for international followers to imitate the product so that the chances of exports are great because the suppliers are able to export the product into follower economies. Product life cycle in the maturity phase is characterized by demand levels off and slower rate of sales volume increases. Imitations are easy in foreign markets and cause decline of export sales. Because of this situation so the original supplier reduces prices in order to maintain market share and sales support. The business still attractive but the profit margins decrease. Last is final phase which is characterized by decreases of sales volume and some products are discontinued because the follower economies are success to develop imitations as good quality as original. The follower economies are able to export the goods even to its original supplier home market. The consequence of this situation is sales and prices depress
From all the stages, the last phase, product and technology is more mature, standardized and accessible to local imitators. It makes low labor cost and international competitors. In this stage host countries have more chances to increase in export and make reversed flow trade. The most important thing is this stage is there is relocate production into host countries and re import to the home country.
Vernon Model was applied by Kojima(1973,1985) He applied Vernon model at level industry and found out that the investment creates effect that there will be increase in the host’s country’s export if FDI is made with origin country has comparative disadvantage and comparative advantage in the host country.
New trade theory stated that the separation of different stages in different countries production or vertical FDI cause trade creation effect. According to Helpman (1993) the vertical FDI causes trade creation effect with export form on finished product from affiliated company to parent company and intra firm transfer of intangible services from parent company to affiliate company.
Theoretical relation between FDI and economic growth
Theoretically, the causal relation between FDI and GDP growth can run in both two directions. There are three concerning theories on the relation between FDI and economic growth that we would like to analyze in this study:
- FDI-Led Growth hypothesis.
Borensztein et al. 1998) with FDI-led growth hypothesis stated that FDI inflows are able to stimulate growth for host countries with capital increase stock, new job opportunities, and ease of technology transfer.
- Market size hypothesis
Mah (2010) stated from market size hypothesis stated that rapid GDP growth create new investment opportunities in the host country and larger inflows FDI. The existing studies suggest that there is positive impact of FDI on economic growth. However the evidence from some studies like Aitken and Harrison (1999) found out that FDI has negative effects on economic growth with crowd out domestic investment, increase external vulnerability, and cause dependence.
- Neutrality hypothesis.
The theory believes that there is no causal relationship between FDI and economic growth.
Theoretical relation between export and economic growth
There are many factors determine the relationship between exports and economic growth. Exports are GDP components so that exports growth has direct contribution to the growth of GDP. According to Helpman and Krugman(1985)exports allow poor countries with narrow domestic markets to get benefit from economies of scale.
According to Balassa (1978) export leads to improve efficiency in resources allocation and capital utilization owing competition in world markets.
There four views which describes the relationship between exports and economic growth:
- Neoclassical export-led growth hypothesis
This theory explains the reasons of the causality direction running from export to economic growth. Helpman and Krugman (1985) stated that export expansion will increase productivity by offering greater economies of scale and export expansion bring higher cause high quality product because the pattern of consumption is international consumption patterns. This theory believes that exports will lead a firm to overinvest a new technology as a commitment to achieve larger output and increase the rate of capital formation and technological change (Rodrick 1988 and Sharma 2001)
- Causality run from economic growth to export
Economic growth affects export growth if there is increase in domestic production which is faster than domestic demand
- Bilateral causal relationship between export and economic growth
The theory that agree that export and economic growth has a bilateral causal relationship
- No causal relationship between export and economic growth theory
Indonesia is the 4 rank top among the East-Asian countries after China, Hongkong and Singapore. Following table presents GDP growth, GDP and FDI of Indonesia from 1981 to 2016.
Table 1. GDP growth. GDP and FDI from 1981 – 2016
|year||GDP growth||gdp||FDI||year||GDP growth||GDP||FDI|
FDI of Indonesia has experienced growth of 23 % in 2013. In 2014, the FDI continued to grow to 25 % or about USD 23 billion. However in 2015, The FDI growth was down to 20 %. Indonesia has allowed foreign investment in the service industries. According to world investment report- UNCTAD 2015, Indonesia has to strengthen the attractive destinations for multinational companies because Indonesia lost its place among the three most attractive destinations for multinational companies.
The study on the relationship between foreign direct investment, export and economic growth has been carried out to examine the co-integrating and causal relationships between foreign direct investment, GDP and exports in Indonesia over the period 1981 to 2015. The study performs the unit root test of Augmented Dickey-Fuller test, lag selection criteria, Johansen test of co-The empirical analysis showed the evidence that integration and the VECM.
The study finds out that there is one co-integration in this model. The trace statistics is smaller (8.9015) than critical value of 5 % (15.41%). It means that the three variables foreign direct investment, gross domestic product growth, and export are co-integrated. The variables have long association and move together in the long run.
There is short run causality running from FDI and export to GDP but there is no short run causality running from GDP to FDI and export because the probability values are more than 5%. The levels are 69.12 and 73.27. For overall analysis, the study finds out that there is long run and short run causality running from FDI and export to GDP. The model has no autocorrelation so the model is significant.
The private sector in Indonesia has opportunity to develop the business since the FDI growth in Indonesia is getting increase and there is long run prediction in the relationship of the financial determinants. In this case, the government has to do better and flexible mutual understanding strategy to boost the investment in Indonesia.
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